fx translated
TRANSCRIPT
DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION®
Client-Driven Solutions, Insights, and Access
30 July 2015
Americas/United States
Equity Research
Accounting & Tax
FX Translated ACCOUNTING
Accounting 101
Exhibit 1: The FX Two-Step
Source: Credit Suisse Accounting & Tax Research
■ Introducing the Accounting 101 (admit it, it was your favorite class) line
of reports. The focus will be on complex topics that are causing lots of
investor confusion. Our goal is simple: explain the accounting in Plain
English. So, if you're looking for a trading idea, stop reading. But if you want
to better understand the accounting to improve your models, analysis and
ability to uncover the underlying economics you've come to the right place.
■ FX impact on results continues to surprise even though we can all
follow changes in FX rates. Why? FX volatility, complex accounting,
opaque disclosures, FX hedging, intercompany transactions, etc. In the
piece we walkthrough FX accounting, including FX hedging and show how
FX changes impact financial statements. The cumulative FX translation loss
(S&P 500) is at a 15-year high over $240 billion (nearly 4% of book value).
■ Don't automatically ignore FX, use constant currency with caution.
There are just two questions that you need to ask yourself when trying to
analyze the impact of FX changes on the companies that you own and
follow: (1) What impact has FX had on the underlying business (e.g., has it
changed the future cash flow stream for the foreign business by affecting the
competitive landscape, cost base, product demand)? And (2) What impact
has FX had on the value of the business (e.g., has FX changed the U.S.
dollar value of the future cash flow stream from the foreign business)?
Research Analysts
David Zion, CFA, CPA
212 538 4837
Ravi Gomatam, CFA
212 325 8137
Ron Graziano, CPA
312 345 6169
30 July 2015
FX Translated 2
Table of contents Table of contents 2 FX Accounting Cheat Sheet 3 FX Translated 4
FX Continues to Surprise 6 FX Exposure from an Economic Perspective 6
If You're Happy and You Know it… 6 Accounting Can Disconnect from Underlying Economics 7 Boiling It Down 9
FX Accounting 10 Functional Currency Is the Key 10 The FX Two-Step 11
Step 1 – Get Everything Measured/Remeasured in the Functional Currency 12 Foreign Currency Transactions 13 If There Are Foreign Currency Books & Records, the Financial Statements Need to
Be Remeasured into Functional Currency Too 18 Step 2 – Translate from Functional Currency into Reporting Currency (FX Translation)
19 FX Translation Gain/Loss Reported in OCI within Shareholders' Equity 20 FX Translation Losses over $240 Billion in Aggregate for S&P 500 21 FX Translation Impacts Earnings Too 22 FX Translation Impacts Reported Cash Flows Too 23
FX Hedging 23 Au Naturale FX Hedges 23 Hedge Accounting, 1,000+ Pages of Fun and Excitement 24 Four Types of FX Hedges 26 1. Fair Value Hedge 26 2. Cash Flow Hedge 28 3. Net Investment Hedge 29 4. Standalone Derivative (Economic Hedge) 29 Where Can You Find Derivative Gains / Losses? 30
Appendix A – FX Remeasurement Example 31 Balance Sheet FX Remeasurement 31 Income Statement FX Remeasurement 32
FX Gain/Loss Reported on Income Statement 34 Appendix B – FX Translation Example 35
Balance Sheet FX Translation 35 FX Translation Gain/Loss Reported in OCI 36
Income Statement FX Translation 37 Cash Flow Statement FX Translation 38
Effect of FX Rate Changes on Cash 40
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FX Translated 3
FX Accounting Cheat Sheet In the midst of another earnings season chock full of FX related hits/misses, we decided to
try our hand at translating the accounting for FX translation. For those interested in the
quick and dirty version, we kick things off with our FX Accounting Cheat Sheet in Exhibit 2.
Print it out and tack it up on the cork board (near the kids art work and that signed Darryl
Dawkins poster), so the next time FX volatility rears its ugly head, you'll be prepared.
Exhibit 2: FX Accounting Cheat Sheet
Source: Credit Suisse Accounting & Tax Research Note: See Exhibit 17 for details on remeasuring foreign currency financial statements 1: Foreign Currency: any currency other than the functional currency 2: Functional Currency: the currency in which the company/subsidiary does most of its business 3: OCI = Other comprehensive income (OCI) 4: Monetary assets/liabilities include cash, receivables, payables, etc. (cash or items expected to be settled in cash) 5: Non-monetary assets/liabilities include inventory, PP&E, deferred revenue etc. 6: FX rate on transaction date, in practice weighted average FX rates are used.
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FX Translated 4
FX Translated With this piece we introduce our Accounting 101 line of reports (we figured why not go
with everyone's favorite class from school). The focus will be on complex topics that are
causing lots of investor confusion. Our goal is simple: explain the accounting in Plain
English. So, if you're looking for a trading idea, we'll save you some time, stop reading. But
if you want to better understand the accounting to improve your models, analysis and
ability to uncover the underlying economics you've come to the right place.
Foreign Currency sure has been a hot topic over the last few earnings seasons (nearly as
hot as the New York Yankees). It seems like FX related hits and misses have been
popping up in every other earnings call, from the nine point drag on second quarter
revenue for IBM, to DuPont's $0.80 per share currency headwind for 2015, to Omnicom's
FX related revenue drop of more than 6%, the list goes on and on, including a few more
examples in Exhibit 3.
Exhibit 3: The FX Impact – Some Company Examples
Source: Company transcripts, Credit Suisse Research
Of course the culprit behind most of the FX related noise is the strong dollar. The U.S.
dollar went on quite a run appreciating 22% against a basket of major currencies from
June 30th 2014 through March 31, 2015 see Exhibit 4 and that had a big (generally
negative) impact on reported results for U.S. companies. The last time we saw the dollar
come close to strengthening like that over such a short period of time was back in 2009,
when it was up nearly 20% over the nine months ending March 31, 2009.
But since the beginning of April the dollar had been hit pretty hard, it dropped by nearly 5%
at one point during the quarter and was down about 2.3% against a basket of major
currencies through June 30th (it has since gained back those losses and then some). So
are we now seeing an FX tailwind in the second quarter? Depends upon how you look at
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FX Translated 5
things, maybe on a quarter-over-quarter basis FX is providing a little bit of help. But if your
focus is year-over-year, we continue to see significant FX headwinds. That's a result of the
U.S. dollar being up 19% over the past year through June 30th, see Exhibit 5. In fact the
recent year-over-year strength in the U.S. dollar is among the most significant in the past
thirty years.
Exhibit 4: Trade Weighted U.S. Dollar Index: Major Currencies Exhibit 5: Year-Over-Year Change U.S. Dollar Index
Source: Board of Governors of the Federal Reserve System (US), Credit Suisse estimates Note: Major currencies include currencies of the Euro Area, Canada, Japan, the United Kingdom, Switzerland, Australia, and Sweden. Trade Weighted U.S. Dollar Index: March 1973 = 100
Source: Board of Governors of the Federal Reserve System (US), Credit Suisse estimates Note: Major currencies include currencies of the Euro Area, Canada, Japan, the United Kingdom, Switzerland, Australia, and Sweden. Trade Weighted U.S. Dollar Index: March 1973 = 100
The FX ups and downs can wreak havoc on analyst estimates, earnings, balance sheets
etc. and FX volatility hit a five year high early this year (remember that's when the Swiss
National Bank removed the cap on the Swiss franc and it shot up), see Exhibit 6.
Exhibit 6: Average USD FX 1m realized volatility (%)
Source: Bloomberg, Credit Suisse estimates Note: Simple average of 1-month realized volatility of currencies of the Euro Area, Canada, Japan, the United Kingdom, Switzerland, Australia, and Sweden.
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FX Translated 6
FX Continues to Surprise
But you knew that already. So if everyone knows what's going on with FX rates, why do
FX impacts (negative and positive) continue to catch analysts and investors by surprise?
We think there are a number of factors: the FX volatility is difficult to deal with, tack on top
the complex accounting, confusing terminology (is it translation or transaction?),
exposures to multiple currencies, varying FX exposures (currency mismatches),
differences in how companies manage the risk (are they hedged or not?), opaque
disclosures (which currencies and cross currencies are they exposed to?), intercompany
transactions, etc. As a result FX is a tough topic for investors and analysts to wrap their
heads around (companies struggle with it too).
What's not a surprise is that we have been getting a steady stream of FX related questions.
Investors want to know how FX flows through the financial statements to tighten up their
models. In addition, to get at the underlying economics of a multinational business
(including, what's driving the results, is it the business or currency fluctuations?) you need
to understand the accounting for FX (which doesn’t always match the economics).
In this piece, we try to translate foreign currency accounting into Plain English (it’s a
struggle) and show how FX movements impact the financial statements. Our plan is to
eventually follow up with a piece that focuses on examining FX exposures and modeling
FX risk using the clues that companies sprinkle around their financial statements,
footnotes, earnings releases, etc.
FX Exposure from an Economic Perspective
Before we dive into the accounting and all that translation/transaction mumbo jumbo, let's
quickly review FX exposures from an economic perspective. There are plenty of
companies with varying degrees and types of FX exposure, that's why we decided to write
this report and probably why you have made it this far (congratulations you are on page
six). Yes, FX exposure comes in lots of different flavors, but if you take a step back and
focus on the underlying economics it can be narrowed down to three simple perspectives,
is the company a net (1) importer, (2) exporter or (3) purely domestic. Just to be clear an
importer / exporter would include the import / export of goods, services, labor, capital, etc.
If You're Happy and You Know it…
In Exhibit 7, we summarize FX exposures for a U.S. company to a stronger/weaker dollar
from these three perspectives (apply it to a foreign company by replacing the U.S. dollar
with their local currency). For example, a stronger dollar is good news (hence the smiley
face) if you're importing stuff from overseas (all else equal) as it would cost less in U.S.
dollars but bad news (hence the frown) if you're an exporter as your product/service would
cost your customers more in their local currency.
An interesting twist on that last point was provided by Royal Caribbean CFO Jason Liberty
during the Q1 2015 Earnings Call: "The majority of our onboard offering are denominated
in U.S. dollars and the significant strengthening of the dollar has slightly weakened the
purchasing power of many of our international guests." In other words Royal Caribbean is
effectively an exporter of its "onboard offering" to its passengers.
