Exchange rates fixed by a contract

Where a company contracts to settle a transaction at a particular rate of exchange, the exchange rate fixed by the contract must be used to record the transaction.
For Example: In 2005, Selvakan Ltd buys a computer system from a US manufacturer for $800,000. The contract specifies an advance payment of $50,000, a further $400,000 to be paid on delivery and the balance when the system has been successfully installed. All payments are to be made at an exchange rate of $1.55/£. The company acquires the computer system on 1 March 2005.

The company will record the purchase of the computer system at the contracted rate of $1.55/£ (i.e. at a cost of £516,130), regardless of the spot rate at 1 March. It will translate the payment of each installment of the purchase price at the same rate. Thus no exchange differences will arise. Even if some of the price remains unpaid at 31 December 2005, the liability will be translated at the contracted rate.

This treatment reflects the economic reality – the company is going to have to pay precisely £516,130 for the computer system, irrespective of how exchange rates move.

Recognition and the accruals concept

Reporting exchange gains and losses: the accruals concept

It might be argued that you shouldn't recognize exchange gains and losses in the profit and loss account until they are realized, or that you should recognize losses but not profits.

This is more of a problem with long-term than with short-term items.

In addition, there is a link between exchange rates and interest rates. A company that borrows in Euros will pay a different rate of interest from one that borrows in sterling. Thus if a company included foreign currency interest that it pays (or receives on a loan or deposit) in the profit and loss account without including exchange gains or losses on the principal sum, its accounts would reflect only part of its economic situation.

If, however, there are doubts about the convertibility or marketability of the currency - for example, if a company has made a loan in a currency that is subject to exchange controls - prudence wins out over the accruals concept. The company can decide to restrict the exchange gains it recognizes in the profit and loss account.

Recognition of unrealized exchange gains and losses on long-term monetary items means that in some cases a company's profits might vary considerably from year to year because of exchange rate fluctuations alone. This is one reason why many companies hedge foreign exchange risks

Recognition of translation gains and losses

Reporting exchange gains and losses

SSAP20 provides that Exchange differences arising on translating monetary items are generally recognized in the Profit and loss account. You will normally find exchange gains and losses arising from trading transactions (such as the £10 loss in the example, and the £150 profit in the first example under ‘other operating income or expense’. Gains or losses from financing arrangements (such as the £10,000 exchange loss on the bank borrowing in the first example) will normally come under ‘other interest receivable (payable) and similar income (expense)’. There is no requirement for the company to disclose in its statutory accounts what exchange differences are contained within these items. However, where a company submits a detailed profit and loss account with its corporation tax return, exchange differences will usually be separately identified.

This means that the company will recognize, as part of its normal operating profit, not only gains or losses on settled transactions but also gains and losses on unsettled items. It could be argued that it is not prudent to recognize exchange gains before they have actually been realized.

There are two exceptions to this general rule that exchange gains and losses form part of normal operating profits:

· Where there are doubts about the convertibility of the currency

· Where a long-term liability (or a currency contract) hedges the company’s investment in a foreign entity

Translating monetary and non-monetary items

Monetary assets and liabilities
Where monetary items, such as debtors, trade creditors or long-term loans, remain outstanding at the balance sheet date, they are translated at the closing rate.

For Example: On 5 November 2004, Selvakan Ltd sold goods to a French customer for €5,000. The exchange rate on that date was £0.62/€, so the company records the sale at £3,100. At the accounting date, 31 December 2004, the debt has not yet been paid. The exchange rate on 31 December is £0.65/€. The company translates the trade debt at the closing rate, so it appears in the balance sheet as £3,250. The company will report an exchange profit of £150.
In 2003, Selvakan Ltd borrowed €200,000 from a bank for five years. In the company’s accounts to 31 December 2003, the loan was translated at the closing rate of £0.60/€, i.e. to £120,000. In its 2004 accounts, Selvakan Ltd must re-translate the loan to the 31 December 2004 rate, so it appears on the balance sheet at £130,000. The company reports an exchange loss of £10,000.

Non-monetary assets

Non-monetary assets are translated at the historical rate of exchange when they were acquired, and are not re-translated.

For Example: On 1 April 2004, when the exchange rate is £0.58/€, Selvakan Ltd buys a lease on an office in France for €500,000. It records the asset at £290,000. The cost of the lease is shown in the company’s balance sheet at 31 December 2004, and subsequent balance sheets, as £290,000. Amortization of the lease charged in the accounts is also based on £290,000.

