Accounting

continued from page 5

hedge their foreign exchange expo-
sures on a con sol ida ted enterprise
basis. Transactions that do not qualify
for hedge accounting have to be
marked-to-market and gains or losses
recorded in current earnings. This nat-
urally makes the functional currency
decision critical to any corporate
hedging program.
Planning considerations
Some advance planning to get th e
ri ght functional currency for a foreign
sub therefore may be worthwhile.
While there are numerous other con-
siderations, the impact of hedge
accounting should be part of the
process. For example:
What type of foreign entity?
Tr eas ury should have input as to
whether a new foreign operation is set
up as a stand-alone subsidiary, which
is likely to be local currency function-
al, or some form of export-sales distri-
bution center, which will more likely
share the parent's functional currency.
The decision must be made carefully
and up front, since once a functional
currency is established there is not
much leeway to change it- i.e., year-
to-year to take advantage of move-
ment in critical exchange rates.
The currency of billing. With inter-
company sales in particular , the
choice of billing currency relative to
the functional currencies of the enti-
ties involved is also important. For
exampl e, if the parent is doll ar func-
tional and the subsidiary is DM func-
tional, the accounting department will
need to chose one or the other and, in
so doing, will determine which entity
records the exchange gain or loss.
While there is limited room to maneu-
ver, operations should be structured
so that the functional currency deter-
mination can be made to support the
management of economic risks on a
consolidated basis- and be eligible
for hedge accounting.
Mr. Herz can be reached at (21 2) 536-
2827 and Mr. Bhave at (212) 536-2861.
6
Progress with US GAAP
Hedge Accounting
The US Financi al Accounting Standards
Board (FASB) continues to discuss issues
relating to its proj ect on hedgi ng and
hedge accounting. These issues are
being considered under the traditional
hedge accounting model and under a
derivative model. The latter would
resolve a number of hedge accounting
issues by incorporating management's
intent into the recognition and measure-
ment provi sions for derivatives.
Indeed, the entire hedge accounting
project is becoming more focused on
derivatives and thei r use in ri sk manage-
ment.
According to a summary of late july
meetings, FASB staff is moving forward
with the construction of a working
model for hedge accounting based on
the following ideas:
All free-standing derivative instru-
ments should be recognized and mea-
l sured at fair value.
Special accounting should be pro-
vided so that some gains or losses that
are perceived to be related to other
positions are recognized in earnings in
the same period as the losses or gains
on those positions.
Desi gnation would be a basis for
special accounting (i .e., would be elec-
tive).
Changes in fair value not recog-
nized in earnings might be recognized
as a separate component of equity (i .e,
comprehensive income) or with related
assets.
Special accounting should be pro-
vided for instruments that are used to
manage cash flow exposures as well as
I those that are used to manage expo-
sures to changes in value.
Special accounting should be pro-
vided for exposures from both firmly
committed and forecasted transactions.
Risk reduction, as opposed to risk
management, should not be a criteri on
for special accounting.
Special accounting should be pro-
vided for a range of risk management
techniques, including dynami c portfolio
management as well as situations
involving desi gnation of a specific
instrument.
Country Risk
Advisor briefing
A Country-level
Decision Matrix
By Jean-Pierre Bourtin
Xerox Corporation
A simple decision matrix, in skilled
hands, can help avoid large invest-
ment bailouts in emerging markets.
A systematic approach to country or
"sovereign risk," used to assess
risk/reward rel ati onships, will help
prevent unpl anned additional invest-
ment in a new country of operation.
Country exposure is more than the
risk of blocked funds, asset expropria-
tion, or war- the political economic
picture is just as important, particular-
ly in the emerging markets.
A matrix practice
In order to facilitate an understanding
of sovereign risk, international treasur-
ers must look at a number of facts and
conditions in systematic fashion . The
outline on page 7 represents the basic
components of a decision-matrix to
identify country-specifi c investment
risks. It can be adapted to the specific
objectives of its user.
Each of the matrix components, fur-
thermore, can be refined by weighting
them to achieve a composite "score"
for a given country. This score in turn
can be used to guide business strate-
gy. A typical approach may be to give
each factor a score from 0-20 with 20
being the most favorable risk assess-
ment, making 100 the best possible
score.
According to country objectives a
minimum could be set as to what
score would be acceptable for a
1 00%-owned operating company, a
minority stake joint venture, limited
L/C business, etc. While an emerging
market country like the Czech
Republic might rate an 85, the
Ukrai ne for example is probably clos-
International Treasurer/ September 5, 1994
er to 35, meaning that business activi-
t y should be limited-e.g ., to L/C
sales.