Exhibit 7: Economic Impact of Stronger/Weaker Dollar on a U.S. Company
Source: Credit Suisse Accounting & Tax Research
Lots of incoming questions
on FX translation
In this piece we focus on the
accounting, we plan to
follow up on FX exposures
What impact has FX had on
the underlying business?
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FX Translated 7
How would our thought process apply to a U.S. company with foreign subsidiaries? Well, if
you are looking at it from the U.S. parent perspective, it's effectively a net exporter of
capital. It has invested its capital in a business that generates cash flows in a foreign
currency. If for example the U.S. dollar strengthens that's bad news (all else equal) as the
return that it receives on its investment (the foreign currency cash flows) are worth less in
U.S. dollars. If you expected FX rates to remain at those levels it could impact the
valuation of the foreign subsidiary and therefore the company as a whole (unless there
was some offsetting currency effect on the underlying business).
FX Can Even Impact A Purely Domestic Company
A stronger dollar may even be bad news for a U.S. company that does all of its business
domestically. Why? Because it could hurt the company's competitive positions by allowing
the foreign competition to cut pricing in the U.S. or it might invite new foreign competition.
This point was addressed several times in the Q1 2015 Earnings Call for Harley Davidson
by the CFO John Olin: "Given the levels of competitive inventories in the retail channel
coupled with foreign exchange that was favorable for our competitors, we expect
aggressive discounting from the competition will continue for some time…Our competitors
are largely Japanese and European. They're certainly realizing a strong benefit when they
sell in the United States."
Accounting Can Disconnect from Underlying Economics
Too bad the accounting for FX exposure doesn’t always match the underlying economics
(that'd be too easy). For example, take FX translation (which we explain in more detail
below), if the dollar is strengthening, the earnings of a foreign subsidiary could appear to
weaken when they are translated into U.S. dollars, even if the foreign business is
performing well. So have things gotten worse (that year's U.S. dollar earnings are lower) or
better (the foreign business is performing well)?
But if the U.S. company has invested in a business that generates cash flows in a different
currency, it’s the results in that currency you should care about most (too bad you don't
tend to get that information, though constant currency may get you in the ballpark).
Especially if the U.S. company was truly reinvesting the foreign currency profits back into
the foreign business (i.e., not converting the foreign currency profits into dollars) for the
long-term.
Before you Ignore FX Translation…
Does that mean you can simply ignore the impacts of FX translation, stop reading this
report and ride off into the sunset? Not so fast cowboy/cowgirl. First off, every line item on
the financial statements could be impacted by FX translation and as a result key metrics
that the market pays attention to (like revenues, earnings, margins, etc.) can all be
affected by FX swings. And in order to gauge the quality of earnings/revenues/cash flows
you must be able to distinguish between the sustainable/core drivers of the results and
those that are not sustainable and non-core (that's why companies provide results in
constant currency).
So, is FX translation more of an accounting risk (that's temporary / non-core) which you
can fuhgeddabout? Should you simply pay attention to the results in constant currency
and ignore the FX impacts? Probably not, remember the company has invested in a
business with foreign currency cash flows that at some point it will want to turn into U.S.
dollars. FX rates will play a part in determining how many dollars it gets.
Before you ignore FX translation because it doesn't really capture the economic exposure
that a company has to FX rates and jump on the constant currency bandwagon, we'd
suggest using FX translation as a signal of FX risk. Start off by evaluating the materiality of
FX translation gains and losses along with the impact of FX translation on individual line
items (like revenues, etc.). Compare the FX translation gain/loss to book value, market
cap, against peers, etc. (see Exhibit 20 for some benchmarks by sector). As for the impact
U.S. company investment in
a foreign business is net
export of capital
FX Translation represents
FX exposure on investments
in foreign businesses
FX Translation could impact
every line item in the
financial statements
Constant currency shows
year-over-year changes in
revenue and other line items
assuming no change in FX
rates, proceed with caution
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FX Translated 8
on specific line items, materiality is in the eye of the beholder, for example, if FX is causing
the top line to move by 50 basis points is that material?
If material, it could signal that FX is a significant risk that you should think long and hard
about when valuing the company. You might consider running sensitivities, for example,
how would different FX rates impact the value of the foreign currency cash flow stream in
U.S. dollars, have FX movements really changed the value of the foreign business?
Turning a Longer-Term Valuation Risk into Shorter-Term Cash Flow Problem
But how much attention you give to FX will depend in part upon your time horizon (long-
term investors may be able to live with some FX related noise assuming it's not a
structural shift in FX rates, heck it might even create some buying/selling opportunities if
the market overreacts to an FX driven earnings surprise).
It will also depend upon how dependent the company is on monetizing its overseas
investment, in other words is it reliant upon turning the foreign currency cash flow stream
into U.S. dollars to pay dividends, buyback stock, pay down U.S. based debt or to support
the U.S. business? That will vary from company to company. Some companies are not
dependent upon it and as a result are able to truly reinvest the foreign profits overseas. On
the other hand there are companies that need to get their hands on the foreign cash,
transforming a longer-term valuation risk into one that has near-term cash implications.
There are a couple of ways that foreign investments can be monetized, first off the U.S.
company could simply sell its foreign business, realizing FX related losses if the dollar has
strengthened or FX gains if it's weakened. Another way that this stuff gets monetized is if
instead of the foreign currency profits being reinvested back into the foreign subsidiary
they are repatriated back to the U.S. or the foreign profits are converted into U.S. dollars.
In other words the foreign currency profits are actually being turned into less
($ strengthens) or more ($ weakens) dollars depending upon FX rate changes.
That may be happening more than you realize, in our March 17, 2015 report, Parking A-
Lot Overseas, At Least $690 Billion in Cash and Over $2 Trillion in Earnings, we found
that companies appear to be repatriating more of their foreign profits and even those
companies that are not repatriating may be storing their foreign profits in U.S. dollars
(sometimes in the U.S.A). We'd suggest that you ask the companies that you own and
follow exactly what they are doing with their foreign profits and in what currency they are
storing them (the disclosure here is pretty vague). Their answer may cause you to look at
FX risks differently from company to company.
Take Avon Products for example, in its most recent 10-K the company discussed how the
"strengthening of the U.S. dollar reduced the expected dividends and royalties that could
be remitted to the U.S. by its foreign subsidiaries, particularly Russia, Brazil, Mexico and
Colombia." In addition to less cash coming to the U.S. from its overseas business the
stronger dollar caused a significant drop in Avon's expected foreign source income. As a
result, the company might not generate enough taxable income to use its deferred tax
assets so it wrote them down by recording a $441 million valuation allowance.
What About FX Transactions?
On the other hand, FX transactions (see below) may reflect a real currency mismatch (e.g.,
revenues in one currency and costs in another) that can result in immediate cash flow
consequences as the transactions are settled in the foreign currency. The related FX gains
and losses may not be sustainable but they could reflect FX risks that need to be taken
into account when valuing a company. Of course they could just be more accounting noise
too. If for example, the assets and liabilities are denominated in the same currency but one
side is required to be remeasured by the accounting rules for changes in FX rates (e.g.,
payables) but you are not allowed to remeasure the corresponding assets (e.g., inventory)
the accounting could provide the appearance of an FX exposure when the assets and
liabilities really are matched.
What impact has FX had on
the value of the business?
Is the company dependent
upon the foreign currency
cash flows to pay dividends,
buyback stock, support the
U.S. parent, etc.?
FX Transaction represents
FX exposure on regular
business activity
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FX Translated 9
Should You Worry About FX?
They say a picture is worth a thousand words, in Exhibit 8 we include a simple framework
to help you determine whether you should worry about the FX translation and FX
transaction exposures for the companies that you own and follow (keep in mind this is a
work-in-progress for us that we expect to fine tune in the future).
Exhibit 8: Should You Worry About FX or Not?
Source: Credit Suisse Accounting & Tax Research
Boiling It Down
There are really two sets of questions that you need to ask yourself, when trying to
analyze the impact of FX changes on the companies that you own and follow:
(1) What impact has FX had on the underlying business? Has it changed the future
cash flow stream for the business (by affecting the competitive landscape, cost
base, product demand, etc.)? See Exhibit 7.
(2) What impact has FX had on the value of the business? Has FX changed the U.S.
dollar value of the future cash flow stream from the foreign business? See Exhibit
8.
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FX Translated 10
FX Accounting The year was 1981, Rick Springfield (when he wasn’t hanging out at General Hospital)
topped the charts with Jessie's Girl, Olivia Newton John was getting physical and the
FASB released FAS 52, Foreign Currency Translation. FAS 52 (now known as ASC 830)
replaced the much maligned FAS 8, Accounting for the Translation of Foreign Currency
Transactions and Foreign Currency Financial Statements, and the accounting for FX
translation has been pretty much the same ever since.
Nowadays companies regularly enter into transactions denominated in a wide variety of
currencies and have subsidiaries spread around the globe. Of course all that information
needs to be pulled together and for a U.S. company eventually translated back into U.S.
dollars so that it can provide you with a set of consolidated financial statements reported in
one currency. But what exchange rate should they use? Where do the FX related gains
and losses get reported? These questions and others are answered by ASC 830.
This stuff can get complicated, but keep in mind there's really just two things (besides
currency hedging) that companies need to account for in FX land (1) transactions and (2)
financial statements, see Exhibit 9.
Exhibit 9: Two Things to Account for in FX Land
Source: Credit Suisse Accounting & Tax Research
Functional Currency Is the Key
The key to applying ASC 830 is the functional currency; in fact the rules are built around
the concept (it’s the sun in the FX solar system, the eye of the FX hurricane, you get the
point). The functional currency will drive what exchange rate companies use and whether
you are dealing with FX translation or FX transaction gains/losses and where they should
be reported.
So, what the heck is the functional currency? It's simply the currency of the main economic
environment that the company operates in. In other words: it’s the currency in which the
company does most of its business (which may or may not be the local currency).
Determining which functional currency a company uses is a management judgment call,
that's based on which currency things like cash flows, sales prices, sales market, costs
and financing are denominated in along with the volume of intercompany transactions. The
company must determine its own functional currency along with the functional currency for
each of its subsidiaries and equity method investees (i.e., each foreign subsidiary of a
Functional Currency:
currency in which the
company does most of its
business
Each foreign subsidiary of a
U.S. company could have a
different functional currency
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FX Translated 11
multinational company could have a different functional currency). Generally companies
don’t provide too much detail about their functional currencies, here's a few random
examples of what they disclose:
■ Coca-Cola (2014 10-K) – In 2014, we used 71 functional currencies. Due to our global
operations, weakness in some of these currencies might be offset by strength in
others.
