When financial statements hit the C-suite, they're often accompanied by detailed analyses explaining what impacted cost of sales, what caused any revenue shortfalls, and why operating expenses exceeded budgets. Explanations of these metrics, however, are often interrupted by pointed questions from senior management: "What happened in foreign exchange? And what the heck caused that FX loss?" An executive with these questions usually has to wait for the answers.

The FX Gain/Loss line on financial statements is poorly understood by most finance and accounting professionals. In fact, it's frequently the only earnings line without Sarbanes-Oxley controls a decade after that law passed and two decades after the COSO framework was released.

On its face, that's surprising. The elements underlying foreign exchange (FX) gains and losses are all arrived at with common math. There's no calculus, no Monte Carlo simulations, and no linear algebra; it's simply addition, subtraction, multiplication, and division. Why, then, is there so much mystery around the result? Why can't every treasury and accounting organization quickly and efficiently explain how it multiplied, divided, subtracted, and added up the numbers?

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Unfortunately, just because the math is easy doesn't mean the process isn't complex. "Legitimate" FX gains and losses are limited to the impacts that non-functional currencies have on functional-currency financial statements, together with certain currency hedges. Distilling the sources of these "legitimate" gains and losses is difficult enough. Making things harder is the fact that ERP systems generate additional, problematic, and—dare we say—"illegitimate" gains and losses.

How should a corporation deal with this issue? The first step is to perform regular analyses, including automated, regular dissection of the FX Gain/Loss line, with the goals of highlighting hedge-program weaknesses, facilitating proactive process improvement, and replacing the "Whac-A-Mole" approach to risk management. Of course, this requires a thorough understanding of the events and the math that create FX gains and losses.*

 

FX Gain/Loss Source #1: Unhedged Exposures

U.S. GAAP requirements (and the programming of most ERP software) dictate that new currency activity be recorded at a "current" FX rate, with the value of unsettled monetary assets and liabilities adjusted at each month-end. Whether this adjustment shows up in the FX Gain/Loss line depends on two factors: the functional currency of the entity recording the transaction and whether the balance that is created is monetary in nature.

Unless you are hedging, only monetary activity in non-functional currencies impacts the FX Gain/Loss. A classic example would be the recording of revenue and the related receivable. When initially recorded, the transaction's functional-currency value is determined using the then-current FX rate, which may be the company's income statement rate or a daily spot rate. At each period-end between the recording of the receivable and receipt of the currency, accounting adjusts the receivable balance to reflect the functional-currency value at the period-end exchange rate. Gains and losses accumulate until the currency is received, at which time the gain or loss is finalized. And even after the currency is received, the company's ERP system will continue to revalue the cash until it is converted into the functional currency.

To check the accuracy of its current-month FX Gain/Loss line, a company can look at its non-functional monetary asset/liability balances at both current and prior month-ends; see Figure 1, below. Mathematically, this takes the balance as of the last month-end and revalues it to the current month-end. It then captures all changes in that balance, at the rate that the ERP system assigned to transactions in the period, and adjusts them to the month-end rate. This calculation can help a treasury team quickly validate the magnitude and direction of currency gains and losses by entity, unless the company has substantial unhedged conversions. 

 

FX Gain/Loss Source #2: Unhedged Conversions

Another element of the FX gain or loss on a transaction is the actual currency rate used for any conversion activity during the period. Conversions either create exposures or settle exposures. But they don't happen at the income statement rate; they happen at the rate agreed upon with the bank that is making the conversion—usually a spot rate.

Figure 1 is built on the assumption that all FX conversions happen at the corporate income statement rate. But because unhedged conversions do not happen at that rate, their impact must be calculated separately. Figure 2, below, shows how to calculate the effects of the currency conversion, which can be used to adjust the value calculated in Figure 1.

One classic problem related to conversions is associated with rolling-hedge programs, in which currency traders tend not to hedge any amounts that they expect to be delivered within the current month. Basically, a trader will hedge an exposure up until the last few days or weeks, then allow it to run unhedged until conversion. Gains or losses in the short unhedged period fall into the "unhedged conversion" category described here. Note that if an entity has a hedging program and the conversions are coordinated with the hedging program, no impact is expected from the conversion activity, as the monetary asset/liability and the hedge will be settled at the same rate.

For companies that do not hedge, the sum of the unhedged exposure and the unhedged conversion should precisely equal (to the penny, if you are that committed) the amount on the FX Gain/Loss line. To look for problems in its processes, a company can calculate its gains and losses in each non-functional currency, then translate them to the reporting currency at the income statement rate, and compare the result with values reported through the consolidation process. Problems this exercise exposes often include:

  • unintended misclassifications between the revenue or cost lines and FX Gain/Loss,
  • differences in intercompany transaction and consolidation rates, and
  • the ongoing recording of FX gains or losses on already-closed transactions—generally associated with transactions recorded in one currency and closed out in a second currency.

