The Effects of FINANCE INCREASING PROFIT MARGINS WITH DECLINING EARNINGS. By Susan M. Sorensen, CPA, and Donald L. Kyle, CPA

Transcription

1 The Effects of INCREASING PROFIT MARGINS WITH DECLINING EARNINGS By Susan M. Sorensen, CPA, and Donald L. Kyle, CPA How and when can you increase profit margins with declining earnings? The quick answer is globalization. Currency translation is rapidly becoming the additional complexity and risk that needs to be factored into every strategic planning, forecasting, budgeting, and financial reporting function. As multinationals increase activities outside their home country, a larger percentage of these activities is initially recorded in a foreign currency, making foreign exchange (FX) rate fluctuation risks and accounting record translation key factors in reported results. This article is designed to help you understand the impact of daily FX fluctuations on forecasting, budgeting, performance evaluation, reported earnings, ratio analysis, and even cash flow expectations, and it advocates additional mandatory disclosures. September 2011 I STRATEGIC FINANCE 35

2 Identifying and planning for FX rate effects has become more significant with the increased volatility during the last three years. For example, McDonald s January 22, 2010, press release announced that its 2009 results included a positive impact of $0.07 per share for the quarter and a negative impact of $0.15 per share for the year because of the effect of foreign currency translation. According to its 2009 annual report, A significant part of the company s operating income is generated outside the U.S., and about 45% of its total debt is denominated in foreign currencies. Accordingly, earnings are affected by changes in foreign currency exchange rates, particularly the euro, British pound, Australian dollar, and Canadian dollar. Collectively, these currencies represent approximately 70% of the company s operating income outside the U.S. If all four currencies moved by 10% in the same direction compared with 2009, the company s annual net income per share would change by about 17 to 19 cents. The recent volatility of FX rates that began during the second half of 2008 has had an effect on reported earnings. With the general strengthening trend of the U.S. dollar (USD) against some major currencies such as the euro, U.S.-based multinational enterprises (MNEs) had to increase their foreign subsidiary profit margins to maintain even a constant level of reported earnings. Since many MNEs now have the majority of their activity outside their home country, analysts and other users need to understand both the complexity and potential effects on performance evaluation and reported results that daily FX rate fluctuations cause when accounting records are kept in multiple currencies. We ll include examples showing fluctuations in reported earnings, ratios, and even cash flow expectations when MNEs with different home countries have activities in the same countries. Hypothetical companies are used to demonstrate translation effects of FX rate fluctuations. The simplified examples use the current rate method, which is the most common method MNEs use and is in compliance with both Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) (SFAS No. 52) and International Financial Reporting Standards (IFRS) IAS 21. Excerpts from annual reports and earnings announcements support the results. Real Effects of Currency Translation The following examples of constant subsidiary profit margins with fluctuating reported earnings facilitate a discussion of some real currency translation effects that companies are dealing with but aren t currently required to disclose. The term real, like many things, is subject to interpretation, so we define real effect as anything that would affect a manager s or an investor s perception of the current performance or the expected future value of an MNE. Thus, it includes the amount of reported earnings as well as the balance in retained earnings available to pay future dividends. The current rate method rules are similar under ASC and IAS 21. Each entity keeps its books and records in its functional currency, which is defined to