The FX Lifecycle Explained
In an earlier post, we discussed the differences in foreign exchange perspectives in the United States versus other open economies such as the United Kingdom, Canada, Australia, and the European Union.
Let’s dive in.
The below is one of my favourite charts. It illustrates how FX moves from forecast to financial statements and then eventually to the equity component of the balance sheet. It is this lifecycle that, in my opinion, explains the greater propensity of US firms to focus on balance sheet FX exposures first as opposed to their peers in other countries who place a greater emphasis on cash flow/forecasted FX exposures.
Forecasted Cash Flows & Margin Risk
For the majority of corporate practitioners whom I work with in Canada, this is the primary focus and where it all starts when it comes to managing FX risk.
In this situation forecasted FX exposures have not yet been recorded on financial statements. The key risk being managed here is the actual financial performance of a business relative to budget. In the budgeting process, budgeted FX rates are determined that tie into targeted margin/profitability and the business executes FX hedging programs to ‘lock’ this performance in.
Balance Sheet FX – Remeasurement Risk
In my experience, recognizing remeasurement risk is more common amongst US firms, especially when compared to Canadian businesses. While there are a few key reasons why (more on this in later articles), here I will focus on the primary reason: it typically comes down to the fact that FX exposures are simply more visible at this point. US businesses tend to be larger, and they tend to emphasize the financial reporting consequence of FX risk, as opposed to Canadians, who are acutely aware of the risk to their margins.
What’s going on at this point?
Cash, investments, Accounts Receivable, Accounts Payable, and Inventory denominated in a foreign currency have all been recognized and are taken onto the balance sheet.
For every reporting period, balance sheet items recorded in a currency other than the reporting/functional currency need to be recognized and reevaluated to reflect the change in FX rates from the beginning to the end of the period.
In essence, FX risk lies in working capital items that are flagged for remeasurement on the balance sheet. The resulting gain/loss is taken onto the Income Statement under non-operating income.
This process is usually set up to happen automatically, as ERP (Enterprise Resource Planning) systems flag transactions for remeasurement; the corresponding journal entries for FX gains/losses are generated by the ERP/accounting system.
My personal belief is that one of the reasons there is a bigger focus on this in the United States is because FX exposures in US businesses can be more easily ‘hidden’. Due to scale, geographic scope, and differences in budgeting processes and priorities, a lot of businesses don’t become aware of FX risk until it appears as an automatically-generated gain/loss in non-operating income.
Part of the challenge is that looking at FX only from a balance sheet perspective can understate its actual impact due to the differences in timing, recognition and measurement that come from accrual accounting.
Net Investment Risk – Equity Impacts
In our Financial Accounting 101 classes we learned that equity on a balance sheet is reflected in large part in residual assets – liabilities. There are some unique ways FX can impact equity items directly.
Since equity is a residual, I would consider this the last stage in the FX lifecycle for a business.
If we are familiar with hedge accounting, we know there is a lot of impact in the OCI (Other Comprehensive Income) section from FX hedging that is in a kind of ‘hinterlands’ between the income statement and balance sheet. In my opinion and experience, that isn’t the most interesting part of this stage of the FX lifecycle.
The actual action is in the Cumulative Translation Adjustment section of the balance sheet. Much of the FX-related activity in this section of the financial statements is due to the existence of foreign subsidiaries whose financial performance needs to be ‘rolled up’ into the consolidated financial statements of the US, Canadian, UK, or other parent.
Changes in the value of foreign subsidiaries or direct foreign investments from currency movements are recorded in this section, and are taken as an adjustment to equity. The foreign exchange risk here is often addressed under the ‘Net Investment Hedge’ model of financial reporting/hedge accounting.
The reality is hedging FX risk at this level can be incredibly complex, requiring alignment between treasury and financial reporting teams, and extensive work with external auditors who understand the nuances of hedge accounting. Net investment hedges are an accounting method that can be applied under hedge accounting. Businesses do this with the help of auditors who understand the ins and outs of hedge accounting.
In our upcoming article, Ask the Auditor, we will share observations on hedge accounting from the perspective of sell-side FX professionals.
Read the next article in the series: Building up from the Balance Sheet
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