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Managing FX Risk During the Euro Crisis Stephen Makar, Li Wang, and Pervaiz Alam

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(Makar, Wang, & ith the advent Alam, 2011). we disof the Great Since the start of the Great Recession in 2007, treacussed why current Recession surers have been challenged to manage cash flow hedge accounting in 2007, treasurers uncertainty—including the impact of exchange practices do not prohave been challenged rate (FX) changes. Today, FX risk management vide timely and sufto manage cash flow has become particularly important for compaficient information uncertainty, including nies doing business in the Eurozone. But current to accurately predict the impact of exchange hedge accounting practices cannot accurately future cash flows. We rate (FX) changes. predict future cash flows in FX risk management. also described the Today, FX risk manIn this article, the authors help treasurers and Financial Accountagement has become CFOs analyze those accounting deficiencies in the ing Standard Board’s particularly important Eurozone context. They also discuss the strategic (FASB) 2010 profor companies doing posed solution to business in the Euroimplications of the hedge accounting problem. such hedge accountzone. Indeed, a recent © 2012 Wiley Periodicals, Inc. ing deficiencies, survey of chief finanand contrasted its cial officers (CFOs) by improvement to the InternaDeloitte (2012b) identified hedged (aka hedge ratio) and tional Accounting Standards the Eurozone crisis as the CFO whether to accomplish such Board’s (IASB) 2010 approach community’s greatest worry for hedge ratios by modifying their that does not fully address the 2012. Liquidity and solvency operations (e.g., geographic existing misalignment between concerns regarding sovereign diversification) and/or by using hedge accounting and FX risk debt and the banking sector FX derivatives (FXDs). When management. have forced European leaders to companies use FXD hedges, Subsequent to our 2011 design a series of rescue efforts, accounting practices may not JCAF article, the FASB has culminating with the establishalign with the FX risk managedelayed its hedge accounting ment of a €750 billion bailout ment. For example, a recent standard to beyond the first fund. Investors remain skeptical, Deloitte CFO Journal (2012b) quarter 2013. The International however, as evidenced by the warns that the Eurozone crisis Accounting Standards Board euro’s reaching a multiyear low may significantly affect a com(IASB), in contrast, expects to vis-à-vis the U.S. dollar in July pany’s ability to use accounting issue its general hedge account2012. methods designed to dampen ing standard later this year. In In the context of the current the earnings impact of FX rate the context of the current EuroEurozone crisis, treasurers are changes (aka hedge accountzone crisis, these accounting making critical strategic choices ing). In our 2011 JCAF article, developments have created a about the portion of their euro“Managing FX Risk: How Use“perfect storm” for FXD hedge denominated transactions to be ful Is Accounting Information?”

© 2012 Wiley Periodicals, Inc. Published online in Wiley Online Library (wileyonlinelibrary.com). DOI 10.1002/jcaf.21809

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accounting and FX risk management. In this month’s article, we intend to help CFOs and treasurers analyze these accounting deficiencies by illustrating the nature (both magnitude and direction) of the misalignment between hedge accounting and FX risk management, in the Eurozone context. We also discuss the strategic implications of the hedge accounting problem.

ILLUSTRATION OF THE PROBLEM IN CONTEXT As introduced in our 2011 JCAF article, current hedge accounting practices do not align with FX risk management when hedge ratios are less than 100% (aka partial hedges or underhedges). According to recent surveys (see, e.g., Bodnar, Graham, Harvey, & Marston, 2011), companies hedge ratios range between 27 and 55%. If partial hedgers use qualifying FXDs to hedge future cash flows (e.g., future FX-denominated exports or imports), these derivatives are accounted for as cash flow hedges. Under current cash

flow hedge accounting, companies are required to report information on changes in the market value of FXD hedges. These mark-to-market (MTM) adjustments, however, do not take into account the market value changes of the corresponding hedged item (e.g., the future euro-denominated export or import). As a result, the MTM adjustments are deficient for predicting the future net cash flow in FX risk management. As described in our 2011 JCAF article, the FASB (2010) has proposed a solution to this information deficiency that takes into account both the FXD hedge and the underlying hedged item. Exhibit 1 illustrates the current accounting problem and the FASB’s proposed solution in the context of a euro-denominated export. We use the euro/USD rates beginning with the December 2006 Great Recession (time period 0) and ending at the July 2012 date this article was written (time period t and t +1). As detailed in Exhibit 1, Panel A, the U.S. exporter who hedges

