For financial professionals and their ERP systems, some foreign currency transactions are more difficult to account for than others. In this blog, we cover 4 difficult and problematic types of transactions that could be misrepresenting your earnings and hedge results – and how to fix them.
The Financial Accounting Standards Board (FASB) released “Foreign Currency Matters” (ASC 830) to govern how foreign currency transactions should be recorded and managed while on company financial statements. Here’s a quick refresher on Topic 830:
When a foreign currency transaction comes onto the books, it uses the exchange rate in the market at the time of the transaction. Whether you use a daily rate or “a method of approximation” (like an average rate or prior month end rate), the concept is the same. The rate used to record the transaction provides an anchor rate for the transaction.
In other words, whatever rate was used to originally record the transaction is fixed and should not change over time.
Additionally, each foreign monetary balance (asset or liability) is required to be re-measured or have its value updated to the month end rate each period. Re-measurement changes the value of the asset or liability and records the change in income and expense. This process happens throughout the life of the transaction. Before it is officially closed out, the P&L is updated for what the gain/loss would be if you were to close it out at that time.
That is how it is supposed to work. However, there are four common types of problematic foreign currency transactions that cause unexpected and incorrect results. Some are income statement geography problems; others are incorrectly reported earnings. In this blog, we cover foreign accruals, foreign credit memos, shadow/ghost balances and elimination errors.
4 Types of Difficult Foreign Currency Transactions
#1. Foreign Accruals
A foreign accrual is an estimate of an existing inflow/asset or cost/liability denominated in a foreign currency that needs to be recorded but has no receipt or payment transaction to record.
Let’s take a company’s bonus accrual for example. Suppose an entity is USD functional and must accrue a foreign liability for its foreign employees’ bonus.
In this example, assume 1,000 Pound sterlings (GBP) were accrued in month one. The way the transaction works is to record vacation expense in GBP and a bonus payable in GBP at the current transaction accounting rate. We will use 1.17 as the exchange rate.
In month one, the expense in USD equaled $1,170. Next, the GBP liability is re-measured to the month end rate. If that rate was 1.20, the liability would increase by $30 to $1,200 and the change in value would be recorded as a loss in income of $30. Geography is $1,170 in operating expense and $30 in Other Income/Expense (or wherever your company records FX). So far so good.
An accrual is very often recorded as a reversing entry. Then, it is re-recorded each period. The problem occurs when the accrual reverses and the replacement accrual is re-recorded in the next period at a new rate.
Remember: The transaction rate should not change. If the accrual increased to 2,000 GBP in month two, the original 1,000 should be recorded at last month’s rate and the new 1,000 at this month’s rate. But what generally happens is that the 1,000 GBP is reversed at last month’s rate, and the new accrual of 2,000 is recorded at this month’s rate.
This changes the income statement geography of a portion of the company’s vacation expense.
The $30 loss that was recorded to FX is reversed in month two and bonus expense is recorded at the current income statement rate. This moves the impact of the reversed FX to the operating expense line in month two, but nothing has really changed.
While net income remains the same, values are shifting from FX to bonus expense. If treasury was hedging the accrual, they would show the offset of the accrual in FX Gain/Loss in month two. But since the re-measurement from month 1 would have been reversed, it makes the hedge appear ineffective.
How to Fix It
The right fix in this case is to more closely manage foreign accruals, rebooking the accruals at the historical rate used at initial booking and then, upon invoice receipt, using the initial accrual rate.
A less intensive approach is to record foreign accruals in USD at the balance sheet rate at month end—providing the assets or liabilities at the same value at month end. This provides the operating expense value closer to the rate it will be recorded at in the coming month and keeps values from moving in and out, sabotaging the balance sheet hedge program.
Coordinating your company’s foreign accrual process with treasury will also allow them to more successfully hedge against currency risk.
#2. Foreign Credit Memos
A credit memo is the reversal of a sale, usually to make an adjustment to one or more line-items on an invoice. This is frequently accomplished by reversing the original invoice.
If a credit memo is recorded six months after the sales invoice is issued, there will be an FX surprise when the credit is issued and six months of FX Gain/Loss reversed.
In most systems, credit memos are reversed at the original invoice rate. Most often, the new invoice is generated to the current income statement rate. Once again, this shifts values out of FX Gain/Loss and, this time, into the Revenue line.
For example, let’s assume an invoice denominated in euro for 1M is recorded on a U.S. set of books at 1.05 (1.05*1M=$1,050,000).
Six months later, the company realizes that the invoice is incorrect and that revenue and accounts receivable need to be reduced by 10K euro.
If the current rate is now 1.10, that means re-measurement of $50,000 ([email protected] vs. 1.10) has already been recorded in income.
If the system credits the invoice at 1.05 and issues a new invoice at the current rate of 1.10, the cumulative remeasurement of $50,000 will reverse in the current month and the replacement revenue will be $50,000 higher – misstating both Revenue and FX Gain/Loss.
