388 Planning and Forecasting The Becton Dickenson statement is the clearest statement of the case for not hedging translation exposure. The key elements of the Becton Dickenson position are that: (1) translation adjustments are included in shareholders’ eq- uity; (2) translation adjustments do not affect conventional net income; and (3) translation adjustments do not affect cash flow. The DaimlerChyrsler reference to the net assets of subsidiaries located abroad not being included in the management of currencies means that they are not hedged. The Quaker Oats Company does do some hedging of net in- vestments in foreign subsidiaries. Both Henry Schein and Titan International emphasize the long-term nature of the investments in foreign subsidiaries in explaining the decision not to hedge this exposure. EXHIBIT 12.23 Hedging of translation exposure: Selected company policies. Company Hedging Policy AGCO Corporation (1999) The Company’s translation exposure resulting from translating the financial statements of foreign subsidiaries into U.S. dollars is not hedged. When practical, this translation impact is reduced by financing local operations with local borrowings. Becton Coulter Inc. (1999) We occasionally use foreign currency contracts to hedge the market risk of a subsidiary’s net asset position. Market value gains and losses on foreign currency contracts used to hedge the market risk of a subsidiary’s net asset position are recognized in “Accumulated Other Comprehensive Income” as translation gains and losses. Becton, Dickenson & The Company does not generally hedge these translation Company (1999) exposures since such amounts are recorded as cumulative currency translation adjustments, a separate component of shareholders’ equity, and do not affect earnings or current cash flows. DaimlerChyrsler AG (1999) The net assets of the Group which are invested abroad in subsidiaries and affiliated companies are not included in the management of currencies. The Quaker Oats Company The Company uses foreign currency forward and option (1999) contracts and currency swap agreements to manage foreign currency rate risk related to certain cash f lows from foreign entities and net investments in foreign subsidiaries. Henry Schein Inc. (1998) The Company considers its investments in foreign operations to be both long-term and strategic. As a result, the Company does not hedge the long-term translation exposure in its balance sheet. Titan International (1999) The Company views its investments in foreign subsidiaries as long-term commitments and does not hedge foreign currency transaction or translation exposures. SOURCES : Companies’ annual reports. The year following each company name designates the annual re- port from which each example is drawn. Global Finance 389 There is some hedging of translation, but the hedging of translation expo- sure is clearly less common than the hedging of transaction exposure. Hedging practice, based upon cited surveys and our own study of hundreds of company reports, suggests the following ordering of management demand for hedging, from high to low: 1. To protect cash flow and earnings, both level and stability. 2. To protect earnings, both level and stability. 3. To protect shareholders’ equity, both level and stability. In continuing to observe hedging motivated by both two and three above, it is important to consider the significance of earnings and equity amounts without regard to the issue of cash flows. For example, there is a tremendous current focus on whether or not earnings meet the consensus forecasts of Wall Street. The penalty for missing the forecast, sometimes by pennies, can be dra- matic reductions in share value. Of the two translation methods, only the tem- poral (remeasurement) method includes the remeasurement gains or losses in the computation of net income. There is no evidence that a failure to meet the Wall Street consensus will be forgiven if it results from unhedged remeasure- ment exposure. Management compensation is often based, directly or indirectly, upon re- ported earnings. This provides an incentive for management to hedge in order to avoid earnings reductions from remeasurement losses. Finally, it is common for debt and credit agreements to include financial covenants that require the maintenance of minimum amounts of shareholders’ equity or minimum ratios of debt to equity. Unhedged translation exposure, under either the all-current or temporal (remeasurement) methods, may re- duce shareholders’ equity and cause these covenants to be violated. Differences in hedging practices are explained in part by different atti- tudes towards bearing currency risk as well as the cost and capacity to hedge exposures in different countries. In addition, firms will differ in their capacity to minimize currency exposure through various operational, organizational and business arrangements. As a final topic in this coverage of currency risk and hedging, an over- view of the current requirements in the accounting for currency derivatives is provided. ACCOUNTING FOR HEDGES: CURRENT GAAP REQUIREMENTS Important changes in the accounting for currency derivatives were introduced with the issuance of SFAS No. 133, Accounting for Derivative Instruments and Hedging. 