Analyzing the Impact of Foreign Currency Fluctuations on Financial Results

So far, we have mostly analyzed a multinational parent company with only one subsidiary. It made the analysis easier as we were able to relate the effect of the translation method chosen to the consolidated financial statements for the specific subsidiary. However, multinational corporations typically have more than one subsidiary. This means that the remeasurement gain/loss in the income statement, the cumulative translation adjustment on the balance sheet, and the parent company’s ratios will incorporate the effects of all subsidiaries.

Companies make important disclosures about the effects of foreign currency fluctuations, which usually include sensitivity analysis. For example, a company might describe the significant exchange sources risk given its countries of operation and then disclose the profit impact of a given change in exchange rates. The company also discloses the methods employed to measure exchange rate risks, such as cash-flow-at-risk models and scenario analyses. This information is essential for decision-making in the area of currency management.

Unfortunately, disclosure requirements are limited, making it difficult for an analyst to get information about the firm’s currencies and the specific exposure to the currencies. In this case, an analyst can use sensitivity analysis disclosures in conjunction with his or her forecast of exchange rates when developing forecasts of profit and cash flow. In the absence of detailed disclosures, the analyst can incorporate sensitivity analysis when gauging the downside risks to base-case profit and cash flow forecasts.

In some cases, it is difficult to determine the translation method that the firm uses for its various foreign operations. Since the management decides the subsidiary’s functional currency, firms operating in a similar industry may end up using different translation methods, complicating comparisons. One solution involves adding the change in the cumulative translation adjustment to the firm’s net income on the income statement. Recall the change in the cumulative translation adjustment is equivalent to the translation gain/loss for the period. Bringing the translation gain or loss into the income statement improves comparisons with a temporal method firm. However, the solution does not entirely resolve the problem, but it is a good start.

The same solution can apply to all non-owner changes in shareholders’ equity. For example, adding the unrealized gains and losses from available-for-sale securities to net income would allow an analyst to compare the company to a firm that owns held-for-trading securities. Including the gains and losses that are reported in shareholders’ equity in net income is known as clean-surplus accounting. The term dirty-surplus is used to describe gains and losses that are reported in shareholders’ equity.

Currency risks can be managed both at a strategic level, i.e., medium and long term, and at an operating level, i.e., short and medium-term. “Natural hedging” is applied at the strategic level to manage foreign exchange risk. It involves increasing the volume of purchases denominated in foreign exchange or increasing the volume of local production, for example, expanding subsidiaries in the significant sales markets. For operating purposes, currency risks are hedged on the financial markets. These hedges include options, futures, and currency hedge funds.

Question

An analyst examines P&G, a hypothetical multinational corporation based in the US, for a client presentation. P&G complies with IFRS, and its presentation currency is the US dollar (USD). P&G’s two subsidiaries, ABC and XYZ, have different functional currencies: ABC uses the Euro (EUR) and XYZ, uses the Canadian dollar (CAD).

The analyst first examines the following three transactions to assess foreign currency transaction exposure:

Transaction 1: P&G imports inventory from Spain under 30-day credit terms, and the payment is to be denominated in Euros.

Transaction 2: ABC obtains a loan in Euros on 1 January 2017 from an American bank with the US dollar as its presentation currency.

Transaction 3: XYZ sells goods to a non-domestic customer that pays in dollars on the purchase date.

Which transaction would most likely generate foreign currency transaction exposure for P&G?

   A. Transaction 1

   B. Transaction 2

   C. Transaction 3

Solution

The correct answer is A.

In Transaction 1, the payment for the inventory is due in Euros, a different currency from the US dollar, which is P&G’s presentation currency. Because the import purchase (account payable) is under 30-day credit terms, P&G has a foreign currency transaction EUR/USD exchange rate during the 30 days between the sale and payment dates. Thus, P&G is exposed to potential foreign currency gains if the Euro weakens against the US dollar or foreign currency losses if the Euro strengthens against the US dollar.

Reading 13: Multinational Operations

LOS 13 (j)  Analyze how currency fluctuations potentially affect financial results, given a company’s countries of operation.