Meaning of Transactions

A transaction, such as a sale or a purchase, is translated at the rate of exchange in operation at the date of the transaction.

For Example: Selvakan Ltd, a manufacturing company which draws up accounts to 31 December, purchased raw materials from a French supplier for €1,000. It recorded the transaction on 1 June 2004, the date of the supplier’s invoice. On that date, the exchange rate was £0.59/€. It therefore recorded the purchase price as £590.

On 28 June 2004 the company sent a draft for €1,000 to the supplier. The exchange rate on that date was £0.61/€. Thus the company records a payment of £610 – it has made an exchange loss of £20.

As an approximation to translating transactions at the spot rate for each day, the company can use an average rate of exchange provided that the currency in question does not fluctuate significantly. For example, a shop selling tourist souvenirs, which accepts large numbers of cash payments in dollars and euros, might translate foreign currency sales at an average exchange rate for the week, or the month. However, it wouldn’t be appropriate for a company which has a small number of high value foreign currency transactions to use an average exchange rate. This would not give a reasonable approximation to using the spot rate for the day of each individual transaction.

Meaning of Branch:

‘Foreign branch’ tends to summon up a picture of an office or factory located in an overseas territory, conducting its own operations with its own staff. But SSAP20 defines branch more widely than this. For example, a shipping company might account for an individual ship, and all the receipts and expenses associated with that ship, as a branch, where the ‘part business’ represented by the ship operates in a foreign currency.

SSAP20 BASIC PRINCIPLES

Translating transactions

The basic principles for translating foreign currency items in an individual company’s accounts are set out in SSAP20.

ACCOUNTING STANDARDS AND FOREIGN INVESTMENT

Investing in foreign enterprises

SSAP20 provides a standard for foreign currency translation in an individual company’s accounts. But it also addresses a second problem. In addition to undertake foreign currency transactions on its own behalf, a company may invest in an enterprise that operates, and keeps its financial records, in a foreign currency.

One of the most common ways a company can invest in a foreign entity is to hold shares in an overseas subsidiary. In this situation, the company must consolidate the results of the foreign subsidiary into its own accounts, either because the company itself publishes consolidated accounts or as a step in preparing consolidated accounts for a larger group. If the subsidiary accounts in a foreign currency, it will be necessary to translate the assets and liabilities in the subsidiary’s balance sheet, and its profit and loss account, into authentic before consolidation.

A company may also have one or more branches that keep financial records, and draw up financial statements, in a foreign currency. The company will need to translate the branch results into pure in order to incorporate them into its individual company accounts. This is almost precisely the same problem as translating the accounts of a foreign subsidiary.

ACCOUNTING STANDARDS AND TRANSLATION

The need for a standard

The question of whether items should be translated at the balance sheet date at the closing rate, or carried at the historical rate, doesn’t just apply to trade debts. The same question arises on any asset or liability denominated in a foreign currency – for example, fixed assets, short or long- term borrowings or investments of various kinds.

A company could:

· translate all its assets and liabilities at the closing rate

· or adopt what is called the temporal method

· or translate current assets and liabilities at the closing rate, and long-term assets and liabilities at the historical rate

· Or translate monetary assets and liabilities at the closing rate, and non-monetary items at the historical rate.

SSAP20 does not apply to small companies that use the Financial Reporting Standard for Smaller Entities (FRSSE). The FRSSE, however, sets out a treatment for foreign currency items that are essentially identical to SSAP20

· Input Mix

Outright additions to facilities overseas accomplish a manufacturing shift. A more flexible solution is to purchase more components the flexibility to shift purchases of outsourcing. Outsourcing gives the company the flexibility to shift purchases of intermediate inputs towards suppliers least affected by exchange rate changes.

· Plant Location

A firm without foreign facilities that is exporting to a competitive market whose currency has devalued may find that sourcing components abroad is insufficient to maintain unit profitability. Third country plant locations are a viable alternative in many cases.

Many Japanese firms, for example, have shifted production offshore to Taiwan, South Korea, Singapore & other developing nations as well as United States in order too cope with the high Yen.

