Foreign exchange risk has been high on the agenda of CFOs of MNCs for many years. With the expansion of the global economy and diverse influences on exchange rates – such as the current climate of economic uncertainty and fear of terrorism in many countries – foreign exchange risk is likely to be a key consideration for most companies trading across borders in years to come.
A transactional foreign exchange gain or loss arises when a transaction (be it a sale or a purchase) is recorded in the accounts at the exchange rate at the time of the transaction but payment is made at a different rate. International Accounting Standards require the transaction to be recorded initially using the exchange rate at the date of the transaction and exchange rate gains/losses to be presented as other income or expense in the profit and loss account.
When a company with transactional foreign exchange exposure suffers a business interruption loss during an extended period and when relevant exchange rates fluctuate, it is important to appreciate the impact that exchange rates can have on lost sales, cost of sales and gross profit. The potential for over- or under stating a profit or loss is not limited to the percentage movement in the exchange rates.
How might an exchange rate movement affect a loss of profit claim? Say, for instance, that a Thai company normally sells to an American customer for USD 25 (roughly equivalent to THB 1,000) and has variable costs incurred in Thailand of THB 700. It normally has a gross profit of THB 300. However, if it receives payment when the number of THB it received for each USD has fallen by 10 percent to 36, it would only receive THB 900, giving a gross profit of THB 200. A 10 percent movement in the exchange rate has resulted in a 33 percent reduction of gross profit for the Thai company.
It is often argued that exchange rate gains and losses are financing issues that do not relate to gross profit. If it can be determined that they relate directly to individual sales or variable cost transactions, then they are not financing costs but adjustments to reflect the actual revenue received or cost paid. In that case, they should be considered as a variable cost or revenue. Care must be taken to not adjust for foreign exchange gains and losses that relate to the general financing of the company (e.g., a foreign loan repayment) or to fixed costs.
In order to reduce the risk of transactional exchange losses, companies often try to hedge their exposure. But there often will be a cost associated with the hedge and the hedge may not always perfectly protect the company. However, as long as the hedge relates directly to identifiable transactions and those transactions relate to revenue or costs that vary with revenue, then the cost of the hedge is also a variable cost and should be deducted in arriving at gross profit.
In these situations, MDD can help measure the loss of profit (business interruption claims and third-party liability claims), for both primary insurance claims and litigation involving the preparation of expert reports.