Turbulent currency markets affect retailers.

AuthorAbahoonie, Edward J.

The recent volatility in the European currency markets underscores the importance of managing currency risks associated with foreign merchandise purchases. Although decisions on whether and how to hedge risk are ultimately determined by overall economic factors, recent changes in the financial accounting rules and the complex tax rules relating to foreign currency transactions create planning opportunities and difficulties of their own.

Retailers may hedge foreign purchases through the use of currency forwards, futures, options or other complex derivative instruments. Under SEC and FASB accounting rules, currency forwards and futures must generally be revalued on a quarterly basis if they are used to hedge anticipated purchases rather than firm commitments. This can cause dramatic earnings swings (especially in a volatile market) that distort a company's overall financial picture. No revaluation is required if an option is used as a hedge. At the same time, however, options are typically more costly. As a result, many purveyors of currency derivatives have been marketing complex derivatives that look and sound like options, but cost and act like forwards. The SEC has now addressed this situation by pronouncing that those complex currency options must also be revalued on a quarterly basis unless they are used to hedge firm commitments.

Complex tax rules can also create tax reporting results that do not reflect the overall economics involved with hedging strategies. Tax reporting can become even more complex when transactions are denominated in currencies of high inflation economies, such as many of the South American countries. Potential pitfalls under the current maze of tax rules addressing foreign currency transactions relate primarily to mismatches in the timing and/or character of income or loss between the foreign currency hedge and the purchase order or payable being hedged. Some pitfalls can be avoided through a solid understanding of the tax rules, proper planning and the use of available elections.

In general, derivative currency products based on enumerated currencies are "marked to market" at year-end and the net gain or loss is included in taxable income for that tax year. This timing rule can force the recognition of large taxable gains due to currency fluctuation that do not reflect the overall...

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