368 Planning and Forecasting case of asset exposure. With the option contract, a call option is acquired in the case of liability exposure and a put option in the case of asset exposure. Some relevant commentary, in relation to the above discussion, on the effects of hedging with currency options, is provided by the disclosures of Ana- log Devices Inc.: When the dollar strengthens significantly against the foreign currencies, the decline in value of the future currency cash flows is partially offset by the gains in value of the purchased currency options designated as hedges. Conversely, when the dollar weakens, the increase in value of the future foreign-currency cash flows is reduced only by the premium paid to acquire the options. 19 The Analog commentary highlights the one-directional nature of a hedge that employs a currency option as opposed to a forward contract. The corollary of the decline in the dollar is a weakening of the foreign currency. This is the unfavorable outcome that the hedge is designed to offset. Indeed, the above comments indicate that a gain on the option contract is produced to offset the decline in future cash flows that result from a strengthening of the dollar. How- ever, when the dollar instead weakens, there is no offsetting loss, beyond “the premium paid to acquire the options.” The corollary of the weakening of the dollar is the strengthening of the foreign currency. A strengthening of the for- eign currency is not the unfavorable currency movement that the currency option was intended to protect against. As with the forward contracts, a sampling of disclosures by companies that are using currency options for hedging purposes is provided in Ex- hibit 12.8. Currency options are used less frequently than forward contracts. Most of the options used are over-the-counter (OTC) as opposed to exchange- traded options. Given the OTC character of these currency options, they share the tailoring feature of the forward contracts. That is, unlike exchange traded options that come in standard amounts of currency and limited maturities, both forward contracts and options can be tailored in terms of currency amount and maturity. However, unlike forward contracts, the currency options do require an initial investment—the option premium. Little or no initial in- vestment is required in the case of the forward contract. Forwards and options are the most popular currency derivatives, and it is very common, as both Exhibits 12.5 and 12.8 reveal, for firms to use both in- struments. The last currency derivative that is only briefly reviewed is the futures contract. The futures contract shares the symmetrical gain and loss feature of the forward contract. Currency Futures Currency futures are exchange-traded instruments. Entering into a futures contract requires a margin deposit and a round-trip commission must also be paid. As is true of exchange-traded currency options, futures contracts come in fixed currency amounts and for a limited set of maturities. Futures contracts Global Finance 369 also have the high level of liquidity that is characteristic of other exchange- traded derivatives. They also share the symmetrical character of the forward contract. That is, gains and losses will be produced by the futures contract to offset losses and gains, respectively, on hedged positions. Currency futures are used rather infrequently in the hedging of foreign-currency exposures. Summary of Currency Exposure and Hedging Positions It is common for firms to first attempt to reduce currency exposure by using their own operating activities and other internal actions. This point is made in the following comments from the disclosures of JLG Industries: “The Com- pany manages its exposure to these risks (interest and foreign-currency rates) EXHIBIT 12.8 Hedging with option contracts. Company Hedging Targets Analog Devices Inc. (1999) The Company may periodically enter into foreign currency option contracts to offset certain probable anticipated, but no firmly committed, foreign exchange transactions related to the sale of product during the ensuing nine months. Arch Chemicals Inc. (1999) The Company enters into forward sales and purchases and currency options to manage currency risk resulting from purchase and sale commitments denominated in foreign currencies (principally Euro, Canadian dollar, and Japanese yen) relating to anticipated but not yet committed purchases and sales expected to be denominated in those currencies. Olin Corporation (1999) The Company enters into forward sales and purchase contracts and currency options to manage currency risk resulting from purchase and sale commitments denominated in foreign currencies (principally Australian dollar and Canadian dollar) and relating to particular anticipated but not yet committed purchases and sales expected to be denominated in those currencies. Polaroid Corporation (1999) The Company has limited flexibility to increase prices in local currency to offset the adverse impact of foreign exchange. As a result, the Company primarily purchases U.S. dollar call/foreign currency put options which allows it to protect a portion of its expected foreign currency denominated revenues from adverse currency exchange movement. Quaker Oats Company (1999) The Company uses foreign currency options and forward contracts to manage the impact of foreign currency fluctuations recognized in the Company’s operating results. York International Corporation To reduce this risk, the Company hedges its foreign (1999) currency transaction exposure with forward contracts and purchased options. SOURCES : Companies’ annual reports. The year following each company name designates the annual re- port from which each example is drawn. 