be the currency of the primary economic environment in which it operates. Assets and liabilities are translated at the exchange rate at the balance-sheet date. Equity accounts are translated at the rates in effect when the transactions occurred. This includes the remittance of dividends to the parent company. Although the standards state that revenues, expenses, gains, and losses are translated at the FX rate in effect at the dates on which those elements are recognized, use of average FX rates is allowed. Because different FX rates are used, a currency translation adjustment (CTA), or plug, is included in other comprehensive income (OCI) in equity to make debits equal credits. The CTA is a mandatory disclosure. But as the following examples show, the change in OCI-CTA may not represent the direction or magnitude of the effect on earnings. 36 STRATEGIC FINANCE I September 2011

3 Table 1: Results for the Four Subsidiaries and the U.S.-Based Consolidated Company for 2008 through 2010 U.S. PARENT JAPANESE SUB GERMAN SUB U.K. SUB U.S. SUB CONSOLIDATED Balance Sheet: In Subsidiary's Currency 5,599,104 34,004 25,038 $50,000 Translated to USD: At 12/31/07 $50,000 $50,000 $50,000 $50,000 $200,000 At 12/31/08 $61,926 $47,752 $36,307 $50,000 $195,985 At 12/31/09 $60,470 $48,861 $40,383 $50,000 $199,714 At 12/31/10 $68,813 $45,369 $38,818 $50,000 $203,000 Earnings - After Tax at 20%: In Subsidiary's Currency 1,119,821 6,801 5,008 $10,000 Translated to USD: Amount for 2008 $10,862 $10,006 $9,291 $10,000 $40,159 Amount for 2009 $11,982 $9,480 $7,838 $10,000 $39,301 Amount for 2010 $12,777 $9,032 $7,744 $10,000 $39,553 Exchange Rates: USD/JPY USD/EUR USD/GBP USD/USD At 12/31/ Effective Average for At 12/31/ Effective Average for At 12/31/ Effective Average for At 12/31/ The examples are designed to isolate FX rate fluctuations effects on reported earnings. The results in Tables 1 and 3 are based on the following assumptions: 1. Parent companies located in Japan, Germany, the United Kingdom, and the United States are created on December 31, 2007, and capitalized with $200,000 or its currency equivalent in the parent s home country. 2. Each parent invests in one domestic and three foreign subsidiaries. The home country subsidiary functions as a control to contrast the effects of FX rate fluctuations on the foreign subsidiary s reported results. 3. Each subsidiary receives one-fourth of the stock investment and then immediately invests that amount in nondepreciable assets in its own country. This assumption simplifies comparison between years since the effects of noncash expenses like depreciation can be ignored. 4. Each subsidiary meets the current rate method functional currency requirements to keep its books and records in the country s currency where the subsidiary and its assets are located. 5. The after-tax earnings are assumed to be held constant over time at 20% per year measured in the subsidiary s functional currency, and, unless stated otherwise, monthly income is 1/12 of yearly income. 6. Unless stated otherwise, earnings are remitted to the September 2011 I STRATEGIC FINANCE 37

4 parent and paid out in dividends to the shareholders before year-end so that the amount of assets remaining on the subsidiary s books remains constant over time measured in their functional currency. By assumption, the parent company doesn t owe additional taxes when it remits dividends. 7. All subsidiaries qualify and have chosen to translate each month s earnings at the average monthly FX rate. 8. The FX rates come from and use the ask prices. 