The impact of exchange rates on the accounts of Ocean Wilsons Holdings Limited.

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Jeffrey Fox
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1 The impact of exchange rates on the accounts of Ocean Wilsons Holdings Limited. Ocean Wilsons Holdings Limited reports in US Dollars which is also the Group s functional currency but due to the Group s substantial interests in Brazil the Group has revenue, costs, assets and liabilities in both Brazilian Real BRL and US Dollar USD. Therefore, movements in the USD / BRL exchange rate can impact the Group both positively and negatively from period to period. This note explains the principal effects on the Group s consolidated accounts from movements in the USD / BRL exchange rate and where these impacts are reported. The impact on the Group s accounts depends both on movements in the period end exchange rate and on exchange rates during the period. The impact of exchange movements on an entity s accounts varies, depending on the functional currency of the entity. The Group includes subsidiary entities with USD functional currency and entities with BRL functional currency7. Conversion of the income statement The income statement is translated into US Dollars on a daily basis using a daily USD/BRL exchange rate. The Group s Brazilian entities maintain accounts in both USD and BRL. If the USD/BRL exchange rate during the period is higher than the previous comparative period, this adversely impacts BRL denominated revenues when converted into USD, as their value is lower in USD terms. However, the same exchange movement will benefit BRL denominated expenses as they cost less in USD. The net impact on the Group s margins and financial results depends on whether BRL denominated revenues exceed or are less than BRL denominated costs and also the timing of their recognition and conversion during the year. The percentage of the Group s revenues or expenses denominated in BRL is not fixed but varies depending on the mix of sales within a business segment and the relative weighting of business segment revenues within the Group. The Group estimates that approximately 50% of the Group s revenues are denominated in USD and the remaining 50% in BRL. The Group estimates that the percentage (excluding depreciation) of operating expenses denominated in BRL is approximately 85%. 1

2 Transaction translation Transactions other than those in the functional currency of the entity are translated at the exchange rate prevailing at the date of the transaction. (i) (ii) (iii) (iv) When a Brazilian entity has a USD functional currency and revenue is denominated in USD, that revenue and receivable will be recorded and maintained in USD in USD denominated accounts. If a USD functional currency entity has revenue denominated in BRL, that will be translated into USD at the exchange rate prevailing at the date of the transaction and recorded in USD denominated accounting records as revenue and a receivable. When a Brazilian entity has BRL as its functional currency and revenue is denominated in BRL, that will be recorded in BRL denominated accounting records as revenue and a receivable. If a BRL functional currency entity has revenue denominated in USD, that will be translated into BRL at the exchange rate prevailing at the date of the transaction and recorded in BRL denominated accounting records as revenue and a receivable. When a Brazilian entity has USD as its functional currency and an expense is denominated in USD, that expense and payable will be recorded and maintained in USD in USD denominated accounts. If a USD functional currency entity has expenses denominated in BRL, that will be translated into USD at the exchange rate prevailing at the date of the transaction and recorded in USD denominated accounting records as an expense and a payable. When a Brazilian entity has BRL as its functional currency and an expense is denominated in BRL, that will be recorded in BRL denominated accounting records as an expense and a payable. If a BRL functional currency entity has expenses denominated in USD, that will be translated into BRL at the exchange rate prevailing at the date of the transaction and recorded in BRL denominated accounting records as an expense and a payable. The BRL functional currency income statement is maintained in BRL and translated into USD on a monthly basis using the average USD/BRL exchange rate for the period. Depreciation on property, plant and equipment in US Dollar functional currency businesses is fixed in US Dollar terms and will not vary with movements in the USD/BRL exchange rate. Principal exchange rate items in the accounts Foreign exchange gains or losses on monetary items Reported in the profit or loss in a single line US$2.3 million gain 2017 US$2.8 million gain Principally USD functional currency Foreign currency gains and losses relate to certain monetary items that are not denominated in an entity s functional currency. The gains or losses on the following monetary items are reported in this line in the profit and loss: 2

