ASSIGNMENT 7

FINANCIAL REPORTING

Don't let foreign currency fluctuations im pair performance measurements Companies need to determine the best approach for translating financial statements to show true operating performance. By Mark D. Mishler, CPA

60 I Journal o f Accountancy December 2015

T he value o f the U.S. dollar rose significantly from June 2014 to April 2015 compared w ith other foreign currencies. For U.S.

companies with international operations, that could have resulted in reduced reported sales and net income. But the stronger dollar could also have had an impact on the companies’ internal perfor­ mance analyses.

ASC Topic 830, Foreign Currency Matters, prescribes methods for translating foreign opera­ tions’financial statements into U.S. dollars for consolidation. But drawing operating performance conclusions from these U.S. GAAP-translated financial statements may result in the wrong conclusions and suboptimal decisions impacting future financial performance.

For example, the U.S. dollar appreciated 17% against the euro from an average $1.3695 in the first quarter o f 2014 to an average $1.1320 in the first quarter o f 2015. Quarterly averages are the basis for translating foreign income statements under U.S. G A A P (Topic 830).

This article ultimately shows that a constant- dollar income statement presentation may best illustrate true operating performance and disaggre­ gate the impact of fluctuating foreign currency.

U.S. d o lla rs to b u y o n e e u ro

Weekly and average quarterly exchange rates show the trend o f the U.S. dollars required to buy one euro from Jan. 1,2014, through April 1,2015 (see the chart “Euro/Dollar Exchange Rate”).

Specific information for the income statement is in ASC Paragraph 830-10-55-11 and ASC Paragraph 830-30-45-3.

Topic 830 requires translating income statement accounts at the foreign currency exchange rates on the recognition date for revenues and expenses. Be­ cause it might be impractical to use the current ex­ change rate for the dates that the numerous income statement elements are recognized, an appropriately weighted average foreign currency exchange rate for the period covered by the income statement may be used to translate those elements. ►

journalofaccountancy.com December 2015 i 61

FINANCIAL REPORTING

The guidance also applies to accounting allocations in the income statement, such as depreciation, amortization, cost o f goods sold from inventory, and deferred revenues and expenses. Thus, these allocations are required to be translated at the foreign currency exchange rates on the date they are included in revenues and expenses, and not the rates on the historical dates the related items originate.

W hile Topic 830 is appropriate for financial reporting, better tools are available for assessing business performance.

PERFORMANCE MEASUREMENT Consider a U.S. entity with operations in Europe. This company would translate its income statement using the average foreign currency exchange rate over the period covered in the income statement.

Euro/dollar exchange rate

1.4500

1.4000

1.3500

1.3000

1.2500

1.2000

1.1500

1.1000

1.0500

1.0000 "x A A' A Ax A. A. A A A A Ado do do do

' V ' V ' V ' V ' V ' ' V , 'V, ' V ' V ' V ' V ' V .s'

£>• $■ v- <r \ v

Euro/U.S. dollar Quarterly average Source: Mark D. Mishler.

IN BRIEF

■ U.S. GAAP requires U.S. companies w ith international business to translate their income statement using average foreign currency exchange rates. These translated income statements are appropriate for financial reporting

purposes but not for measuring operational performance.

■ income statements in the local currency are of limited use for measuring performance because they make it difficult for the parent company to calculate efficiency and profitability metrics. Also, the

overseas business unit may combine several regional currencies in the local currency statement.

■ A constant-dollar income statement is the best approach for measuring performance because it provides true operating performance and addresses foreign currency fluctuations.

To comment on this article or to suggest an idea for another article, contact Sabine Vollmer, senior editor, at [email protected] or 919-402-2304.

62 I Journal of Accountancy December 2015

U.S. G A A P -tra n s la te d P&L

The U.S. dollar income statement for the first quarter ended March 31,2015, of a company’s European operations prepared according to Topic 830 is appropriate for financial reporting purposes (see the chart “European Operations P& L Trans­ lated Into Dollars”).

The income statement in the chart “European Operations P& L Translated Into Dollars” is not appropriate for performance measurement because it is not sufficient for reaching meaningful operat­ ing conclusions and, as a result, could lead to poor decisions with unfavorable consequences.

The operating performance conclusions from this income statement are that sales o f $15.2 mil­ lion are below both budget and prior year. Income is relatively flat, coming in slightly above budget but slightly below the prior year. It appears that management may have positively reacted to the sales decline by aggressively reducing expenses.