370 Planning and Forecasting principally through its regular operating and financing activities.” 20 These approaches to reducing currency exposure are usually referred to as natural hedges. A number of examples of natural hedges were provided in Exhibit 12.2. When natural hedges do not close out sufficient currency exposure, it is com- mon for firms to turn to currency derivatives to reduce exposure still further. Based upon the previous discussion of selected currency derivatives, the posi- tions to be taken in the face of asset versus liability exposure are summarized in Exhibit 12.9. The information in Exhibit 12.9 indicates how a number of different in- struments can be used to hedge currency risk. However, management must de- cide whether, and to what extent, to hedge such risk. Some of the factors that bear on the hedging decision are discussed next. Inf luences on the Hedging Decision The first hedging decision is whether or not to hedge currency exposure at all. The decision of whether or not to hedge currency exposure is influenced, at least in part, by the attitude of management towards the risk associated with foreign-currency exposure. Other things equal, a highly risk-averse manage- ment will be more inclined to hedge some or all currency-related risk. More- over, not all currency exposure is seen to be equal. Firms have different demands for hedging based upon whether the exposure has the potential to af- fect cash flows and earnings, or simply the balance sheet. Finally, the materi- ality of currency exposure as well as expected movement in exchange rates will also influence the demand for hedging. Is Currency Exposure Material? A common disclosure made by firms with currency exposure is the effect that a 10% change in exchange rates would have on results. For example, Titan Inter- national, Inc. has currency exposure from its net investment in foreign sub- sidiaries. Titan discloses the potential loss associated with an adverse movement in the exchange rates of these subsidiaries: The Company’s net investment in foreign subsidiaries translated into U.S. dol- lars at December 31, 1999, is $55.4 million. The hypothetical potential loss in EXHIBIT 12.9 Foreign currency exposure and hedging decisions: Forwards, options, and f utures. Hedging Exposure Instrument Asset Liability Forward contract Sell foreign currency Buy foreign currency Option Buy put options Buy call options Futures Sell futures contract Buy futures contracts Global Finance 371 value of the Company’s investment in foreign subsidiaries resulting from a 10% adverse change in foreign-currency exchange rates at December 31, 1999 would amount to $5.5 million. 21 Titan International disclosed no currency hedging activities. This is not sur- prising given that the $5.5 million loss in investment value amounts to only about 2% of its total shareholders’ equity at the end of 1999. Beyond this, as we will see in the subsequent discussion of the translation of the statements of foreign subsidiaries, the potential reduction in Titan’s investment value does not affect either earnings or cash flow. 22 This, combined with the immaterial size of the potential loss in value, can easily explain the absence of hedging activity. What Are Hedging Motivations and Objectives? Much information on hedging motivation is implicit in the information pro- vided in Exhibits 12.5 and 12.8. Recurrent themes are those of protecting earnings and cash flow from the potential volatility produced by exchange rate fluctuations. Information on the ranking of alternative hedging objectives, from a survey conducted at the Wharton Business School, is provided in Ex- hibit 12.10. The dominance of the desire to protect cash flows and earnings is clearly the dominant motivator for hedging. However, as will be discussed in the section on translation of the statements of foreign subsidiaries, there is some level of hedging of balance-sheet exposure. How Much Exposure Is Hedged? The extent to which currency exposure is hedged ranges from zero to 100%. It is common for firms to announce that they simply do not use currency deriva- tives to hedge against currency risk. However, such firms may have already reduced currency risk to tolerable levels through natural hedges. Again, the ap- petite of management for bearing currency risk will in large measure determine the extent of the hedging. The cost and availability of hedging instruments is EXHIBIT 12.10 Rankings of alternative hedging objectives. Percent of Respondents Ranking Hedging Objective the Objective as Most Important 1. To manage volatility in cash f lows 49% 2. To manage volatility in accounting earnings 41 3. To manage market value of the firm 8 4. To manage balance sheet accounts or ratios 2 100% SOURCE : G. Bodnar, G. Hayt, and R. Marston, “The Wharton Survey of Derivatives Usage by U.S. Non-Financial Firms,” Financial Management, 25 (Winter 1996), 114–115. 