Market forces and commercial interests are shrinking the world into a single mega store. Goods and services are transcending national borders like never before. Today, many entities engage in a wide range of trans-national transactions such as exports/imports, external commercial borrowings, overseas direct investments, portfolio investments, and carry trade. All of these involve foreign currencies.
Reporting this is an important accounting aspect for a few reasons. One, the correct ‘translation’ of foreign currency transactions/foreign operations into the reporting currency of the financial statements has to account for currency fluctuations. This can have a major impact on the financial results. And how does not one assess the impact of foreign currency fluctuations and distinguish the same from the actual business performance of the company?
Functional currency
To understand this, it is important to know key terms such as functional currency. This is the currency of the primary economic environment in which the entity operates. For instance, the functional currency of Tesla is US Dollars (USD). The functional currency is generally the same as the presentation currency except in cases of overseas subsidiaries whose financial statements might be presented in the currency of the parent company.
Such companies face foreign currency translation risks. Transactions in foreign currencies are usually recorded at the exchange rate prevailing on the date of transaction. Foreign currency denominated monetary assets and liabilities are re-measured into the functional currency at the exchange rate prevailing on the balance sheet date.
Risk management policy
It also helps to understand the risk management policies for covering the foreign exchange risks as approved by the Board of Directors. The framework used by companies usually aims to create a stable business planning environment by reducing the impact of currency fluctuations on the company’s business plan and to achieve greater predictability to earnings by determining the financial value of the expected earnings in advance. Disclosure of an enterprise’s foreign currency risk management policy is also encouraged.
Entities use various kinds of derivative contracts such as foreign currency forward contracts, options, swaps, and structured products to hedge the risks associated with foreign currency fluctuations. The entities designate these derivative contracts in a cash flow hedging relationship by applying the hedge accounting principles and these derivative contracts are stated at fair value at each reporting date. Changes in the fair value of these derivative contracts are recognised in other comprehensive income (net of tax) and the ineffective portion is recognised immediately in the statement of profit and loss. Hedge accounting is discontinued when the hedging instrument expires or is sold, terminated, or exercised, or no longer qualifies for hedge accounting.
Exchange rate mechanism
The prices at which the foreign currencies are bought and sold are called foreign exchange rates. The foreign exchange market determines the exchange rate for global currencies. Over the Counter (OTC) foreign exchange market is, by far, the largest financial market in the world and comprises a global network of financial centres that transact 24 hours a day, closing only on the weekends.
According to BIS Triennial Survey, 2019, trading in OTC markets reached $6.6 trillion per day in April 2019, up from $5.1 trillion three years earlier. As compared to the OTC market, exchange-traded Foreign Exchange derivatives have a minor presence with a daily average turnover of $127 billion in 2019.
There are two ways of quotes continuously available in the market with bid and ask rates. For instance, USD/INR being quoted at 74.75/74.76 in the market means that one unit of Dollar can be bought with 74.76 (Ask Price) units of Rupee and one unit of Dollar can be sold at 74.75 (Bid Price) units of Rupee.
Foreign currency translation
The fluctuation in foreign exchange rates may have a potential impact on the income statement and equity considering the economic environment of the currencies involved. For instance, an Indian exporter who exports to the US is benefited whenever the Rupee is facing accelerated depreciation against the US Dollars. An Indian debtor who borrowed through Dollar Denominated Bonds is impacted negatively during the same time.
Tata Motors Ltd
Let us take the example of Tata Motors Ltd, which has different kinds of foreign currency exposures through its imports/exports, foreign currency borrowings, and overseas subsidiaries. During 2016-17, the British Pound Sterling (GBP) declined significantly relative to the Indian rupee and US dollar following the Brexit referendum held on June 23, 2016. According to RBI Reference Rate archives, the GBP/INR currency pair fell from 99.4721 as on June 23, 2016 to 80.8797 as on March 31, 2017.
Tata Motors which has a large presence in the UK through its subsidiary — Jaguar Land Rover Plc — reported a foreign exchange loss of ₹3,910.10 crores in its consolidated financial statement for the year 2016-17 as against the loss of ₹1,616.88 crore in the previous year (2015-16). During the next financial year (2017-18), as the GBP recovered against USD and INR and the GBP/INR currency pair moved to 92.2846 as on March 28, 2018, Tata Motors reported a foreign exchange gain of ₹1,185.28 crore as against the loss of ₹3,910.10 crore in 2016-17.
Earnings sustainability
As seen above, for a company having trans-national operations, financial results are driven not only by their business performance but also by exchange rate fluctuations in the reporting currency and currency against which the company is having various kinds of exposures. Arguably, the growth in sales/profit that comes from the genuine business performance of the company is more sustainable than the growth achieved mainly due to the favourable changes in exchange rates.
It is important to distinguish between results whether achieved due to great business performance or due to the favourable exchange rate environment. The ability to understand the material impact of foreign currency translation on the financial results of a company is vital for a successful financial analyst.
(The writer is Chartered Financial Analyst (CFA), Assistant General Manager (International Banking), State Bank of India, Chennai.)
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