■ Murphy Oil (2014 10-K) – Local currency is the functional currency in Canada and for
former refining and marketing activities in the UK. The U.S. dollar is the functional
currency used to record all other operations.
■ Williams Sonoma (10-K for fiscal ending 2/1/2015) – Some of our foreign operations
have a functional currency different than the U.S. dollar, such as those in Canada
(Canadian dollar), Europe (euro or British pound) and Australia (Australian dollar).
■ EMC Corporation (2014 10-K) – The local currency is the functional currency of the
majority of our subsidiaries.
A company must use the reporting currency (US$) as its functional currency when a
foreign sub operates in a highly inflationary environment (i.e., the cumulative inflation is
100% or more over the past three years) like in Venezuela.
If all of a company's transactions are denominated in the functional currency and that also
happens to be the reporting currency, the currency in which the financial statements
presented to investors are denominated (e.g., for a U.S. company the reporting currency is
the US$), there is no FX exposure from an accounting perspective.
However, there may still be FX exposure from an economic perspective as we highlighted
above (remember our purely domestic company from Exhibit 7).
The FX Two-Step
Yes, the accounting for FX can be complex but when you break it all down it’s just a two-
step process. The first step is to measure/remeasure all foreign currency transactions and
foreign currency financial statements into the functional currency followed by step two
where the functional currency financial statements are translated into the reporting
currency. See Exhibit 10 for the FX Two-Step.
Exhibit 10: The FX Two-Step
Source: Credit Suisse Accounting & Tax Research
Reporting Currency:
currency in which the
financial statements
presented to investors are
denominated
Foreign Currency: any
currency other than the
functional currency
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FX Translated 12
Before we take you on a spin through the FX Two-Step see Exhibit 11 for a good real
world description provided by Procter & Gamble CFO Jon Moeller of the various ways that
FX movements can impact a company's reported results:
Exhibit 11: FX Two-Step – A Real World Example
Source: Company transcripts. Credit Suisse Accounting & Tax Research
Step 1 – Get Everything Measured/Remeasured in
the Functional Currency
This step involves initially measuring foreign currency transactions in the functional
currency for the company and each of its foreign subsidiaries and then at each period end
remeasuring FX transactions that remain on the balance sheet (or for those transactions
that have settled remeasuring them at the settlement date). It also involves remeasuring
the financial statements of a foreign subsidiary if the books and records happen to be
maintained in a currency other than the functional currency.
In order to run you through how FX accounting works in this report we'll use a fictional
multinational company with the following key characteristics:
Parent: Uncle Sam Inc, domiciled in the U.S., functional currency and reporting
currency are the U.S. Dollar
o UK subsidiary: God Save the Queen (GSTQ) Plc
Euro is the functional currency
Transactions in foreign currencies (such as Russian ruble)
Books and records maintained in British pounds
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FX Translated 13
Foreign Currency Transactions
A foreign currency transaction is any transaction denominated in a currency other than the
functional currency and includes the import or export of goods, services, capital etc. (see
Exhibit 12). They can be transactions entered into by the U.S. parent (e.g., Uncle Sam Inc.
issues debt in Swiss francs) or its foreign subsidiaries (e.g., the UK sub GSTQ has a
payable in Russian rubles to a supplier in Russia or a receivable in Japanese yen from a
customer in Japan) and it even includes intercompany transactions.
Exhibit 12: FX Transactions for a UK Subsidiary with Euro Functional Currency, Some Examples
Source: Credit Suisse Accounting & Tax Research
Note how the same transaction can have a very different accounting result for a company,
depending upon the functional currency. For example, let's say GSTQ issues debt
denominated in euros (that is not an FX transaction since the debt is denominated in the
functional currency) but if the U.S. parent issued that same debt it would be treated as an
FX transaction (since the debt is in euros and the functional currency for the U.S. parent is
U.S. dollars) and in that case changes in the US$/Euro exchange rate would result in FX
transaction gains/losses that impact earnings.
Measure / Remeasure
Foreign currency transactions are initially measured in the functional currency using the
exchange rate in effect on the date of the transaction (in practice a weighted average rate
is typically used for income statement stuff, like revenue and expenses). If the FX
transactions remain on the balance sheet at the end of the quarter or in future quarters
they may need to be remeasured at the FX rate in effect on the balance sheet date (or for
those transactions that have settled, remeasured at the settlement date), depending on
whether the asset or liability is monetary or non-monetary. Check out Exhibit 13 for the FX
rates used to measure/remeasure a foreign currency transaction.
Exhibit 13: Foreign Currency Transaction Timeline - FX Rates Used to Measure/Remeasure
Source: Credit Suisse Accounting & Tax Research Note: Examples of monetary assets/liabilities include cash, payables, receivables etc. (cash or items expected to be settled in cash). Non-monetary assets/liabilities include inventory, PP&E, deferred revenue etc. 1: When transaction is settled or removed from the balance sheet
Foreign Currency
Transaction: transaction
denominated in a currency
other than the functional
currency
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FX Translated 14
An FX transaction is only remeasured if it’s a monetary asset or liability (see Exhibit 14 for
some examples). That's because those transactions will need to be settled in a foreign
currency at some point in the future (e.g., paying off a payable) and that can have
functional currency cash flow consequences (see our example below for a further
discussion).
Exhibit 14: Monetary and Non-Monetary Assets and Liabilities, Some Examples
Source: Credit Suisse Accounting & Tax Research
On the other hand non-monetary assets and liabilities (see Exhibit 14) are initially
measured at the FX rate on the transaction date but are not subsequently remeasured (i.e.,
they are not adjusted for changes in FX rates), in other words they are held at historical FX
rates. That's because those assets and liabilities don't need to be settled in the future. The
related income statement item (e.g., COGS, depreciation, amortization) is also determined
using the historical FX rate.
That said, you could still argue that there are FX holding gains/losses on non-monetary
assets and liabilities that are eventually recognized even though those assets and
liabilities are not remeasured for FX rate changes. Take inventory as an example,
changing FX rates can change the amount of cash (in functional currency) that the
company will receive on the sale of the inventory but that gets buried in the profit margin
when the sale is recognized (cutting margins if the functional currency strengthens and
boosting margins if it weakens). In other words the margin really has two components, the
margin in the underlying foreign currency and an FX piece due to changes in exchange
rates.
Impact of FX Rate Changes on Initial Measurement of Foreign Currency Transactions
You can see the effects on the financial statements of a stronger or weaker functional
currency against the currency in which the FX transaction is denominated in Exhibit 15.
Notice how we split the exhibit into two parts, measure and remeasure, both of which can
impact earnings.
Let's start with the initial measurement of FX transactions, if the functional currency is
strengthening against the foreign currency, new layers of FX transaction related revenues,
expenses, assets and liabilities will fall (all else equal). On the other hand, if the functional
currency weakens, new amounts of foreign currency transaction related revenues,
expenses, assets and liabilities would increase (all else equal). That appears to be what
happened to Procter & Gamble in Russia as explained by CFO Jon Moeller during its Q2
2015 earnings call, changes in the Euro/Ruble exchange rate increased the Russian unit's
costs of razors which it imports from Germany reducing its profit.
In other words (our own) if the Russian unit buys 100 euros worth of razors in Q1 when the
Euro/Ruble exchange rate was 75 (1 Euro = 75 Rubles) the cost of those razors when
measured in rubles was 7,500. If the ruble weakens in Q2 and the FX rate goes to 85 and
it buys another 100 euros worth of razors the cost of those razors in ruble now jumps to
8,500. The cost of razors goes up in the functional currency (Russian ruble) driving profits
down when the razors are sold assuming they can't pass the higher costs along to their
customers. Just to be clear this is the result of new layers of inventory getting measured at
different FX rates and those layers flowing through the income statement driving up COGS,
not FX related remeasurement which we discuss next (inventory is not remeasured).
Only monetary assets and
liabilities are remeasured
Non-monetary assets and
liabilities are not
remeasured (i.e., held at
historical FX rates)
Changes in exchange rates
impact initial measurement
of FX transactions, earnings
too
30 July 2015
FX Translated 15
Exhibit 15: FX Transactions - Impact of FX Rate Changes on Functional Currency Financial Statements
Source: Credit Suisse Accounting & Tax Research Note: Examples of monetary assets/liabilities include cash, payables, receivables etc. (cash or items expected to be settled in cash). Non-monetary assets/liabilities include inventory, PP&E, deferred revenue etc. Monetary assets and liabilities are remeasured using end of period exchange rates. Non-monetary assets/liabilities are not remeasured, the historical (i.e., transaction) FX rate is used.
Impact of FX Rate Changes, Remeasuring Foreign Currency Transactions
Certain FX transactions (i.e., monetary assets and monetary liabilities) that linger on the
balance sheet must be remeasured from the foreign currency into the functional currency.
The change in the value of the monetary asset or liability in functional currency due to
changes in exchange rates from the remeasurement process results in a foreign currency
transaction gain or loss that's run through the income statement impacting earnings. Or as
Kansas City Southern described it in its 10-K "The difference between the exchange rate
on the date of the transaction and the exchange rate on the settlement date, or balance
sheet date if not settled is included in the income statement as foreign exchange gain or
loss."
FX Transaction Gains & Losses Hit Earnings (Usually)
As you can see in the bottom half of Exhibit 15 a stronger functional currency will drive the
value of the monetary assets and liabilities down as they are remeasured, resulting in FX
transaction related losses/(assets) and gains/(liabilities), while a weaker functional
currency will have the opposite effect increasing the value of the monetary assets and
liabilities resulting in FX transaction related gains and losses respectively. Note that
there's no accounting impact on non-monetary assets/liabilities from FX rate changes
since they are not remeasured.