372 Planning and Forecasting also a factor. As with insurance generally, closing out fully the possibility of loss is more expensive. Some firms provide information on the extent of their hedging through schedules of net exposure. E.I. DuPont de Nemours & Company (DuPont) pro- vides such a schedule. A slightly abridged version is presented in Exhibit 12.11. DuPont also declares the following about the objective of its hedging program: The primary business objective of this hedging program is to maintain an approximately balanced position in foreign currencies so that exchange gains and losses resulting from exchange rate changes, net of related tax effects, are minimized. 23 Exhibit 12.11 reveals that DuPont has hedged almost all of its exposure. The extent of their hedging means that their earnings and cash flows will not be affected in a material way from the hedged exposures. This is reinforced by the following disclosure: Given the company’s balanced foreign exchange position, a 10 per cent adverse change in foreign exchange rates upon which these contracts are based would result in exchange losses from these contracts that, net of tax, would, in all ma- terial respects be fully offset by exchange gains on the underlying net monetary exposures for which the contracts are designated as hedges. 24 Other firms disclose more limited hedging activity. For example, The Quaker Oats Company reported that about 60% of its net investment in foreign subsidiaries was hedged. This disclosure is presented in Exhibit 12.12. 25 Other Hedging Considerations Discussed above are a number of factors that bear on the hedging decision, such as whether or not to hedge, what to hedge, how to hedge, and how much to hedge. Some other issues center on the cost and term or duration of hedging arrangements. A sampling of company references to these issues is provided in Exhibit 12.13. EXHIBIT 12.11 Net currency exposure: E.I. DuPont de Nemours & Company, December 31, 1999 (in millions). After-Tax Net After-Tax Monetary Open Contracts Net Asset/(Liability) to Buy/(Sell) After-Tax Exposure Currency Exposure Foreign Currency Asset/(Liability) Brazilian real $ 109 $(101) $ 7 British pound (337) 334 (3) Canadian dollar 514 (509) 5 Japanese yen 76 (71) 5 Taiwan dollar (136) 136 — SOURCE : E.I. DuPont de Nemours & Company, annual report, December 1999, 37. Global Finance 373 EXHIBIT 12.12 Disclosure of net investment hedge: The Quaker Oats Company, December 31, 1999 (in millions). Currency Net Investment Net Hedge Net Exposure Dutch guilders $15.1 $ 9.1 $6.0 German marks 18.3 11.9 6.4 SOURCE : The Quaker Oats Company, annual report, December 1999, 56. EXHIBIT 12.13 Company references to hedging cost and the terms of currency derivatives. Company Reference Hedging Costs Baxter International Inc. (1999) The Company’s hedging policy attempts to manage these risks to an acceptable level based on management’s judgment of the appropriate trade-off between risk, opportunity, and costs. As part of the strategy to manage risk while minimizing hedging costs, the Company utilizes sold call options in conjunction with purchased put options to create collars. Compaq Computer Corporation The Company also sells foreign exchange option contracts, (1999) in order to partially finance (reduce their cost) the purchase of these foreign exchange option contracts. Interface Inc. (1999) The Euro may reduce the exposure to changes in foreign exchange rates, due to the netting effects of having assets and liabilities denominated in a single currency.As a result, the Company’s foreign exchange hedging activity and related costs may be reduced in the future. Derivative Maturities Blyth Industries Inc. (2000) The foreign exchange contracts outstanding at January 31, 2000 have maturity dates ranging from February 2000 through June 2000. Compaq Computer Corporation The term of the Company’s foreign exchange hedging (1999) instruments currently does not extend beyond six months. Johnson & Johnson (1999) The Company enters into forward foreign exchange contracts maturing within five years to protect the value of existing foreign currency assets and liabilities. Pall Corporation (2000) The Company enters into forward exchange contracts, generally with terms of 90 days or less. Polaroid Corporation (1999) The term of these contracts (forward exchange contracts) typically does not exceed six months. Tenneco Inc. (1998) Tenneco uses derivative financial instruments, principally foreign currency forward purchase and sale contracts, with terms of less than one year. SOURCES : Companies’ annual reports. The year following each company name designates the annual re- port from which each example is drawn. 374 Planning and Forecasting Hedging Costs There is little discussion in company reports about the cost of hedging. In some cases cost issues surely underlie decisions of firms not to hedge currency risk, but the consideration of cost is not reported. Also, the act of using internal operations to reduce currency exposure can be seen as de- signed to reduce the exposure that may then be hedged with currency deriva- tives—thus reducing hedging costs. Clear efforts to reduce hedging costs are represented by the activities of Baxter International and Compaq Computer. Each sells (is a writer of the option) currency option contracts from which it receives an option premium. They then use these amounts to reduce the cost of currency options used for hedging and where, as the holder of the option, they are paying an option premium. Many firms report that they expect to be able to reduce hedging activity and hedging costs as a result of the introduction of the Euro. This will result from the replacement of 11 European currencies with the Euro. Transactions can take place by one