353 12 GLOBAL FINANCE Eugene E. Comiskey Charles W. Mulford MANAGER IAL AND FINANCIAL REPORTING ISSUES AT SUCCESSIVE STAGES IN THE FIRM’S LIFE CYCLE Fashionhouse Furniture started as a small southern retailer of furniture pur- chased mainly in bordering southeastern states. With a growing level of both competition and affluence in its major market areas, Fashionhouse decided that its future lay in a niche strategy involving specialization in a high quality line of Scandinavian furniture. Its suppliers were mainly located in Denmark, and they followed the practice of billing Fashionhouse in the Danish krone. Title would typically pass to Fashionhouse when the goods were dropped on the dock in Copenhagen. Payment for the goods was required within periods ranging from 30 to 90 days. As its business expanded and prospered, Fashion- house became convinced that it needed to exercise greater control over its furniture supply. This control was accomplished through the purchase of its principal Danish supplier. Because this supplier also had a network of retail units in Denmark, the manufacturing operations in Denmark supplied both the local Danish market as well as the U.S. requirements of Fashionhouse. More recently, Fashionhouse has been searching for ways to increase manufacturing efficiency and lower product costs. It is contemplating a reloca- tion of part of its manufacturing activity to a country with an ample and low-cost supply of labor. However, Fashionhouse has noted that many such countries experience very high levels of inflation and other potentially disrup- tive economic and political conditions. It has also become aware that in some of 354 Planning and Forecasting the countries under consideration business practices are occasionally employed that could be a source of concern to Fashionhouse management. In some cases, the practices raise issues that extend beyond simply ethical considerations. Fashionhouse could become involved in activities that could place it in viola- tion, not of local laws, but of U.S. laws. Fashionhouse management is still at- tempting to determine how to evaluate and deal with some of the identified managerial and financial issues associated with this contemplated move. Each of the new stages in the evolution of the Fashionhouse strategy cre- ates new challenges that have important implications for both management and financial reporting. The evolution from a strictly domestic operation to one in- volving the purchase of goods abroad thrusts Fashionhouse into the global marketplace, with its attendant risks and rewards. It is common for U.S. firms with foreign activities to enumerate some of these risks. These disclosures are normally made, at least in part, to comply with disclosure requirements of the Securities and Exchange Commission (SEC). As an example, consider the dis- closures made by Western Digital Corporation of risk factors associated with its foreign manufacturing operations: • Obtaining requisite U.S. and foreign governmental permits and approvals. • Currency exchange-rate fluctuations or restrictions. • Political instability and civil unrest. • Transportation delays or higher freight fees. • Labor problems. • Trade restrictions or higher tariffs. • Exchange, currency, and tax controls and reallocations. • Loss or nonrenewal of favorable tax treatment under agreements or treaties with foreign tax authorities. 1 While not listed above as a specific concern, there is the risk that a for- eign government will expropriate the assets of a foreign operation. There were major expropriations of U.S. assets, for instance, located in Cuba when Fidel Castro came to power. There were also expropriations by Iran surrounding the hostage taking at the U.S. embassy in Tehran. Moreover there has been turmoil in Ecuador in recent years. Baltek, a New Jersey corporation with most of its operations in Ecuador, disclosed that it had taken out expropriation insurance to deal with this risk: All of the Company’s balsa and shrimp are produced in Ecuador. The depen- dence on foreign countries for raw materials represents some inherent risks. However, the Company, or its predecessors, has operated without interruption in Ecuador since 1940. Operating in Ecuador has enabled the Company to pro- duce raw materials at a reasonable cost in an atmosphere that has been favor- able to exporters such as the Company. To mitigate the risk of operating in Ecuador, in 1999 the Company obtained a five-year expropriation insurance policy. This policy provides the Company coverage for its assets in Ecuador Global Finance 355 against expropriatory conduct (as defined in the policy) by the government of Ecuador. 2 Some of the important issues implicit in the Fashionhouse scenario out- lined above are identified below and are discussed and illustrated in the bal- ance of this chapter: 1. Fashionhouse incurs a foreign-currency obligation when it begins to ac- quire furniture from its Danish suppliers. A decrease in the value of the dollar between purchase and payment date increases the dollars required to discharge the Danish krone obligation and results in a foreign-currency transaction loss. Financial reporting issue: How are the foreign-currency obligations initially recorded and subsequently accounted for in the Fashionhouse books, which are maintained in U.S. dollars? Management issue: What methods are available to avoid the currency risk associated with purchasing goods abroad and also being invoiced in the foreign currency, and should they be employed? 