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Daily Exchange Rates: Easy to Implement, Hard to Explain

Increasingly general ledger systems can upload daily rates from service providers – but too many accountants aren’t giving enough thought to the impact of a change.

Treasury and finance professionals need to put their finger in the dike before operating margin is overwhelmed by the wave of confusion that generally surrounds FX Gain/Loss currently hidden away in Other I&E. There are very few benefits – and those are of marginal value – to moving from a monthly income statement rate to a daily rate in the recording of non-functional currency transactions in functional currency.

FAS 52 requires that “for revenues, expenses, gains, and losses, the exchange rate at the dates on which those elements are recognized shall be used.” However they indicate that “literal application of the standards in this Statement might require a degree of detail in record keeping and computations that could be burdensome as well as unnecessary to produce reasonable approximations of the results. Accordingly, it is acceptable to use averages or other methods of approximation.”

By translating all non-functional currency transactions at a single “current” rate for a month (rather than each day’s rate), management can understand and easily validate amounts recognized in foreign exchange gains and losses through very simple math equations. The ability to understand and analyze all non-functional currency transactions (revenue, expenses, other) is equally straightforward. The use of a daily rate, on the other hand, makes the validation of the foreign exchange gain and loss – no less revenue, expense or other non-functional currency transactions – impractical.

In addition there are a large number of transactions that occur throughout the month, but are booked only at the end of the month. The booking of these large transactions and related booking dates could clearly be used to manipulate non-functional currency denominated revenues, expenses, etc. The uncertainty management feels going into a period with respect to the values to be recorded in FX Gains and Losses would be replaced with uncertainty of the valuation of all non-functional income and expense items during a month (i.e., we would not know what rate non-functional income items would be recorded at in the current month). Anomalies would be created should a USD100 transaction be recorded in Euro at one rate at the beginning of the month and then “translated” back into USD during the consolidation at USD102 or USD96. Intercompany transactions would be booked at daily rates and consolidate using average rates resulting in FX Gains and Losses that would be difficult to explain, manage or substantiate.

The only benefit of using daily rates is that the uncertainty of remeasurement gains and losses would be moved (geographically) up the income statement. This reflects the “rule” that all transactions in the month will net/net be recorded at the Balance Sheet Rate at month end. To further clarify: If a company records Euro revenue on a USD functional entity at the prior month Balance Sheet Rate of 1.35 and remeasures the receivable at month end to 1.30, earnings will reflect Revenue of 1.35 and FX Loss of .05, for a net impact on earnings of 1.30. If, however, the revenue was recognized the day prior to month end at 1.31 and the receivable revalued to 1.30 at month end, earnings will reflect Revenue of 1.31 and FX Loss of .01, for a net impact on earnings of 1.30. Even if Revenue was booked at the month end Balance Sheet Rate 1.30 and no FX was recorded, the net impact to earnings in that period would equal 1.30. Clearly, the daily versus a single rate used throughout the month has no impact on net income.

The difficulty with using daily rates, then, becomes explaining other lines in the income statement. What rates was Euro revenue booked at during the month? Did people not book items until later in the month to manipulate revenue – or, worse, in the expectation that the Euro might strengthen? This would cause even greater problems in the FX gain/loss line. Revenues and expenses in the same period would not be recognized at the same rate, meaning any natural (economic) hedge would not necessarily be reflected in operating margin. FX gains and losses would be less explainable, requiring delving into the daily transaction volumes … not likely.

The only potential improvement of a move to daily rates would be the ability of Treasury to hedge more frequently by tracking changes (up and down) of exposures and hedging them. This could introduce what might appear to be “churning” trading activity as exposures would go up one day when revenues were booked, so treasury would sell currency, then when expenses were booked they would buy the position back – lucky because their trades were matching (at least somewhat) the rates that the transactions were booked at. Little or no FX gain or loss would be generated.

In conclusion, we do not see any benefit to the use of daily rates to a company. What we do see is reduced ability to explain the impact of all non-functional currency transactions in the financial statements.