Magazine article The CPA Journal

Remember Foreign Exchange Fluctuations When Reporting and Analyzing Operating Results

Magazine article The CPA Journal

Remember Foreign Exchange Fluctuations When Reporting and Analyzing Operating Results

Article excerpt

A multinational company is exposed to some exchange risk when it generates revenues or expenses in foreign currencies. This presents challenges for users comparing period-to-period operating results. Currency exchange-rate fluctuations are expected because many currencies are not tied to the U.S. dollar. In order to report consolidated financial statements, companies must effectively convert multiple currencies into a single reporting currency. In recent years, major currencies such as the British pound, the Euro, and the Canadian dollar have appreciated significantly against the U.S. dollar. This trend tends to inflate the revenues and expenses of an entity reporting in U.S. dollars.

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 × .75 = US$75 million in 2004; Can$100 million × .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. …

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