2. The purchase of one of its Danish suppliers requires that this firm hence- forth be consolidated into the financial statements of Fashionhouse and its U.S. operations. Financial reporting issues: (a) How are the Danish statements con- verted from the krone in order to consolidate them with the U.S. dol- lar statements of Fashionhouse? (b) What differences in accounting practices, if any, exist between Denmark and the United States and what must be done about such differences? Management issues: (a) Is there currency risk associated with the Dan- ish subsidiary comparable to that described previously with the for- eign purchase transactions? Are there methods available to avoid the currency risk associated with ownership of a foreign subsidiary and should they be employed? (b) How will the financial aspects of the management of the Danish subsidiary be evaluated in view of (1) the availability of two different sets of financial statements, those ex- pressed in krone and those in U.S. dollars, and (2) the fact that most of its sales are to Fashionhouse, its U.S. parent? 3. Fashionhouse relocates its manufacturing to a high-inflation and low- labor cost country. Financial reporting issues: How will inflation affect the local-country financial statements and their usefulness in evaluating the perfor- mance of the company and its management? Management issues: (a) Are their special risks associated with locating in a highly inflationary country and how can they be managed? (b) What are the restrictions on U.S. business practices related to deal- ing with business and governmental entities in other countries? 356 Planning and Forecasting For clarification and to indicate their order of treatment in the subse- quent discussion, the issues raised above are enumerated below, without dis- tinction between those that are mainly financial reporting as opposed to managerial issues: 1. Financial reporting of foreign-currency denominated transactions. 2. Risk management alternatives for foreign-currency denominated trans- actions. 3. Translation of the financial statements of foreign subsidiaries. 4. Managing the currency risk of foreign subsidiaries. 5. Dealing with differences between U.S. and foreign accounting policies. 6. Evaluation of the performance of foreign subsidiaries and their management. 7. Assessing the effects of inflation on the financial performance of foreign subsidiaries. 8. Complying with U.S. restrictions on business practices associated with foreign subsidiaries and governments. FINANCIAL REPORTING OF FOREIGN-CURRENCY DENOMINATED TRANSACTIONS When a U.S. company buys from or sells to a foreign firm, a key issue is the cur- rency in which the transaction is to be denominated. 3 In the case of Fashion- house, its purchases from Danish suppliers were invoiced to Fashionhouse in the Danish krone. This creates a risk, which is born by Fashionhouse and not its Danish supplier, of a foreign exchange transaction loss should the dollar fall in value. Alternatively, a gain would result should the dollar increase between the time the furniture is dropped on the dock in Copenhagen and the required payment date. With a fall in the value of the dollar, the Fashionhouse dollar cost for the furniture will be more than the dollar obligation it originally recorded. Fashionhouse is said to have liability exposure in the Danish krone. If, instead, Fashionhouse had been invoiced in the U.S. dollar, then it would have had no currency risk. Rather, its Danish supplier would bear the currency risk associated with a claim to U.S. dollars, in the form of a U.S. dollar account receivable. If the dollar were to decrease in value, the Danish supplier would incur a foreign exchange transaction loss, or a gain should the dollar increase in value. The Danish firm would have asset exposure in a U.S. dollar account receivable. The essence of foreign-currency exposure or currency risk is that existing account balances or prospective cash flows can expand or contract simply as a result of changes in the values of currencies. A summary of foreign exchange gains and losses, by type of exposure, due to exchange rate movements is pro- vided in Exhibit 12.1. To illustrate some of the computational aspects of the Global Finance 357 patterns of gains and losses in Exhibit 12.1, and the nature of exchange rates, assume that Fashionhouse recorded a 100,000 krone purchase when the ex- change rate for the krone was $0.1180. That is, it takes 11.8 cents to purchase one krone. This expression of the exchange rate, dollars per unit of the foreign currency, is referred to as the direct rate. Alternatively, expressing the rate in terms of kroner per dollar is referred to as the indirect rate. In this case, the indirect rate is 1/0.1180, or