3 - trade and other receivables; - trade and other payables; - deferred tax; - current tax; - provisions for tax, labour and civil disputes; and - Cash. (Exchange movements on borrowings, which are also monetary items, are reported separately in the profit and loss under finance costs). The gains or losses reported in foreign exchange gains or losses on monetary items are predominately driven by movements in the USD/BRL exchange rate impacting the USD value of BRL denominated monetary items in USD functional currency entities. These monetary items are revalued at each period end using the USD/BRL period end exchange rate with the resulting gains or losses recorded in the line foreign exchange gains or losses on monetary items in the profit and loss. Example A sale denominated in BRL of R$100 is made by a USD functional currency entity when the BRL exchange rate for the day relative to the US Dollar is 1:1. Revenue of US$100 is recognised in the profit and loss. At period end the Group has not received payment and therefore has a receivable (debtor) of R$100 recorded in the accounts. The period end USD/BRL exchange rate is 1:1.25 so the BRL denominated debtor is now valued at US$80. The difference between the current USD value of the debtor of US$80 and the sale of US$100 is reported as an exchange loss of US$20 in the foreign exchange gains or losses on monetary items line. If the BRL had strengthened relative to the USD at period end, an exchange gain would be recognised. An expense and creditor would have an opposite exchange effect. An expense denominated in BRL of R$100 is incurred by a USD functional currency entity when the BRL exchange rate for the day relative to the US Dollar is 1:1. An expense of US$100 is recognised in the profit and loss. At period end the Group has not paid the expense and an outstanding payable (creditor) of R$100 is recorded in the accounts. The period end USD/BRL exchange rate is 1:1.25 so the BRL denominated creditor is now valued at US$80. The difference between the current USD value of the creditor of US$80 and the expense of US$100 is reported as an exchange gain of US$20 in the foreign exchange gains or losses on monetary items line. If the BRL had strengthened relative to the USD at period end, an exchange loss would be recognised. The net impact on these exchange movements on the profit and loss in the period depends on: - the net balances of monetary items not denominated in an entity s functional currency (whether the Group has more monetary debit or credit balances not denominated in an entity s functional currency); - the movement in the period end exchange rate relative to the prior period exchange rate; and - the movement in the period end exchange rate relative to the exchange rates used during the period. 3

4 BRL functional currency treatment. If the same BRL denominated monetary item was held by a BRL functional currency entity, no loss would be recognised in the income statement as no change in the BRL value has occurred. In this case when the business is consolidated the US$20 loss will be recognised as Exchange differences arising on translation of foreign operations and included in other comprehensive income/loss for the period and not in the profit and loss. For example, a USD denominated bank account will generate an exchange gain or loss if held in a BRL functional currency entity but will not generate an exchange gain or loss in a USD functional currency entity. Conversely, a BRL denominated bank account will generate an exchange gain or loss if held in a USD functional currency entity but will not generate an exchange gain or loss in a BRL functional currency entity. Example A US Dollar functional currency entity holds a BRL denominated bank account of R$100. The previous period end exchange rate was 1:1 valuing the account at US$100. At current period end, the exchange rate is 1:1.25 valuing the bank account at US$80. A loss of US$20 will be recognised in the income statement. If the same BRL denominated bank account was held in a BRL functional currency entity no loss will be recognised in the income statement as no change in the BRL value has occurred. In this case when the business is consolidated the US$20 loss will appear when the BRL denominated accounts are translated into USD and will be recognised as Exchange differences arising on translation of foreign operations and included in other comprehensive income/loss for the period at the end of the statement of comprehensive income. This is not included in the earnings per share calculation. This is taken directly to the hedging and translation reserve in the statement of changes in equity. Exchange gains / losses on foreign currency borrowings Reported in the profit and loss in the finance cost line and detailed in Note 9 to the annual report Finance costs 2016 US$12.8 million gain US$0.8 million loss Principally BRL functional currency Finance costs include exchange gains or losses on foreign currency borrowings. Where borrowings are denominated in currencies other than the functional currency of the borrowing entity, they are translated into the functional currency at the period end rate. This applies to BRL denominated loans in USD 4

5 functional currency entities and USD denominated loans in BRL functional currency entities. The resulting gain or loss from the previous period end is recognised in the income statement. In the OWHL Group accounts, the majority of exchange movements are attributable to USD denominated borrowings in BRL functional currency entities i.e. Tecon Salvador. Like other monetary items, borrowings are treated differently depending on the functional currency of the business where the loan is held. Example A USD functional currency entity holds a BRL denominated loan of R$100. The previous period end exchange rate was 1:1 valuing the loan at US$100. At current period end the exchange rate is 1:1.25 valuing the loan at US$80. A gain of US$20 will be recognised in the profit and loss. If the same BRL denominated loan was held in a BRL functional currency entity no gain would be recognised in the income statement as no change in the BRL value has occurred. When the entity is consolidated the US$20 gain will be recognised as Exchange differences arising on translation of foreign operations and included in other comprehensive income/loss for the period at the end of the income statement. This is not included in the earnings per share calculation but is taken to the hedging and translation reserve in the statement of changes in equity Note. If the period end exchange rate is the same as the previous period end, there may still be a gain or loss in the period if new loan disbursements were made during the period at an exchange rate different from the period end rates. Summary BRL functional currency If a Brazilian BRL functional currency entity has USD denominated loans then it will recognise exchange gains or losses on the outstanding balances of those loans in the income statement USD functional currency If a Brazilian USD functional currency entity has USD denominated loans then it will not recognise exchange gains or losses on the outstanding balances of those loans in the income statement. Deferred tax Reported in the profit and loss in the income tax line and detailed in note 10 - Income tax expense and note 24 to the balance sheet Deferred tax 5