less than 100% of its euro exposure records a $7,895 MTM gain at the time t reporting date. This MTM gain, however, does not align with the net cash outflow of $3,948 at the time t + 1 settlement date. Although the hedge ratio and FX rates both are held constant (in period t and t + 1) for clarity in this illustration, the nature of the misalignment can be calibrated to a company’s actual hedge ratio and cogent FX rates. Because the accounting information at the time t reporting date (i.e., the $7,895 MTM gain) does not align with the future net cash flows in FX risk management ($3,948 cash outflow), decision makers seeking to evaluate the company’s cash and risk management efforts cannot rely on the balance sheet information (i.e., MTM gain is reported as an increase to equity). Panel B details how the FASB’s 2010 proposed hedge accounting standard addresses this information deficiency. The only change from Panel A is at the time t reporting date. By taking into account the

Exhibit 1

Cash Flow Hedge Accounting for U.S. Exporter Facing USD Increase Panel A: Underhedge—Current Accounting Problem

Panel B: Underhedge—FASB Proposed Solution

Time 0 – Contract Date: 1 USD = .76 Euro Firm XYZ, anticipating €150,000 export, enters into a FX derivative (FXD) contract to sell €100,000.

Time 0 – Contract Date: 1 USD = .76 Euro Firm XYZ, anticipating €150,000 export, enters into an FX derivative (FXD) contract to sell €100,000.

Time t – Reporting Date: 1 USD = .82 Euro MTM Gain (Balance Sheet) = [(.76 – .82) / .76] * (100,000 FXD) = 7,895

Time t – Reporting Date: 1 USD = .82 Euro MTM Loss (Income Statement) = [(.76 – .82) / .76] * (100,000 FXD – 150,000) = –3,948

Time t + 1 – Settlement Date: 1 USD = .82 Euro Net Cash Outflow = [(.76 – .82) / .76] * (100,000 FXD – 150,000) = –3,948

Time t + 1 – Settlement Date: 1 USD = .82 Euro Net Cash Outflow = [(.76 – .82) / .76] * (100,000 FXD – 150,000) = –3,948

DOI 10.1002/jcaf

© 2012 Wiley Periodicals, Inc.

The Journal of Corporate Accounting & Finance / November/December 2012

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Exhibit 2

Cash Flow Hedge Accounting for U.S. Importer Facing USD Increase Panel A: Underhedge—Current Accounting Problem

Panel B: Underhedge—FASB Proposed Solution

Time 0 – Contract Date: 1 USD = .76 Euro Firm XYZ, anticipating €150,000 import, enters into an FX derivative (FXD) contract to buy €100,000.

Time 0 – Contract Date: 1 USD = .76 Euro Firm XYZ, anticipating €150,000 import, enters into an FX derivative (FXD) contract to buy €100,000.

Time t – Reporting Date: 1 USD = .82 Euro MTM Loss (Balance Sheet) = [(.76 – .82) / .76] * (100,000 FXD) = –7,895

Time t – Reporting Date: 1 USD = .82 Euro MTM Gain (Income Statement) = [(.76 – .82) / .76] * (100,000 FXD – 150,000) = 3,948

Time t + 1 – Settlement Date: 1 USD = .82 Euro Net Cash Inflow = [(.76 – .82) / .76] * (100,000 FXD – 150,000) = 3,948

Time t + 1 – Settlement Date: 1 USD = .82 Euro Net Cash Inflow = [(.76 – .82) / .76] * (100,000 FXD – 150,000) = 3,948

MTM adjustment on both the €100,000 FXD hedge and the €150,000 hedged item, the $3,948 MTM loss reported in the income statement aligns with the future $3,948 net cash outflow. Exhibit 2 parallels the Exhibit 1 analysis for a eurodenominated import. Together, these two exhibits illustrate both the direction (net cash outflow for exporter, or net cash inflow for importer) and magnitude (€7,895 MTM adjustment versus €3,948 net cash flow) of the current problem, for a given FX rate change and hedge ratio. By calibrating these exhibits to company-specific euro exposures (i.e., FX rate changes, hedge ratios), CFOs and treasurers can analyze the accounting problem for their company.

