Accounting

Accounting for FX Volatility: A Q&A With Columbia’s Trevor S. Harris and Shiva Rajgopal

With dramatic shifts in currency markets, ongoing strength in the U.S. dollar and geopolitical uncertainty, financial leaders face expanding challenges in managing foreign exchange risk and reporting the results of the effects of FX volatility on their companies’ performance.

To understand how financial leaders are dealing with FX volatility issues, the Financial Executives Research Foundation, the Center for Excellence in Accounting and Security Analysis at Columbia Business School, and EY are collaborating on a survey and report titled Addressing Foreign Exchange Volatility.

FEI Daily spoke with Trevor S. Harris, The Arthur J. Samberg Professor of Professional Practice and Co-Director, Center for Excellence in Accounting and Security Analysis at Columbia Business School, and Shiva Rajgopal, Kester and Byrnes Professor of Accounting and Auditing at Columbia Business School.

FEI Daily: Can you describe the FX environment today?

Trevor Harris:  There are two impacts of the exchange rate environment that affect many companies.  The dollar has been strengthening over the last 12 months beyond what people expected. With the economic and geopolitical situation in the rest of the world, this appreciation has also occurred against other major currencies like the euro, sterling, the yen and the yuan. There are many who believe this trend is continuing and many market participants believe we’re going to reach parity with the euro. This change seems to be a structural shift but the path is not smooth so there is daily volatility that makes it tricky for those transacting in multiple currencies. This first impact, on transactions, is relatively easy to isolate, understand and then manage over the short to medium term.

The second impact relates to the more complex question of how the exchange rate trend and volatility impacts the reported results of multinational businesses with subsidiaries operating and reporting in multiple currencies.  The issue revolves around how consolidated accounts reflect the underlying economic reality and how this is dealt with for internal measurement, performance evaluation, transaction activity, and communication with senior executives — non-financial executives in particular — as well as board members and investors.

So when you ask about the foreign exchange environment, it is useful to differentiate between the transaction-based space, which is where most people start in their thinking, and the more complex aspect of how foreign operations end up being incorporated into consolidated data, whether it’s internal or external data.

FEI Daily: Within that performance management reporting aspect, what are some of the biggest challenges that companies have to consider?

Trevor Harris:  To appreciate the issues, we know most managers and investors look to relative revenue growth over different points in time. So let’s start with a simple situation. If you have 100 euros in sales in a subsidiary in Europe, let’s say that would have translated to $130 not long ago when it was $1.30 per euro. Now, if the value changes to $1 to a euro, and we’re getting close to that, suddenly that’s only $100. The underlying fundamentals of the sales didn’t necessarily change. It’s just the translation of those sales into dollars that’s changed. The reported measure changes significantly, but how sustainable is this and what inference should we take from it?

That’s just revenue, but then there’s the question of how your costs are impacted and reflected relative to that, and that’s where you get into factors such as where it’s manufactured, how long the inventory holding periods are, et cetera. If it’s sourced in a dollar-linked currency such as some of the Asian currencies, you get a lot of margin differences as well.

Let’s say their earnings previously was $50 and now it’s, say, $40. That’s a different percentage difference to the change in revenue. What are you communicating to the CEO or the board? How much are you actually explaining the translation of it versus the actual underlying performance?

Then the question is, if you wanted to hedge the reported measure or measures, what would you choose to hedge: the revenue, the costs, the earnings or some other measure? Are you hedging accounting numbers or are you hedging actual cash flows, and if it the latter, which flows? People can make a lot of different choices and this has implications for how users interpret the data especially if using comparative data across companies and/or time.

One of the misunderstandings or distortions is that people assume that they can just focus on cash. That’s not true, because if cash is flowing in multiple currencies, how do you reflect that in the dollar cash-flow measures? Again, there are lots of different ways that people do this. What does it really mean and how would you extrapolate that going forward? How do you look at the starting point of both trends?

Then, how much are you communicating with your investor community? Many public companies give guidance for earnings, but do they indicate the potential exchange rate impacts in that guidance? That’s looking forward. Once the actuals occur, how much are they actually splitting up their performance to reflect the various currency effects? In principle, you could split it up at most line items, and we’re just talking about the income statement. The question is what companies are actually doing. Anecdotally, we know managers make different choices, but we want to get more systematic information on the practices.

It’s a very complex array of potential measurements that can arise, and then there is a question of how you communicate these to different participants in the system? This is as much an internal reporting issue as an external reporting issue.

Shiva Rajgopal: To add to that, there’s often a variation between what companies tell the board and what they tell the investors or analysts. A lot of companies break out the balance impact on revenue and net income, while some break out operating cash flow, or assets or liabilities.

FEI Daily: It’s not uncommon to see, in earnings reports, a GAAP number, then a non-GAAP constant currency number.

Trevor Harris: Even that’s interesting. In principle, constant currency sounds plausible, but what does it mean? From a business point of view, the other complication is how much you absorb the impact of those currencies and how much you pass on to your customers. Again, depending on which way the currencies are going, you may end up being more, or less, competitive so currency volatility can have a more direct effect on the underlying success of the products and businesses.

The other part of that is, people talk always about the earnings number, which is fine, but there’s also the adjustment to other comprehensive income, which in volatile times is often very large relative to income. When you start doing various ratio analyses using return on equity or other mixes of income and balance sheet measures, it starts becoming quite interesting as to what one should do.

FEI Daily: Are we seeing more companies pay attention to these exposures?

Trevor Harris: Absolutely. What’s interesting about the debate in the U.S. at the moment with respect to potential changes in the globalization of markets is that it’s getting to be more complicated because of the currency situation. The Mexican peso, for instance, has declined by about 20 percent since the election. If you’re talking about shifting production to the United States, irrespective of other cost structure issues, that’s a fifth you’re adding to your costs. How does that affect your competitiveness?

That’s why I say it goes beyond the simple accounting issues. It’s a much more problematic issue. There’s always a question of whether these shifts are structural versus just some short-term volatility. For a while, people thought that the strengthening dollar was part of short-term volatility, so it was just part of everyday business. But as we’ve seen, the trend of a strengthening dollar has been occurring over the last couple of years suggesting it is more structural which means companies have to adapt their strategies.

FEI Daily: Do hedging strategies tend to vary by company size?

Trevor Harris: Yes and no. I think there are different degrees of sophistication and resources, and the larger the company, to some extent, the more they can do. The other thing that does happen, and this can work for you or against you, if you have a global spread of business, potentially you have the ability to have more internal hedges, because you can have, for example, receivables or sales in one business in euros and costs and payables in a different business in euros. When you look at them together, you can actually get some natural hedging. To be able to do that, to be able to capture that and analyze it properly, you have to have centralization of cash management and exposures which can differ depending on the size and complexity of a business. But it may be easier to justify in a large business.

Another interesting part of this is, that while the consolidation and netting of exposures is fine for the consolidated results, a question arises as to what you do with the individual subsidiary’s and business unit’s results?  If you’re a small entity, in some ways it’s easier because it’s much easier to see the actual positions and flows and you understand how the consolidated results are impacted.

The survey we are conducting is to learn from as many companies and senior financial executives what they are doing so we can bring more clarity to these many questions.

To participate in the Addressing FX Volatility Survey, please click here.