This is a fairly technical article, but written for a non-accounting audience. I hope to give insight into foreign currency entries you see on the P&L, when to rely on them for useful insights and I also give some ideas about understanding real foreign currency risk and how to deal with it.

Are you interested in knowing when you should hedge currency risk, and when you should manage it as a profit-making business risk?

If so, please see my article here: When hedging currency risk is shooting yourself in the foot

A “real” currency effect is one which affects cash available for the business and for the shareholders. I'm going to assume that the reporting currency is AUD.

“Accounting foreign currency effects” are the effects that foreign currency has on the financial reports. These are not a reliable measure of real foreign currency effects. Instead, they are determined by accounting requirements to balance entries, and to report assets at ‘fair value’. The accounting entries have important differences to real currency results:

  • All foreign currency results are reported in the accounts as AUD (since this is the reporting currency), even though the real currency results may be driven by EURO vs USD effects, or some other combination

  • The realised gain/loss results are only designed to allow accounting entries to balance.

  • In particular, gain/loss entries only happen when there are accrual accounting entries. Businesses like online retail have cash transactions for sales but purchases on credit: they will not get representative foreign currency entries. I refer to this as an asymmetric effect.

Understanding accounting gain/loss entries

There are two reasons for gain/loss accounting. The first, realised gain/loss, is a technical correction for accrual accounting and is not designed to be useful for decision making.

The technical reason is to make sure the accounts balance when using accrual accounting. Accrual accounting means sales and expenses are recognised before cash changes hands. A invoiced sale of 10 GBP at an exchange rate of GBP/AUD 2.00 means we book a sale of $20 and increase the AR asset for $20. Let’s say it was a marketing services sale with no cost of goods sold: the gross margin is the same as the sales value: $20.

The next day, the customer pays GBP10. The exrate is now GBP/AUD 1.50

The bank account is natively GBP, and so is the AR account for this customer . Cash increases by 10GBP and AR decreases by GBP 10 (although both are reported in AUD at end of month, the accounting system keeps the balance of these accounts in GBP). However, the profit needs to equal the change in equity (the increase in cash). The GBP 10 cash increase is worth AUD $15 today. So we have to decrease the profit by $5 to balance; we do this with a “realised loss” of $5.

So the P&L shows a gross margin of $20 and a currency loss of $5, a net result of $15.

What if the customer made the transaction on Tuesday, and paid cash? The result would be the same, but the accounting would show a sale of $15 using Tuesday’s exchange rate, and a gross margin of $15.

So in both cases, the cash arrives on the same date and effect is the same to the shareholders, but the accounting is different. The realised loss is created by accrual accounting and is designed to correct for timing differences, but the realised loss does not mean the loss was avoidable. It simply restates the result of accrual accounting to be accurate after real cash changes hand.

Another reason why accounting entries for realised gain/loss can be misleading: they track only changes in currency based on when and what transactions occur (and only for transactions that need accrual accounting)

This can be pictured with a chart:

currencyChart

 

Imagine the red line indicates the exchange rate; the overall trend means our home currency is getting stronger compared to the currency we sell and buy in. In this business, customers pay cash and the sales activity is spread evenly each day, so the red line which indicates the daily exrate movements also accurately reflects the real-world effect of the exrate on revenue. Revenue will be decreasing overall when measured in the home currency, although there is a reversal of the trend in the middle. There are no accounting entries for foreign exchange results on cash sales, because there are no credit terms offered to customers (this is not strictly true: bank account revaluations still happen at month end). Rather than being mislead by the lack of gain/loss accounting entries, we should be reviewing the non-accounting KPI “average price per unit”, which does show the currency effect.I have a saying: there may be non-accounting numbers in the business, but there are very few non-financial numbers in the business.

 

However, if a one-off sale on credit is made to a trade customer as indicated on the chart, the timing would generate an accounting exchange rate result against the trend: a realised gain. This is an accurate measure of the exchange development between the time of the booking and the payment, but it stays as a result on the P&L even as the exchange rate goes back to the trend again. If we got to the end of the year with this as the only accrual transaction, the P&L would declare a realised gain in the full-year P&L, although obviously currency movements were strongly negative.

How to action realised gain/loss results?

First, understand how accurate a measure they are. Gain/loss entries may be inaccurate because transactions are asymmetric, or exchange rate translations may have happened before the entries are made to the accounts (sales actually occurring in DEK may be translated to AUD by an external reporting system before being booked, for example).

A very important part of this is to understand what foreign currency effects are not shown in the gain/loss entries.

Next, after we understand the numbers, we still have to know what actions to take.

There are two main reasons to consider exchange rate effects. Historically, management may find that changes in exchange rate pollute comparability of results. That is, exchange rate effects may hide mistakes or correct decisions made by management. In that case, we restate historical results at today's rates, to get more comparable results.