K8.475. It requires 8.475 kroner to purchase one dollar. Both the direct and indirect rates are typically provided in the tables of exchange rates found in the financial press. The rates at which currencies are currently trading are called the spot rates. When Fashionhouse records the invoice received from its Danish sup- plier, it must do so in its U.S. dollar equivalent. With the direct rate at $0.1180, the dollar equivalent of K100,000 is $0.1180 × K100,000, or $11,800. That is, Fashionhouse records an addition to inventory and an offsetting account payable for $11,800. Assume that Fashionhouse pays this obligation when the dollar has fallen to $0.1190. It will now take $11,900 dollars to acquire the K100,000 needed to pay off the account payable. The combination of liability exposure and a decline in the value of the dollar results in a foreign-currency transaction loss. This result is summarized below: The exchange rate is $0.1190 when the account payable from the purchase is paid. Dollar amount of obligation at payment date, 100,000 × $0.1190 $11,900 Dollar amount of obligation at purchase date, 100,000 × $0.1180 11,800 Foreign exchange transaction loss $ 100 The dollar depreciated against the krone during the time when Fashionhouse had liability exposure in the krone. As a result, it took $100 more to discharge the account payable than the amount at which the liability was originally recorded by Fashionhouse. If the foreign exchange losses incurred were significant, it might prove difficult to pass on this increased cost to Fashionhouse customers, and it could cause its furniture to be somewhat less competitive than that offered by other U.S. retailers with domestic suppliers. Fashionhouse might attempt to avoid the currency risk by convincing its Danish suppliers to invoice it in the dollar. However, this means that the Danish suppliers would bear the currency risk. EXHIBIT 12.1 Type of foreign currency exposure. Change in Foreign Exposure Currency Value Asset Liability Appreciates Gain Loss Depreciates Loss Gain 358 Planning and Forecasting Experience indicates that such suppliers would expect to be compensated for bearing this risk and would charge more for their products. 4 An alternative approach, the use of various hedging procedures, is the more common method employed to manage the risk of foreign-currency exposure. RISK MANAGEMENT ALTERNATIVES FOR FOREIGN-CURRENCY DENOMINATED TRANSACTIONS Hedging is designed to protect the dollar value of a foreign-currency asset po- sition or to hold constant the dollar burden of a foreign-currency liability. 5 At the same time, the volatility of a firm’s cash flow or earnings stream is also reduced. This reduction is accomplished by maintaining an offsetting position that produces gains when the asset or liability position is creating losses, and vice versa. These offsetting positions may be created as a result of arrange- ments involving internal offsetting balances created through operational activ- ities, or they may entail specialized external transactions with financial firms or markets. Hedging with Internal Offsetting Balances or Cash Flows Firms generally attempt to close out as much foreign-currency exposure as pos- sible by relying upon their own operations. These arrangements are often re- ferred to as natural hedges. As an example, consider the following commentary about currency exposure from the 1999 annual report of Air Canada: Foreign exchange exposure on interest obligations in Swiss francs and Deutsche marks is fully covered by surplus cash flows in European currencies, while yen- denominated cash flow surpluses provide a natural hedge to fully cover yen in- terest expense. 6 Air Canada is able to prevent net exposure in the identified foreign currencies by having offsetting cash flows in the same currencies or in currencies whose values move in parallel to the currencies in which Air Canada has interest obli- gations. With the full transition to the Euro in 2002, Air Canada’s currency ex- posure should be markedly reduced because most of the European Community countries will share the Euro as their currency. 7 This will not, of course, alter their exposure in the case of Asian currencies. A sampling of other arrangements that could be characterized as natural hedges is provided in Exhibit 12.2. Virtually all of these examples illustrate the offsetting of exposure through the results of normal operations. In the cases of Baldwin Technologies and Interface, the hedges could be seen to be seminat- ural if they result from a conscious action to create offsetting exposure. That is, does Baldwin Technology determine the cash balances to maintain after first Global Finance 359 determining the extent of their liability exposure? Similarly, does Interface make decisions about the currency in which to borrow depending upon its ex- isting asset exposure? 