Companies that use automated remeasurement in their ERP systems, but haven't implemented ongoing processes to identify and correct improper currency activity, are almost certain to be recording some amount of FX incorrectly. It is important for corporate treasurers to understand the difference between the income statement currency rate used in consolidations and the rate at which intercompany transactions are recorded by the subsidiary that uses the non-functional currency. Using one rate to record intercompany revenue or costs and a second rate to translate entities' financial statements into the reporting currency creates intercompany P&L activity that does not eliminate. For example, if a foreign subsidiary's transaction in a non-functional currency is translated into U.S. dollars by the parent company using the daily rate, but during consolidation the offsetting transaction is converted to dollars using the average FX rate for the month, the end result will be a balance that does not offset.

ERP modules recognize that intercompany activities must eliminate; the translation rate trumps other rates, and the system forces an entry to record the difference as an FX gain or loss. In effect, the entry recasts intercompany revenue or costs on both entities' books using the income statement rate from the consolidations process. Few companies understand this source of "mysterious" gains or losses that arise during consolidations. In calculating an entity's unhedged FX Gain/Loss, companies generally look to the rate at which intercompany transactions were booked, then revalue the transactions to the balance sheet rate. Instead, they should use the income statement rate in order to capture all the gains and losses in consolidated earnings that result from using different rates to record transactions and consolidations.

Understanding this nuance in rates is critical in capturing the timing impact of hedges. To correctly calculate it, analysts need to compare the hedge rate with the correctly identified P&L rate when evaluating intercompany activity.

 

FX Gain/Loss Source #3: Over- or Under-hedging

When the notional amount of open hedges that a company has in a particular currency at the end of a period does not equal the notional amount of exposures to that currency pair at the same period-end, the organization is either over-hedged or under-hedged. Either scenario reflects a lack of perfect knowledge by the hedging team. Under-hedging is definitely preferable, as companies that over-hedge have hedges that increase, rather than mitigating, risk.

If, for example, a U.S. dollar entity had short-hedge open positions totaling EUR400 and a long remeasurement exposure of EUR500, the entity would be under-hedged by EUR100. To calculate the impact on the FX Gain/Loss line, we would have to distinguish between the impact of the EUR100 shortfall and the timing of when the EUR400 hedge was placed. So we would need to calculate the impact of the rate at which the trade was executed to determine the timing impact (see FX Gain/Loss Source #4). Meanwhile, we would need to determine the impact of being under-hedged using our month-end notional balances.

The circuitous route to capturing the effect of over- or under-hedging is to apply the calculation from Figure 1, independently, to both the exposures and the hedge. But the same impact can be captured more quickly using the net notional of the exposure and the hedge; see Figure 3, below. This captures the change in value of the net balance over the current period (from end of last period to end of this period), then captures the change in net balance from last period to this period from the period income statement rate to the balance rate.

 

 

FX Gain/Loss Source #4: Timing

The timing effect quantifies the slippage between the spot rate on new hedges executed during the period and the income statement rate at which the exposures were created or closed in the accounting system. This impact is captured by comparing:

  • the rate executed on any hedges opened or closed in the period, and
  • the income statement rate used in the over- or under-hedge calculation, applied to the notional amount of the hedge.

Consider a company that hedges an amount exactly equal to its exposure balance at month-end, and that executes the hedge on the last day of the month. That company's FX Gain/Loss line would not reflect any gains or losses related to being over- or under-hedged. All of its hedge ineffectiveness in that month would arise from the difference between the FX rates on the dates of the transactions that generated the currency exposure and the FX rates on the last day of the month, when the hedges were placed. Conversely, if the company set its income statement rate on the last day of the prior month and executed hedges at that spot rate, it would not record a timing-related FX gain or loss.

To eliminate FX gains or losses caused either by timing of hedges or by over- or under-hedging, a company using the prior-month balance sheet FX rate as its income statement FX rate would need to place a hedge on the last day of the month for an amount equal to both:

  • the month-end exposure balance on the rate-setting date, and
  • all the new activity for the new month.

And the hedge would need to be placed at the exact rate used to translate non-functional-currency activity into functional currency.

The lion's share of ineffectiveness in balance sheet hedging programs arises from a combination of timing and over- or under-hedging of positions. Hedgers frequently choose the lesser of two evils and focus on either reducing the timing difference by hedging when income statement rates are set, even if the hedging team doesn't have perfect information at that time, or else waiting until good information is in hand but possibly missing the chance to enter a hedge at the exact exchange rate that will be used to record each exposure. Perfect hedging would require both perfect information and the ability to execute the hedge at the rate used to value the exposure on the company's financial statements.

 

FX Gain/Loss Source #5: Forward Points

Many hedgers expect the forward points on a hedge to amortize consistently over the life of the hedge. Although the total gain or loss associated with forward points can be precisely forecast at trade execution (barring early compensation), the timing of gains or losses may vary from period to period. In unusual market environments, forward points that are guaranteed to provide a loss over the life of the derivative may actually provide gains in one period or another.

