208 CHAPTER 5. USING FORWARDS FOR INTERNATIONAL FINANCIAL MANAGEMENT
Many accountants would howl in protest. For instance, they might say, if one
converts thenzd2.5m at the forward rate, then thecadaccounting entry would
depend on whether the credit period is 30 days or 60 or 90 etc. This is true. But
there is nothing very wrong with it. The root of this problem is that accountants
arealways booking face values, not corrected in any way for time value. If they
had usedPVs everywhere, nobody would have a problem with the finding that an
invoice’s present value depends on how long one has to wait for the money.
This, of course, might be hard to grasp for some of the accountants. If so, at
this point you take advantage of his confusion and ask him whether, if valuation
for reporting purposes is done at the spot rate, there is a way to actually lock in
that accounting value—that is, make sure you actually get the book value ofcad
2.25m. The only truthful answer of course is that there is no way to do this. You
can then subtly point out that thereis a way to lock in the accounting value of
2.20m: hedge forward. Giving no quarter, you then ask whether the spot rate
takes into account expected exchange-rate changes and risks. Of course not, the
accountant would bristle: in Accounting, there surely is no room for subjective
items like “expectations“ and “risk adjustments”. The spot rate, he would add, is
objective, as any valuation standard should be. You can then subtly point out that
the forward rate actually is the risk-adjusted expectation, and that it is a market-set
number not a subjective opinion. At this point your scorecard for the competing
translation procedures looks as follows:
convert convert
criterion atSt atFt,T
can be locked in at no cost? no yes
takes into account expected changes? no yes
takes into account risks? no yes
objective? yes yes
understandable to accountants? yes hmThe accountant’s last stand might be that valuation at 0.88 instead of 0.90 lowers
sales and therefore profits; and more profits is good. This is an easy one. First,
for other currencies there might be a forward premium rather than a discount; and
forA/Pa discount would increase operating income rather than decreasing it. So
there is no general rule as to which valuation approach would favor sales and lower
costs. Second, you point out, total profits are unaffected by the valuation rule: the
only thing that is affected is the way profits are split up into operating income and
financial items.
Example 5.33
Suppose, for instance, that our Canadian firm does not hedge thenzd2.5m, and
atT the spot rate turns out to be 0.92. Suppose also that the cost of goods sold
iscad1.5m. Then profits amount to 2.5m×0.92 – 1.5m = 2.3m – 1.5m = 0.8m
regardless of what you did with theA/R.