Published: June 15, 2009
The answer is: of course, when it’s an embedded derivative (at least sometimes)!
I am, of course, talking about foreign currency contracts with suppliers and customers, which are in a currency which differs from both your functional currency and that of the third party. According to US GAAP and IFRS these are deemed, in some cases, as embedded derivatives and the fair value of these contracts needs to be re-valued, with changes in fair value going to the P&L. Thus, if my functional currency is Euro and my customer has a Swedish Krona functional currency then if the contract is denominated in Sterling, this in many cases would be deemed as an embedded derivative. If my client happened to be in the UK with Sterling as their functional currency, then the same contract would be not an embedded derivative and thus not re-valued through income from the outset.
I believe that a foreign currency contract with a supplier or customer is not a derivative and should never be an embedded derivative.
I keep implying that in some cases the contract in Sterling would not be deemed an embedded derivative. The rules are unfortunately rather vague and open to all types of interpretation. The lack of clarity is further clouded by accounting consultants, who are (always) keen to help. There are exceptions for certain currency contracts in combination with certain functional currency third parties. Thus, it is generally accepted that a US Dollar contract with a Chinese Reminbi third party is not an embedded derivative, while a US Dollar contract to a Thai Baht functional currency third party is sometimes an embedded derivative and sometimes not. Certain products, like oil, are generally traded in US Dollars, so this is exempted from these rules, whereas other products are not.
I believe that a foreign currency contract with a supplier or customer is not a derivative and should never be an embedded derivative. Here are my main reasons:
Having discussed the issue with three of the ‘big four’ accounting firms, the advice is far from consistent. Different application of rules could lead to two different companies with exactly the same contracts and functional currencies reporting different results depending on who their auditors happen to be. Thus, the user of the statements would need to fully understand the position of all the particular audit firms on each relevant currency pair for each corporate to understand the income statement. I know that users of statements need to be experts these days, but this seems rather excessive.
I believe that the original reason for implementing this rule was to stop companies speculating on foreign exchange by using these contracts. It seems to me that choosing the currency of a contract with a third party is an extremely roundabout way of taking a position on that currency. There are much easier ways of hiding risk from your shareholder, if this is your game. Just ask the shareholders of a bank with a large portfolio of asset backed structured securities, who actually believed the Value at Risk figures in the 2007 annual reports.
After discussion of this issue with a few auditors, I conclude that there is no evidence that corporates speculate or have ever speculated in this way.
I have now worked in a Treasury department of two reasonably complex companies for nearly eleven years. Those of you in the same position will immediately recognise that the topic of functional currencies is very far from fun. I have had many a jolly discussion with legal entities on what their functional currency is or should be. Now, I need to know not only the functional currency of my own legal entities, but also the functional currency of the legal entities of all my trading partners. I need to keep track of them and any changes. I find this rather ridiculous and of limited added value, if any. [[[PAGE]]]
Further, were a company to mistakenly or otherwise select the wrong functional currency for one or more legal entity and later be forced to change and restate results, the mistake would spread to every corporate with which it had a long dated commercial contract in currencies which differ from their own functional currency. Given an Enron scale of event, the accounts of hundreds of non affiliated companies could be affected! Thus accounting issues would have domino effects from one company to another. Clearly this contagion is not desirable.
I know that some of my accounting friends are rather sceptical about this, but I would like to think that accounting should help drive good risk management behaviour. (The scepticism always lies in the fact that treasurers often argue what is meant by ‘good risk management’ - I think it is a healthy debate).
I would like to think that accounting should help drive good risk management behaviour.
However, treasurers rarely argue in favour of something that costs money when a cheaper alternative is available. Consider a Swedish entity, functional currency Swedish Krona, which sells to a Taiwanese client with the Taiwanese Dollar as functional currency. Clearly the contract cannot be in Taiwanese Dollars due to currency controls and inability to source the Taiwanese Dollars outside Taiwan. You could of course select Swedish Krona. The problem arises if you try and exchange these Swedish Krona in Taiwan. It may not be actually possible and those of you who have travelled widely in emerging markets will see my point immediately - the local banks will give you a rate which would make even me (an ex-investment banker) blush.
The natural solution would be to use US Dollars. However, current accounting rules may penalise such a choice by treating such a contract as an embedded derivative and hence revaluing through income. Remember there are many CFOs in the world, who would prefer eliminating the volatility in income by choosing Swedish Krona at the cost of some transaction fees. Clearly this choice and related outcome should not be encouraged.
I came across an even more extreme case recently. Consider a contract between a Brazilian Real functional currency legal entity and a Taiwanese Dollar functional currency supplier. The Real does not exist outside Brazil and the Taiwanese Dollar does not exist outside Taiwan. I would like to understand how a contract between the two can ever not be an embedded derivative under the strictest interpretation of the rules!
Some of the ‘Big Four’ accounting firms appear to accept the use of US Dollars and in Eastern Europe occasionally the Euro as an alternative currency to trade with a third party. In all cases I observed, the Euro was never accepted as an alternative currency for trade with Asian customers and suppliers if their functional currency was the local currency.
I believe this informal acceptance of what is a suitable third currency actually inhibits the growth of the Euro as a global trading currency and as such puts European companies at a disadvantage being forced always to trade through the US Dollar.
I think simple foreign currency supply contracts can never be a derivative and should never be confused with one. If we are to improve and simplify the accounting rules, here is a very simple change, which would make many lives simpler, bring clarity to the user and preparer and ensure that the corporate risk management teams focus on the real embedded derivatives and not simple foreign currency contracts.
Let’s call a spade a spade when indeed it is one!
How Thought Leadership Can Reduce the Cost of Sales by Patrik Havander, Havander & Partners A focused attention on the costs incurred by the global sales and marketing processes is becoming increasingly important for corporate banks and their transaction banking departments. While the client/bank relationship remains vital, research has shown that in fact relationship selling […]