 

If the realised/gain loss accounts are not reliable as a measure of exchange rate risk, they shouldn’t be used. More accurate measures are to restate all results in foreign currency at different rates (restate historical results at today’s rates, or vice versa). A model showing the mix of currencies used in the business can then have different exchanges rates.

Hedging which is aimed purely at eliminating gain/loss entries will not be a true cash flow hedge if the gain/loss entries are asymmetric, and therefore risk will not be eliminated; such hedging is actually speculative even if not intended to be (and accounting standards require it to be treated as such).

 

Example: Assymetric businesses: cash sales, credit purchases

Consider a business which sells 1 units a day at 1 GBP, each day for a month, for cash.

On day 1, a delivery of 30 units is made, at GBP 0.70 each; the supplier is paid at the end of the month. So at the end of the month, there is 9 GPB in the bank.

At the end of the month, the GBP is worth $1.50 AUD, so the profit is worth $13.50 AUD. That’s the real world result. There is actually no need to buy or sell currency: the necessary GBP to pay the supplier was generated by customers. Of course, exactly the same result is obtained in AUD, although it looks more complicated:

P&L

 

Sales

$ 37.50

Less

 

Purchases

$ -21.00

Gross margin

$ 16.50

Less realised loss on purchases

$ -10.50

Plus gain on bank account reval

$ 7.50

   

Result

$ 13.50

 

(the gain on the bank account comes about because the cash receipts from sales are valued at the average rate, but at the end of the month, the GBP is the bank is worth more than the average rates indicates: another way of saying this is that the average rate undervalued the sales).

Overall, this result indicates a loss of $3, which seems pretty high as a percentage of EBIT. It also seems odd considering the AUD got weaker in the time period: UK operations should appear to have a favourable result under these circumstances.

Now, if the instead of selling for cash, we sold 30 units on day 1 at 30 day terms, the P&L looks like:

P&L

 

Sales

$ 30.00

Less

 

Purchases

$ -21.00

Gross margin

$ 9.00

Less realised loss on purchases

$ -10.50

Plus gain on payment of invoice

$ 15.00

   

Result

$ 13.50

 

Now we show an overall gain/loss of $4.50, getting to the same result. Since the overall trend is for the AUD to get weaker, this result at least has the correct sign.

Hedging: an introduction

Are you interested in knowing when you should hedge currency risk, and when you should manage it as a profit-making business risk? If so, please see my article here: When hedging currency risk is shooting yourself in the foot

A naïve hedging policy is to hedge transactions. In the second example, we would hedge the sale and the purchase. Hedging means you buy currency for future delivery at today’s rate (this is close enough, anyway). So we would look in the opening rates for both transactions.

On the sale the hedging result would be a loss of $15, and we would gain $10.50 on the purchase.

The final result would a profit of $9. Hedging in the case means we would lock in the rates at the opening of the month: on day 1 we know what our profit is going to be. As it turned out, the GBP got stronger and we lost out, but that’s the risk that hedging eliminates. This is therefore a perfect hedging result.

On the first example, a naïve hedging approach has only one transaction to hedge: the purchase.

The result would be a massive profit of $24. This is actually a terrible hedging result: we have greatly magnified our exchange rate risk (we have unintentionally taken on currency speculation). If the exchange rate had moved the other way, the loss would be a major problem. Unlike options, hedging contracts are firm contracts (and secured with collateral).

Hedging must be based on cash flow forecasts for a firm that has cash sales and credit purchases. You must effectively hedge net cash positions to hedge to eliminate risk. If we are looking at AP with 30 day terms, we have to pick up cash inflows over the same period, and that means using a sales forecast. Usually, when you hedge you hedge more than one month ahead; you hedge for 6 to 12 months (on a rolling basis). In that case, both purchases and sales are based on forecasts. Note that there are many problems with hedging and it may not be the best choice. To be discussed later.

The first reason for currency accounting entries is the technical requirement to have balance entries in accrual accounting, as discussed above.

The second reason behind foreign currency accounting is fair value of monetary items. Invoices in foreign currencies are restated each month at the end of month exchange rate, to make sure the AUD value of all these items is up to date. For example, holding GBP100 at the end of Feb is an asset worth $170 AUD (the rate from March 1 is used from the table above, as being an estimate of the Feb 28 rate). One month later, it is worth $180, so we get an unrealised gain of $10 in the March P&L. This process is repeated for all customer and supplier invoices.

Note that hedging contracts are also picked up by this and cause P&L effects, unless the hedging is a genuine cash flow hedget.

What’s the best way to deal with foreign currency accounting effects?

Budgeting: it is impossible to predict future foreign currency exchange rates.