And, once again, both the cash flow hedge of revenue in the current period and the balance sheet hedge of the receivable will look ineffective.
How to Fix It
We have seen this fixed in two ways. First, by overriding the current accounting rate on the replacement invoice back to the exchange rate of the sale. Second, by capturing the FX Gain or Loss for multiple transactions and, in a topside entry, reclassifying the Revenue slippage back into FX Gain/Loss.
#3. Shadow (or Ghost) Balances
A shadow balance or ghost balance is a monetary asset or liability that creates foreign currency gains and losses on a closed transaction. It occurs when a foreign currency transaction is recorded in one currency but relieved in another currency, leaving behind an open balance to revalue.
Identifying these types of transactions can be tricky, but some common culprits are seeing credit balances in cash accounts or asset balances in traditional liability accounts. For example, a company might accrue a VAT payable in euro but pay it off using a USD cash account. If the entry is posted in USD (driven by the cash), the result is an open liability in euro offset by a USD debit to the same liability account. Most (if not all) ERP systems can’t handle two currency transactions with one entry. You can’t debit in one currency and credit in another currency using a single journal entry.
One serious consequence of these balances is their inclusion in exposures that are collected and hedged by the treasury team.
How to Fix It
The solution is to use two sets of entries when using two currencies, using a clearing account (P&L – usually in the FX Gain/Loss account).
One set relieves the liability in euro. Debit VAT payable and credit FX clearing in euro.
Then, record the cash entry. Credit cash and debit FX clearing in USD.
The two FX entries offset to the realized gain/loss amount, and both cash and VAT accounts are now correct.
Some accounts in some systems can be setup so that they will not accept anything but a specified currency into the account (usually cash accounts). Using this feature can help reduce this problem.
It is important to note that most companies have this problem, and it can create income volatility and incorrect accounting results.
People come and go, and this institutional knowledge might erode over time. So, Hedge Trackers suggests creating an annual (or quarterly) shadow balance prevention training session for all of your legal entities.
#4. Elimination Errors
Inter-company should be a simple transaction. It’s akin to moving something from one pocket to another. But, many times, this area creates a problem for companies in consolidation. There are several areas of intercompany transactions that can be problematic.
The second scenario is when two subsidiaries transact, but they each use their own functional currency as the transaction currency.
This frequently happens because, in a spot transaction, each entity is sending or receiving currency in their functional currency. However, one transaction can’t be denominated in two currencies.
What ends up happening is that neither subsidiary records a foreign currency gains/loss. However, in consolidation, the change in value will create a mismatch in balances that will get “eliminated” to the FX gain/loss line.
The GAAP books will be okay as long as the elimination created by the inter-co is recorded to P&L, but the local statutory books of one of the entities will be off since the appropriate gain/loss amounts were never recorded on the statutory set of books.
How to Fix It
The currency of denomination should be clear from inter-co agreements. This type of issue can be identified by reconciling the intercompany account balances by transaction currency.
On occasion, the initial inter-company transactions may be recorded correctly, but the re-measurement might be set up in the ERP system to book the inter-company adjustment to another account (usually a miscellaneous balance sheet account). If the impact of re-measurement is not recorded directly into the inter-company account but rather to another balance sheet account, the inter-company balance may look out of balance—even though on a net basis they are actually fine.
This may prompt the ERP system to “adjust” the inter-company accounts again to eliminate, creating a second, incorrect FX impact.
How to Fix It
Best practice is to adjust each intercompany account with the re-measurement impact.
This item is not an error in elimination but rather an error in how folks hedge intercompany that’s impacted by the elimination process. Where companies use one currency to record a transaction (perhaps a daily rate) and another to translate its financial statements, the elimination process will reset the booking rate of the non-functional balance to the translation rate. Also, balance sheet hedges executed at the daily rate to match the transaction rate will not be effective.
How to Fix It
By recording this adjustment to inception value to FX Gain/Loss, the transaction moves from the recording rate to the translation rate and inter-company will balance. This rate is also important for cash flow hedge accounting because OCI collection is stopped when the forecasted transaction occurs at the transaction rate. In this case, the translation rate should be used to stop the collection of OCI.
Accountants and ERP systems often book these four types of foreign currency transactions in a way that can drive incorrect FX gain/loss accounting.
Credit memos and accrual issues drive P&L geography issues, making hedge programs look ineffective. Shadow balances and inter-company eliminations drive incorrect exposure positions, ultimately causing incorrect hedge decisions.
Companies need to manage these four common and problematic foreign currency transactions so earnings and hedge results are not misrepresented.
Our consulting experts can provide expertise to help fix these errors – and we can also streamline FX exposure capture to help you quickly and efficiently identify these problem transactions. Schedule a consultation to learn more.