Because o f U.S. G A A P’s foreign currency guidance limitations for operating performance measurement, a more appropriate approach may be to evaluate operating performance using local foreign currency financial statements before transla­ tion into U.S. dollars.

P&L b e fo re tra n s la tio n

The income statement for the first quarter ended March 31,2015, in euros appears much different from the one measured in U.S. dollars (see the chart

Drawing operating performance conclusions from U.S. GAAP-translated

financial statements may result in suboptimal decisions impacting future

financial performance.

“European Operations P& L Before Translation Into Dollars”).

Unlike the currency-translated income state­ ment, which showed poor performance, the operating performance assessment in euros is very favorable with sales higher than both budget and the prior year and with gross margin improvement from cost o f goods sold increasing at a lower rate than sales. The European operations also achieved operating leverage from smaller overall cost in­ creases versus revenues, despite operating expenses growing faster than expectations and faster than sales. There is not enough information to know whether the gross margin improvement is due to product mix or manufacturing expense control, but it can be concluded that operating expenses are not being controlled. ►

E u ro p e a n o p e ra tio n s P&L tra n s la te d in to d o lla rs

First q u a rte r e n d e d M arch 3 1 ,2 0 1 5

(All d o lla r fig u re s in th o u s a n d s ).

$ Variance fa v /(u n fa v )

% Variance fa v /(u n fa v )

Actual B udget Prior year V Bud V P Y V Bud V P Y

Sales $ 1 5 ,1 6 8 $ 1 5 ,7 2 3 $ 1 7 ,803 $ (555) $(2,635) (3.5)% (14.8)%

C ost o f g o o d s sold 12,559 13,160 14,996 601 2,437 4.6% 16.3%

Gross p r o fit 2,609 2,563 2,807 46 (198) 1.8% (7.1)%

% o f sales 17.2% 16.3% 15.8% 0.9% Pt 1.4% Pt

O p e ra tin g expenses 1,121 1,125 1,294 4 173 0.4% 13.4%

O p e ra tin g in c o m e $ 1,488 $ 1,438 $ 1,513 $ 42 $ (25) 3.5% (1.7)%

9.8% 9.1% 8.5% 0.7% Pt 1.3% Pt

Source: M a rk D. M ishler.

journalofaccountancy.com December 2015 i 63

FINANCIAL REPORTING

A constant-dollar income statement presentation will provide true operating performance and disaggregate the impact of fluctuating foreign currency.

It may appear that using a local currency income statement for performance analysis would be ideal, but the approach has the following shortcomings: ■ It can be difficult for the management o f a

parent company to put foreign currency financial statements into perspective regarding magnitude and proportion related to other operations and to the overall business.

■ The income statement is not in U.S. GAAP, which, in addition to this limitation outright, could make it more difficult to calculate efficiency and profitability metrics that rely on income statement items tied to the balance sheet and statement of cash flows. Examples are

return on assets, return on equity, and working capital turns.

■ There could be subtranslations o f other foreign currencies into euros, such as from Swiss or U.K. operations, which reduce the purity o f what appears to be a single currency.

■ It does not explain the overall impact o f foreign currency changes on the consolidated income statement, which is required for proper foot­ note disclosure and for public company SEC management discussion & analysis (M D&A) disclosure.

■ It would not provide functional department per­ formance measurement, such as for the treasury department that could be responsible for foreign currency risk management.

CONSTANT-DOLLAR PRESENTATION FOR PERFORMANCE MANAGEMENT A performance management approach that will provide true operating performance and disag­ gregate the impact of fluctuating foreign currency is a constant-dollar income statement presentation. In this approach, the comparable budget and prior-year periods are all translated using the same current-period foreign currency exchange rate.

Constant-dollar P&L The constant-dollar income statement for the period ended March 31,2015, was prepared by

European operations P&L before translation into dollars First q u a rte r e n d e d M a rch 3 1 ,2 0 1 5

(All d o lla r fig u re s in th o u s a n d s ).