9. The international standard code letters are used for currency abbreviations: U.S. dollar (USD), Japanese yen (JPY), euro (EUR), and Great Britain pound (GBP). Effect on Reported Earnings Table 1 shows the U.S. subsidiary s earnings are $10,000, while the earnings of the foreign subsidiaries fluctuate each year even though their bottom-line profit margin remains at 20% measured in their functional currency. Although the total reported earnings of $40,159 for 2008 is close to $40,000, the increase of $862 in reported earnings from the Japanese subsidiary is almost completely offset by the decrease of $709 from the U.K. subsidiary. In 2010, the reported earnings vary from a high of $12,777 for the Japanese subsidiary to a low of $7,744 for the U.K. subsidiary. As a general rule, when the parent company s currency weakens (strengthens) during the year, the consolidated reported earnings are higher (lower) than they would have been had FX rates remained constant during the year. Effect on Reported Assets As Table 1 shows, the book value of the assets in the consolidated balance sheet changes year-to-year even though during 2008 through 2010 the amount didn t fluctuate on the subsidiary s books. The interpretation of a change in a balance-sheet account year-to-year is more difficult when books and records are kept in multiple currencies. The reported value of assets, such as land, can change year-to-year without purchases, sales, or impairments. Shell Oil s 2009 Footnote 9 to the financial statements prepared under IFRS using USD included a table that disclosed a negative currency-translation-differences effect on its property, plant, and equipment of $25.9 billion for 2008 and a positive effect of $14.9 billion for Table 1 also shows that the original $50,000 asset investment in the Japanese, German, and U.K. subsidiaries now translates to $61,926, $47,752, and $36,307, respectively, at December 31, As a result, the consolidated company s book value of the assets declined to $195,985. The consolidated balance of $199,714 for 2009 is close to the original $200,000 because, over the two years, the USD s weakening against the JPY was almost completely offset by its strengthening against the EUR and the GBP. If all of the original investment had been made in the Japanese subsidiary, the translated assets would have increased to $275,252 ($68,813 4) for 2010, while an investment in the U.K. would have translated to $155,272 ($38,818 4). Effect on Common Ratios Table 2 uses two ratios to demonstrate potential effects on ratio analysis: return on investment (ROI) and return on assets (ROA) for the U.S.-based MNE in Table 1 along with ratios computed as if the parent company had originated in each of the three other countries. The absence of liabilities makes the ROA comparable to a return on equity (ROE). The ROA can be contrasted with the ROI. Reported earnings are affected by both the pattern of earnings recognized in the functional currency and the pattern of FX rate fluctuations during the year. Reported earnings are the numerator in both the ROI and ROA. The ROI denominator is the original investment in the reporting currency, and the ROA denominator is the average of the beginning and end-of-year translated asset balances. The ROI ranges from a low of 8.44% for the U.K. subsidiary of the Japanese-based MNE to a high of 32.81% for the Japanese subsidiary of the U.K.-based MNE. The Japanese-based MNE s consolidated ROI of 13.87% for 2010 is significantly less when compared to the U.K.-based MNE s 25.50%. For the U.S.-based MNE, the effect of the USD strengthening against both the EUR and the GBP is 38 STRATEGIC FINANCE I September 2011

5 Table 2: Computation of the Return on Original Investment and the Return on Assets for a Parent Company Located in the U.S., Japan, Germany, or the U.K. JAPANESE SUB GERMAN SUB U.K. SUB U.S. SUB CONSOLIDATED U.S.-Based MNE ROI for % 20.01% 18.58% 20.00% 20.08% ROI for % 18.96% 15.68% 20.00% 19.65% ROI for % 18.06% 15.49% 20.00% 19.78% ROA for % 20.47% 21.53% 20.00% 20.28% ROA for % 19.62% 20.44% 20.00% 19.86% ROA for % 19.17% 19.56% 20.00% 19.64% Japanese-Based MNE ROI for % 18.52% 17.38% 18.47% 18.59% ROI for % 15.82% 13.21% 16.71% 16.44% ROI for % 11.37% 8.44% 15.68% 13.87% ROA for % 20.91% 21.84% 19.24% 23.46% ROA for % 20.05% 20.88% 20.46% 19.88% ROA for % 21.58% 21.26% 21.52% 18.78% German (Eurozone)-Based MNE ROI for % 20.00% 18.55% 20.09% 20.10% ROI for % 20.00% 16.53% 21.15% 20.73% ROI for % 20.00% 17.16% 22.19% 21.90% ROA for % 20.00% 21.07% 19.63% 19.60% ROA for % 20.00% 20.84% 20.44% 20.33% ROA for % 20.00% 16.99% 20.88% 18.23% U.K.