37 Initial required application of the standard begins with the first fis- cal quarter of the first fiscal year beginning after June 15, 2000. One of the most important requirements of the new standard is that all derivative instruments must be recognized on the balance sheet and carried 390 Planning and Forecasting at their fair values. Whether or not these changes in fair value go immedi- ately into the computation of net income will depend upon (1) whether or not the derivative is used for hedging purposes and (2) the nature of the hedge applications. The accounting for changes in the fair value of a foreign-currency deriva- tive depend upon its intended use. Possibilities include (1) the hedging of exposure to changes in the fair value of a recognized asset, liability or an un- recognized firm commitment, (2) the hedging of exposure to variable cash flows of a forecasted transaction, and (3) the hedging of a net investment in a foreign operation. These three hedging applications are referred to as fair value, cash flow and net-investment hedges, respectively. Changes in the fair values of currency derivatives will either be reported in the income statement as these changes take place or they will initially be re- ported in other comprehensive income (OCI). The gains and losses that are ini- tially included in OCI will subsequently be included in the income statement when the hedged transaction affects net income. Fair Value Hedges A firm purchase commitment in a foreign currency is an example of a transac- tion that could be a fair-value hedge candidate. Normally, there is no initial recording on the books of the firm commitment. However, there is currency risk and subsequent increases and decreases in the value of the foreign cur- rency give rise to losses and gains, respectively. To illustrate how a hedge would be accounted for in this case, assume a purchase commitment made for 100 million yen when the yen rate was $0.008976. By the end of the account- ing period the yen has appreciated to $0.009000. This increase in the yen of $0.000024 ($0.009000 − $0.008976) creates a loss on the purchase commit- ment of $2,400 ($0.000024 × 100 million yen). Also assume that the firm had entered into a forward contract to buy 100 million yen as a hedge of the firm commitment. We will assume that the forward contract (the currency deriva- tive) also increased in value by $2,400. Under SFAS No. 133, the $2,400 increase in the cost of the purchase commitment would be recorded as a loss on the commitment. In addition, the forward contract would also be marked to market value, creating an offsetting gain of $2,400. Each of these items would be reported in the income statement where they will offset each other. The special feature of the above accounting (i.e., hedge accounting), is the recognition of the loss on the purchase commitment. Prior to SFAS No. 133, it would have been common not to recognize the loss on the purchase commitment, but to recognize and defer the gain on the forward contract. Then the loss on the purchase commitment would not be recognized until the purchase was made. At this time, the deferred gain on the currency derivative would be deducted from the cost of the purchase. SFAS No. 133 basically eliminates this type of gain or loss deferral on financial derivatives. Global Finance 391 Many of the hedging examples disclosed in Exhibits 12.5 and 12.8 in- volved balances that were already recorded on the balance sheet of the hedging firms. The use of hedges in these cases requires no special hedge ac- counting. For example, consider the case of a one million pound sterling ac- count receivable recorded when the sterling rate was $1.50. By the end of the year, but before the pound receivable was collected, the pound depreciated to $1.45. Assume that the U.S. firm hedged the full amount of the pound sterling account receivable by entering a forward contract to sell the one million pounds at the expected collection date. Under current GAAP, the pound receivable must be revalued to the new rate of $1.45, and a foreign currency transaction loss of $50,000 would be rec- ognized. Moreover, the currency derivative would be marked to its new market value, which is assumed to be $50,000, a perfect hedge. 38 This activity is sum- marized below: £ Account Receivable Initial value of £1,000,000 at $1.50 equals $1,500,000 Value at year-end: £1,000,000 at $1.45 equals 1,450,000 Foreign-currency transaction loss 50,000 Currency Derivative End-of-period value of the currency derivative $ 50,000 Initial value of the forward contract 0 Gain on the currency derivative (50,000) Net effect on earnings $ 0 No special hedge accounting is required in the above case to cause the loss on the receivable and the gain on the currency derivative to offset each other in the income statement. Cash Flow Hedges Hedges of forecasted transactions, cash flow hedges, are distinguished from hedges of firm commitments, which are classified as fair value hedges. As an example, a forecasted transaction might involve the future receipt of royalty payments in a foreign currency. There is currency exposure here because a de- cline in the value of the foreign currency will reduce the dollar value of the royalty, a cash flow, when it is received. A hedge of this