Reporting: because they can’t be budgeted, they should be reported separately, not grouped with expenses which are budgeted.

Part 2: Understanding Real currency effects

A real currency effect is a change in cash available for shareholders based on changes in exchange rates. Real currency effects are caused by timing effects but to deal with them, there are both strategic and operational considerations. The key point to keep in mind is what can be influenced: how can managers make decisions to make currency effects more favourable? Even when currency effects can not be influenced, knowing how currency effects are different to past results is also interesting. It’s typical for business results to be restated to historical exchange rates; if this is taken all the way to the earnings, then it shows the real effect of currency movements, although the conclusion to be drawn is still a valid question.

I consider currency effects a business risk. Other business risks are that you warehouse may burn down, a competitor will introduce an important innovation in your core product area, you decode to launch a new product, or that a key customer may go broke. Some of these risks you insure against, and some of them are core risks related to the expertise of the business. Some risks seem to have only downsides, and others are an essential part of how profit is made. Some risks are so catastrophic that they can cause the business to fail, and others are much smaller in potential impact.

There are many risks due to timing effects in business. From day to day, the prices of a supplier may change, and buying on one day could be more or less favourable than buying an another day. Some of these effects are strategic (long term price erosion in consumer electronics, for example, or the decision to source from China instead of Germany) and some are large swings around an average. Highly liquid markets in future currency contracts allow both speculation and risk hedging. Hedging means aiming for a neutral effect (substituting known exchange rates for uncertain future exchange rates) which balances potential upsides and downsides to reach a neutral result. Many business risks can be hedged, but some risks are central to the value a business adds, and such risks should not be hedged since it negates competitive advantage. A book-maker could hedge his entire book to avoid the risk of loss; this also means he will make no profit.

Don’t hedge competitive advantage. Another example is an Australian-based iron ore trader who buys iron ore in world markets at various currencies, and sells it to China and India (in USD). Since profits are repatriated in AUD, the USD/AUD rate is important. The price of iron ore changes over time, and the USD/AUD exchange rate of the selling contract changes over time. The trader can hedge both risks: his buying price of iron ore, and the exchange rate. But the trader makes his profit by timing his buying better than his customers, so to hedge away his advantages in spot price would give him no profit. Likewise, a currency trader should not hedge his risk in exchange rates, because then he has no profit.

So it is vital to understand if currency risk is part of added value of the business, or not.

Is currency risk potentially fatal? The other thing to understand is the size of the risk exposure. Can foreign currency movements send the business to failure, or are they less significant? A warehouse burning down can kill a business: is currency in the same category? (the answer varies from business to business).

A real-world example of currency effects

A business has the following exchange rate profile

Currency Sales Mix Purchase Mix

AUD 25% 20%

EUR 50% 5%

USD 25% 75%

This business reports in AUD.

The main exchange rate risk has nothing to do with AUD: it’s the disparity between Euro receipts and USD outgoings. This is a business which will sell Euros to buy USD. The changes in this exchange rate are reported in AUD.

Let’s say it is an online retailer. All sales are cash sales, so changes in exchange rates don’t result in any realised gain or loss entries. But purchases are made on account, causing the accounting entries for gain/loss. If the AUD gets weaker by 5% against both currencies, then realised losses will be booked on the USD purchases, but the higher AUD revenues from cash sales do not cause any accounting gains (the average unit price in AUD increases, but that’s not part of the P&L).

But just because the accounting entries are no guide doesn’t mean there is no currency risk.

Let’s say the USD/AUD rate stays the same, but the EURO gets weaker by 10% against both currencies. In reality, the gross margin will fall because sales will appear to decline significantly (high Euro component) but cost of goods sold will hardly decline (small Euro component). The real currency result is hidden in the gross margin.

How can operational exchange rate risk be mitigated?

Operational exchange rate risk refers to the need for cash to run the business. The other exchange rate risk is financing exchange rate risk: the currencies needed to pay investors, shareholders and long-term lenders (and to fund capital works).

Risk is inherent in business. Exchange rate risk can be treated as an opportunity to gain advantage, or it can be an uncontrollable risk which is mitigated. The choice depends partly on the value chain of the business, and partly on management decisions.

For operational risk, hedging is a common approach for mitigation. Natural hedging means balancing your flow of currencies by rearranging operations. For example, if you open sales to European customers, earning EUR, then you could naturally hedge by increasing sourcing from European suppliers. This approach often doesn’t make sense, because your added value may in fact be sourcing from Asia and selling to Europe; increasing European sourcing doesn’t make sense. Another opportunity for borrowers is to borrow funds in a currency of surplus.

If you do execute natural hedging, you still have the problem that your profits in EUR need to be repatriated in AUD to pay dividends to shareholders. The natural hedging approach would be to find more European shareholders.