€ Variance fav/(unfav)

% Variance fav/(unfav)

Actual Budget Prior year V Bud VPY V Bud VPY

Sales € 1 3 ,4 0 0 € 1 2 ,5 7 5 € 1 3 ,0 0 0 € 825 € 40 0 6.6% 3.1%

C ost o f g o o d s sold 11,095 10,525 10,950 (570) (145) (5.4)% (1.3)%

Gross p ro fit 2,305 2,050 2,050 255 255 12.4% 12.4%

% o f sales 17.2% 16.3% 15.8% 0.9% Pt 1.4% Pt

O p e ra tin g expenses 990 900 945 (90) (45) (10)% (4.8)%

O p e ra tin g in c o m e € 1,315 € 1,150 € 1,105 € 165 € 210 14.3% 19%

9.8% 9.1% 8.5% 0.7% Pt 1.3% Pt

Source: M a rk D. M ishler.

64 I Journal of Accountancy December 2015

translating all periods at the current quarterly period foreign currency exchange rate. The rec­ onciliation is between the operating and currency performance variances, and the reported budget and prior-year variances are calculated according to Topic 830 (see the chart “European Operations P& L Using Constant Exchange Rate”).

The constant-dollar table shows the true operat­ ing performance and the impact o f foreign currency fluctuations compared with budget and the prior year. Although this is not U.S. GAAP, it does provide a better performance measurement format.

Unlike the U.S. GAAP presentation that re­ ported decreasing sales and flat net income growth compared with budget and the prior year (columns 1 and 2), this constant-dollar table shows strong sales and net income growth. In addition, unlike the local-currency income statement, operating

performance is measured in the parent entity’s reporting currency, the U.S. dollar. Finally, the impact of foreign currency fluctuation is quantified in terms o f U.S. dollars.

It also reconciles the performance measurement reported in the U.S. GAAP presentation translated into U.S. dollars with the constant-dollar presenta­ tion. This analysis meets both internal operating performance assessment and quantifies the foreign currency impact o f SEC M D& A.

INCENTIVE PROGRAM IMPLICATIONS In addition to measuring operating performance, other reporting implications are affected by foreign currency rate fluctuations. Companies design management and employee incentive systems for profit sharing contributions, annual bonus pay­ ments, and long-term, share-based awards. For ►

E u r o p e a n o p e r a t i o n s P & L u s i n g c o n s t a n t e x c h a n g e r a t e First q u a rte r e n d e d M arch 3 1 ,2 0 1 5

(All d o lla r fig u re s in th o u s a n d s ).

S ta te d a t 1 Q 1 5 a c tu a l FX

B u d g e t v a ria n c e e x p la in e d b y fa v /( u n f a v )

PY v a ria n c e e x p la in e d by f a v /( u n f a v )

A c tu a l B u d g e t P rio r y e a r O p e r a tio n s FX O p e r a tio n s FX

Sales $ 1 5 ,1 6 8 $ 1 4 ,2 3 4 $ 1 4 ,7 1 5 $ 9 3 4 $ (1,4 8 9 ) $ 4 5 3 $ (3,0 8 8 )

C ost o f g o o d s sold 1 2 ,5 5 9 1 1 ,9 1 4 1 2 ,3 9 5 (6 4 5 ) 1 ,2 46 0 6 4 ) 2,601

Gross p ro fit 2 ,6 0 9 2 ,3 2 0 2 ,3 2 0 2 8 9 (2 4 3 ) 2 8 9 (4 8 7 )

% o f sales 17.2% 16.3% 15.8% 0 .9% Pt 1.4% Pt

O p e ra tin g expenses 1,121 1 ,019 1 ,0 7 0 0 0 2 ) 1 06 (51) 2 2 4

O p e ra tin g in c o m e $ 1 ,488 $ 1,301 $ 1 ,2 5 0 $ 187 $ 0 3 7 ) $ 2 3 8 $ (2 6 3 )

9 .8% 9 .1% 8 .5% 0 .7 % Pt 1.3% Pt

t t R e p o rte d

b u d g e t v a ria n c e

V a r ia n c e c o m p o n e n ts V a ria n c e c o m p o n e n ts R e p o rte d

PY v a ria n c e

R e c o n c ilia tio n fa v /( u n f a v ) O p e r a tio n s FX O p e r a tio n s FX fa v /( u n f a v )

Sales $ (5 5 5 ) $ 9 3 4 $ (1 ,4 8 9 ) $ 4 5 3 $ (3 ,0 8 8 ) $ (2,6 3 5 )

C ost o f g o o d s sold 601 (6 4 5 ) 1 ,246 (164) 2,601 2 ,4 3 7

Gross p r o fit 4 6 2 8 9 (2 4 3 ) 2 8 9 (4 8 7 ) (1 9 8 )

O p e ra tin g expenses 4 0 0 2 ) 106 (51) 2 2 4 173

O p e ra tin g in c o m e $ 5 0 $ 1 87 $ 0 3 7 ) $ 2 3 8 $ (2 6 3 ) $ (25) Source: Mark D. Mishler.

jo u rn a lo fa c c o u n ta n c y .c o m D e ce m b e r 2015 I 6 5

F IN A N C IA L R E P O R T IN G

Since foreign currency fluctuations are neither controllable nor accountable (except for finance departments and C-level executives in certain situations), the currency impact should be excluded from incentive plans.

