Managing the P&L and cash flow impacts related to foreign exchange exposures can appear daunting. The following steps, while not all-inclusive, make this task easier:
Develop a foreign currency policy and procedure. Include the company goals related to foreign exchange management, types of derivatives that may be employed, and personnel authorized to execute transactions.
Apply a bottom-up approach to identifying consolidated foreign currency exposures. Determine in what currencies each subsidiary collects receivables and makes payments. Identify assets and liabilities that are denominated in a currency other than the individual subsidiary’s functional currency, including intercompany receivables and payables.
Prepare a consolidation of all subsidiaries’ foreign currency assets and liabilities. The consolidation should result in a natural offset or netting of some of the foreign currency balance sheet exposure. Remaining net consolidated balance sheet positions by foreign currency should represent the exposure that will be remeasured due to changes in foreign exchange rates with the impacts recorded in the income statement.
Determine the anticipated annual foreign currency cash flows of each subsidiary. Estimate the total receipts and payments made by each subsidiary in each currency by month for the next 12 months (longer if possible). Add up the total projected receipts and payables by foreign currency (other than the respective subsidiary’s functional currency) for each subsidiary by month to arrive at the company’s total annual net anticipated foreign currency cash flows.
Develop a strategy to manage consolidated exposure. For foreign currency net balance sheet positions, consider forward contracts in combination with currency swaps—selling one currency for another and simultaneously agreeing to exchange the same currencies at a specified time in the future—to substantially offset the P&L effects of changes in currency rates when the balance sheet positions are remeasured.
Review accounting treatment prior to the execution of contracts. Determine whether a derivative will qualify for designation as a hedge. To qualify for hedge accounting treatment, consider whether the hedging relationships between the hedged exposure and the foreign exchange derivative will be highly effective in offsetting changes in the fair values or cash flows attributed to the hedged item for an extended time. Develop the substantial documentation required prior to hedge inception if hedge accounting is elected, and design periodic tests to measure hedge effectiveness to determine financial statement recognition for designated hedge transactions. For derivatives that are not designated as a hedge, the changes in the fair market value of the derivative flow through the P&L in the period of change (see FASB ASC Topic 815).
Seek appropriate approvals. Obtain approvals from company management before trade execution per corporate policy as well as agreement from external auditors regarding proposed hedge accounting treatment and methodologies for the determination of hedge effectiveness.
Monitor on an ongoing basis. Periodically review the foreign currency balance sheet positions and update changes in the anticipated foreign currency cash flows by subsidiary. Review monthly income statements and ensure foreign currency gains and losses are reasonable based on identified exposures and derivative contracts in place. If they are not, a foreign currency exposure has likely changed or not been identified, requiring further investigation.
—By Pam Heye, CPA, (firstname.lastname@example.org) a treasury management expert based in Raleigh, N.C.
Sample Foreign Currency Management Policy
Foreign currency management policies, including amount thresholds, will vary from company to company. The following sample policy is presented to assist in the development of a policy and to suggest issues to be considered when developing a formal policy. Click here to download in Microsoft Word.
Sample Cash Flow Worksheets
Notice: This Microsoft Excel template is for the personal, noncommercial use of the reader. Click here to download in Microsoft Excel.
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