If you are not naturally hedged, then currency imbalances are a long term fact of life, and the only thing you can do is minimise short-term swings. “Short term” is defined by your risk management strategy.

Currency market hedging is the main approach. This means you buy or sell foreign currency at today’s rates for delivery in the future. If you know you need GBP100 in a one month’s time, you can buy the pounds today at today’s rate, but pay in one month. If you do this, the loss on the payment will be exactly balanced by the gain on the hedging contract.

Note: forward contracts are not strictly based at today’s spot rates: they are based at today’s spot rates adjusted for differences in interest rates. They are never forecasted or predicted rates by currency traders. Apart from the interest rate difference, they are today’s spot rates.

Hedging requires accurate forecasting of future foreign currency cash flows. Once entered into, a forward contract will produce a loss or a gain; if the prediction about future cash flows was 100% correct, then the result on the hedging contract will be the opposite of the real cash flow result.

For example, take the invoice booked on February 1 in the table above. We book the invoice and on the same day arrange for delivery of 100 GBP at a cost of $200 (I’ll ignore the interest rate effect on forward rates). Then on March 1 we pay the supplier. We give $200 to the bank, the bank gives us 100GBP. Technically, we pay the supplier $170 (the value of GBP100 at the March 1 rate), so we get the gain of $30 shown above. The hedging contract is a loss of $30 (because we are forced to buy GBP at an unfavourable rate).

Hedging contracts are themselves subject to revaluations each month. If you have a contract committing you to buy GBP 100 at a fixed rate in three months time, then you may be ahead or behind at any time depending on today’s actual rate. How these swings in hedging contract fair value are reported is based on the how well the hedging is protecting against real cash flow: if these test are failed, the contracts are treated as “speculative” and hit the P&L.

In practice, a common hedging strategy is to review the next six months of currency needs, and make deals for these amounts. This is reviewed each month as a rolling forecast, so each month a new “sixth month” is contracted for. Changes in intermediate months may need changes to those contracts. There are various optimisations (for example, distant months may be hedged at only 50% of forecast flows to allow for uncertainty in the forecast). The result is that the business swaps a daily spot rate for a rolling average six month rate. If a currency is trending long term in one direction, the long term result makes no difference, but month to month swings are smoothed.

The existence of hedging contracts minimises the ability to take opportunity of favourable exchange rate movements. A business which can switch sourcing among currencies may not be served by hedging.
Alternatives to forward contract hedging

Put and call currency options can be purchased, which can hedge for movements in exchange rate outside of a certain boundary. These are appropriate for organisations which will live with movements of currency within a bandwidth, but want protection from extreme movements. The cost of the contracts can be seen as an insurance payment. Like all derivatives, the huge leverage potential can lead to large losses, but used properly they are highly cost effective.

Managing operational risk through business flexibility

An alternative to hedging is business flexibility. For example, dynamic pricing per currency: if the EUR weakens against the USD and this market is supplied by USD , then raise EUR prices. This ability depends on what competitors do (and where they source from).

The ability to change suppliers to take advantage of currency movements is another example of flexibility.

Hedging wins certainty but sacrifices flexibility. Hedging assumes you are locked-in to cash flows per currency (and the contracts definitely lock you in). If your business is flexible, hedging may not be wise. Imagine you have a EURO surplus. Agreeing to buy GBP1m to pay a supplier in three months time isn’t very helpful if you switch sourcing to a USD supplier : then you still need to buy the pounds to meet the hedging contract, but you also need to find $1.5m USD for your supplier. So you’ll be forced to buy the pounds with your EURO surplus and sell them for USD; without the hedging contract, you could have simply bought USD with the EURO (in reality there are some transaction shortcuts, but the fundamental point remains: hedging with forward contracts works if you currency exposure is predictable. All you gain is averaging of short term rates, and you face transaction costs, tying up cash in security to honour contracts, and a potential loss of flexibility

Such a hedging strategy minimises the losses or gains of exchange rate changes. The effectiveness is based on the accuracy of cash flow forecasting.

 

Appendix

 

Accounting entries for the simple example

 

     

AUD

 

GBP

Item

Exrate

Account

DR

CR

DR

CR

Purchase 30 units at GBP 0.70

1.0

Purchases

21

 

21

 
   

AP

 

21

 

21

             

Pay invoice

1.5

AP

21

 

21

 
   

Realised Gain loss

10.5

     
   

Cash

 

31.5

 

21

 

 

 

 

 

 

 

Record sales

average 1.25

Cash

37.5

 

30

 
   

Sales

 

37.5

 

30

 

 

 

 

 

 

 

Revalue bank account

Note: cash balance before revalue is $6: see from entries above

Cash

13.5

     
 

Final balance is 9 GBP

Realised Gain loss

 

7.5