· Raising Productivity

Raising productivity through closing inefficient plants, automating heavily & negotiating wage & benefit cutbacks & work rule concessions is another alternative to mange economic exposure. Employee motivation can also be used to heighten productivity & improve product quality.

PRODUCTION MANAGEMENT OF EXCHANGE RISK

Sometimes, the exchange rate moves so much that pricing or other marketing strategies do not save the product. Product sourcing & Plant location are the principle variable that companies manipulate to manage competitive risks that cannot be managed through marketing changes alone.

· Product Sourcing

Multinational firms with worldwide production systems can allocate their several plants in line with the changing home currency cost of production, increasing production in a nation whose currency has devalued & decreasing production in a country where there has been a revaluation.

A strategy of production shifting presupposes that a company has already created a portfolio of plants worldwide.

The cost of multiple sourcing is especially great where there are economies of scale that would ordinarily dictate the establishment of only one or two plants to service the global market. Despite the higher unit cost associated with the smaller plants, currency risk may provide one more reason for the use of multiple production facilities

· Promotional Strategy

Promotional Strategy should similarly take into account anticipated exchange rate changes. A key issue in any marketing program is the size of the promotional budget for advertising, personal selling & merchandising.

Promotional decisions should explicitly build in exchange rates, especially in allocating budgets among countries.

A firm exporting its products after a domestic devaluation may well find that the return per dollar expenditure on advertising or selling is increased because of the product’s improved price positioning. Foreign currency devaluation, on the other hand, is likely to reduce the return on marketing expenditures & may require a more fundamental shift in the firm’s product policy.

a. Frequency of Price Adjustments:

Firms in international competition differ in their ability and willingness to adjust prices in response to exchange rate changes. Some firms constantly adjust their prices for exchange rate changes. However, other companies feel that stable prices are a key ingredient in maintaining their customer base.

For example: A customer who have invested in machinery or other assets that operate best with supplies from the selling firm may value a contract that is fixed in both price & quantity. Similarly, the company may try to shield risk-averse customers by offering them prices fixed in their local currency for a certain period of time.

It is important also not to neglect the effect of frequent price changes on the exporter’s distributors, who must constantly adjust their margins to conform to the prices they pay. A number of firms now have different list prices for domestic & foreign customers in order to shield their foreign customers- especially those who sell through catalogues from continual revisions of overseas prices.

a. Market Share Vs Profit Margin:

In the wake of a rising dollar, a US firm selling overseas or competing at home against foreign imports faces a Hobson’s choice: Does it keep its dollar price constant to preserve its profit margin & thereby, lose sales volume, or does it cut its dollar price to maintain market share & thereby, suffer a reduced profit margin? Conversely, does the firm use a weaker dollar to regain ground lost to foreign competitors or does it use the weak dollar to raise prices & recoup losses incurred from the strong dollar?

To begin the analysis, a firm selling overseas should follow the standard economic proposition of setting the price that maximizes dollar profits (by equating marginal revenues & marginal costs) .n making this determination, however, profits should be translated using the forward exchange rate that reflects the true expected dollar value of the receipts upon collection.

Following appreciation of the dollar, this is equivalent to foreign currency (FC) depreciation; a firm selling overseas should consider opportunities to increase the FC prices of its products. The problem, of course, is that local producers now will have a competitive cost advantage, limiting an exporter’s ability to recoup dollar profits by raising FC selling prices.

· Product Strategy

Companies can also respond to exchange rate changes by altering their product strategy, which deals with such areas as new product introduction

a. Product Line Decisions

b. Product Innovations

Following home currency devaluation, a firm will potentially be able to expand its product line & cover a wider spectrum of consumers abroad & at home. Conversely, following home currency appreciation, a firm may have to reorient its product line & target it to a higher income, more quality conscious, less price sensitive consumers.

Equivalent strategy for firm selling to the industrial, rather than the consumer, market and confronting a strong home currency is product innovation, financed by an expanded R & D budget.

· Pricing Strategy

Two key issues that must be addressed when developing a pricing strategy in the face of currency unpredictability are whether to emphasize market share or profit margin & how frequently to adjust prices.