Learning from GE
The experience of MNCs in Hungary
illustrates why such a decision matri x
is important. Hungary was one of the
most economically advanced, and
hence least risky countries of the old
Soviet Bloc . Yet, even General
Electric, one of the more astute global
companies, has had trouble with its
investment there.
In 1989, General Electric acqu ired
50.1% ofTungsram, a manufacturer -of
li ghting products, for $150 million.
Five years later, its level of investment
has ballooned to $550 million with lit-
tle return.
Most early investors in Hungary-
not just GE- have suffered from a
culmination of factors caused by 50
years of waste and inefficiency at all
levels of the pub! ic and private sector.
The ultimate impact of these factors
was largel y unforeseeable to anyone
seeking to enter emerging Eastern
European markets at the time.
Plain-van i !Ia macro-economic fac-
tors, however, which were not totally
unpredictable, wreaked more havoc
with GE and others' investment plans,
for example:
a 30% wage advantage was wiped
out by hi gh inflation and under -
devaluation of the Hungari an forint
_ (caused ill part by the forint basl<eC
structure: 50% USD: 50%DEM)
the collapse of the Russian market
took away key export earnings.
The under-devaluat ion of the forint
relative to inflation was perhaps the
most crucial problem. Over the period
1989 to 1993 inflation was up 173%
while devaluation amounted to only
61%. (This trend could have been
"validated" simply by checking the
stream of Hungarian tourist buses car-
rying shoppers to Vienna, Munich and
Venice.) For US MNCs operating in
Hungary, this meant that the doll ar
cost of Hungarian labor content went
up by 69% in 4 years. This rise turned
Internati onal Treasurer/ September 5, 1994
a 30% cost advantage into a 18% cost
penalty (China investors take note!)
The only sustainable remedy to this
situation is a 69% productivity
increase- or a combination of a pro-
ductivity push and wage inc reases
below inflation- to get back to the
original cost structure.
Produ ct ivity ga ins come large ly
through worker layoffs. GE, for exam-
ple, has l ai d off half of Tun gs ram's
20,000 workers and gra nted wage
increases below inflation (a 22-point
gap in 1993 and a forecasted 6-point
gap in 1994).
A new skill set
In the initi al stages of East er n
European investment, much attention
was paid to evaluations of indi vidual
target co mpani es. " Rea l " balance
sheets and income statements had to
be hastil y put together in advance of
foreign purchasers, and investing
companies had to dete rmine how
much of recorded "sales" were based
on voucher payments of questionable
quality.
While the proper evaluation of a tar-
get company is important on the
micro-level, due diligence should also
be done at the macro-level.
Companies should recogn ize that
the treasury skill-set for the emerging
markets must incorporate an under-
standing of political economics- in
particular, its impact on prices and
exchange rates. This skill set is a sub-
stantiall y different one than that of the
typical treasurer. As the focus of over-
seas business activities shifts to th e
emerging markets, these skills must be
developed or purchased . Acquiring
these skills (as GE did) with hundreds
of millions in unplanned investment
dollars is cost ly.
Mr. Bourtin is assistant treasurer for
Canada and the emerging markets at
Xerox, (203) 968-4340 or (203) 762-9674.
Country Risk
Sovereign Risk Assessment
Simple Definition
"Soverei gn Ri sk" can be defined
in terms of:
How can I get my money in?
How can I protect it whil e it' s there?
How can I get it back?
Key Indicators of "Sovereign Risk" :
1) Ease of converting local currency to
US dollars (0-20), factoring in:
Current system
Histori cal experience
2) Inflation versus devaluation (0-20),
considering:
Cumulative indices- do they indicate
sustainability of current exchange rate?
Identi fying a chroni c imbalance- a
continued major imbalance between
inflation and currency devaluation will
ultimately impact the current
system/ policies.
3) Foreign reserves (0-20), considering:
Trends in current and capital accounts.
Surpluses/deficits as a% of GOP.
4) Economic policies (0-20), considering:
Fiscal-how effective, or restrai ned is
government spending?
Monetary- is the money supply in line
with economic growth ?
Exchange rate-is there a policy to
make it over- or undervalued rel ative to
major trade currencies?
5) Political conditions (0-20), including:
Type of government- favorable to
business and market economi cs?
Ethnic bal ance/ imbalance-are the
major elements of society cohesive?
Likelihood of major changes- what is
the popularity of current government and
its policies?
El ections-are they forthcoming and
who is li kely to be elected and what type
of government and policies might they
implement?
Unions-do they have a hi story of
uneconomical wage demands and lever-
age to effect business flows?
7