Euro country with up to 10 others without incurring any currency exposure. Terms of Currency Derivatives The terms of derivative contracts are kept relatively short, usually less than one year. This partly reflects the fact that the maturity of the underlying item being hedged, an account payable or account receivable, for example, is also quite short. Moreover, the typical maturity of exchange traded derivatives are short. Also, the cost to acquire currency through either a forward or option contract also increases with the maturity. For example, the forward rate (rate at which the foreign currency can be pur- chased for future delivery) for the British pound sterling was the following at the end of 2000: Contract Term Forward Rate One month $1.4574 Three months $1.4588 Six months $1.4606 The prices of currencies in both futures and option contracts display the same increasing cost as maturity lengthens. The discussion to this point has focused on currency risk and actions that management can take to reduce the effect of fluctuations in currency values on the volatility of earnings and cash flow. The examples have centered on what are normally termed transaction exposures. Examples of transaction exposure include accounts payable, accounts receivable and bonds payable that are de- nominated in foreign currencies. If left unhedged, increases and decreases in exchange rates cause these balances to expand and contract. This expansion and contraction produces transactional gains and losses. Transaction gains and losses are also produced by the combination of (1) positions in currency derivatives and (2) increases and decreases in ex- change rates. Offsetting losses and gains result when the derivatives are used Global Finance 375 for hedging purposes. Holding a derivative contract for other than hedging purposes is normally termed a speculation. It is common for companies to declare that they do not hold derivatives for speculative purposes: “The Com- pany does not use financial instruments for speculative or trading purposes, nor is the Company a party to leveraged derivatives.” 26 The disclaimer on the use of currency derivatives, as well as leveraged derivatives, is the legacy of huge losses incurred on certain derivative transactions in the late eighties and early nineties. Attention now turns to translation currency risk. Here, currency exposure results from having foreign subsidiaries or investments in foreign firms that are accounted for using the equity method. 27 TRANSLATION OF THE STATEMENTS OF FOREIGN SUBSIDIARIES A number of new financial and managerial issues were added to the Fashion- house agenda when it purchased its former Danish supplier. Transactional issues continue to the extent that (1) Fashionhouse continues to make some of its purchases from foreign suppliers and (2) the foreign suppliers continue to invoice Fashionhouse in the foreign currency. In addition, the Danish sub- sidiary may also have its own transactional exposure. However, with the emergence of the euro, the Danish subsidiary’s currency exposure should be limited to the extent that it deals mainly with countries that have adopted the Euro. 28 Since the Danish company is a wholly owned subsidiary, U.S. GAAP will call for its consolidation. However, the financial statements of the Danish subsidiary are in the Danish krone. This introduces a translational issue; the Danish subsidiary statements must be restated into dollars before their consol- idation with its parent, Fashionhouse, can take place. To the extent that the ac- counting practices used in preparing a subsidiary’s statements differ from those of their parent, the subsidiary’s statements would need to be restated to conform to the accounting practices of the parent. 29 This would, of course, be the case with Fashionhouse and its Danish subsidiary. International GAAP dif- ferences are discussed in a subsequent section of this chapter. FINANCIAL STATEMENT TRANSLATION Translation means that the foreign-currency balances in the financial state- ments of a foreign subsidiary are restated into U.S. dollars. There is no conver- sion of currencies, which means that one currency is exchanged for another. Translation is accomplished by simply multiplying the foreign-currency state- ment balances by an exchange rate. Translation would be a nonevent if every balance in the statements of the foreign subsidiary were multiplied by the 376 Planning and Forecasting same exchange rate. Translation would simply amount to a scaling of the state- ments of the foreign subsidiary. However, each of the translation alternatives requires the translation of some balances at different exchange rates. In accounting parlance, this throws the books out of balance. The amount by which the books are thrown out of balance by translation is termed the translation adjustment or remeasurement gain or loss, depending upon the translation process being applied. In the pro- cess of illustrating statement translation, the creation and interpretation of these translation balances will be discussed. TRANSLATION ALTERNATIVES There are two different translation methods under current GAAP. However, the second method is technically a remeasurement method as opposed to a translation method. As translation methods, the two alternatives are called the (1) all-current and (2) temporal methods, respectively. The key features of these two methods are summarized in Exhibit 12.14. Examples of accounting policy notes