FX transaction gain/loss:
Change in value of net
monetary asset or liability
due to changes in FX rates
30 July 2015
FX Translated 16
To sum up, it’s the monetary assets/liabilities multiplied by the change in exchange rates
(functional currency / foreign currency) that determine the FX transaction gain or loss
reported on the income statement. That gain or loss reflects expected/actual functional
currency cash flow consequences that changing FX rates have on these transactions (e.g.,
an FX transaction loss indicates a company has paid (or will pay) more or received less (or
will receive less) in functional currency on a foreign currency transaction and vice versa for
an FX transaction gain) which is why it's generally reported in earnings. Keep in mind that
it includes both remeasurement (unrealized) and settlement (realized) gains and losses.
The FX transaction gain/loss must be disclosed either on the face of the income statement
or in the footnotes. However, the specific location on the income statement can vary, for
example:
■ Mattel (in its 2014 10-K) reported $44 million of 2014 currency transaction gains in
operating income and the remaining $2.8 million in other non-operating income.
■ Procter & Gamble disclosed in its 10-Q for the quarter ending March 31, 2015, that
total FX transaction charges added approximately 50 basis points to SG&A as a
percentage of net sales, (due to revaluing receivables and payables from transactions
denominated in a currency other than a local entity’s functional currency).
■ Avon disclosed in its 10-Q that foreign currency transaction losses were recorded
within cost of sales and selling, general & administrative expenses, which had an
unfavorable impact to adjusted operating profit of an estimated $45 million for the
three months ended March 31, 2015.
Keep in mind there are exceptions to running the FX transaction gain or loss through
earnings for foreign currency transactions that have been designated as a hedge and
intercompany transactions that are of a long-term investment nature which are treated as
part of the net investment in the foreign subsidiary. In both cases the FX gains and losses
would be reported in other comprehensive income (in shareholders' equity) instead of the
income statement.
FX Transaction Example
To hammer home all this FX transaction stuff let's run through a simple example, say
Uncle Sam's UK sub, God Save the Queen's functional currency is the euro and it has a
payable to a Russian supplier in rubles. Since the payable is denominated in a currency
(ruble) that differs from the functional currency (euro) it’s a foreign currency transaction
that must first be measured in the functional currency and then remeasured (since it’s a
monetary liability).
Let’s assume that the payable remains outstanding for two quarters until it's paid. In
Exhibit 16 you can see how the payable in rubles stays the same from period to period but
the amount in euro changes as it is remeasured using different exchange rates (resulting
in an FX transaction gain in the first period followed by an FX transaction loss). Notice how
this example, differs from the P&G case discussed above because of different functional
currencies, here the functional currency is the euro and the foreign currency transaction is
in rubles (it’s the opposite for P&G).
FX Transaction gain/loss
reflects expected/actual
cash flow consequences of
changing FX rates
30 July 2015
FX Translated 17
Exhibit 16: FX Transaction Gain/(Loss) Example - Russian Ruble Payable, Functional Currency is Euro
Source: Credit Suisse Accounting & Tax Research 1: Drop in the value of the liability in the functional currency results in an FX transaction gain. 2: Increase in the value of the liability in the functional currency results in an FX transaction loss.
By settling the payable at the end of Q2 the company would need to rustle up €167 to pay
off the 10,000 rubles that it owes. Relative to the €133 when the transaction was first
entered into, that's €34 more than would have been needed initially, or a €34 FX
transaction loss. That loss was reported on the income statement over two quarters, a €15
gain in Q1 (as the euro strengthened initially) followed by a €49 loss in Q2 (due to the euro
weakening). FX transaction gains and losses are included in earnings because they
eventually impact functional currency cash flows (in this case an FX transaction loss
because more euros were needed to settle the ruble payable).
Intercompany FX Risk?
Have you ever come across companies discussing FX exposure related to intercompany
transactions (some companies even hedge this "intercompany" risk) and wondered what
the heck they were talking about, like in the following examples?
■ Mattel (2014 10K) – The company uses foreign currency forward contracts to hedge
intercompany loans and advances denominated in foreign currencies. Due to the
short-term nature of the contracts involved, Mattel does not use hedge accounting for
these contracts.
■ Keurig Green Mountain Inc (3/28/2015 10Q) - We have certain assets and liabilities
that are denominated in Canadian currency. During the 2015 YTD period, we incurred
a net foreign currency loss of $17.9 million as compared to a net loss of $19.3 million
during the prior YTD period. The net foreign currency losses were primarily attributable
to re-measurement of certain intercompany notes with our foreign subsidiaries which
fluctuate due to the relative strength or weakness of the U.S. dollar against the
Canadian dollar.
■ Baxter (3/30/2015 10Q) - In 2015, other income, net included $89 million of income
related to foreign currency fluctuations, principally relating to intercompany
receivables, payables and monetary assets denominated in a foreign currency. The
company also enters into derivative instruments to hedge certain intercompany and
third-party receivables and payables and debt denominated in foreign currencies.
Yes, even though intercompany transactions are eliminated in consolidation they can still
leave behind FX transaction gains and losses. How you ask? Best way to explain it is with
an example.
30 July 2015
FX Translated 18
Let's say our UK sub has a loan from its U.S. parent denominated in U.S. dollars. Since
the functional currency of GSTQ is the euro, the U.S. dollar loan payable is a foreign
currency transaction (from GSTQ's perspective) and must be remeasured each period into
euros (since it’s a monetary liability). So if the euro weakens against the U.S. dollar, that
will cause the payable to increase in euros (even though the dollar amount has stayed the
same) resulting in an FX transaction loss (larger liability = loss). Despite the fact that the
payable is eliminated in consolidation (along with the parent company's corresponding
loan receivable) the FX transaction loss survives. It is reported on GSTQ's euro
denominated income statement, driving down the net income in functional currency. So
that loss along with everything else on GSTQ's income statement gets translated into U.S.
dollars and becomes part of the consolidated financial statements.
If There Are Foreign Currency Books & Records, the Financial Statements Need to
Be Remeasured into Functional Currency Too
Another scenario where we see an FX gain or loss reported on the income statement is
when a company happens to have a foreign subsidiary where the books and records are
denominated in a currency that differs from the functional currency. For example, if GSTQ
maintained its books and records in British pounds it would need to remeasure its British
pound financial statements into the functional currency (euro).
As with FX transactions, monetary assets/liabilities on the balance sheet are remeasured
using FX rates in effect on the balance sheet date, while non-monetary assets/liabilities
and equity are kept at historical FX rates. On the income statement revenues and
expenses are typically remeasured using weighted average FX rates for the period
(technically they should use the FX rate when the transactions are recognized, but in
practice a weighted average rate is used). Unless the income statement items relate to
non-monetary assets/liabilities like depreciation (PP&E), amortization (intangibles), COGS
(inventory) or recognizing deferred revenues. In that case historical exchange rates are
used.
Exhibit 17 provides an overview of the FX rates used to remeasure foreign currency
financial statements into the functional currency along with the impact of a
stronger/weaker functional currency.
Intercompany transactions
can result in FX transaction
gains/losses
Accounting Geek Alert -
This paragraph describes
the "Temporal Method"
30 July 2015
FX Translated 19
Exhibit 17: Remeasure Foreign Currency Financial Statements – FX Rates Used and Impact on Functional
Currency Financial Statements
Source: Credit Suisse Accounting & Tax Research 1: FX rate on transaction date, in practice weighted average FX rates are used. 2: Even though non-monetary assets/liabilities are not remeasured for FX rate changes new purchases of PP&E, inventory, intangibles, etc. along with new bookings of deferred revenue are initially measured using FX rates on the transaction date. As a result if the functional currency strengthens/weakens new amounts of foreign currency PP&E, inventory, intangibles and deferred revenue will be measured into lower/higher functional currency amounts relative to prior purchases and bookings. When those amounts flow through the income statement it will drive COGS, depreciation, amortization, revenue, etc. down/up respectively. 3: FX rate on balance sheet date. 4: Even though shareholders' equity is not remeasured for FX rate changes, new layers of equity (e.g., net income) are measured using FX rates for the period. As a result if the functional currency is strengthening/weakening it will generally result in lower/higher net income in functional currency relative to the prior period which will drag/boost shareholders' equity.
In Appendix A – FX Remeasurement Example we run you through an example that
remeasures the balance sheet and income statement of our hypothetical UK subsidiary
(GSTQ) from British pounds into the functional currency, euro. The Appendix includes
Exhibit 32 which shows the math behind the FX gain or loss from remeasurement that's
reported on the income statement.
Keep in mind that the FX gain or loss is not the only impact that changing FX rates have
on earnings. In our example in Exhibit 31 you can see that the same amount of British
pound revenues results in different amounts in euros from period to period due to FX rate
changes, less euros when the pound weakens and more euros when the pound
strengthens. Notice also how the gross margins change as COGS are kept at historical FX
rates but the FX rate used to measure revenues changes from period to period.
Step 2 – Translate from Functional Currency into
Reporting Currency (FX Translation)
After getting everything measured in the functional currency the next step is to translate
those functional currency financial statements for each and every subsidiary into the
reporting currency (e.g., US$ for a U.S. company). Sticking with our example, we'd need to
translate the euro denominated GSTQ financial statements into U.S. dollars.
In Exhibit 18 you can see that all of the assets and liabilities on the balance sheet are
translated at the current FX rates in effect on the balance sheet date (notice that the
translation process ignores whether the assets/liabilities are monetary or non-monetary),
while historical rates are used for shareholders' equity. Both the income statement and
Accounting Geek Alert –
This paragraph describes
the "Current Rate Method"
30 July 2015
FX Translated 20
cash flow statement are translated at the rates in effect when the items are recognized but
in practice companies use a weighted average exchange rate for the period instead. The
weighting is supposed to reflect when the transactions take place, for example, if a
company tends to book most of its sales in the last week of the quarter the average
exchange rate for the quarter should be heavily weighted toward that time frame.
Exhibit 18: Translation – FX Rates Used and Impact on Reporting Currency Financial Statements
Source: Credit Suisse Accounting & Tax Research 1: FX rate on transaction date, in practice weighted average FX rates are used. 2: FX rate on balance sheet date. 3: Reported in Other Comprehensive Income within shareholders' equity.
FX Translation Gain/Loss Reported in OCI within Shareholders' Equity
Because the FX translation process involves the use of different exchange rates, (e.g.,
current exchange rates for assets and liabilities, weighted average rates on the income
statement and historical rates for equity) the balance sheet would be out of balance if not
for the FX translation gain/loss (i.e., accounting plug).