exposure could be achieved by selling a futures contract, investing in a put option, or selling the f oreign currency through a forward contract. In order to illustrate hedge accounting for a cash-flow hedge, assume that a firm forecasts the receipt of one million German marks (DM) from roy- alties. A currency derivative is acquired to hedge all of this exposure. At the date that the derivative contract is entered into, the DM rate is $0.45. At the end of the accounting period, but before the royalties are received, the DM depreciates to $0.43. The value of the derivative contract increases by $20,000. SFAS No. 133 requires that a gain from the increase in the fair value 392 Planning and Forecasting of a derivative con tract be recognized as it occurs. However, GAAP does not permit recognition of the loss from the decline in the dollar value of the fore- casted DM cash flow. Recognition of the $20,000 gain on the currency derivative as part of earnings would present a problem. There would be no offsetting loss in the in- come statement from the decline of the dollar value in the DM royalties. Hedge accounting deals with this problem by providing that the $20,000 gain on the derivative be included in other comprehensive income and not net in- come. Then, when the DM royalties are received, the $20,000 gain is reclassi- fied out of accumulated other comprehensive income and in to net income. To illustrate the above fully, assume that the one million DM of royalties are received, and that the value of the DM has not changed in value from its previous year-end rate of $0.43. The hedge accounting is summarized in Ex- hibit 12.24. Notice that the total income recognized in the income statement in the period in which the royalty is received is $450,000. This is equal to the original value of the expected royalty cash flow. However, the $450,000 is made up of only $430,000 in royalty value and the remainder is the product of the cash flow hedge. Hedges of Net Investments in Foreign Operations Earlier discussion of statement translation revealed far less hedging of transla- tion as opposed to transaction exposure. Most translation of the net investments in foreign operations, typically foreign subsidiaries, employs the all-current method. Under this translation procedure, all translation adjustments (transla- tion gains and losses) are recorded in other comprehensive income. These trans- lation adjustments are only included in the computation of net income if all or a significant portion of the foreign operation is sold or otherwise disposed of. Some firms do hedge their translation exposure. Consistent with the trans- lation adjustments being included in other comprehensive income, offsetting gains and losses on currency derivatives used to hedge translation exposure are EXHIBIT 12.24 Hedge accounting for expected cash f low. Period of Receipt Initial Period of Royalties Included in net income Gain on currency derivative 0 $ 20,000 Royalty cash inflow 0 430,000 $450,000 Included in other comprehensive income: Gain on currency derivative $20,000 $ (20,000) Global Finance 393 also recorded in other comprehensive income (see Becton Coulter Inc. in Ex- hibit 12.23 for an example of this treatment). The review of current accounting requirements has not explored a num- ber of technical points related to hedging. These matters go beyond the goals of this chapter. However, many of these items are included in more technical and comprehensive treatments of hedging and derivative instruments. 39 U.S. AND INTERNATIONAL GAAP DIFFERENCES A variety of new financial, accounting, tax, and managerial issues faced Fashionhouse when it acquired a Danish subsidiary. The issues of statement translation and currency risk-management were discussed above. Recall that the requirement to consolidate the Danish subsidiary into the dollar- based statements of Fashionhouse, the parent, requires translation. In addi- tion, to the extent that Danish accounting practices differ from those in the U.S., adjustments must be made so that the subsidiary’s statements conform to U.S. GAAP. International GAAP Differences and the IASC A review of the statements of companies located in different countries will reveal cases of both agreement and disagreement between foreign and U.S. GAAP. In order to address the high level of international disagreement found in accounting practices, the International Accounting Standards Committee (IASC) was formed in 1973. The IASC, which was comprised initially of rep- resentatives from the leading professional accounting bodies of Australia, Canada, France, Germany, Japan, Mexico, the Netherlands, the United King- dom, Ireland, and the United States, began working toward the harmoniza- tion of accounting standards internationally. Today, the IASC represents accounting bodies from over 70 countries. Each member body has agreed to work towards the compliance of accounting standards in their home countries with the standards issued by the IASC. In fact, a number of countries, such as India, Kuwait, Malaysia, Singapore, and Zimbabwe, either adopt IASC standards as their own generally accepted accounting principles or place heavy reliance on them in developing their own accounting standards. To date, 39 international accounting standards and several exposure drafts have been issued. The IASC has also issued a document that both identifies major differences in international accounting practices and catego- rizes them in terms of their being, (1) the required or preferred treatment, (2) the allowed alternative treatment, or (3) the treatment eliminated. 