6 Taxation includes charges and credits relating to deferred tax assets and liabilities. Note 24 to the balance sheet in the annual report details the four major deferred tax categories. The four major deferred tax asset and liability categories are: - Exchange variance on loans; - Retranslation of non-current asset valuation; - Accelerated tax depreciation; and - Other differences. The two major categories driven by exchange rate movements are exchange variance on loans and retranslation of non-current asset valuation. (i) Deferred tax on exchange variation on loans 2016 US$14.3 million charge 2017 US$1.2 million charge This deferred tax adjustment Is used in the Brazilian tax calculation. The Group s Brazilian tax calculations are BRL denominated calculations. The Group has substantial USD and BRL denominated loans linked to the US Dollar, which for Brazilian tax purposes generate exchange gains or losses based on movements in the USD/BRL period end exchange rates. These exchange gains or losses are deductible or payable for Brazilian tax purposes. Deferred tax adjustments arise from the portion of the exchange gain or loss that is not deductible or payable for tax in the period in which it arises. Exchange gains on these loans are taxable when settled and not in the period in which the gain arises. For the Brazilian tax purposes, the treatment is the same whether the Brazilian entity has USD or BRL as its functional currency. If the BRL depreciates against the USD in the period this should generate a deferred tax credit. If the BRL appreciates against the USD in the period this should generate a deferred tax charge. (ii) Deferred tax on the retranslation of property plant and equipment 2014 US$1.4 million credit 2015 US$22.4 million credit This deferred tax adjustment is not used in the Brazilian tax calculation. 6

7 In USD functional currency entities, additions to property plant and equipment that are denominated in BRL are translated into USD at the exchange rate at the date of the transaction and the USD value fixed in the accounts at this rate (the historical exchange rate). As the Group s Brazilian tax calculations are BRL denominated calculations, the historical BRL denominated balances of property plant and equipment are used in the Group s Brazilian tax calculations. The USD value of these balances (and potential benefit to the Group in terms of future tax deductions) at current USD/BRL exchange rates may be different from the historical USD balances recorded in the Group s accounts held in USD functional currency businesses. Deferred tax is therefore calculated on the difference between the historical USD balances recorded in the Group s accounts and the BRL balances used in the Group s Brazilian tax calculations. Although the tax allowances from property plant and equipment will be realised over time, any change in the current USD value of all future tax allowances due to movements in the USD/BRL exchange rate are recognised in the period in which they occur. Example A Brazilian US Dollar functional currency business purchases an asset at R$100 when the USD / BRL exchange rate was 1:1. The asset is recorded in the IFRS accounts at the historical USD value of US$ 100. The asset will be depreciated over 10 years benefiting the Group with a R$10 tax deduction each year to be included in its Brazilian tax calculation. At the historic rate used in the IFRS accounts, this is a US$10 deduction. The exchange rate later changes to 1.25:1 so the future tax benefits to the Group in current USD terms is US$80 equivalent to a US$8 deduction each year. The current USD value of US$80 is different from the historic USD value of US$100 recorded in the IFRS accounts. A notional deferred tax adjustment is therefore recorded in the IFRS accounts on the difference between the historical USD balances, (US$100) recorded in the Group s IFRS accounts and the current USD value (US$80) of the BRL denominated value used in the Group s Brazilian tax calculations. The Brazilian tax calculation is BRL denominated so there is no impact for Brazilian tax purposes as the asset value of R$100 is unchanged and the BRL Group will continue to benefit from an R$10 annual deduction. (Historic USD value) US$100 (Current USD value) US$80 = US$20 x 34% (tax rate) = US$6.8 deferred tax liability. If the BRL depreciates against the USD in the period this should generate a deferred tax charge. If the BRL appreciates against the USD in the period this should generate a deferred tax credit. (iii) Accelerated tax depreciation This deferred tax adjustment is used in the Brazilian tax calculation. 7