An FX translation gain/loss for a given period reflects the impact of FX rate changes on (1)
the net investment in the foreign subsidiary (i.e., net asset or net liability) at the beginning
of the period and on (2) the net investment arising during the period (e.g., net income).
In Appendix B – FX Translation Example we translate the balance sheet, income
statement and cash flow statement of our imaginary UK sub from its functional currency
euro into the U.S. dollar, the reporting currency of its parent. As part of the translation
process we walkthrough the calculation of the FX translation gain/loss in Exhibit 36.
The FX translation gain or loss initially bypasses the income statement and is reported in
shareholders' equity as part of accumulated other comprehensive income (AOCI). It’s not
until the business is sold or liquidated that the cumulative FX translation gain or loss that
had been stored in equity is transferred to earnings.
Why are FX translation gains and losses tucked away in shareholders' equity? That's
because the translation related FX exposure is tied to the net investment (assets –
liabilities) in the foreign subsidiary. As a result FX translation might not have much of an
impact on a day to day basis. Take our fictional company as an example, the UK sub does
most of its business in euros and assuming the U.S. parent reinvests those euros in its UK
sub (though you do need to be careful with that assumption), how much those euros are
worth in dollars doesn’t really matter all that much for now (at least in theory).
30 July 2015
FX Translated 21
FX Translation Losses over $240 Billion in Aggregate for S&P 500
For the S&P 500 companies the cumulative FX translation losses have grown quite a bit
over the last couple of quarters as the U.S. dollar has strengthened and are now $244
billion in the aggregate, see Exhibit 19. That's the highest level in the past 15 years.
Exhibit 19: Cumulative FX Translation Gain/(Loss), S&P 500 (2007-3/31/2015)
Source: Compustat, Credit Suisse estimates Note: Data up to 3/31/2015. The last period in the chart contains data from the fiscal quarters ending between 1/1/2015 and 3/31/2015.
To help you put the FX translation gains and losses into perspective for the companies
you own and follow we provide benchmarks by sector. In Exhibit 20 we compare the
cumulative FX translation gain/loss by sector to book value and market cap. For those
companies that you follow which differ significantly from their peers you might want to do a
little digging to better understand why they appear to have more/less FX exposure (see
Exhibit 8).
Exhibit 20: Benchmarks - Cumulative FX Translation Gain/(Loss) as of 3/31/2015 by Sector, S&P 500
Source: Compustat, Credit Suisse estimates Note: Cumulative FX translation gain/loss, book value and market cap are as of the last fiscal quarter ending on or before 03/31/2015. Measures involving book value exclude companies with negative book values.
30 July 2015
FX Translated 22
FX Translation Impacts Earnings Too
Even though the FX translation gain/loss is not (initially) reported on the income statement
the FX translation process can still have an impact on earnings. As you saw in Exhibit 18,
the translated revenues and expenses will fall (all else equal) if the reporting currency is
strengthening against the functional currency and vice versa when the reporting currency
weakens. As a result the stronger dollar tends to cause reported revenues and earnings to
drop for many U.S. multinationals. Though the margins (in percentage terms) stay the
same (functional currency vs. reporting currency) bottom line earnings can be impacted.
That said the FX translation process can throw a monkey wrench into your ratio analysis
whenever the numerator and denominator of the ratio are translated at different FX rates.
For example, any ratios that involve both the income statement (weighted average FX
rates) and the balance sheet (period end FX rates) like a return on assets could be very
different after FX translation since you are comparing apples and oranges.
Lots of companies have highlighted the impacts of FX translation on the income statement
over the last couple of earnings seasons, here are a few examples:
■ Illinois Tool Works (Q1 2015 Earnings Call) – "Foreign currency translation reduced
revenues by 7%, resulting in total revenues declining 6%." Paul Lundstrom, Director,
Investor Relations. 4/21/2015.
■ United Technologies (Q1 2015 Earnings Call) - "Overall foreign exchange translation
was an 11-point earnings headwind and a nine-point sales headwind." Michael M.
Larsen, CFO. 4/21/2015.
■ Starbucks (Q2 2015 Earnings Call) – "Revenues grew to $4.6 billion, an 18% increase
over prior year, despite nearly two percentage points of headwind through foreign
currency translation. Revenue growth for fiscal 2015 remains targeted at 16% to 18%,
despite two points of headwind from foreign currency translation" Scott Maw, CFO.
4/23/2015.
■ Caterpillar (Q1 2015 Earnings Call) - (Q2 2015 Earnings Call) – "Foreign currency
translation is forecasted to reduce 2015 U.S. dollar sales by 6% to 7%, up from a
previous range of 4% to 5%." Nicholas C. Gangestad, CFO. 4/23/2015.
Companies Respond with Constant Currency
Some companies have responded to the spike in FX volatility by providing information in
constant currency (i.e., currency neutral), showing year-over-year changes in revenue and
other line items assuming no change in exchange rates. This information can be helpful to
get at the performance of the underlying business in the functional currency especially for
those companies that are reinvesting the functional currency profits back into their foreign
subs. But (as discussed earlier) constant currency info should be used with caution,
especially for those companies that are repatriating the foreign earnings or turning them
into U.S. dollars.
Constant currency comparisons can also hide the pricing pressure a company may be
facing. For example, take an industry where there is competition from around the world
and a supply chain that is also global. If the currency in a particular country weakens, that
may put pressure on all the companies operating in that country to increase the price of
their products to maintain their margins (remember they have costs in other now stronger
currencies). If a company were to blame the entire decline in revenues on FX translation,
that may not be the whole story. What if other companies were able to pass on the
additional costs to customers, but the company you are analyzing wasn't? They lost
pricing power on a relative basis and as a result their revenues were lower than what they
would have been if they were able to maintain it. So, pay attention to what is happening to
the peers with comparable FX exposures. If a company is impacted more than the rest,
there may be more to the story than just FX translation.
FX translation can throw a
monkey wrench into your
ratio analysis
30 July 2015
FX Translated 23
FX Translation Impacts Reported Cash Flows Too
Even though the FX translation process has no real impact on the cash flows in the
functional currency it can cause the numbers on the reported currency cash flow
statement to bounce around. Each line item on the cash flow statement is typically
translated into the reporting currency using weighted average FX rates for the period (like
on the income statement).
If that's the case you might be wondering what's that line item labeled something like:
"Effect of exchange rate changes on cash and cash equivalents" that you'll find at the
bottom of the cash flow statement? Well if you take all the line items on the cash flow
statement and translate them at a weighted average FX rate for the period you won't be
able to reconcile cash from the beginning of the period to the end of the period especially
when the beginning and ending cash balances are translated at different exchange rates.
So that line is a plug number to get it all to reconcile. See our example in Exhibit 43 of
Appendix B – FX Translation Example for the math. In other words the change in reported
cash has two components, (1) actual cash flows and (2) the impact of changing exchange
rates.
As with earnings this line item is not the only impact that FX translation has on the cash
flow statement. In our example, you can see that the change in inventory is €52 each
period, but the U.S. dollar amount fluctuates solely due to FX rate changes. A stronger
dollar results in weaker reported cash flows all else equal and vice versa for a weaker
dollar.
FX Translation Causes Disconnect Between Cash Flow Statement and Balance Sheet
The FX translation process can also create a disconnect between the changes in line
items in the reporting currency on the balance sheet and what you see on the cash flow
statement. That's because different exchange rates are used. Take inventory, in our
example it appears to fall by $176 on the balance sheet from 03/31/15 to 6/30/15 in Exhibit
35 while on the cash flow statement in Exhibit 42 it looks like inventory dropped by only
$62. That's similar to Archer Daniels Midland Co where on the balance sheet inventory
dropped by $1,002 million, but on the cash flow statement inventory dropped by only $739
million during the quarter ending 3/31/2015.
FX Hedging
Hopefully what you've read so far makes sense and has helped to alleviate some of the
confusion around the accounting for FX. Now we can really get the party started by
switching over to FX hedging.
Au Naturale FX Hedges
Some companies have natural currency hedges in place, for example they might localize
production in foreign markets (incurring labor, raw material costs, etc. in the same
currency that they are selling product), or by financing the foreign business in local
currencies (e.g., issuing debt in the same currency as their assets, etc.). Keep in mind that
just because revenues and costs are incurred by the same foreign subsidiary doesn’t
automatically mean there's a natural FX hedge in place as the revenues and costs could
still be denominated in different currencies.
Those natural hedges reduce the net exposure a company has to a particular currency, so
that currency related losses are offset to some extent by currency gains and vice versa
(though there may still be timing differences). That's one of the reasons why you'll see a
difference between the top line and bottom line impact of FX across companies; some
have the revenues and costs matched up while others have mismatches.
In Exhibit 21 we compare and contrast the impact of a 10% stronger/weaker dollar on the
results of three hypothetical companies, one with a natural hedge in place (revenues and
expenses are in the same currency) and two with currency mismatches (revenues and
FX is one of the reasons
why you can't tie out the
changes in the balance
sheet to the cash flow
statement
Natural Hedge - matching
currency revenues &
expenses, assets &
liabilities reduces FX
exposure
30 July 2015
FX Translated 24
expenses are in different currencies). Notice how when naturally hedged the margin
remains at 20% though it does fluctuate in dollars, from $20 to $22 when the dollar
weakens and from $20 to $18 when the dollar strengthens. Contrast that with both the
exporter and importer with currency mismatches (i.e., foreign currency transactions) where
both the margin % and dollars fluctuate.
Exhibit 21: FX Exposure – Natural Currency Hedge vs. Mismatch, Example
Source: Credit Suisse Accounting & Tax Research
There are plenty of companies with currency mismatches (e.g., revenues in one currency
and costs in another). Here's a couple of examples:
■ Ralph Lauren - in its Q4 conference call, the CFO Christopher Peterson discussed the
impact of a revenue / cost mismatch "so when we look at the FX impact on the top-line
of 5.5%, the flow-through of that to the bottom line is a little bit over 40%...which is
what leads to the $185 million headwind, because our cost structure is not
denominated in local currency."
■ McDonald's – from its Q4 conference call, CFO Pete Bensen addressed the weakness
in McDonald's Europe margins driven by Russia and the Ukraine "Over half of this
margin decline reflected a significant impact of weakening currencies on imported
commodity costs in these two markets. We expect this currency impact to significantly
pressure the segment's company-operated margins again in 2015, especially in the
first half."