describing the use of each of these translation policies are provided below: The all-current translation method: H.J. Heinz Company (1999) For all significant foreign operations, the functional currency is the local cur- rency. Assets and liabilities of these operations are translated at the exchange rate in effect at each year-end. Income statement accounts are translated at the average rate of exchange prevailing during the year. Translation adjustments arising from the use of differing exchange rates from period to period are in- cluded as a component of shareholders’ equity. The temporal remeasurement (translation) method: Storage Technology Corp. (1999) The functional currency for StorageTek’s foreign subsidiaries is the U.S. dollar, reflecting the significant volume of intercompany transactions and associated cash flows that result from the fact that the majority of the Company’s storage products sold worldwide are manufactured in the United States. Accordingly, monetary assets and liabilities are translated at year-end exchange rates, while non-monetary items are translated at historical exchange rates. Revenue and ex- penses are translated at the average exchange rates in effect during the year, except for cost of revenue, depreciation, and amortization that are translated at historical exchange rates. The key to the determination of the use of the all-current translation method by H.J. Heinz is its statement that the functional currency is the local currency for its foreign subsidiaries. That is, these subsidiaries conduct their op- erations in their local currency. The company does not identify its translation method as all current, but the combination of (1) the use of year-end, or cur rent, Global Finance 377 exchange rates and (2) the inclusion of translation adjustments in shareholders’ equity marks it as using the all-current translation method. Unlike H.J. Heinz, Storage Technology declares that the functional cur- rency of its foreign subsidiaries is the U.S. dollar, not the local foreign cur- rency. The explanation for this condition is found it its reference to significant volume of inter-company transactions and the manufacture of most of its prod- ucts in the United States. As with H.J. Heinz, Storage Technology does not identify the translation method it is using. However, the fact that the U.S. dol- lar is the functional currency of its foreign subsidiaries determines that it must be the temporal method. Moreover, it describes its method as translating mon- etary assets and liabilities at year-end exchange rates and nonmonetary items at EXHIBIT 12.14 Alternative translation methods. All-Current Translation Method The all-current translation method is the standard procedure applied to foreign subsidiaries whose operations are conducted in the local foreign currency. That is, the local currency is the subsidiary’s functional currency. The local foreign currency is expected to be the functional c urrency when the foreign subsidiary’s operations are “relatively self-contained and integrated within a particular country.” A further requirement for use of the all-current method is that the subsidiary not be located in a country that has experienced cumulative inflation over the previous three-year period of 100% or more. The logic is that meaningful results cannot be produced under these conditions by simply multiplying the foreign currency balances by current exchange rates. • All asset and liability balances are translated at the current or end-of-period exchange rate. • Paid-in capital is translated at the exchange rate when the funds were raised. • Revenues and expenses are translated at the average exchange rate for the current period. • The translation adjustment is included in other comprehensive income. Temporal (Remeasurement) Translation Method This method is applied in those cases where the local foreign currency is not the functional currency of the subsidiary. The functional currency is defined as “the currency of the primary economic environment in which the entity operates; normally, that is the currency of the environment in which the entity generates and spends cash.” Moreover, as noted above, “A currency in a highly inflationary environment is not considered stable enough to serve as a functional currency and the more stable currency of the reporting parent is to be used instead.” • All monetary assets and liabilities are remeasured at current exchange rates. • All nonmonetary assets, liabilities, and equity balances are remeasured at historical exchange rates. • Revenues and expenses are remeasured at average exchange rates for the period. However, cost of sales and depreciation are remeasured at the same rates used to remeasure the related inventory and fixed assets, respectively. • The remeasurement gain or loss is included in realized net income. . significantly against the foreign currencies, the decline in value of the future currency cash flows is partially offset by the gains in value of the purchased currency options designated as hedges. Conversely, when. commitments denominated in foreign currencies (principally Australian dollar and Canadian dollar) and relating to particular anticipated but not yet committed purchases and sales expected to be denominated in those. exposure at all. The decision of whether or not to hedge currency exposure is influenced, at least in part, by the attitude of management towards the risk associated with foreign-currency exposure.