Export accounting for the small and midsized company.

EXPORT ACCOUNTING FOR THE SMALL AND MIDSIZED COMPANY

Since the 1988 devaluation of the U.S. dollar, a large number of small and midsized American companies have entered the export market. For many, this is their first direct experience in dealing with foreign currencies.

The 1988 export boom that accompanied the devaluation of the U.S. dollar helped reduce the U.S. merchandise trade deficit to $137 billion from a record $170 billion in 1987. This improved performance was partly the result of a surprisingly large number of small and medium-sized manufacturers--those with sales of less than $300 million--moving into the export market for the first time.

Several factors facilitated the entry of these companies into the international arena. Spurred by the affordability of the dollar relative to foreign currencies and the growing number of foreign competitors in the domestic marketplace, thousands of U.S. companies with no export history began to learn the ropes. Several states have stepped in to promote exports, and about a dozen have export-finance funds for small and midsized companies. The availability of international airfreight services and advances in FAX communication also aid efforts to sell abroad. Many believe this export drive is only the beginning and will help reduce the U.S. trade deficit in the years to come.

FOREIGN EXCHANGE EXPOSURE

In an era of floating exchange rates, changes in the relative values of currencies occur daily. Those who manage international business activities must understand the kinds of risks such changes expose them to. Three types of risks a company can face when its operations involve foreign exchange are

1. Translation exposure.

2. Transaction exposure.

3. Economic exposure.

Translation exposure exists when the financial statements of a foreign subsidiary must be translated into U.S. dollars so they can be incorporated into a company's financial statements by consolidation, combination or the equity method of accounting. Translation is governed by accounting conventions and therefore also is referred to as accounting exposure. Translation exposure stems from differences in foreign exchange rates between consolidation dates and the effects of these changes on the valuation of a company's assets and liabilities abroad.

An item is considered exposed if accounting rules require it to be translated at the current exchange rate--the rate on the consolidation date. An item is unexposed if it's translated at the historic exchange rate--the rate when the item was acquired.

A company with exposed assets in excess of exposed liabilities in a foreign country is susceptible to translation losses from declines in value of the foreign currency between two fiscal periods. A company with exposed liabilities in excess of exposed assets is susceptible to translation losses from appreciation in value of the foreign currency. Such translation gains and losses, however, have no direct cash flow effects.

Transaction exposure exists when a company has a foreign-currency-denominated receivable or payable. A change in the exchange rate between the foreign currency and the reporting currency affects the amount of the reporting currency that will be received or paid. A company with net receivables in a foreign currency is susceptible to transaction losses from declines in the exchange rate. Conversely, a company with net liabilities in a foreign currency stands to realize gains in such circumstances. Unlike translation gains and losses, transaction gains and losses have direct cash flow effects.

Economic exposure. While transaction exposure relates to one or more specific business transactions, economic exposure is considerably broader and more basic. The essence of economic exposure is that fluctuations in exchange rates can affect the competitiveness of a company across markets. Therefore, a company must consider these changes in its medium- and long-term strategies.

AN EVOLUTIONARY PROCESS

A company's involvement in a foreign country is an evolutionary process. In the early stages, a company is generally content to test the waters by simply exporting abroad. As it gains experience and confidence, it increases its foreign activity and ultimately might even set up foreign manufacturing facilities. Since most of the small to mid-sized U.S. companies addressed in this article are at the early stages of this evolution, they don't have significant operations abroad and don't have to deal with translation gains and losses. Small and mid-sized companies mainly face foreign exchange transaction exposure. That exposure is the focus of the remainder of this article.

HOW EXCHANGE RATES AFFECT PROFITABILITY

The following illustration demonstrates the effects fluctuations in exchange rates can have on the profitability of a foreign-currency-based transaction. A U.S. manufacturing company, USCo, enters into a contract with a British company, UKCo, on January 1 to manufacture and deliver its product on March 1. Under the terms of the sale, UKCo will pay USCo 1 million [pounds] on May 1. The rate of exchange is 1 [pound] = $1.65 on January 1, 1 [pound] = $1.70 on March 1 and 1 [pound] = $1.60 on May 1.

Exhibit 1 How to account for foreign-currency-denominated transactions details the journal entries USCo should record to account for these transactions. On January 1, no entry is recorded because neither party has performed yet under the agreement. On March 1 the company records the sale and receivable. Between January 1 and March 1, it has benefited from the strengthening of the pound against the dollar, and this is reflected in the sale being recorded at $1.7 million rather than at $1.65 million. On May 1, the company receives payment of 1 million [pounds], which buys only $1.6 million on that date. During this two-month period, the company has incurred an exchange loss of $100,000--the reduction from $1.7 million to $1.6 million.

If management considers the effects of fluctuating exchange rates in relation to gross profit, the significance of transaction exchange risk becomes more apparent. For example, if the company earned a $400,000 gross profit on the British transaction, the exchange loss amounts to 25% of that profit. That's significant for any company.

ADDING A HEDGE

Fortunately, it's possible for companies to manage this exposure and minimize its effects on profitability and competitiveness. Using simple hedging techniques, a company can effectively lock in a sales or purchase transaction at a predetermined exchange rate and offset the risk of transaction gains or losses between the transaction date and the settlement date.

To illustrate, USCo wanted to know on the date it entered into the agreement the amount of dollars it ultimately would earn from the sale. It could do this by entering into a forward exchange contract (an agreement to exchange different currencies at a specified future date and at a specified rate of exchange) with its bank on January 1 to sell 1 million [pounds] on May 1. When it receives payment of 1 million [pounds] from its customers on May 1, the proceeds would be used to satisfy the forward exchange contract obligation. Assuming that on January 1 the forward rate was 1 [pound] = $1.68, the sales price the company would receive is effectively locked in at $1.68 million.

Financial Accounting Standards Board Statement no. 52, Foreign Currency Translation, has been in effect since December 15, 1982. It generally requires that gains or losses on forward exchange contracts be included in the determination of net income. However, the statement provides the gain or loss on certain hedging transactions can be deferred and included in the measurement of the related foreign currency transaction. (See JofA, Nov89, page 48 for a discussion of hedge accounting.) The journal entries necessary for these foreign exchange transactions are detailed in exhibit 2 How to account for foreign-currency-denominated transactions when there's a hedge.

The May 1 journal entries include both a charge to a foreign exchange loss and an equal and offsetting credit to a foreign exchange gain. No economic gain or loss occurred, and no gain or loss would be reported in the financial statements. The journal entries are designed to indicate in the accounting records the existence of the hedge transaction. [Exhibits 1 and 2 Omitted]

Shahrokh M. Saudagaran, CPA, PhD, assistant professor of accounting at Santa Clara University and a KPMG Peat Marwick research fellow, Santa Clara, California, and Alan J. Black, CA, senior manager, KPMG Peat Marwick, San Jose, California.