MANAGING ECONOMIC EXPOSURE

Some of the proactive marketing & production strategies which a firm can pursuer in response to anticipated or actual real exchange rate changes are as follows:

· MARKETING INITIATIVES

· Market selection

a. Product Strategy

b. Pricing Strategy

c. Promotional Strategy

· PRODUCTION INITIATIVES

a. Product sourcing

b. Input mix

c. Plant Location

d. Raising Productivity

MARKETING MANAGEMENT OF EXCHANGE RISK

· Market Selection

Major strategy considerations for an exporter are the markets in which to sell, i.e., market selection. It is also necessary to consider the issue of market segmentation with individual countries. A firm that sells differentiated products to more affluent customers may not be harmed as much by a foreign currency devaluation as will a mass marketer. On the other hand, following a depreciation of the home currency, a firm that sells primarily to the upper income group may now find itself able to penetrate mass markets abroad.

MEASURING ECONOMIC EXPOSURE -

The degree of economic exposure to exchange rate fluctuations is significantly higher for a firm involved in international business than for a purely domestic firm. Assessing the economic exposure of an MNC is difficult due to the complex interaction of funds that flow into, out of and within the MNC. Yet, economic exposure is crucial to operations of the firm in the long run. If an MNC has subsidiaries around the world, each subsidiary will be affected differently by fluctuations in currencies. Thus, attempts by the MNC to measure its economic exposure would be extremely complex.

ONE method of measuring an MNC’s economic exposure is to classify the cash flows into different items on the income statement & predict movement of each item in the income statement based on a forecast of exchange rates. This will help in developing an alternative exchange rate scenario & the forecasts for the income statement items can be revised. By assessing how the earnings forecast in the income statement has changed in response to alternative exchange rate scenario, the firm can assess the influence of currency movements on earnings and cash flows.

· Exposure Netting

Exposure netting involves offsetting exposures in one currency with exposures in the same or another currency, where exchange rates are expected to move in such a way that losses(gains) on the first exposed position should be offset by gains (losses ) on the second currency exposure.

The assumption underlying exposure netting is that the net gain or loss on the entire exposure portfolio is what matters, rather than the gain or loss on any individual monetary unit.

· ECONOMIC EXPOSURE (MONETARY)

It refers to the level to which a firm’s present value of future cash flows can be influenced by exchange rate fluctuations. It is a more managerial concept than an accounting concept. A company can have an economic exposure to say Pound/Rupee rates even if it does not have any transaction or translation exposure in the British currency. This situation would arise when the company’s competition are using British imports .If the Pound weakens, the company loses its competitiveness or vice versa if the Pound becomes strong.

Economic exposure to an exchange rate is the risk that a variation in the rate will affect the company’s competitive position in the market and hence its profits. Further, it affects the profitability of the company over a longer time span than transaction or translation exposure.

Under the Indian exchange control, economic exposure cannot be hedged while both transaction & translation exposure can be hedged.

Economic exposure measures the impact of an actual conversion on the expected future cash flows as a result of an unexpected change in exchange rates. A MNC may have established its subsidiary in a country with price stability, favorable balance of payments, low rates of taxation & readily available funds. However, if the economic situation of the country were to deteriorate, these positive aspects may get reduced over time & the local currency will depreciate. The subsidiary is likely to face immediate problems if it has to pay its imports in hard currencies & in case it has borrowed from abroad.

· Options Market Hedge

In many circumstances, the firm is uncertain whether the hedged foreign currency cash inflow & outflow will materialize (turn up). Currency options obviate this problem.

There are two kinds of options.

A PUT OPTION gives the buyer the right, but not the obligation, to sell a specified number of foreign currency units to the seller at a fixed price up to the option’s expiration date.

Alternatively, a call option is the right, but not the obligation, to buy a foreign currency at a specified price, up to the expiration date.

A CALL OPTION is valuable, for example, when a firm has offered to buy a foreign asset, such as another firm, at a fixed foreign currency price but is uncertain whether its bid will be accepted.

The GENERAL RULE to follow when choosing between currency options & forward contracts for hedging purposes are summarized as follows:

1. When the quantity of a foreign currency cash outflows is known, buy the currency forward, when the quantity is unknown, buy a call option on the currency.

2. When the quantity of a foreign currency cash inflow is known, sell the currency forward, when the quantity is unknown, buy a buy option on the currency.

3. When the quantity of foreign currency cash flow is partially known & partially uncertain, use a forward contract to hedge the known portion & an option to hedge the maximum value of the uncertain remainder.