40 The immediate goal of the proposal is to eliminate most of the choices in account- ing treatment now available in standards issued by the IASC. The IASC enu- merated the expected benefits of this harmonization in financial reporting as follows: 41 394 Planning and Forecasting 1. Improve the quality of financial reporting. 2. Make easier the comparison of the financial position, performance and changes in financial position of enterprises in different countries. 3. Reduce the costs borne by multinational enterprises that presently have to comply with different national standards. 4. Facilitate the mutual recognition of prospectuses for multinational secu- rities offerings. A subsequent statement has reported responses to this initial document and outlined plans for implementation of some of the initial proposals and ad- ditional study for others. 42 The major approach to implementation of the IASC proposals is to incorporate those proposals on which agreement has been reached into revised International Accounting Standards. Examples of some of the accounting treatments that would be eliminated under the IASC proposals follow: 1. Completed contract method for the recognition of revenue on construc- tion contracts. 2. Deferral of exchange gains and losses on long-term monetary items. 3. Translation of statements of subsidiaries operating in hyperinflationary economies, without first applying price-level adjustments. 4. Use of the closing (end of period) exchange rate to translate income state- ment balances. 5. Maintenance of investment properties on the books without depreciation 6. Immediate deduction of goodwill against shareholders’ equity. Examples of U.S. and international GAAP differences are provided in the next section along with an illustration of how international firms mitigate the impact of differences for U.S. statement users. 43 U.S. and International GAAP Differences In spite of the harmonizing efforts of the IASC, there remain numerous dif- ferences between the GAAP applied in countries around the world. A sampling of some areas of current or previous differences between U.S. GAAP and GAAP in selected other countries is provided in Exhibit 12.25. As GAAP in different countries are constantly changing, as well as the specific methods selected by firms within countries, some of the GAAP differ- ences in Exhibit 12.25 may no longer be current. However, they remain illus- trative of areas in which major GAAP differences are found between U.S. GAAP and those employed in other countries. Fortunately, in the United States the Securities and Exchange Commission requires that listed foreign firms provide disclosures of differences between the GAAP on which their state- ments are prepared and U.S. GAAP. Global Finance 395 SEC Requirements for Disclosing the Effects of GAAP Differences With the continuing globalization of financial markets, international firms have become more sensitive to the analytical burdens that result from differ- ences between foreign and domestic GAAP. Further, the U.S. Securities and Exchange Commission requires that some foreign firms file reports that EXHIBIT 12.25 Examples of U.S. and international GAAP differences. Accounting Policy Country/Company GAAP Difference Software costs England /Reuters Holdings Reuters expenses all software costs; a portion of such cost would normally be capitalized under U.S. GAAP. Tax accounting Malaysia/United Malacca Deferred taxes are not booked if Rubber Estates temporary differences are deferred indefinitely; deferred taxes are booked on all temporary differences under U.S. GAAP. Investments Australia/BHP Limited Equity accounting is not applied to investments in excess of 20% of voting shares; U.S. GAAP generally requires application of the equity method. Property Hong Kong/Hong Kong Tangible fixed assets and property Telecommunications may be restated on the basis of appraised values; upward revaluations are not permitted under U.S. GAAP. Sale/leaseback gains Netherlands/PolyGram Gains on sale/leaseback transactions are recognized in the year of sale; such gains are normally deferred and amortized into future earnings under U.S. GAAP. Construction interest Sweden/Pharmacia Interest related to the construction of assets is expensed; U.S. GAAP requires capitalization and amortization. Foreign exchange gains England /British Airways Foreign exchange gains and losses are and losses (on loans to deducted from or added to the cost of acquire aircraft) aircraft; included in income as incurred under U.S. GAAP. Unrealized foreign Germany/Continental Losses are deducted from income but exchange gains and Aktiengesellschaft gains are not recorded; U.S. GAAP losses recognizes both in earnings. 