8 Being the product of calculation and design does not make the seminat- ural hedges any less effective or desirable. In fact, their existence prompts management to be proactive in identifying hedging opportunities that do not EXHIBIT 12.2 Natural foreign currency hedges. Company Natural Hedge Adobe Systems Inc. (1999) We currently do not use financial instruments to hedge local currency denominated operating expenses in Europe. Instead, we believe that a natural hedge exists, in that local currency revenue from product upgrades substantially offsets the local currency denominated operating expenses. Armstrong World Industries Inc. Armstrong’s global manufacturing and sales provide a (1999) natural hedge of foreign currency exchange-rate movements as foreign currency revenues are offset by foreign currency expenses. Baldwin Technology Company The Company also maintains certain levels of cash Inc. (1999) denominated in various currencies which acts as a natural hedge. Baltek Corporation (1998) During 1997, the Company began borrowing in Ecuador in local currency (sucre) denominated loans as a natural hedge of the net investments in Ecuador. Interface Inc. (1999) During 1998, the Company restructured its borrowing facilities which provided for multi-currency loan agreements resulting in the Company’s ability to borrow funds in the countries in which the funds are expected to be utilized. Further, the advent of the Euro has provided additional currency stability with the Company’s European markets. As such, these events have provided the Company natural hedges of currency fluctuations. Pall Corporation (2000) About one quarter of Pall’s sales are in countries tied to the Euro. At current exchange rates, this could reduce our sales by close to 4%. Fortunately, many of our costs in Europe are also reduced by a weak Euro. The weak British Pound also reduces our exposure as most Pall sales to Europe are manufactured in England. This provides a natural hedge and helps preserve profitability. Teleflex Inc. (1999) Approximately 65% of the company’s total borrowings of $345 million are denominated in currencies other than the US dollar, principally Euro, providing a natural hedge against fluctuations in the value of non-domestic assets. SOURCES : Companies’ annual reports. The year following each company name designates the annual re- port from which each example is drawn. 360 Planning and Forecasting require, for example, the use of either exchange-traded or over-the-counter de- rivative instruments. While somewhat less contemporary, there are other examples of using a firm’s own operations and activities to offset foreign-currency exposure. For example, California First Bank (now part of Union Bank) had a Swiss franc borrowing in the amount of Sfr20 million. 9 As this represented liability expo- sure to California First, Exhibit 12.1 shows that an increase in the value of the Swiss franc results in a foreign-currency transaction loss. The goal of the hedge would be to create a gain in this circumstance to offset the loss on the Swiss franc borrowing. Again, Exhibit 12.1 reveals that a gain would be produced from asset exposure in the Swiss franc in the case where the Swiss franc ap- preciated in value. California First Bank sought an opportunity to establish an asset position in the Swiss franc for the same amount and term as the existing Swiss franc obligation. It created this offsetting position by making a loan and denominat- ing the loan in the Swiss franc. This apparently met the borrower’s needs and also served the hedging objective of California First Bank. In an even more creative arrangement, Federal Express created a natural hedge of a term loan that was denominated in the Japanese yen. 10 This was ac- complished by a special structuring of transactions with its own customers. As Federal Express explained: To minimize foreign exchange risk on the term loan, the Company has commit- ments from certain Japanese customers to purchase a minimum level of freight services through 1993. Federal Express needed Japanese yen to make periodic repayments on the term loan. The arrangements with its Japanese customers ensured that yen would be available to pay down the term loan. If the yen appreciates against the dollar, the dollar burden of the Federal Express yen debt increases and re- sults in a transaction loss. However, this loss is offset in turn by the increase in the dollar value of the stream of yen receipts from the freight-service con- tracts. 11 If instead the yen depreciates, a gain on the debt will be offset by losses on the service contracts. A summary of the operation of this hedge is provided in Exhibit 12.3. California First and Federal Express both employed arrangements with their customers in order to create hedges. In addition, purely natural hedges EXHIBIT 12.3 Offsetting gains and losses produced by Federal Express hedge. Change in the value of Change in Dollar Value Change in Dollar Value Foreign Currency of the Loan (Liability) of the Revenue (Asset) Appreciates Increases (loss) Increases (gain) Depreciates Decreases (gain) Decreases (loss) Global Finance 361 may exist due to offsetting balances that result from ordinary business transac- tions with no special arrangements being required. Several hedges that appear to be of this nature were presented in Exhibit 12.2, for example, Adobe Sys- tems and Armstrong World Industries. Two other