As a result of a currency mismatch some companies may look to try and minimize that risk
by entering into FX hedging transactions. Hedging long-term structural mismatches might
make some sense (depending upon the costs involved) but hedging accounting risk is a
whole other ball of wax.
Hedge Accounting, 1,000+ Pages of Fun and Excitement
The accounting guidance for FX hedging is laid out in ASC 815, Derivatives and Hedging
(the standard formerly known as FAS No. 133). It allows companies to hedge the FX risk
on certain assets and liabilities, unrecognized firm commitments (legally binding
Is the company hedging a
structural FX mismatch or
an accounting risk?
30 July 2015
FX Translated 25
agreements that include, fixed price, timing, quantity, etc.), forecasted transactions (e.g.,
forecasted purchases and sales), net investments in foreign subsidiaries even certain
intercompany transactions (e.g., receivables and payables). All of these potential hedged
items must be denominated in a currency other than the functional currency in order to be
"hedgeable" from an accounting perspective.
Companies can use derivatives (FX forward, options, swaps, etc.) or in some cases non-
derivative financial instruments (e.g., debt) to hedge FX risks. We include a few examples
of what companies have to say about hedging FX risk in Exhibit 22.
Exhibit 22: FX Hedging – Company Examples
Source: Company filings and transcripts
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FX Translated 26
Four Types of FX Hedges
From an accounting perspective we can put these hedging transactions into four buckets:
(1) Fair Value Hedge
(2) Cash Flow Hedge
(3) Net Investment Hedge
(4) Standalone Derivative
Before we describe each in a bit more detail including journal entries (admit it now you're
excited), Exhibit 23 provides a high level overview of how each of the different ways to
account for an FX hedge impact the financial statements.
Exhibit 23: FX Hedge Accounting Summary
Source: Credit Suisse Accounting & Tax Research Note: I/S – Income Statement, OCI – Other Comprehensive Income 1: Changes in fair value of hedges that qualify for hedge accounting can be divided into effective and ineffective portions. 2: Generally represents the difference between change in fair value of hedge and change in fair value of hedged item due to FX risk. 3: Ineffectiveness on a cash flow hedge is recognized in earnings only with an "overhedge", that's when the cumulative change in the fair value of the hedge exceeds the cumulative change in the expected future cash flows of the hedged item. 4: Represents change in fair value of the hedged item due to FX risk 5: If hedged item is FX transaction monetary asset/liability then the impact of changes in FX rates will run through the income statement
1. Fair Value Hedge
A derivative that is being used to protect the fair value of an asset or liability on the
balance sheet or an unrecognized firm commitment from FX risk and that meets the
laundry list of hedge accounting requirements in ASC 815 is treated as a fair value hedge.
The derivative is reported on the balance sheet as an asset or liability at fair value.
Changes in fair value run through the income statement as a gain or loss on a quarterly
basis. That sounds a lot like the accounting for a stand-alone derivative (see below). The
difference is that gains and losses on the hedged item, as a result of the specific risk being
hedged are also reported in the income statement.
For example, in Exhibit 24 a U.S. company with a firm commitment to buy a piece of
machinery from a French manufacturer for €1,000,000 enters into a forward contract to
buy €1,000,000 for $1,250,000, hedging the fair value of its commitment against FX
fluctuations (i.e., it effectively locked in the price of the machine in dollars). It would report
a loss on the derivative and a gain on the firm commitment in earnings when the dollar
30 July 2015
FX Translated 27
strengthens and vice versa if the dollar weakens. The change in value of the derivative
and hedged item will offset each other to some extent in earnings. If the hedge is perfect
(as in our example) they will offset entirely and there will be no impact on earnings, if not
there will be some residual impact on earnings, that's known as hedge ineffectiveness.
In our example notice how the dollar has weakened over the course of the year and as a
result if there were no hedge in place the €1,000,000 piece of machinery would end up
costing $1,300,000. But our fictional U.S. company hedged the firm commitment with a
forward contract and as a result of the $50,000 gain on the forward (a successful hedge)
the machine ends up costing the company only $1,250,000. Of course if the dollar had
strengthened the forward contract would have gone against the company (an unsuccessful
hedge) and the machine would have ended up costing more in dollars than if unhedged.
Exhibit 24: Fair Value Hedge Example
The Journal Entries With the hedge On 3/31/2015 1. To recognize the change in the fair value of the forward contract and the firm commitment due to FX rate changes
DEBIT Gain/(Loss) on the Forward Contract $100,000 DEBT Firm Commitment Asset $100,000 CREDIT Forward Contract Payable $100,000 CREDIT Gain/(Loss) on the Firm Commitment $100,000
On 6/30/2015 2. To recognize the change in the fair value of the forward contract and the firm commitment due to FX rate changes
DEBIT Forward Contract Payable $100,000 DEBIT Forward Contract Receivable $50,000 DEBT Gain/(Loss) on the Firm Commitment $150,000 CREDIT Gain/(Loss) on the Forward Contract $150,000 CREDIT Firm Commitment Asset $100,000 CREDIT Firm Commitment Liability $50,000
On 12/31/2015 (continued on the next page)
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3. To record settling the forward contract (receive $50,000 in cash) DEBIT Cash $50,000 CREDIT Forward Contract Receivable $50,000
4. To recognize the purchase of the machine for €1,000,000 measured at $1,300,000 (the $50,000 gain from the forward contract offsets the price of the machine recorded on the balance sheet). DEBIT PP&E $1,250,000 DEBIT Firm Commitment Liability $50,000 CREDIT Cash $1,300,000
Without the hedge On 12/31/2015 5. To recognize the purchase of the machine for €1,000,000 measured at $1,300,000.
DEBIT PP&E $1,300,000 CREDIT Cash $1,300,000
Source: Credit Suisse Accounting & Tax Research Note: Example ignores taxes and time value. Assumes forward rates and spot rates move in lock-step.
2. Cash Flow Hedge
A derivative that is being used to protect a forecasted cash inflow or outflow from FX risk
and that meets another laundry list of hedge accounting requirements in ASC 815 is
treated as a cash flow hedge. Once again the derivative is reported on the balance sheet
as an asset or liability at fair value. The difference with a cash flow hedge is that changes
in the fair value of the derivative are reported in OCI within shareholders' equity. They will
remain there until the hedged forecast cash flow affects the income statement.
For example, a U.S. company has a forecasted sale of rubber ducks to a customer located
in Turkey for 1,000,000 Turkish lira. The company enters into a forward contract to sell
1,000,000 Turkish lira for $400,000 to lock in the price in dollars. The gains and losses on
the forward contract are initially reported in OCI. As a result the forward contract does not
impact earnings (assuming no ineffectiveness) until the rubber ducks are sold. When the
revenue is recognized on the sale of the rubber ducks the gain or loss on the forward
contract is moved out of AOCI and into earnings. Exhibit 25 runs through this example.
Exhibit 25: Cash Flow Hedge Example
The Journal Entries (continued on the next page)
30 July 2015
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With the hedge On 3/31/2015 1. To recognize the change in the fair value of the forward contract due to FX rate changes
DEBIT Forward Contract Receivable $42,857 CREDIT AOCI $42,857
On 6/30/2015 2. To recognize the change in the fair value of the forward contract due to FX rate changes
DEBIT AOCI $142,857 CREDIT Forward Contract Receivable $42,857 CREDIT Forward Contract Payable $100,000
On 12/31/2015 3. To record settling the forward contract (by paying $100,000 in cash)
DEBIT Forward Contract Payable $100,000 CREDIT Cash $100,000
4. To reclassify the loss on the hedge from AOCI into earnings DEBIT Sales $100,000 CREDIT AOCI $100,000
5. To recognize selling rubber ducks worth 1,000,000 Turkish lira measured at $500,000 DEBIT Cash $500,000 CREDIT Sales $500,000
Without the hedge 6. To recognize selling rubber ducks worth 1,000,000 Turkish lira measured at $500,000
DEBIT Cash $500,000 CREDIT Sales $500,000
Source: Credit Suisse Accounting & Tax Research Note: Example ignores taxes and time value. Assumes forward rates and spot rates move in lock-step.
In our example notice how the dollar has weakened over the course of the year and as a
result if there were no hedge in place the 1,000,000 Turkish lira received on the sale of the
rubber ducks would have been reported as $500,000 in revenue. But our fictional U.S.
company hedged the forecasted sale with a forward contract and as a result of the
$100,000 loss on the forward contract (an unsuccessful hedge) the company only books
$400,000 in revenue. Of course if the dollar had strengthened the forward contract would
have gone in the company's favor (a successful hedge) and the revenue would have been
higher in dollars than if unhedged.
So if you don’t see revenue move in line with changes in exchange rates that could be a
sign that the company is hedging FX risk. Take Google as an example, in its Q4
conference call, CFO Patrick Pichette discussed the benefits of its FX hedge program
"Just as a reminder, we hedge profits right, we don't hedge revenue. It just happens that
we book the profits to revenue because of the accounting rules and so we have seen in
Q4 approximately $150 million of hedge benefits."
3. Net Investment Hedge
Companies can also hedge the FX risk associated with the net investments in their foreign
subsidiaries. In this case the derivative (or financial instrument) is reported on the balance
sheet as an asset or liability at fair value. As with a cash flow hedge the changes in the fair
value of the derivative are reported in OCI alongside the related FX translation gain or loss.
Both will remain in shareholders' equity until the foreign sub is sold or liquidated.
For example, a U.S. company with a subsidiary in Mexico that uses the Mexican Peso as
its functional currency has a net investment equal to 1 billion pesos. The company issues
1 billion pesos of debt to protect against the FX exposure on its net investment in the
Mexican sub. Normally the peso debt would be treated as an FX transaction, with FX
related gains and losses reported in earnings. However, since it's treated as a net
investment hedge, the gains and losses on the debt are reported in OCI (instead of
earnings) along with the FX translation loss/gain on the Mexican net investment. So when
you don't see the cumulative translation adjustment moving in line with changes in
exchange rates that may be a sign that the company is hedging that exposure too.