STRATEGIC IMPLICATIONS OF THE PROBLEM Effective hedging of FX rate changes is a strategic imperative, and can affect the market value of the firm. In the context

© 2012 Wiley Periodicals, Inc.

of the Asian financial crisis, for example, studies have shown that FX rate volatility increased the external financing costs of multinationals with operations in crisis countries (see, e.g., Verschoor & Muller, 2007). Moreover, the increased globalization of product and financial markets has created FX exposure for companies whose operating and financing activities are strictly domestic in nature (see, e.g., Aggarwal & Harper, 2010). In the context of the Eurozone crisis, effective FX risk management can increase the market value of both multinational and domestic companies by reducing the direct and indirect exposures to changes in the Euro. For example, effective FX risk management has been shown to reduce the need for costly external financing during a financial crisis (Beisland, 2010). To recap, both internal and external decision makers need to evaluate the effectiveness of FXD use. However, as illustrated in Exhibits 1 and 2, current accounting practices do

not provide timely and sufficient information to accurately predict the future cash flows for companies using FXD to accomplish hedge ratios less than 100%. These two exhibits help treasurers and CFOs analyze their exposure to such accounting deficiencies, by illustrating both the direction and magnitude of the deficiency in the Eurozone context. By understanding the misalignment between hedge accounting and FX risk management, companies also can take a more informed position on the proposed hedge accounting standards. The FASB chairman has called for comments on the 2010 IASB proposed standard (Lamoreaux, 2011). By maintaining the status quo for companies using FXDs with hedge ratios less than 100%, the IASB proposal does not fully address such misalignment. This impending standard, together with the delay of the FASB’s proposed solution, has created a “perfect storm” that will only become worse with increased volatility

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of the euro. Thus, it is imperative for companies to understand the nature of this accounting deficiency and to incorporate estimates of the potential storm damage in their comments to the FASB.

REFERENCES Aggarwal, R., & Harper, J. (2010). Foreign exchange exposure of “domestic” corporations. Journal of International Money and Finance, 29, 1619–1636. Beisland, L. (2010, December). A note on fair value in a crisis: The influence of

the hedge accounting regulations. Business and Economics Journal, pp. 1–6. Bodnar, G., Graham, J., Harvey, C., & Marston, R. (2011). Managing risk management. Social Science Research Network (SSRN) working paper. New York, NY: SSRN. Deloitte (2012a). The Eurozone crisis: Are you prepared for the future? London, England: Deloitte AG. Deloitte. (2012b, July 10). Financial reporting implications of the Eurozone’s economic struggles. CFO Journal, pp. 1–13. Financial Accounting Standards Board (FASB). (2010). Accounting for financial instruments and revisions to the accounting for derivative instruments

and hedging activity [Exposure draft]. Norwalk, CT: Author. International Accounting Standards Board (IASB). (2010). Hedge accounting [Exposure draft]. London, England: Author. Lamoreaux, M. (2011, March). FASB chairman provides update on financial instruments. Journal of Accountancy Online. Retrieved from www.aicpa.org. Makar, S., Wang, L., & Alam, P. (2011, November/December,). Managing FX risk: How useful is accounting information? Journal of Corporate Accounting & Finance, 23(1), 59–63. Verschoor, W., & Muller, A. (2007). The Asian crisis exchange risk exposure of US multinationals. Managerial Finance, 33, 710–740.

Stephen Makar is chair of the Department of Accounting and a professor in the College of Business at the University of Wisconsin Oshkosh. His primary research and teaching interests are in the use of accounting information in decision making. He has previously published in both academic and practitioner journals, including the Journal of Corporate Accounting & Finance. Li Wang is an assistant professor at the University of Akron. She has previously published in both academic and practitioner journals, including the Journal of Corporate Accounting & Finance. Pervaiz Alam is a professor at Kent State University. He has previously published in the Journal of Corporate Accounting & Finance, and other practice and academic journals.

DOI 10.1002/jcaf

© 2012 Wiley Periodicals, Inc.

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