396 Planning and Forecasting in clude schedules reconciling earnings under U.S. and foreign GAAP (the 20-F Report). An example of such disclosure is provided below from the 20-F report of the Portuguese firm, Electricidade de Portugal SA (EP). As is required, EP provides a reconciliation of Portuguese to U.S. GAAP for both net income (Ex- hibit 12.26) and shareholders’ equity (Exhibit 12.27). A selection of the princi- pal differences between U.S. and Portuguese GAAP underlying these statements are discussed below: 1. EP writes up the value of its fixed assets. It in turn records depreciation on these revalued amounts. This causes depreciation in the Portuguese- GAAP statements to be greater than it would be under U.S. GAAP, where such revaluations are not permitted. This higher depreciation caused the EP earnings to be reduced below their level under U.S. GAAP. This ex- plains the addition to net income made for “depreciation of revaluation of fixed assets” in the Exhibit 12.26 reconciliation of Portuguese GAAP to U.S. GAAP net income. Also notice that the cumulative effect of this GAAP difference results in a reduction in Portuguese GAAP shareholders’ EXHIBIT 12.26 Reconciliation of net income under Portuguese GAAP to income under U.S. GAAP: Electricidade de Portugal, year ended December 31, 1998 (in thousands except for per-share amounts and shares outstanding). Escudos U.S.$ Net income as reported under Portuguese GAAP 104,808,918 539,307 U.S. GAAP adjustments increase (decrease) due to: a. Depreciation of revaluation of fixed assets 48,045,972 247,226 b. Capitalized overheads (949,690) (4,887) c. Depreciation of exchange differences 5,121,052 26,351 d. Deferred costs (1,537,691) (7,912) e. Hydrological correction adjustments — — f. Distribution to management and employees (3,845,532) (19,788) g. Pension and other post-retirement benefits — — h. Self-insurance — — i. Employee termination benefits 19,969,334 102,755 j. Accounts receivable—municipalities (10,429,115) (53,664) k. Power purchase agreements (343,236) (1,766) m. Income taxes (19,642,655) (101,074) Net adjustments 36,388,439 187,241 Approximate net income in accordance with U.S. GAAP 141,197,357 726,548 Net income per share 235 1.21 Number of shares outstanding 600,000,000 600,000,000 SOURCE : Electricidade de Portugal SA, annual report, December 1998. Information obtained from Dis- closure Inc., Compact D/SEC: Corporate Information on Public Companies Filing with the SEC (Bethesda, MD: Disclosure Inc., June 2000). Global Finance 397 equity in the Exhibit 12.27 reconciliation of shareholders’ equity. Writing up its fixed assets increased EP’s shareholders’ equity. 2. EP capitalized a portion of general and administrative overhead that would not be permitted under U.S. GAAP. This called for a reduction in both Portuguese GAAP net income and in shareholders’ equity. These ad- justments follow the same pattern as those required by the revaluation of fixed assets. 3. EP capitalized and amortized foreign exchange gains and losses. Under U.S. GAAP, the capitalization of these items is not permitted. EP’s dis- closures indicate that this practice is not followed for new exchange gains and losses after 1995. The adjustment in Exhibit 12.26 required an addi- tion to Portuguese GAAP income of $26,351,000. This is the amount by which Portuguese GAAP earnings were understated in 1998. The adjust- ment of $422,925,000 in Exhibit 12.27 represents the remaining cumula- tive overstatement of shareholders equity that resulted from the capitalization of net foreign exchange losses under Portuguese GAAP. EXHIBIT 12.27 Reconciliation of shareholders’ equity under Portuguese GAAP to income under U.S. GAAP: Electricidade de Portugal, year ended December 31, 1998 (in thousands). Escudos U.S. $ Shareholders' equity as reported under Portuguese GAA P 1,228,414,979 6,320,958 U.S. GAAP adjustments increase (decrease) due to: a. Revaluation of fixed assets (476,437,696) (2,451,568) b. Overheads capitalized (139,891,196) (719,287) c. Exchange differences capitalized (82,191,222) (422,925) d. Deferred costs (4,906,140) (25,245) e. Hydrological correction account 77,688,063 399,213 f. Distribution to management and employees (3,736,760) (19,228) g. Pension and other post-retirement benefits 21,868,807 112,529 h. Self-insurance — — i. Employee termination benefits 25,844,334 132,985 j. Accounts receivable—municipalities (10,429,115) (53,664) k. Power purchase agreements 2,317,186 11,923 l. Investments 12,659,000 65,139 m. Income taxes 183,082,286 942,072 Net adjustments (394,132,453) (2,028,056) Approximate shareholders' equity in accordance with U.S. GAAP 834,282,526 4,292,902 SOURCE : Electricidade de Portugal SA, annual report, December 1998. Information obtained from Dis- closure Inc., Compact D/SEC: Corporate Information on Public Companies Filing with the SEC (Bethesda, MD: Disclosure Inc., June 2000). . (1,766) m. Income taxes (19,642,655) (101,074) Net adjustments 36,388,439 187, 241 Approximate net income in accordance with U.S. GAAP 141, 197,357 726,548 Net income per share 235 1.21 Number of shares outstanding. of the fore- casted DM cash flow. Recognition of the $20,000 gain on the currency derivative as part of earnings would present a problem. There would be no offsetting loss in the in- come statement. IASC enu- merated the expected benefits of this harmonization in financial reporting as follows: 41 394 Planning and Forecasting 1. Improve the quality of financial reporting. 2. Make easier the