8 This is the timing difference between accelerated depreciation used for taxation purposes and accounting depreciation. (iv)other differences These deferred tax adjustments are used in the Brazilian tax calculation. These are all other timing differences in the Brazilian tax calculation. The main item here is unused tax losses available for offset against future profits. In Brazil there is no Group offset for tax losses so tax losses in a Group Company may only be offset against future taxable profits in the same Company and not offset against profits in another Group company. Additionally cumulative tax losses can only be used to offset up to 30% of the annual taxable profit in each taxation year. (See effective tax rate section below for a summary of the major items impacting the Group s effective tax rate). Effective Tax rate The Group earns its profits primarily in Brazil. Therefore, the tax rate used for tax on profit on ordinary activities is the standard rate in Brazil of 34%, consisting of corporation tax, at 25% and social contribution at 9%. The Group s effective tax rate can vary significantly from period to period principally due to the following causes: 1) Income earned or expenses incurred in our Bermudian companies: our Bermudian companies are not subject to income or capital gains tax. Therefore, if material income is earned from our investment portfolio in the period our effective tax rate will be lower. If material losses arise from our portfolio in the period or significant expenses are incurred then our effective tax rate will be higher. (In prior periods, the Group s cash settled long-term incentive plans LTIP generated significant expenses in some periods and a credit to income in others). These cash settled LTIPs have now terminated so will not materially impact expenses going forward. The WSL LTIP was replaced with a share option scheme whose annual expense will be subject to less variation. 2) Foreign exchange rate impacts on deferred tax balances: outlined in items (i) deferred tax on exchange variation on loans and (ii) deferred tax on the retranslation of property, plant and equipment as explained above. Movements in the USD/BRL period end exchange rate impact the effective tax rate. If the BRL depreciates against the USD at period end relative to the previous period end, this will create a deferred tax charge on the retranslation of property, plant and equipment and a deferred tax credit from the exchange variation on loans. The net effect of these two items will be a deferred tax charge in the period as the Group has more fixed assets in USD functional currency businesses than loans denominated in USD. If the BRL appreciates against the USD, the net effect will be a deferred tax credit in the period. 3) Tax losses in Brazilian Group companies: there is no group offset for profits and losses between companies in the Brazilian group so losses in one Group company may not be offset against profits in another Group Company. Deferred tax assets are recognised only to the extent that it is probable that they will be recovered through sufficient future taxable profit in the same company. If a Group company incurs losses and has no foreseeable future taxable profits then no deferred 8

9 tax asset is recognised. If these Group companies incur material losses in the period and no deferred asset is recognised this will increase the effective tax rate in the period. Exchange differences arising on the translation of foreign operations This is not reported in the profit and loss but reported in other comprehensive income or loss that passes through the hedging and translation reserve and non-controlling interests in the statement of changes in equity US$32.7 million gain US$6.5 million loss BRL functional currency The net exchange differences arise on the translation of non-usd functional currency entities and represent the following: In respect of income, expenses and capital transactions, the difference between translating these items at average exchange rates and using the exchange rate at the reporting date. In respect of the opening balance of equity (excluding the translation and hedging reserve) the difference between translating these items at the rate used at the reporting date at the end of the previous period and using the rate at the reporting date at the end of the current period. This is not included in the profit and loss for the period but is included in other comprehensive income or loss for the period and accumulated in the hedging and translation reserve in equity. The amount attributable to non-controlling interests is allocated to and recognised as part of non-controlling interests. Exchange rates The period end exchange rate and the exchange rates during the period do not necessarily move in the same direction. It is possible that the movement in the exchange rates during the period compared with the exchange rates during the previous period will be in the opposite direction to the movement in the period end exchange rate compared to the previous period end exchange rate. This may result in anomalous exchange rate movements. Example Following a period where the exchange rate was unchanged at 1:1, the exchange rate during period 1 depreciates consistently during the period from 1:1 to 1:1.2 resulting in an average exchange rate of 1:1.1. Then in period 2 the exchange rate remains constant during the period at 1:1.2 before appreciating to 1:1.1 at the period end. 9

10 Exchange Exchange Period 1 movement Period 2 movement Opening exchange rate 1:1 1:1.2 Average exchange rate 1:1.1-10% 1:1.2-9% Period end exchange rate 1:1.2-20% 1:1.1 +9% In this example the average exchange rate in period is 9% lower in period 2 compared to period 1 although the period end exchange rate is 9% higher. 10

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