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April 4, 2017

Feeling Trumped by fluctuations in the currency market?

Here’s what to do about foreign exchange gain or loss

As a business owner, you can’t help wondering about the impact of Donald Trump’s presidency not to mention the UK’s Brexit vote on your company. What impact will such protectionist developments have on your business here in Canada? And, if there is an impact, will it affect you in selling your goods to different countries or even sourcing materials for your business from international markets?

Protectionism around the globe may have significant repercussions on foreign currency markets. Before you know it, these repercussions could reach you and alter your bottom line.

As a business owner, you can’t control the fluctuations in the currency markets. However, you can implement a foreign exchange strategy – an option that should be in every business owner’s toolkit.

When to consider a foreign exchange strategy 

If your business sells or purchases goods or services in different countries, you’re most likely paying vendors using their respective source currency, or else receiving funds in a foreign customer’s source currency.

When preparing your financial statements in accordance with generally accepted accounting principles (GAAP), you denominate (meaning, express in a specified money unit) the balances in your company’s source currency. For most Canadian companies, this source currency is the Canadian dollar. When converting foreign-denominated balances on your balance sheet into Canadian dollars, you will most likely have a foreign exchange gain or loss. This gain or loss is reflected in your company’s bottom line.

Now, managing foreign exchange risk may at first seem too time-consuming or even costly. Some companies will choose to be optimistic. They’ll assume that foreign exchange rates will either not change or will fluctuate in their favour. These optimists, therefore, won’t bother taking any action.

The problem with adopting their speculative, wait-and-see approach is that it makes you vulnerable to exposure, both downward and upward.

You’re far better to be cautious and reduce any surprise adjustments related to foreign exchange. This means going with a foreign exchange strategy. Down the road, when you prepare your monthly financial statements, the strategy you’ve set in place will assist you with any unexpected adjustments.

Common foreign exchange strategies

Okay, so now you’ve decided that a foreign exchange strategy is in your company’s best interest. First up, you need to develop a formal policy for dealing with foreign exchange matters. Consider:

  • Who in your organization will be responsible for developing this policy

  • When the policy will be applied; and how its effectiveness will be measured.

Once the formal policy is in place, you can think about different management strategies for applying your foreign exchange policy.

Some businesses both sell and purchase goods and services in foreign currencies. In a perfect world, their foreign-denominated transactions from revenues and expenses would offset each other when settled. However, in converting foreign-denominated balances on the balance sheet, you’ll find it highly unlikely that the foreign assets will equal the foreign liabilities of the same currency. To implement a hedging policy, you must ensure that your foreign assets are offset to an extent by your foreign liabilities.

How forward contracts can work for you

Most financial institutions or currency brokers commonly make available the use of a forward contract, that is, a contract with you to buy/sell an asset for a specified price at a future date. Forward contracts are handy for managing foreign exchange risks. And, being easy to use and not usually having any up-front costs, these contracts are more popular with companies than other methods, such as currency options or swaps.

Forward contracts allow a company to buy and sell a pre-determined amount of foreign funds over a fixed period of time or date. Companies most commonly tend to use a forward contract if they know the amount of funds they will receive in foreign currency over a set period of time – or if the amounts of debt obligations are to be repaid over a set period of time.

Here’s an example of when you’d use a forward contract – and what would happen if you didn’t have one.

Say your company sells goods to a customer in the US for $100,000 USD. The customer has indicated they will pay the invoice in 30 days. Your company is now exposed to foreign exchange fluctuations on this $100,000 USD receivable over the 30-day period.

Scenario #1: You have a forward contract.

On day one, this $100,000 USD receivable is valued at $125,000 CDN. On day 30, the customer pays the outstanding invoice by delivering $100,000 USD to your company. When your company sold the $100,000 goods in USD to the customer, you entered into a forward contract with your financial institution to sell $100,000 USD in 30 days. You will receive $125,000 CDN in return. Over the 30-day period, your company received the same amount of CDN dollars as it would have received on day one – therefore recognizing no gain or loss on this transaction. 

Scenario #2: You don’t have a forward contract.

On day one, the $100,000 USD receivable is valued at $125,000 CDN. On day 30, the customer pays the outstanding invoice by delivering $100,000 USD to your company. You deposit the money into your company’s Canadian bank account. The money is now valued at $115,000 CDN. Over the 30-day period, you received $10,000 less than if the balance had been received on day one. This $10,000 fluctuation will be recognized as a foreign exchange loss – and reflected in your company’s net income.

From the above scenarios, you can see how the use of a forward contract limits a company’s foreign exchange exposure.

Conclusion: Key considerations for you

The impact of foreign exchange fluctuations can have a significant impact on your business. Better to not ignore the potential impact of foreign exchange. Instead, consider evaluating your business’s exposure to foreign exchange. Then, develop a foreign exchange strategy as needed. The fact is until you review your exposure, you won’t realize if foreign exchange fluctuations could be an issue for you – one that you should look into further.

For further information about this developing a foreign exchange strategy, please contact us.

The above content is believed to be accurate as of the date of posting. Canadian Tax laws are complex and are subject to frequent changes. Professional tax advice should be sought before implementing any tax planning. Manning Elliott LLP cannot accept any liability for the tax consequences that may result from acting based on the information contained therein.