Remember Foreign Exchange Fluctuations When Reporting and Analyzing Operating Results

By John DeCristofaro

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Rapid fluctuations in currency rates could impact a parent company’s income statement, even if local currency results remain the same. Consider company P, a U.S. dollar (US$)–reporting parent company with a major office in Canada. Assume that the Canadian dollar (Can$) was the functional currency of that office, which reported Can$100 million in revenues in 2004 and in 2005. In 2004, assume Can$1.00 was worth on average US$0.75, and in 2005, Can$1.00 was worth on average US$0.80. In order to report revenues in U.S. dollars, company P would be required to translate Canadian dollars into U.S. dollars using the exchange rates above. Translation would increase year-over-year revenues by US$5 million (Can$100 million x .75 = US$75 million in 2004; Can$100 million x .80 = US$80 million in 2005). Consequently, the parent company would report a revenue increase of US$5 million solely due to the impact of foreign currency, because the subsidiary’s local revenues did not change. Note that sales also yield Canadian dollar receivables, which would also be impacted by exchange rate movements, but the net impact of all financials are combined and accumulated in other comprehensive income.

GAAP Requirements

Under SFAS 52, Foreign Currency Translation, local currencies are translated into U.S. dollars using current rates for assets and liabilities, historical rates for equity accounts, and current rates (or if impractical, average rates) for income statement accounts. This methodology is used if local currencies are the functional currencies of a foreign operation (provided the local currency is not hyperinflationary). Otherwise, remeasurement is used. Under remeasurement, revenues or expenses related to nonmonetary assets are translated based on historical asset exchange rates. Net translation impacts other comprehensive income under the current rate method and the income statement directly under remeasurement. Translation remains unrecognized in income until the associated net investment in a foreign operation is realized, such as upon liquidation.

Many financial statement users closely review the income statement in order to evaluate future earnings, so it is important to consider how companies deal with exchange rates in analyzing operating results. Dissenters to SFAS 52 were highly critical of a one-sided financial statement approach for translation. They envisioned reporting problems because revenue changes due to currency fluctuations would impact reported earnings while corresponding changes in receivables would not impact earnings until liquidated.

Paragraph 144 of SFAS 52 notes that FASB considered requiring disclosures of both the mathematical and economic effects that rate changes may have on revenue and earnings. They opted against requiring the disclosures, however, “primarily because of the wide variety of potential effects, the perceived difficulties of developing the information, and the impracticality of providing meaningful guidelines.” Instead, FASB encourages supplemental disclosures of exchange rate impacts on operating results as a means to assist financial statement users in understanding currency and comparative movements.

Consequently, companies have considerable latitude in choosing what, if anything, to report.

SEC Reporting Examples

The problem that arises from the effect of currency exchange rates on earnings is illustrated by management’s discussion and analysis (MD&A) section of a multinational company’s annual report. Companies report currency exchange impacts in a variety of ways. For SEC registrants, foreign exchange impacts often are found in the MD&A and in the disclosure of market risks section of the 10-K and 10-Q. As noted previously, isolating foreign-exchange impacts on earnings is a non-GAAP financial measure, so there are a variety of ways it can be reported, if it is reported at all. Furthermore, currency impacts may also not be meaningful in explaining a company’s revenue or operating results, especially if it generates a relatively small amount of revenue and expenses in local currency. In addition, hedging activities may limit any impact on net income.

The examples below illustrate some of the various reporting methods used, but are not intended to single out any deficiencies. Some disclosures are high-level, while others are detailed. For example, Steinway Musical Instruments noted in its 2005 annual report that foreign exchange impacted both revenues and expenses in such a way that the profit impact was generally not material. American Express noted in its 2005 annual report that both revenues and expenses were affected by the relative changes in currency. The company quantified the percentage impact by explaining year-on-year results.

It is assumed in the above examples that currency movements in revenues are naturally hedged by relatively equal movements in expenses. For example, a $10 million sales increase due to currency translation results in a $9 million expense increase and a $1 million increase in profit, assuming a 10% profit margin. Revenue and expense movements are not always affected the same way, however. Cisco Systems noted in its 2005 annual report that net foreign currency fluctuations impacted certain expenses by roughly 2%, but the revenue impact wasn’t material because sales were denominated mostly in U.S. dollars. McDonald’s disclosed foreign-exchange impacts prominently in its 2005 annual report and 2006 press releases, and has detailed foreign-exchange impacts for at least the past 10 years. The fast-food giant reports the impact of foreign currencies for each major caption on the income statement, including earnings per share (EPS). McDonald’s defines constant currency as current-year results converted at prior-year average exchange rates. Amazon.com also reports currency effects for all major income statement lines, including EPS, adjacent to its consolidated results.

