When Currency Fluctuations Flatten Profits

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Large swings in currency values can twist financial reports like a pretzel. That overseas subsidiary that did so well last quarter can look like a loser that damages overall financial performance if a large devaluation undermines profits once they get translated into dollars. Of course, the reverse also is true. Managers can look like geniuses when a subsidiary’s currency appreciates, even if an operation lost ground.

Given that currencies have become more volatile – there is even talk of currency wars lately – the question of how to manage and report these fluctuations is taking on new importance, says Catherine M. Schrand, a Wharton accounting professor.

Currency fluctuations flow right to the bottom line and can distort shareholder reaction. Many investors “tend to focus on short-term results, so income declines due to currency fluctuations may disturb them,” Schrand says. This myopic, short-term view often ignores an important point: Many currency fluctuations are temporary and are reversed by natural market movements a quarter or two down the road.

That leaves companies with a challenge around how to report such results in a way that avoids over-reaction. Some companies solve the problem with hedging, which works like an insurance policy that locks in exchange rates over some period and smoothes out financial reporting. But currency hedging can be expensive and complicated to do. It requires a lot of investment — in technology and staff — and so is not right for all organizations.

Should companies instead try to explain in footnotes why, say, that Brazilian subsidiary actually had a big uptick in net profits in-country that unfortunately looks like a technical loss after accounting for currency translation? They could report results in the local currency to strip out market fluctuations and focus solely on a unit’s economic performance.

This “constant-currency” financial reporting has parallels with how retail chains sometimes differentiate in their financial reporting between sales from stores open a year or more (same-store sales) and newly opened stores. This approach allows investors to make an apples-to-apples comparison of sales progress by factoring out data from the new stores that could skew financial appraisals of the underlying business overall.

Arguing against this approach is the fact that, while many analysts place currency fluctuations under careful consideration, others simply react negatively to any kind of complexity at all, says Chris Rhodes, accounting advisory partner at PricewaterhouseCoopers (PwC). Constant-currency reporting could be viewed as too complex for some analysts to unravel.

Each of the approaches to accounting for currency fluctuations depends on many variables, including economic growth trends in different countries and individual company circumstances. Experts from Wharton and PwC offer some suggestions on how to cope in the following paper.

How Should Global Companies Communicate Currency Risk?

 

 

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