-Based MNE ROI for % 27.16% 20.00% 21.75% 23.12% ROI for % 27.16% 20.00% 25.61% 25.81% ROI for % 23.33% 20.00% 25.85% 25.50% ROA for % 23.45% 20.00% 18.30% 17.18% ROA for % 21.51% 20.00% 19.58% 19.19% ROA for % 19.61% 20.00% 20.47% 19.57% ROI=reported earnings divided by the original investment. ROA=translated earnings divided by the average of the beginning- and end-of-year asset balances. offset by its weakening against the JPY, and, as a result, the consolidated ROI is close to 20% for all three years. Table 2 shows ROAs that range from a low of 16.83% for the Japanese subsidiary of the U.K.-based MNE to a high of 23.45% for the German subsidiary of the U.K.- based MNE. Although the ROI for the Japanese subsidiary of the U.S.-based MNE ranges from 21.72% for 2008 to 25.55% for 2010, the ROA ranges from 19.41% to September 2011 I STRATEGIC FINANCE 39

6 Table 3: U.S.-Based MNE Consolidated Balance Sheet for 2008 Effect of Dividend Payment on Retained Earnings and Other Comprehensive Income CONSOLIDATED Without With Dividends Remitted Remitted to Dividends Parent Paid Out JAPANESE GERMAN U.K. U.S. PARENT ELIMINATION 12/31/08 Cash 12,385 9,551 7,262 10,000 39,198 0 Investment 200,000 (200,000) 0 0 Land 61,926 47,752 36,307 50, , ,985 Total 74,311 57,303 43,569 60, ,000 (200,000) 235, ,985 Common Stock 50,000 50,000 50,000 50, ,000 (200,000) 200, ,000 Retained Earnings 10,862 10,006 9,291 10,000 40, OCI-CTA 13,449 (2,703) (15,722) 0 (4,976) (4,976) Total 74,311 57,303 43,569 60, ,000 (200,000) 235, , %, respectively. The Japanese subsidiaries of foreign parents have lower ROAs even though their ROIs are higher because of the effect of the strengthening JPY on the translated asset balances at the end of each year. The U.K. subsidiaries of foreign parents have higher ROAs since they benefit from the relative weakening of the GBP. The ROA of the U.K. subsidiary of the U.S.-based MNE is 21.53% for 2008, even though Table 1 shows the ROI is 18.58% because the translated balance of assets dropped to $36,307. Effect on Equity Table 3 shows the consolidated balance sheet for 2008 with and without the subsidiaries remitting earnings and the parent paying a dividend equal to the amount of dividends remitted. On December 31, 2008, the amount of cash available for dividends is $39,198. Yet this amount is $961 less than the retained earnings balance at the end of If an investor assumes that the amount in retained earnings is available to pay dividends, the fact that the amount foreign subsidiaries remitted to the parent is less than the amount of reported earnings may be an effect on cash flow expectations. The OCI-CTA balance remains the same. Effect of Timing of Earnings The timing of revenue and expenses during a year affects the amount of the translated earnings. Although the use of monthly averages is common, some MNEs, such as Shell Oil, use quarterly averages. Per ACS : Average rates used shall be appropriately weighted by the volume of functional currency transactions occurring during the accounting period. For example, to translate revenue and expense accounts for an annual period, individual revenue and expense accounts for each quarter or month may be translated at that quarter s or that month s average rate. The translated amounts for each quarter or month should then be combined for the annual totals. If the pattern of monthly or quarterly earnings changes, the amount of translated earnings reported for the year changes. Table 4 shows an extreme example of a pattern of monthly earnings along with the earnings computations for the German subsidiary from Table 1. The calculations are based on the assumption that their total earnings remain at 6,801. A loss of 30,000 is assumed to occur in July when the 2008 monthly average FX rates were at their peak. Income of 36,801 is assumed to be earned in November when the monthly average FX rate had declined to its lowest average. Although the untranslated earnings are the same, the translated earnings now show a loss of $568 for 2008 instead of the $10,006 profit in the first part of Table 4. This same pattern of earnings now translates to $12,607 rather than $9,480 for 2009, an increase of approximately 33%. Effect of Relative FX Rates To discuss the relationship between the mandatory disclo- 40 STRATEGIC FINANCE I September 2011