4. Standalone Derivative (Economic Hedge)
There is one other way to account for an FX derivative, if it does not qualify for special
hedge accounting it's treated as a stand-alone derivative. It is reported on the balance
sheet as an asset or liability at fair value. Changes in fair value run through the income
statement as a gain or loss on a quarterly basis (see below for where they might be
30 July 2015
FX Translated 30
reported). Just from an accounting perspective this type of treatment works if the FX risk
being hedged is already reported on the income statement (e.g., the company is
economically hedging a foreign currency transaction monetary asset/liability); as that
would result in the gain/loss from the derivative naturally offset in earnings against the
loss/gain on the monetary asset or liability.
Where Can You Find Derivative Gains / Losses?
Where oh where are the derivative gains and losses reported? Despite the 1,000 plus
pages of rules, there's not a lot of guidance in ASC 815 regarding the income statement
location of derivative gains/losses. But in practice most companies using derivatives that
have qualified as a hedge, tend to put the derivative gain or loss on the same line item as
the hedged item (e.g., COGS, revenues, interest expense, etc.). Some companies will
strip out the ineffective piece and include that in another line item, like "other
income/expense" (though the FASB might change that). We'd argue it’s a cost of hedging
so it shouldn’t be ignored.
As for derivatives that don't qualify for hedge accounting treatment the practical guidance
that we have come across from the big accounting firms says the gains and losses
(including any ineffectiveness) could go into a separate line item like "other
income/expense" or be reported in the same place as the economically hedged item.
That said, companies should disclose where this stuff is reported, take Google as an
example. The company has exposure to three different types of currency hedges that all
result in different accounting treatment (per the 2014 10-K):
■ Cash Flow Hedge – Google uses options designated as cash flow hedges to hedge
certain forecasted revenue transactions denominated in currencies other than the U.S.
dollar. The company reflects gain or loss on the effective portion of a cash flow hedge
as a component of AOCI and subsequently reclassifies cumulative gains and losses to
revenues or interest expense when the hedged transactions are recorded.
■ Fair Value Hedge - Google uses forward contracts designated as fair value hedges to
hedge foreign currency risks for our investments denominated in currencies other than
the U.S. dollar. Gains and losses on these forward contracts and interest rate swaps
are recognized in interest and other income net along with the offsetting losses and
gains of the related hedged items.
■ Standalone Derivative - Other derivatives not designated as hedging instruments
consist of forward and option contracts that we use to hedge intercompany
transactions and other monetary assets or liabilities denominated in currencies other
than the local currency of a subsidiary. Google recognizes gains and losses on these
contracts, as well as the related costs in interest and other income, net, along with the
foreign currency gains and losses on monetary assets and liabilities.
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FX Translated 31
Appendix A – FX Remeasurement Example
In order to run you through the process of remeasuring foreign currency financial
statements into the functional currency we're going to focus on our fictional British
subsidiary: God Save the Queen Plc (GSTQ). GSTQ happens to maintain its books and
records in British pounds. However, GSTQ uses the euro as its functional currency
(because the majority of its business is done in euros). As a result, at the end of each
reporting period the financial statements need to be remeasured from the foreign currency
- British pounds (even though it’s the local currency, it is treated as a foreign currency from
an accounting perspective since it differs from the functional currency) into the functional
currency - euros.
Balance Sheet FX Remeasurement
In Exhibit 26, we present the balance sheet of GSTQ in British pounds. The financial
statements have been simplified to contain fewer items and where possible fewer period
over period changes in order to make it easier for you to follow the FX impact (e.g., no
new inventory is purchased, the payable remains unpaid, no additional deferred revenue is
booked, etc.).
Exhibit 26: GSTQ's Balance Sheet in British Pounds
Source: Credit Suisse Accounting & Tax Research
Monetary assets and liabilities are remeasured each period using the exchange rates as of
the balance sheet date. So things like cash, receivables and payables are remeasured
using current exchange rates at the end of the reporting periods.
Non-monetary assets and liabilities are not remeasured, that is, the original transaction
date exchange rate sticks (i.e., the historical rate is used). For example, if GSTQ buys
£500 worth of inventory it's initially measured as €650 since the exchange rate is 1.30
GBP/EUR. Regardless of future FX rate changes that inventory (or whatever's left of it) will
continue to be measured using the same 1.30 GBP/EUR exchange rate. However, if the
company subsequently buys another batch of inventory and the FX rate has changed, the
new rate will be used to measure the new batch.
In Exhibit 27 we see the exchange rate over time and the rates used to
measure/remeasure each line item on the balance sheet from British pounds into euros.
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FX Translated 32
Exhibit 27: Exchange Rates Used to Remeasure GSTQ's Balance Sheet
Source: Credit Suisse Accounting & Tax Research
We arrive at the functional currency (euro) balance sheet for GSTQ in Exhibit 28 by
applying the FX rates in Exhibit 27 to the British pound balance sheet in Exhibit 26. For
example, the £1,000 of cash at 12/31/14 is remeasured into €1,300 (£1,000 x 1.30) when
the FX rate is 1.30 EUR/GBP.
Exhibit 28: GSTQ's Balance Sheet Remeasured in Euros – Functional Currency
Source: Credit Suisse Accounting & Tax Research 1: Each period's remeasured net income is added to retained earnings (check Exhibit 31)
We have discussed how the assets and liabilities are treated but what about shareholders'
equity? Similar to non-monetary assets and liabilities the components of equity are
measured once at the FX rate in effect when the common stock is issued, net income is
earned, etc. and are not subsequently remeasured for changes in FX rates. Let's take the
period ending 3/31/15, notice how the paid-in-capital remains at €520 as it's not
remeasured. As for retained earnings, it increased by €184 of net income (see Exhibit 31)
to arrive at the new retained earnings balance of €314.
Income Statement FX Remeasurement
Moving on, in Exhibit 29 you'll find the income statement of GSTQ in British pounds. For
simplicity it's identical for all three periods so that you can really see the FX effects of
remeasuring into euros (and it ignores taxes, don't you wish you could ignore taxes too).
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FX Translated 33
Exhibit 29: GSTQ's Income Statement in British Pounds
Source: Credit Suisse Accounting & Tax Research Note: Assumes income is not taxed (remember, this is fiction)
The line items on the income statement are typically remeasured using weighted average
FX rates for the period, unless they are associated with non-monetary assets/liabilities. As
a result items like COGS, depreciation, amortization, etc. use a historical FX rate (e.g., the
FX rate when the inventory was originally purchased). In Exhibit 30 we provide the
exchange rates used to remeasure the income statement from British pounds into euros.
Exhibit 30: Exchange Rates Used to Remeasure GSTQ's Income Statement
Source: Credit Suisse Accounting & Tax Research
We arrive at the functional currency (euro) income statement for GSTQ in Exhibit 31 by
applying the FX rates in Exhibit 30 to the British pound income statement in Exhibit 29. For
example, the £60 of SG&A at 12/31/14 is remeasured into €78 (£60 x 1.30), when the
weighted average FX rate is 1.30 GBP/EUR.
Exhibit 31: GSTQ's Income Statement Remeasured in Euros – Functional Currency
Source: Credit Suisse Accounting & Tax Research Note: Assumes income is not taxed 1: Exhibit 32 shows the math behind the FX Gain/(Loss)
30 July 2015
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FX Gain/Loss Reported on Income Statement
There is one line item on the functional currency income statement that needs some
further explaining, the FX Gain/(Loss). It can be broken down into two parts: the impact of
FX rate changes on the (1) net monetary assets at the beginning of the period and on the
(2) net monetary assets arising during the period.
For example, here's how we came up with the €52 FX gain in the quarter ended
3/31/2015:
■ The net monetary assets of £500 (£1,000 of cash - £500 of payables) at the beginning
of the 3/31/2015 quarter were last remeasured using an FX rate of 1.30 GBP/EUR on
12/31/2014.
■ When they are subsequently remeasured on 3/31/2015, the exchange rate is up by 10
euro cents moving to 1.40 GBP/EUR. This results in an FX gain of €50 (£500 x 0.10).
■ Similarly, the net monetary assets arising during the quarter, £40 increase in cash
(£100 of cash revenue - £60 of SG&A) were first measured on the income statement
using a weighted average exchange rate of 1.35 GBP/EUR.
■ When they are remeasured at the end of the quarter using the 1.40 GBP/EUR
exchange rate at that time, it results in an additional FX gain of €2 (£40 x (1.40 –
1.35)).
■ The two components add up to a total FX gain of €52 for the 3/31/2015 quarter.
We show the math behind the FX gain/(loss) from each period in Exhibit 32.
Exhibit 32: FX Gain/(Loss)
Source: Credit Suisse Accounting & Tax Research
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FX Translated 35
Appendix B – FX Translation Example
Let's continue with our example of God Save the Queen Plc (GSTQ) and its U.S. parent
Uncle Sam Inc. As seen in Appendix A – FX Remeasurement Example, GSTQ now has a
set of financial statements denominated in its functional currency, the euro. However,
Uncle Sam Inc. reports its results in U.S. dollars, so the financial statements of GSTQ
need to be translated from the functional currency - euros into the reporting currency - U.S.
dollars.
Balance Sheet FX Translation
We start with the GSTQ balance sheet in euros in Exhibit 33 (it may look familiar, since it’s
the same as Exhibit 28).
Exhibit 33: GSTQ's Balance Sheet Remeasured in Euros – Functional Currency
Source: Credit Suisse Accounting & Tax Research
When it comes to FX translation, current FX rates (i.e., rates in effect as of the balance
sheet date) are used to translate all assets and liabilities. Historical FX rates are used for
shareholders' equity (i.e., paid-in capital, retained earnings, etc. are accumulated over
time at FX rates in effect when equity is raised, net income is earned, dividends are paid,
etc.) In Exhibit 34, you can see the exchange rates over time and the FX rates used to
translate each line item on the balance sheet from euros into U.S. dollars.
Exhibit 34: Exchange Rates Used to Translate GSTQ's Balance Sheet
Source: Credit Suisse Accounting & Tax Research
30 July 2015
FX Translated 36
We arrive at the reporting currency (U.S. dollar) balance sheet in Exhibit 35, by applying
the exchange rates in Exhibit 34 to the functional currency balance sheet in Exhibit 33. For
example, the €1,300 cash in the functional currency balance sheet as of 12/31/2014 when
the FX rate is 1.20 EUR/USD gets translated into $1,560 (€1,300 x 1.20).
