FX Cash Flow Risk Management: Financial Reporting Issues and Practical Implications

Published date01 January 2015
DOIhttp://doi.org/10.1002/jcaf.22020
Date01 January 2015
59
© 2015 Wiley Periodicals, Inc.
Published online in Wiley Online Library (wileyonlinelibrary.com).
DOI 10.1002/jcaf.22020
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Li Wang
and Stephen Makar
Companies having foreign sales can avoid large
fluctuations in earnings and cash flows caused by
changes in foreign exchange (FX) rates through the
use of foreign exchange derivatives (FXDs). FXDs
used to mitigate the effect of FX rate changes on
forecasted transactions can qualify as cash flow
hedges under Statement of Financial Account-
ing Standards No. 133 (SFAS 133). According
to SFAS 133, the mark-to-market (MTM) gains/
losses on effective cash flow hedges are reported
in other comprehensive income on the balance
sheet, instead of on the income statement. This
article explains how CFOs and treasurers may
benefit from understanding the strategic and prac-
tical implications of reporting foreign-exchange
hedges, including the disclosure of hedge ratio
data (i.e., the extent of cash flow hedge use).
© 2015 Wiley Periodicals, Inc.
F X Cash Flow Risk Management:
Financial Reporting Issues and Practical
Implications
Companies that
have less volatile
future earnings
and cash flows are
more appealing to
risk-averse investors,
so they enjoy the stra-
tegic benefits of higher
market valuations
and less costly capital.
To avoid large fluc-
tuations in earnings
and cash flows due
to changes in foreign
exchange (FX) rates,
companies sometimes
use foreign exchange
derivatives (FXDs).
The use of FXDs
has increased rapidly
in recent years. The
notional amount of
over-the-counter FXD
contracts in 2013 reached $70.6
trillion (Bank for International
Settlements, 2014), more than
four times the gross domestic
product.
FXD used to mitigate the
effect of FX rate changes on
forecasted transactions can
qualify as cash flow hedges
under current accounting
policy, Statement of Financial
Accounting Standards No.
133, or SFAS 133 (Financial
Accounting Standards Board,
1998). According to SFAS 133,
the mark-to-market (MTM)
gains/losses on effective cash
flow hedges are reported in
other comprehensive
income on balance
sheet, instead of
income statement.
In this way, the
volatility introduced
by such MTM gains/
losses are removed
from earnings and
reported as a com-
ponent of equity.
Thus, effective FXD
cash flow hedges
reduce fluctuations
in earnings and cash
flows.
However, there
is a significant
limitation in SFAS
133 that may
hinder investors’
understanding of
a company’s cash
flow risk management and thus
reduce the intended strategic
benefits of FX hedging. This
article provides an in-depth
review of this limitation and
considers the practical impli-
cations of recent research for
chief financial officers (CFOs)
and treasurers.

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