7 Table 4: Examples Showing Effect of Timing on Earnings AMOUNTS COMPUTED FOR TABLE 1 GERMAN (EUROZONE) SUBSIDIARY'S TRANSLATED EARNINGS NET INCOME/(LOSS) AT 2008 RATES AT 2009 RATES AMOUNT AVERAGE IN USD AVERAGE IN USD MONTH IN EUR FX RATE COLUMN B*C FX RATE COLUMN B*E A B C D E F Totals 6,801 10,006 9,480 Table displays rounding differences. EXTREME TIMING EXAMPLE GERMAN (EUROZONE) SUBSIDIARY'S TRANSLATED EARNINGS NET INCOME/(LOSS) AT 2008 RATES AT 2009 RATES AMOUNT AVERAGE IN USD AVERAGE IN USD MONTH IN EUR FX RATE COLUMN B*C FX RATE COLUMN B*E A B C D E F (30,000) (47,351) (42,222) , , , Totals 6,801 (568) 12,607 Table displays rounding differences. sure of the change in OCI-CTA and the undisclosed effects on earnings, we ll examine the relative relationships between the FX rates at the beginning of the year (BOY), end of the year (EOY), and the effective average (AVG). For purposes of this discussion, the AVG rate is the earnings in the home country currency divided by the earnings in the foreign currency to provide an average factor that doesn t depend on the averaging convention used by September 2011 I STRATEGIC FINANCE 41

8 Table 5: Relationships Between Relative FX Rates, Change in OCI-CTA, and Effect on Earnings and Frequency of Occurrence of these Relationships RELATIVE CHANGE IN OTHER EFFECT ON CASE RELATIONSHIP OF COMPREHENSIVE EARNINGS FREQUENCY OF OCCURRENCE** NUMBER THE DIRECT FX RATES INCOME AS DEFINED* USD/JPY USD/EUR USD/GBP AVERAGE WITHIN RANGE OF BEGINNING- AND END-OF-YEAR FX RATES 1 BOY < AVG < EOY Positive Positive 42.5% 52.5% 43.4% 2 EOY < AVG < BOY Negative Negative 24.2% 20.8% 25.0% 66.7% 73.3% 68.4% AVERAGE OUTSIDE RANGE OF BEGINNING- AND END-OF-YEAR FX RATES 3 AVG < BOY < EOY Positive Negative 11.7% 5.8% 7.5% 4 AVG < EOY < BOY Positive or Negative Negative 8.3% 7.5% 8.3% 5 EOY < BOY < AVG Negative Positive 9.2% 4.2% 7.5% 6 BOY < EOY < AVG Positive or Negative Positive 4.2% 9.2% 8.3% 33.3% 26.7% 31.6% Total 100.0% 100.0% 100.0% *Assumes positive earnings earned equally throughout the year and a positive effect on earnings defined in relationship to the BOY rates. **Frequency of occurrence for fiscal year-ends during the 10-year period ended 12/31/10. the MNE or the pattern of earnings during the year. Table 5 links the relationship between BOY, EOY, and AVG to the mandatory disclosure of the change in OCI- CTA and the effect on earnings when earnings are positive. By assumption, the earnings effect is said to be positive when the AVG is greater than the BOY. This can be contrasted with the constant currency disclosures some companies, such as McDonald s, make where they translate the current-year earnings information at the prior-year rates and then compare it to the current-year reported amounts. In cases 1, 5, and 6, the average FX rate is greater than or equal to the beginning-of-the-year rate, so the effect on earnings is by definition positive, but the reported change in OCI-CTA may be positive, negative, or undetermined without more information. Cases 2, 3, and 4 have a negative defined effect on earnings, but, again, the reported change in OCI-CTA may be positive, negative, or undetermined. Cases 1 and 2 are the more common cases, as Table 5 shows, and the reported change in OCI-CTA in equity is the same as the direction of the effect on earnings, assuming the effect on earnings is determined in relationship to the BOY rates. In cases 3 and 5, the effect on current-year earnings is opposite of the reported change in OCI-CTA. In cases 4 and 6, knowledge of the FX rate relationships and the amount of the change in OCI-CTA doesn t provide definitive information, so supplemental information would be necessary. Table 1 shows some of the cases. The German and U.K. subsidiaries are examples of cases 5 and 2, respectively, for The Japanese subsidiary is an example of case 1 for 2008 and 2010 and case 4 for For 2009, the relationship of the FX rates is AVG < EOY < BOY. In this case, the effect on earnings is negative by definition, and the change in OCI-CTA would be affected by factors such as the amount of earnings for 2009, the amount of net assets at December 31, 2008, and December 31, 2009, and the magnitude of the differences in the FX rates. Table 5 shows the occurrence of each of the six cases for the USD/JPY, USD/EUR, and GBP/USD. We analyzed FX rates by assuming that income was earned equally each month for each possible fiscal year-end during the 10-year period ending December 31, Then we compared these rates to the BOY and the EOY rates for that fiscal year to determine the frequency of the occurrence of each case. Table 5 shows that cases 1 and 2 42 STRATEGIC FINANCE I September 2011