Many other companies detail information somewhere in between the above examples. As part of its 2005 MD&A commentary, Revlon quantified, in a narrative format, currency impacts in explaining revenue, cost of sales, and administrative expense movements. Caterpillar explained year-over-year movements in its revenue and operating profit by isolating the components of such movements, including currency, in a bar chart.

It is sometimes unclear whether currency fluctuations refer only to translation or if they include transaction gains or losses from balance sheet movements or hedging activities. This may be why certain companies identify only revenue impacts, and it is one of the problems envisioned by FASB under SFAS 52. In its 2005 annual report, 3M reported revenue comparisons isolating currency impacts in a table but did not similarly isolate currency comparisons for expenses. Instead, in a separate paragraph, it estimated the currency earnings impact, both including and excluding hedged derivatives and transaction gains and losses. IBM provided a table showing revenue comparisons, both in total and in constant currency, to the prior year in its 2005 annual report. Similar to 3M, IBM did not quantify currency impacts in discussing expenses. IBM did note, however, that currency fluctuations are pervasive and include not only translation and hedging but also may affect pricing and buying decisions. The company concluded that it was impractical to quantify the impact currency had on net income but did note that a weaker dollar was generally favorable and a stronger dollar was generally unfavorable.

Importance of Foreign Currency Translation on Earnings

Reported exchange translation may occasionally be a major factor in explaining overall earnings movements. For example, Wrigley reported that foreign exchange translation represented half of the $0.10 increase in diluted EPS from the prior year and also noted that future fluctuations will continue to impact earnings in its 2005 annual report. In 2003, McDonald’s diluted EPS was improved by $0.07 by currency translation, or roughly 10% of the year-on-year change. See the Exhibit for an illustration of recent translation impacts for McDonald’s Corporation.

Foreign exchange movements can impact segment results even if the impact is not significant for the whole company. Wal-Mart noted in its 2005 annual report that foreign currency fluctuations improved consolidated revenue by $1.5 billion and operating income by $64 million. While the currency effect appears significant, it represented less than 1% of revenue and operating income. The impact was much more noticeable when analyzing its international segment. Foreign currency translation increased year-over-year revenue by 23% and operating income by 21%. Wal-Mart also noted that foreign currency fluctuations increased its international segment’s revenues relative to other segments.

Recommendations for Reporting and Analyzing Results

An important difficulty in analyzing and reporting currency fluctuations is that they are closely tied into other economic events, most notably inflation and interest rates. There is usually an inverse relationship between inflation and currency movement, so countries experiencing abnormal inflation tend to have weaker currencies. This creates challenges and distortions in isolating the impact of foreign exchange movements from the impact of inflation. For example, assume one Argentine peso is worth one U.S. dollar and the cost of materials is 100 pesos in Year 1 at average rates. The U.S. dollar equivalent would be $100. In Year 2, prices suddenly increase three-fold and the cost of materials is now 300 pesos, but due to inflationary effects, the average exchange rate has now dropped so that one Argentine peso is now worth $0.40 (assume an imperfect correlation). The U.S. dollar equivalent is now $120, or a foreign-exchange impact of $20, an apparent strengthening of the peso. However, this is misleading because the peso actually weakened and inflation had a greater impact than the decrease in the exchange rate. Emerging economies such as Argentina have experienced high levels of inflation in the past, so there are real-world situations where this could distort disclosures and should be considered in any analysis of translation impacts.

No one can correctly predict exactly how much exchange rates will move. While it appears that the dollar has stabilized somewhat against major currencies recently, further movements could favorably or unfavorably affect earnings of both U.S. and non-U.S. companies. For example, McDonald’s reported a $0.05 increase in EPS due to a weaker U.S. dollar in 1995. A stronger U.S. dollar reduced the company’s diluted EPS by an estimated $0.01 in 1996 and by an estimated $0.08 in 1997. Similar trends could take place in the future if the dollar suddenly gains strength.

Because FASB encouraged, but did not require, disclosures of currency impacts on earnings, there are many different analyses and presentations. SEC regulations require a discussion of comparative results and market risks. Companies should be mindful of how foreign currency translation impacts operating results, and disclose useful information in their MD&A and market risk sections. For now, users can only review such voluntary disclosures and draw their own conclusions on how much exchange fluctuations affected reported operating results.

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