Although the current-period impact of the forward points in each open forward contract is generally not a major driver of the FX Gain/Loss line, it can be identified. To start, a company should capture the notional on each contract at its starting value—the all-in rate for a new contract in the period, or the spot rate and forward points used to value an existing contract at prior period-end. Then it should recalculate the notional at the spot plus forward points used at contract-end (zero forward points for contracts that close during the month) or current period-end. From the difference between these values, subtract the spot-to-spot changes in the contract during the period. The result is the forward point impact.

On a quarter-to-quarter basis, this number is generally expected to amortize downward, consistently moving from the value locked in at contract execution to zero. On occasion, however, when the interest rate or currency markets are agitated, currency forward points can swing unexpectedly. Currencies in which a company has historically earned points may swing so that the company is paying points. When these market anomalies occur, it is important to recognize that although the forward point values may swing around, the company will always end up earning (or paying) the forward points on the contract unless the contract is terminated early.

 

FX Gain/Loss Source #6:  Market Rate vs. Month-End Rate

Occasionally, a company will use a different balance sheet rate for remeasurement than it uses to determine the fair value of the derivatives that hedge those exposures. When that occurs, the discrepancy will be reflected in the FX Gain/Loss entry.

The use of different rates may reflect a requirement to use a government rate, but more often it occurs because the balance sheet rate is set in advance of month-end and auditors are not comfortable using that rate in determining the market value of the company's hedges. Historically, companies would set their balance sheet rates two business days prior to month-end to facilitate communicating the rate to subsidiaries around the world. In addition, treasury departments preferred to set rates early because they rolled their entire hedge portfolios every month, and settling in cash two days after the roll but before month-end enabled them to avoid accrual accounting.

Corporate controllers and their auditors need to weigh the benefit of setting the balance sheet rate on the last day of the month against the cost of waiting. Most international subsidiaries have closed their books hours before U.S. close of business, and their financials need to be submitted within days—or, in some cases, within hours.

 

FX Gain/Loss Source #7: Next-Period Hedges

Some entities place hedges for the coming period before the month-end. This practice is most common among companies that use the prior period's balance sheet rate as the current period's income statement rate; they see hedging upcoming exposures as key to minimizing the "timing" impact of currency gains and losses. However, holding hedges for the next period on the books over month-end can generate gains or losses that do not effectively offset any of the company's current exposures. In this case, the goal of eliminating FX gains and losses in the next period can actually create currency impacts in the current period.

 

FX Gain/Loss Source #8: Special Hedge Accounting

The last area in which gains and losses can be created, and are not offset by remeasurement, is the use of the FX Gain/Loss line in the financial statements to collect impacts from special hedge accounting associated with ineffectiveness or excluded time value—option premiums, forward points, etc.

In this case, the company has decided to collect these values and report them in the FX Gain/Loss line. As a result, it should not expect the values to be offset by remeasurement exposures, but to be calculated and evaluated as part of the special hedge accounting program (e.g., cash flow, fair value, net investment hedging under ASC 815).

 

Explaining Imperfection

Hedging cannot deliver a zero, or perfect, FX Gain/Loss line. "Perfect" hedging programs would require instruments that did not have a time-value component, and would demand perfect knowledge, perfect timing, and currency trading that never strayed from mid-market rates. Although it's not realistic, many treasury and finance teams go to great lengths to present their hedging programs as perfect when they deal with corporate management. For example, they may refuse to process intercompany transactions that were not forecast, or they may book all activity in the period at the period-end rate, to mention two extremes.

Management's confidence grows in the treasury team who understand why FX Gain/Loss is not zero and can quickly isolate and communicate the cause of that imperfection. Treasurers who proactively provide an FX Gain/Loss analysis will undoubtedly prevail over those who are surprised—over and over—by currency losses, engaging in a recurring cycle of leaving management's questions unanswered while the treasury team works to uncover "What hit FX this month?"

Today's technology enables treasury and accounting teams to slice and dice the components of the FX Gain/Loss line to isolate and address the sources of currency gains and losses in each period. Absent the proper tools and controls—including the techniques described in this piece and/or software designed for this use case—the FX Gain/Loss line will remain the black box of the income statement.

 

* We've assumed the reader works for a company that has both currency exposures and hedges. Representatives of corporations that do not hedge need only familiarize themselves with two sections of the article: "FX Gain/Loss Source #1: Unhedged Exposures," above, and  "FX Gain/Loss Source #2: Unhedged Conversions."

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Helen Kane is a recognized leader in the application of ASC 815 (formerly FAS 133, "Accounting for Derivative Instruments and Hedging Activities") within corporate environments. She founded Hedge Trackers in 2000 as a FAS 133 consulting and outsourcing firm providing deeply technical yet practical solutions to Fortune 1000 companies. Hedge Trackers' exhibit at the AFP Annual Conference, November 2-5, 2014, will include demonstrations of its Capella FX software, with Reconcile-to-Zero® functionality.

 

 

 

 

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