As trade and tariff wars wage on, companies are turning increasingly to non-GAAP accounting to try to explain the resulting currency volatility in reported financial results.
Under Accounting Standards Codification Topic 830, companies are required to report transactions in their functional currency, so U.S. companies report their results in U.S. dollars. Where companies have sales or expenses denominated in other currencies, as with overseas operations, those numbers must be reported in U.S. dollars as well.
The accounting rules require any conversion, whether it produces a gain or a loss depending on the dollar’s strength or weakness against other currencies, to be reported through the income statement. “It must be reflected in earnings as a currency gain or loss, so it could have great impacts on P&L depending on swings in currency,” says Alex Fredericks, a partner at EY.
Those are earnings swings that may have nothing to do with how a company’s core business operations are performing. Hedging, or investing in financial instruments that offset identified risk, is one way to deal with that volatility. Companies routinely hedge their foreign currency risk in an effort to smooth net income, but hedging is not a silver bullet.
In today’s geopolitical environment, swings may occur so abruptly hedging strategies may have difficulty keeping up, especially for smaller companies that have thinner treasury operations. Hedging gets more difficult when certain currencies are especially volatile and time horizons on risk are more uncertain, says Neri Bukspan, also a partner at EY.
Disclosure is an important way for companies to explain volatility, says PwC. Companies should consider taking a fresh look at what they tell investors about their foreign operations and foreign currency transactions, not just in required disclosure but in voluntary additional footnotes to be sure investors can understand material risks arising from currency differences.
“We’ve already seen with companies early adopting the standard that more companies will enter the hedging realm due to the simplification of the rules. But just because you do hedge accounting, that doesn’t eliminate all the volatility in earnings.”
Alex Fredericks, Partner, EY
Constant currency reporting is another way to deal with the volatility, and its use has risen in the past handful of years in part due to increasing geopolitical uncertainty that is producing volatility in foreign currency values. “Constant currency tries to remove that foreign currency volatility from non-GAAP reporting,” says Fredericks.
Constant currency reporting involves the use of non-GAAP accounting measures to try to explain core earnings from operations by removing the effects of currency fluctuations. Companies may report such figures in their management discussion and analysis, press releases, or other materials, often by using exchange rates from an earlier period end and applying it to current balances.
Helen Kane, CEO at hedge management firm Hedge Trackers, says constant currency reporting has become “quite prevalent” among multinational companies. “Sometimes the information they’re reporting is very useful,” she says.
Kane has concerns, however, that in some cases investors may have difficulty sorting out what’s really happening. As a sophisticated user of financial statements, she’s seen some reporting that she imagines could be difficult for investors to understand.
“In many situations, I believe it’s a little more smoke and mirrors,” says Kane. In some cases, she says, companies don’t necessarily do a good job of explaining how they’ve adjusted their numbers to remove the effects of currency fluctuations.
Non-GAAP reporting like constant currency reporting is not forbidden by the Securities and Exchange Commission, but companies have some clear guidelines to follow that are meant to assure non-GAAP measures are not abused so as to mislead or confuse investors. The SEC has been on a mission the past few years to shore up non-GAAP reporting abuses.
Under non-GAAP reporting rules, for example, companies are not permitted to present non-GAAP figures more prominently than GAAP figures. That’s been one of the biggest slipping points where the SEC has harped on companies to clean up their reporting.
PwC on foreign currency volatility
As a result of increased currency volatility, companies should take a fresh look at their disclosures about foreign operations and foreign currency transactions. In addition to required disclosures, companies should consider supplemental disclosure in the footnotes to enhance stakeholders’ understanding of the material currency risks.
In MD&A, management should consider describing how trends in reported amounts may be attributable to currency volatility, and explain potential future effects of changes in exchange rates on the financial statements. Discussion of foreign operations in a disaggregated manner may be necessary, particularly for businesses operating in highly inflationary environments.
Disclosures could include a description of the broader economic circumstances surrounding exchange rate volatility, and its effect on business practices and plans. Companies should describe strategies for managing currency risk, like hedging programs, and identify material unhedged foreign currency items.
Robust disclosure of these key currency risks and impacts enhances comparability with previous periods.
Constant currency measures
Another way to explain the impact currency volatility has had on the financial results is through the use of constant currency reporting. Constant currency measures are non-GAAP measures, sometimes used in MD&A or press releases, to present core earnings without the effects of exchange rate fluctuations.
Because they are non-GAAP measures, there are no rules on how to present constant currency disclosures. Typically, they are calculated by translating current balances at prior period rates. As with all non-GAAP measures, public companies that include these metrics in their SEC filings should reconcile them to the comparable GAAP measures, which need to be shown with equal or greater prominence, and disclose why the measures are useful. In addition, we encourage companies to calculate the constant currency measures consistently from period to period and to be transparent as to how they are calculated.
The rules also require companies to explain the non-GAAP number and why it is considered useful in understanding the company’s operations. They must reconcile any non-GAAP measure to the nearest GAAP equivalent. They also must report non-GAAP measures consistently and without bias from one period to the next, not simply cherry picking the numbers in any given period that present the company’s results in the most favorable light.
In the context of currency volatility, that means a non-GAAP adjustment one period to explain away a loss or a reduction in profit shouldn’t disappear from reporting in the next period if the same adjustment would seem to boost earnings.
Kane says her biggest concern with constant currency reporting that she’s analyzed are cases where methods used to calculate the non-GAAP presentation are not consistent with how the company’s financial systems or financial reporting actually work. As an example, Kane says, she’s seen companies with cyclical or uneven revenues using simple averages of exchange rates over extended periods to explain currency effects to investors when they use more time-specific factors in their financial statements. “That’s misleading,” she says.
Historically, companies often evened out currency effects by reporting unit sales, average selling prices, or other metrics that are not affected by currency variations, says Kane. “Now you rarely hear of it,” she says. “Constant currency reporting didn’t come into fashion until currencies started hurting companies.”
Kane, an advocate for hedging, wonders if companies might be over-relying on non-GAAP reporting rather than taking a more proactive approach to managing their currency risks. “Maybe they’re just trying to take currency out of the equation, but currency is part of the equation, and you have to manage that,” she says.
Managing currency differences across multinational corporations is a complex undertaking, says Bukspan. Managers within business units are juggling numerous operational considerations that may have some built-in elasticities, like labor, supply chain, or pricing issues, which can act as “natural hedges,” he says.
That all factors into the equation when it comes to determining how to manage currency risk, says Bukspan. “There are a lot of operational complexities before you even get into how to transcribe it in accounting and how you want to report it to investors,” he says.
New, simpler hedge accounting rules taking effect this year might also spur more companies to consider more hedging, says Fredericks, but it won’t eliminate constant currency reporting. Some companies have shied away from hedging in certain situations due to the complexity of the accounting rules, but the new rules are already drawing more into hedging, he says.
“We’ve already seen with companies early adopting the standard that more companies will enter the hedging realm due to the simplification of the rules,” says Fredericks. “But just because you do hedge accounting, that doesn’t eliminate all the volatility in earnings.”