9 Table 6: Comparison of the Direction of a McDonald s Type of Constant Currency Disclosure to the Direction of the Effect When Measured in Relation to the Beginning-of-the-Year Foreign Exchange Rate for the 10-Year Period Ended 12/31/10 FREQUENCY OF OCCURRENCE USD/JPY USD/EUR USD/GBP Both Disclosures Positive 40.8% 52.5% 46.7% Both Disclosures Negative 43.3% 22.5% 32.5% Total Same Direction 84.1% 75.0% 79.2% Constant Currency is Positive and Effective AVG - BOY is Negative 9.2% 11.7% 8.3% Constant Currency is Negative and Effective AVG - BOY is Positive 6.7% 13.3% 12.5% Total Different Directions 15.9% 25.0% 20.8% occur with the greatest frequency. In the rest of the cases, the AVG falls outside the range of the BOY and the EOY rates with frequency of 33.3% for the USD/JPY, 26.7% for the USD/EUR, and 31.6% for the USD/GBP. In these cases, the mandatory disclosure of the change in OCI- CTA may not be a good proxy for the direction of the effect on earnings. Table 5 also shows that the direction of the change in OCI-CTA may be opposite of the effect on earnings and becomes unclear when the AVG falls outside the BOY and EOY range. McDonald s reported change in OCI- CTA in equity was a negative $1.223 billion for 2008, which was opposite the overall positive effects it reported on revenue and earnings. In 2009, it reported a positive $714 million change in OCI-CTA but a negative impact on earnings. Since the formats of voluntary disclosures about effects on reported earnings aren t mandated, we compared the McDonald s-type constant currency disclosure to the assumption of positive and negative earnings effect in Table 6. McDonald s compares the current-year reported earnings to the earnings that would have been reported at the prior-year rates. We did the computations for the same 10-year period with income again assumed to be constant each month. We compared the results to the computations for Table 5 to determine how often the direction of the earnings-effect disclosure would have been the same under both definitions. Table 6 shows that a U.S.-based MNE with a subsidiary in the Eurozone would have reported a different direction to the effect on earnings 25% of the time. Recommendation In 1981, when Statement of Financial Accounting Standards (SFAS) No. 52 was passed, the Statement encouraged, but didn t mandate, disclosing the effect of FX rate fluctuations on earnings. Given the current and anticipated continuing volatility in daily FX rates, this appears to be an appropriate time for accountants to revisit this decision. It may be easy to agree on the need for more disclosures, but the format may be more difficult. Geographic segment information may provide some indication of the earnings and asset risks by country, but the segment information is reported by activity location or asset and not by the functional currency used to record the activity. As we demonstrated, companies like McDonald s are voluntarily disclosing some effects, risks, and sensitivity of the company s results because of FX rate fluctuations. Agreeing on the content and format would increase the usefulness of the currencytranslation-effects disclosures on decisions. SF Susan M. Sorensen, CPA, Ph.D., is the accounting chair at the University of Houston at Clear Lake, where she teaches international accounting and business taxation. In her prior 30-year career in public accounting, she worked for three of the Big 4 accounting firms. You can reach her at Sorensen@uhcl.edu. Donald L. Kyle, CPA, Ph.D., is a professor at the University of Houston at Clear Lake, where he teaches managerial and cost accounting. He also is a member of IMA s Houston Chapter. You can reach him at Kyle@uhcl.edu. September 2011 I STRATEGIC FINANCE 43