examples that appear to be totally natural are the cases of Lyle Shipping and Australian mining companies. Lyle Shipping, a Scottish firm, had borrowings in the U.S. dollar. An in- crease in the value of the dollar would increase the pounds required to repay Lyle’s dollar debt and result in a transaction loss. However, because Lyle’s ships were chartered out at fixed rates in U.S. dollars, there would be an off- setting increase in the pound value of future lease receipts—a transaction gain. 12 A similar natural hedge is generally held to exist for Australian mining companies whose product is priced in U.S. dollars. Should the U.S. dollar de- preciate, the exposure to shrinkage in the Australian dollar value of U.S. re- ceipts (asset exposure) is offset by similar shrinkage in the Australian dollar value of their U.S. dollar debt (liability exposure). 13 Fashionhouse would probably find it difficult to duplicate the hedging techniques used above by California First and Federal Express. Circumstances giving rise to a natural hedge, as in the case of Lyle Shipping, may not exist. It might have some capacity to hedge by applying the method of leading and lag- ging. This method involves matching the cash flows associated with foreign- currency payables and receivables by speeding up or slowing down their payment or receipt. Moreover, once Fashionhouse has operations in Denmark, it may be able to create at least a partial hedge of its asset exposure by funding operations with Danish krone debt. If natural hedging opportunities are not available, then Fashionhouse has the full range of both exchange-traded and privately negotiated currency derivatives that it can use as a hedging instru- ment to hedge currency risks. The hedging requirements of the European operations of Fashionhouse should be reduced by the introduction of the Euro. Even though Denmark is not one of the original 11 members of the European Monetary Union (EMU), its European exposure with the 11 countries will be reduced to a single cur- rency, the Euro. Hedging with Foreign-Currency Derivatives Foreign-currency derivatives are financial instruments that derive their value from an underlying foreign-currency exchange rate. Some of the more common currency derivatives include forward contracts to buy or sell currencies in the future at fixed exchange rates, foreign-currency swaps, foreign-currency fu- tures, and options. The forward contracts and over-the-counter options have the advantage of making it possible to tailor hedges to meet individual require- ments in terms of amounts and dates. The exchange-traded futures and options have liquidity and a ready market, but a limited number of dates and contract sizes. Examples of the use of both types of instruments, privately negotiated and exchange traded, are discussed next. 362 Planning and Forecasting Forward Exchange Contracts A forward contract is an agreement to exchange currencies at some future date at an agreed exchange rate. The exchange rate in a contract for either the pur- chase or sale of a foreign currency is referred to as the forward rate. For ward contracts are among the most popular of the foreign-currency derivatives, fol- lowed by privately negotiated (over-the-counter) currency options. 14 These pri- vately negotiated contracts can be tailored to meet the user’s needs in term of both the amount of currency and maturity of the contract. Exchange-traded currency derivatives, such as options and futures, come in standard amounts of currency and a limited number of relatively short maturities. Forward-Contract Hedging Example An example may help to illustrate the application of a forward contract to hedging currency exposure. Near the end of 2000, the forward contract rate for the British pound sterling (£), with a term of one month, was about $1.45. The $1.45 is the direct exchange rate be- cause it expresses the price of the foreign currency in terms of dollars. The comparable indirect rate is found by simply taking the reciprocal of $1.45: 1/$1.45 equals 0.69. The dollar is worth 0.69 pounds. If a U.S. firm had an account payable of 100,000 pounds due in 30 days, a hedge of this liability exposure could be effected by entering into a forward contract to buy £100,000 for delivery in 30 days. Buying the currency through the forward contract is necessary because the firm needs the pound in 30 days to satisfy its account payable. If the dollar were to decline to $1.48 against the pound over this 30-day period, then the dollar value of the account payable would increase, creating a foreign-currency transaction loss. That is, it would take more dollars to purchase the £100,000. However, offsetting this loss would be a gain from an increase in the value of the forward contract. The right to buy £100,000 at the fixed forward rate of $1.45 increases in value as the value of the pound increases to $1.48. The effects of this foreign-currency exposure and associated forward-contract hedge are summarized in Exhibit 12.4. For the EXHIBIT 12.4 Hedge of foreign-currency liability exposure with a forward contract. Item hedged: account payable of £100,000 Value of the account payable at payment date, £100,000 × $1.48 = $148,000 Value of the account payable when initially recorded, £100,000 × $1.45 = 145,000 Foreign currency transaction loss $ 3,000 Hedging instrument: forward contract to buy £100,000 @ $1.45, 30 days Value of the forward contract at maturity, £100,000 × ($1.48 − $1.45) = $ 3,000 Value of the forward contract at inception, £100,000 × ($1.45 − $1.45) = 0 Gain on forward contract $ 3,000 [...]