About the author Mark D. Mishler (mishler@umich. edu) is a principal at CFO Resource Management in Morristown, N.J., and an adjunct professor of accounting and finance at Seton Hall University in South Orange, N.J.

long-term shareholder value, it is important that incentive programs properly reward controllable and accountable performance.

Since foreign currency fluctuations are neither controllable nor accountable (except for finance departments and C-level executives in certain situations), the currency impact should be excluded from incentive plans. These situations are largely determined by corporate risk tolerance, operating philosophy, and culture, because these character­ istics also play a role in incentive program design. This article focuses on foreign currency fluctuation impacts on measuring operating performance, without debating the merits of different incentive program designs.

Some companies structure incentive programs based on overall consolidated results with the philosophy that incentivizing internal cooperation triumphs over separate business operating perfor­ mance that is more controllable at the country level. Globally, however, there may be foreign country statutory requirements for profit sharing that would not coincide with this consolidated incentive program design.

A potential pitfall o f excluding the impact o f foreign currency fluctuations from incentive programs is where country management has some control and accountability for foreign currency decisions, especially when the foreign entity can elect to transact in other currencies. For example, a German subsidiary that has significant sales to Swiss customers in Swiss francs may have some control over sales currency impact by purchasing materials and entering into contracts where costs are denominated in Swiss francs.

Lastly, finance and treasury departments may be accountable for foreign currency hedging programs. Thus, foreign currency exchange rate fluctuations should impact their incentive programs. ■

AICPA RESOURCES JofA a r tic le s

“T h r e e C o m m o n C u r re n c y -

A d ju s t m e n t P itfa lls," Feb. 2012, p a g e 3 0

" C h e c k lis t: H o w t o M a n a g e

F lu c tu a tio n s in F o re ig n C u r re n c y

Rates," A p r il 2011, p a g e 19

" C u rr e n c y T ra n s la tio n

A d ju s tm e n ts ," J u ly 2 0 0 8 , p a g e 42

" F o u n d in T ra n s la tio n ," F eb. 2007,

p a g e 38

G o t o jo u r n a lo f a c c o u n t a n c y . c o m

t o f in d p a s t a rtic le s .

P u b lic a tio n

Special Issues Related to Foreign Currency Translation, C e n te r fo r Plain E n g lis h A c c o u n tin g , tin y u r l.

c o m / p h 5 8 v n k ( m e m b e r lo g in

r e q u ir e d )

CPE s e lf-s tu d y

F o re ig n C u r re n c y Risk

M a n a g e m e n t a n d T ra n s la tio n

(#165342, o n e -y e a r o n lin e access)

IFRS: T h e E ffe c ts o f C h a n g e s in

F o re ig n E x c h a n g e Rates (#159744,

o n e -y e a r o n lin e access)

F or m o r e in f o r m a t io n o r t o m a k e

a p u rc h a s e , g o t o c p a 2 b iz .c o m o r

c a ll t h e I n s titu te a t 8 8 8 -7 7 7 -7 0 7 7

PCPS In t e r n a t io n a l S e rv ic e C e n te r

T h e P riv a te C o m p a n ie s P ra c tic e

S e c tio n (PCPS) In te r n a tio n a l

S e rv ic e C e n te r p r o v id e s p ra c tic a l

in fo r m a tio n , g u id a n c e , a n d to o ls

t o h e lp CPA fir m s a c h ie v e t h e ir

g o a l o f o b t a i n i n g a n d r e ta in in g

c lie n ts t h a t h a v e in t e r n a tio n a l

s e rv ic e n e e d s a n d a s p ira tio n s .

PCPS m e m b e r s c a n s ig n in t o t h e In te r n a tio n a l S e rv ic e s C e n te r a t

t in y u r l.c o m /b y jd m a 7 .

6 6 i Journal o f A c c o u n ta n cy D e ce m b e r 2015

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