If you were to compile a list of the reasons companies give for their earnings falling short of estimates, I wouldn't be surprised if the most common excuse was foreign currency "issues." I attribute this to fact that the impact of foreign currency on financial statements is something that's often misunderstood. This makes it an easy scapegoat.
Companies I have seen relate earnings problems to foreign currency issues include three holdings in our portfolio: Coca-Cola (NYSE: KO), Intel (Nasdaq: INTC), and Pfizer (NYSE: PFE). Xerox (NYSE: XRX), Gillette (NYSE: G), and Procter & Gamble (NYSE: PG) are three others. Today, I'd like to take a first step in explaining how foreign currency affects financial statements.
Every company has a currency in which it reports its financial results to the investing public. This is commonly referred to as its "functional currency," or the currency used in the operating environment in which it is doing business. If the company is based in the U.S., then the functional currency for its business in the U.S., as well as for financial reporting purposes, is the U.S. dollar.
However, if a company conducts business through a business unit located outside the U.S., transactions are more typically conducted in the currency of that region. For example, when doing business in the United Kingdom, transactions are likely to be in British pounds; in Australia, the Australian dollar; in Japan, the yen.
Things in most of Europe are getting easier than they used to be as the adoption of the euro is reducing the number of foreign currencies. Many businesses now use euros for financial reporting purposes, but you won't be able to find euro coins until January 1 of next year.
Some regions of the world have more volatile currencies, primarily due to their inflationary economic environments and economic instability. Often, companies that conduct business in these countries will look to transact in a more stable currency like the U.S. dollar instead of, for example, the Brazilian reais, or the Mexican peso. As a matter of fact, under Generally Accepted Accounting Principles (GAAP), U.S. companies that do business in countries with highly volatile currencies might even be required to account for such transactions in U.S. dollars rather than local currency. This results in more complex rules for translating local currency transactions than those I'm about to explain.
We'll take a look at the income statement first. Foreign currency transactions that are recorded on the income statement are translated at the average rate for the period covered by the statement. Therefore, if you're looking at the income statement in an annual report, all the foreign currency transactions for the year have been translated at the average exchange rate for all relevant currencies for the past year. Let's make up an example to make this a little clearer.
Assume that we're putting together an annual income statement for a U.S.-based company reporting under GAAP. It also has business units (subsidiaries) in the U.K. and Japan.
We'll start by looking at its local currency revenues and expenses for the past year in each of these locations. You should note that I've simplified the process a little, as the actual calculation of cost of goods sold involves some balance sheet accounts -- these are translated differently.
$US ï¿½ ï¿½ (*)
Revenue 200,000 50,000 8,000,000
Cost of Sales 80,000 30,000 4,000,000
Expenses 70,000 9,000 3,000,000
Net Income 50,000 11,000 1,000,000
(*) Amounts in (000)
Next, we translate each of these amounts into U.S. dollars using the following exchange rates so that we can report the company's results in one common currency. We'll assume that the average exchange rate for the last year for each of these countries is as follows:
1 UK ï¿½ = $1.50
1 ï¿½en = $0.0075
Here are the translated results that we get by multiplying the local currency amounts by the applicable exchange rate in each of the subsidiary countries (so that all figures below are in U.S. dollars):
U.S. U.K. Japan Total
Revenue $200,000 75,000 60,000 335,000
Cost of Sales 80,000 45,000 30,000 155,000
Expenses 70,000 13,500 22,500 101,500
Net Income 50,000 16,500 7,500 74,000
On the surface, that calculation should look pretty straightforward. But, there's more to it than what we see here. Exchange rates fluctuate from day to day, week to week, and year to year, due to a few key factors: local interest rates, inflation, and future expectations.
Now, let's change the exchange rates and see what happens to our results:
1 UK ï¿½ = $1.60
1 ï¿½en = $0.01
Again, all figures below are now in U.S. dollars:
U.S. U.K. Japan Total
Revenue $200,000 80,000 80,000 355,000
Cost of Sales 80,000 48,000 40,000 168,000
Expenses 70,000 14,400 30,000 114,400
Net Income 50,000 17,600 10,000 77,600
In this case, the exact same local results with stronger foreign currencies caused the company's net income to increase by about 5%. The company didn't do anything special to increase its income by 5% either. It could have a positive earnings surprise simply because the foreign currencies in the regions in which it did business got stronger.
When companies put together their budgets for the year ahead, they set an exchange rate for the year. It's not likely that a company's expectations about rates will be exactly in-line with expectations. If the local currency is actually stronger relative to the dollar, as in the above example, then its results will look better. If the currency weakens during the year, then translating the results into dollars will yield poorer results than anticipated, and earnings can disappoint.
Companies can do things to mitigate the impact of exchange rates on their income, and many do. They can hedge against fluctuations in exchange rates in the foreign currency markets. In the past, I've been part of meetings where our financial and treasury people met to decide how to best hedge their foreign currency exposure. They can try and complete a greater proportion of their transactions in U.S. dollars. They can also endeavor to conduct the majority of their transactions in each foreign jurisdiction in local currency. In this way, like amounts of expenses and revenues offset each other, which reduces the overall impact of exchange rates.
It's rare that you'll find a company stating that better-than-expected earnings are a result of a stronger U.S. dollar. Companies should approach both sides of this equation equally and not use weaker foreign currencies as a reason for poorer results. In future reports I'll talk more about the actions that companies can take to minimize the affect of currency fluctuation, as well as the balance sheet treatment of foreign currency.
Have a great day.
Phil Weiss, TMF Grape on the Discussion Boards