MANAGING TRANSACTION EXPOSURE

The various methods available to a firm to hedge its transaction exposure are:

· Forward Market Hedge

In a Forward Market Hedge, a company that is long in a foreign currency will sell the foreign currency forward, whereas a company that is short in a foreign currency will buy the currency forward. In this way the company can fix the dollar value of future foreign currency cash flow.

If funds to fulfill the forward contract are available on hand or are due to be received by the business, the hedge is considered “Covered” “Perfect” or “Square” because no residual foreign exchange risk exists.

Funds on hand or to be received are matched by funds to be paid. In situations where funds to fulfill the contract are not available but have to be purchased in the spot market at some future date, such a hedge is considered to be “ Open” or “Uncovered”. It involves considerable risk as the hedger purchases foreign exchange at an uncertain future spot rate in order to fulfill the forward contract.

· Money Market Hedge

A Money Market Hedge involves simultaneous borrowing & lending activities in two different currencies to lock in the home currency value of a future foreign cash flow. The simultaneous borrowing & lending activities enable a company to crate a home-made forward contract.

The firm seeking the money market hedge borrows in one currency & exchanges the proceeds for another currency. If the funds to repay the loan are generated from business operation then the money market hedge is covered. Otherwise, if the funds to repay the loan are purchased in the foreign exchange spot market then the money market hedge is uncovered or open.

TRANSACTION EXPOSURE BASED ON CURRENY VARIABILITY

In actual practice, MNC’s have their own method for developing exchange rate projections.

· Historical method

MNC’s can use the historical data for the past few years to assess the expected movement for each currency.

· Standard method

MNC’s use the standard deviation method very frequently to measure the degree of movement for each particular currency. The idea of this method is to assess & broadly identify some currencies which fluctuate more widely than others.

For example, during the period 1974-1989, it was found that the German mark had a standard deviation of about 6%, Canadian dollar of approx 2%, British pound & French franc of approx 5%. Based on the above information, a US based MNC’s may feel that an open asset or liability position in Canadian dollars is not as problematic as an open position in other currencies.

The standard deviation of a currency may change over time. Thus, a MNC may not be able to predict the future variability of a currency with perfect accuracy; it can only identify currencies whose values are most likely to be stable or highly variable in the future. Thus, assessing the currency variability over time helps an MNC to measure its transaction exposures.

MEASUREMENT OF TRANSACTION EXPOSURE

Transaction exposure measures gains or losses that arise from the settlement of existing financial obligation whose terms are stated in a foreign currency.

STEPS for measuring transactions exposure are:

1. Determine the projected net amount of currency inflows or outflows in each foreign currency.

2. Determine the overall exposure to those currencies.

The first step in transaction exposure is the projection of the consolidated net amount of currency inflows or outflows for all subsidiaries, classified by currency subsidiary.

For example:

· Incase of a centralized approach, while assessing the MNC’s exposure, it is advisable, to determine the MNC’s overall position in each currency as a first step.

Like, Subsidiary A may have net inflows of $ 6, 00, 000 while subsidiary B may have net outflows of $ 7, 00, 000. The consolidated net inflows here would be - $ 1, 00 ,000. If the other currency depreciates, Subsidiary A will be adversely affected while Subsidiary B will be favorably affected. The net effect of the Dollars depreciation on the MNC”S is minor since an affecting effect takes place. It could have been substantial if most subsidiaries of the MNC”S had future inflows of US dollars.

· Incase of a non-centralized approach, each subsidiary acts independently & assesses & manages its individual exposure to exchange rate risk. Such an approach gives important responsibilities to each subsidiary to plan out its future strategy in accordance with currency movements.

Like, MNC’s has two subsidiaries in France. One subsidiary receives 10 million British pounds each month as a result of exports sent to UK. The other subsidiary pays 10 million pounds per month to purchase supplies from a UK firm. The subsidiaries act independently to hedge their exposure & the local bank that helps both subsidiaries has a bid-ask spread of approx 1% on its forward rates. Thus, it provides French francs in exchange for pounds to one subsidiary & sells these pounds to the other subsidiary in exchange for French francs for 1% more. The spread on 10 million pounds represents 1, 00,000 pounds per month or 1.2 million pounds per year. If the MNC’s were to centralize its exposure management, hedging would not be necessary as the exposures of the individual subsidiary would offset each other. The transaction fee paid to the bank could also be avoided.