... Hedging a Euro receivable with a forward contract will result in a gain on the forward contract when the Euro declines in value and a loss when the Euro increases in value These gains and losses will in turn offset the loss on Global Finance 367 the account receivable that results when the Euro declines in value and the gain that results when the Euro increases in value The behavior of a hedge using... excluding excise taxes) and operating companies income by $46 million during 1999 Declines in operating revenues and operating companies income arising from the strength of the U.S dollar against Western European and Latin American currencies were partially mitigated by currency favorabilities recorded against the Japanese yen and other Asian currencies Praxair Inc (1999) The sales decrease of 4% in 1999... implicit in the information provided in Exhibits 12. 5 and 12. 8 Recurrent themes are those of protecting earnings and cash f low from the potential volatility produced by exchange rate f luctuations Information on the ranking of alternative hedging objectives, from a survey conducted at the Wharton Business School, is provided in Exhibit 12. 10 The dominance of the desire to protect cash f lows and earnings... hedges Again, the appetite of management for bearing currency risk will in large measure determine the extent of the hedging The cost and availability of hedging instruments is EXHIBIT 12. 10 Rank ings of alternative hedging objectives Hedging Objective Percent of Respondents Ranking the Objective as Most Important 1 To manage volatility in cash f lows 2 To manage volatility in accounting earnings 3 To... strengthening of the U.S dollar against foreign currencies in 1999, 1998 and 1997 resulted in decreased operating revenues of $59 million in 1999, $122 million in 1998 and $166 million in 1997 and decreased net income by approximately 1 cent per diluted share in 1999 and 4 cents per diluted share in 1998 and 1997 Philip Morris Companies Inc (1999) Currency movements decreased operating revenues by $782 million... summarized in Exhibit 12. 7 The symmetrical behavior of the forward contract in its hedging application is evident in Exhibit 12. 7 In each of the four combinations of exposure and exchange rate movement the gains and losses on the balance sheet exposure are offset in turn by the losses and gains on the forward contracts However, the option contracts produce offsetting gains and losses only in those cases... contraction produces transactional gains and losses Transaction gains and losses are also produced by the combination of (1) positions in currency derivatives and (2) increases and decreases in exchange rates Offsetting losses and gains result when the derivatives are used Global Finance 375 for hedging purposes Holding a derivative contract for other than hedging purposes is normally termed a speculation... purchase and sale commitments denominated in foreign currencies (principally Euro, Canadian dollar, and Japanese yen) relating to anticipated but not yet committed purchases and sales expected to be denominated in those currencies The Company enters into forward sales and purchase contracts and currency options to manage currency risk resulting from purchase and sale commitments denominated in foreign... In particular, firms that must no longer include all translation gains or losses arising from their foreign operations in their income statements are more likely to have stopped or reduced hedging translation exposure.”36 To gain some insight into translation hedging practices, disclosures of translation-hedging policies by a number of firms are presented in Exhibit 12. 23 The examples in Exhibit 12. 23... net income for the year is added to retained earnings through a later process of closing the books The translated balance sheet and income statements are presented in Exhibits 12. 16 and 12. 17 They can be constructed from the translated data above The translation of the FC data is presented again in these statements simply to reinforce the nature of the translation process EXHIBIT 12. 16 Translated income . offsetting exposure. That is, does Baldwin Technology determine the cash balances to maintain after first Global Finance 359 determining the extent of their liability exposure? Similarly, does Interface make. borrowing in Ecuador in local currency (sucre) denominated loans as a natural hedge of the net investments in Ecuador. Interface Inc. (1999) During 1998, the Company restructured its borrowing facilities. value. Hedging a Euro receivable with a forward contract will result in a gain on the forward contract when the Euro declines in value and a loss when the Euro increases in value. These gains and losses