Exhibit 35: GSTQ's Balance Sheet Translated in U.S. Dollars – Reporting Currency
Source: Credit Suisse Accounting & Tax Research Note: Numbers may not sum due to rounding 1: Each period's translated net income is added to retained earnings (see Exhibit 39). 2: FX translation gains/(losses) from each period are accumulated (see Exhibit 36)
FX Translation Gain/Loss Reported in OCI
There is one line item that shows up on the translated balance sheet which needs some
further explaining, the cumulative translation adjustment. It has two components: the
impact of FX rate changes on the (1) net investment in GSTQ at the beginning of the
period and on the (2) net investment arising during the period.
For example, here's how we came up with the $74 FX translation gain for the quarter
ended 3/31/2015:
■ At the beginning of the 3/31/2015 quarter, Uncle Sam had a net investment in GSTQ
of €650, which was last translated using an exchange rate of 1.20 EUR/USD on
12/31/2014.
■ However, the exchange rate moved to 1.30 EUR/USD by the end of the quarter
resulting in an FX translation gain of $65 (€650 x 0.10).
■ The net income of €184 (was the only additional net investment during the quarter)
and it was originally translated at a weighted average exchange rate of 1.25
EUR/USD.
■ Translating it at the end of the quarter using the 1.30 EUR/USD exchange rate results
in an additional FX translation gain of $9 (€184 x (1.30-1.25)) after rounding.
■ The total FX translation gain for the 3/31/2015 quarter is $74 ($65 + $9).
We show the math behind the FX translation gain/(loss) from each period in Exhibit 36.
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FX Translated 37
Exhibit 36: FX Translation Gain/(Loss)
Source: Credit Suisse Accounting & Tax Research
Unlike the FX gain/(loss) due to remeasurement in Appendix A – FX Remeasurement
Example, the FX translation gain/(loss) does not (initially) hit the income statement. Given
the long term nature of the investments, these potentially temporary and possibly volatile
gains/losses will hang out in the Accumulated Other Comprehensive Income (AOCI)
section of shareholders' equity on the balance sheet. The FX translation gains/losses are
eventually reclassified into earnings when the foreign subsidiary is liquidated or sold.
Income Statement FX Translation
Next, in Exhibit 37 you'll find the income statement of GSTQ in its functional currency, the
euro (it should look familiar, since it’s the same as Exhibit 31).
Exhibit 37: GSTQ's Income Statement Remeasured in Euros – Functional Currency
Source: Credit Suisse Accounting & Tax Research Note: Assumes income is not taxed
30 July 2015
FX Translated 38
The line items on the income statement are supposed to be translated at the rates in effect
when the revenues/expenses are recognized but in practice companies typically use a
weighted average exchange rate for the period. In Exhibit 38 we provide the exchange
rates used to translate the income statement from euros into U.S. dollars.
Exhibit 38: Exchange Rates Used to Translate GSTQ's Income Statement
Source: Credit Suisse Accounting & Tax Research
We arrive at the reporting currency income statement for GTSQ in Exhibit 39 by applying
the FX rates from Exhibit 38 to the euro income statement in Exhibit 37. For example, the
€78 of SG&A for the period ended 12/31/2014 is translated into $94 (€78 x 1.20), when the
weighted average FX rate is 1.20 EUR/USD.
Exhibit 39: GSTQ's Income Statement Translated in U.S. Dollars – Reporting Currency
Source: Credit Suisse Accounting & Tax Research Note: Assumes income is not taxed
Cash Flow Statement FX Translation
In Exhibit 40 you'll find GSTQ's cash flow statement in its functional currency, euro. It's
been simplified and assumes that there were no investing or financing cash flows.
30 July 2015
FX Translated 39
Exhibit 40: GSTQ's Cash Flow Statement Remeasured in Euros – Functional Currency
Source: Credit Suisse Accounting & Tax Research
Exhibit 41 shows the exchange rates used to translate the different line items on the
GSTQ cash flow statement from euros into U.S. dollars. Beginning of period cash is
translated using beginning of period exchange rates and end of period cash is translated
using the end of period exchange rate. All cash inflows and outflows are supposed to be
translated using the FX rates when the cash flows occur. But in practice, weighted
average rates FX rates are used instead.
Exhibit 41: Exchange Rates Used to Translate GSTQ's Cash Flow Statement
Source: Credit Suisse Accounting & Tax Research
We arrive at the translated cash flow statement for GSTQ in U.S. dollars in Exhibit 42 by
applying the exchange rates shown in Exhibit 41 to the euro cash flow statement in Exhibit
40. For example, the €52 change in inventory for the period ended 6/30/14 is translated
into $62 (€52 x 1.20), when the weighted average FX rate is 1.20 EUR/USD.
30 July 2015
FX Translated 40
Exhibit 42: GSTQ's Cash Flow Statement Translated in U.S. Dollars – Reporting Currency
Source Credit Suisse Accounting & Tax Research Note: Numbers may not sum due to rounding
Effect of FX Rate Changes on Cash
Once again we have a line item that appears from out of nowhere and needs some
explaining, the Effect of FX Rate Changes on Cash. Well if you take all the line items on
the cash flow statement translated at a weighted average FX rate for the period you won't
be able to reconcile cash from the beginning of the period to the end of the period
especially when the beginning and ending cash balances are translated at different
exchange rates. You can think of it as a plug that allows the cash flow statement to
reconcile.
That plug has three components: the impact of FX rate changes on the (1) cash balance
from the beginning of the period and on the (2) cash flows during the period, plus any (3)
effect of FX rate changes on the functional currency cash flow statement that needed to be
translated into the reporting currency; we walkthrough the math in Exhibit 43.
Basically, you need to take each cash flow item and adjust it for the difference between
the FX rate at which it was translated earlier and the FX rate at the end of the period.
For example:
■ At the beginning of the 3/31/2015 quarter the €1,300 of cash was translated at a rate
of 1.20 EUR/USD.
■ However, by the end of the period, the rate was higher by 10 cents at 1.30 EUR/USD.
That results in an FX translation impact of $130 (€1,300 x 0.10).
■ Similarly cash flow from operations of €54 was earlier translated at the weighted
average rate of 1.25 EUR/USD, applying the end of period rate of 1.30 EUR/USD
results in another $3 of translation impact (€54 x (1.30-1.25)) after rounding.
■ Last but not least the €102 effect of FX rate changes from the functional currency cash
flow statement is translated into $133 (€102 x 1.30).
■ Those three components make up the $265 (after rounding) of effect of FX rates
changes on the 3/31/2015 cash flow statement.
30 July 2015
FX Translated 41
Exhibit 43: Effect of FX Rate Changes on Cash During Translation
Source: Credit Suisse Accounting & Tax Research Note: Numbers may not sum due to rounding
30 July 2015
FX Translated 42
Companies Mentioned (Price as of 28-Jul-2015)
Abbott Laboratories (ABT.N, $50.94) Archer Daniels Midland Inc. (ADM.N, $48.35) Avon Products Inc (AVP.N, $5.35) Baxter International Inc. (BAX.N, $38.09) Caterpillar Inc. (CAT.N, $77.78) E.I. du Pont de Nemours and Company (DD.N, $55.9) EMC Corp (EMC.N, $26.78) Google, Inc. (GOOGL.OQ, $659.66) Green Mountain (GMCR.OQ, $71.8) Harley-Davidson (HOG.N, $58.18) Hasbro (HAS.OQ, $79.57) Hexcel Corporation (HXL.N, $48.67) Honeywell International Inc. (HON.N, $104.2) Illinois Tool Works, Inc. (ITW.N, $88.74) International Business Machines Corp. (IBM.N, $160.05) McDonald's Corp (MCD.N, $97.33) Murphy Oil Corp. (MUR.N, $34.12) Nike Inc. (NKE.N, $113.47) Phillips-Van Heusen (PVH.N, $113.41) Procter & Gamble Co. (PG.N, $80.23) Ralph Lauren (RL.N, $126.61) Red Hat, Inc. (RHT.N, $78.73) Royal Caribbean Cruises (RCL.N, $82.7) Starbucks (SBUX.OQ, $57.14) The Coca-Cola Company (KO.N, $40.55) United Technologies Corp (UTX.N, $98.97) Williams-Sonoma (WSM.N, $81.77)
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30 July 2015
FX Translated 43
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Principal is not guaranteed in the case of equities because equity prices are variable.
Commission is the commission rate or the amount agreed with a customer when setting up an account or at any time after that.
Important Credit Suisse HOLT Disclosures
With respect to the analysis in this report based on the Credit Suisse HOLT methodology, Credit Suisse certifies that (1) the views expressed in this report accurately reflect the Credit Suisse HOLT methodology and (2) no part of the Firm’s compensation was, is, or will be directly related to the specific views disclosed in this report.
The Credit Suisse HOLT methodology does not assign ratings to a security. It is an analytical tool that involves use of a set of proprietary quantitative algorithms and warranted value calculations, collectively called the Credit Suisse HOLT valuation model, that are consistently applied to all the companies included in its database. Third-party data (including consensus earnings estimates) are systematically translated into a number of default algorithms available in the Credit Suisse HOLT valuation model. The source financial statement, pricing, and earnings data provided by outside data vendors are subject to quality control and may also be adjusted to more closely measure the underlying economics of firm performance. The adjustments provide consistency when analyzing a single company across time, or analyzing multiple companies across industries or national borders. The default scenario that is produced by the Credit Suisse HOLT valuation model establishes the baseline valuation for a security, and a user then may adjust the default variables to produce alternative scenarios, any of which could occur.
Additional information about the Credit Suisse HOLT methodology is available on request.
The Credit Suisse HOLT methodology does not assign a price target to a security. The default scenario that is produced by the Credit Suisse HOLT valuation model establishes a warranted price for a security, and as the third-party data are updated, the warranted price may also change. The default variable may also be adjusted to produce alternative warranted prices, any of which could occur.
CFROI®, HOLT, HOLTfolio, ValueSearch, AggreGator, Signal Flag and “Powered by HOLT” are trademarks or service marks or registered trademarks or registered service marks of Credit Suisse or its affiliates in the United States and other countries. HOLT is a corporate performance and valuation advisory service of Credit Suisse.
For Credit Suisse disclosure information on other companies mentioned in this report, please visit the website at https://rave.credit-suisse.com/disclosures or call +1 (877) 291-2683.
30 July 2015
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