An Economic Analysis of Hedging and the Canadian Accounting Treatment of Revenue Hedges

Laurence Booth University o/Toronto

Section 1650 ofthe CICA Handbooh allowsfinns to &firforeign exchange gains and losses onforeign currency denominated debt, as long as the debt was raised to hedge either afireign currency reuenue stream orforeign currency assets. Hence, the accountingtreat- ment offireign current debt is tied to the underlying motiuationfor issuing it.

This paper analyse~ this hedging motivation f o r issuingforcign currency debt. It concludes the following: First, the hedging decision may conjlict with the nonnal rationale for the financing decision as one that maximises t h e j h ’ s market value. Hence, i f mahes sense to separate the hedging decisionfrom thefinancing decision by using ofher hedging vehicles, like forward and futures contracts. Second, real hedges must be dtferentiated from nominal hedges, since the exchange uncertainty may merely repect domestic uncertainty through purchasingpowerparity. Finally, men in the simplest case ofpure exchange uncertainty, theforeign exchange gainAoss must be included in the income statement to offset reuenue uncerfainty.

The main conclusion of the paper i s that the basic hedging rutionalefor issuing foreign debt is extremely tenuous, and that euen where it holds, theproposed accounf- ing treatment in Section 1650 may be inconsistent with the definition of a hedge.

Effective for fiscal year 1984, all Canadian companies must adopt the new foreign currency translation rules of the revised Section 1650 of the CICA

Handbook. In a nutshell, these rules mandate the use of the cument rate method for all self-sustaining foreign operations. Any foreign exchange gain or loss that arises is then closed directly to a separate component of shareholder’s equity and thus does not flow through the income statement. Ostensibly this new policy will require changes in reporting for most Canadian firms, since Amernic and Calvin (1 985) have found that only 16.5 per cent used the current rate method prior to the adoption of Section 1650. However, i t will bring Canada into line with the translation policies of both the United Kingdom and the United States, which along with most of Canada’s trading partners use a variant of the current rate met hod.

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Section 1650 is not, however, as rigid as it first appears. It maintains the same qualifications as SFAS no. 52 of the us Financial Accounting Standards Board. That is, for integrated operations and self-sustaining operations in ‘hyperinflationary’ environments the temporal method of SFAS no. 8 and the original Section 1650 should be used. Both qualifications will moderate the impact of the current rate method. Additionally, and unlike SFAS no. 52, gains and losses on non-current monetary items are not closed immediately to equity. Instead, they are deferred and amonised over the life of the instrument With a depreciating Canadian dollar, the Canadian value of foreign debt will still increase and stockholder’s equity decrease. However, the deferral and amortisation rule of Section 1650 will moderate the effect; a significant adjustment to the current rate meethod given the large amount of foreign currency financing undertaken by Canadian firms.

The above flexibility built into Section 1650 serves to mitigate the effects of its adoption. However, Section 1650 also includes a rule that if widely adopted could destroy any similarity between it and the current rate method. The new rule Is an extension of the concept of a foreign currency hedge. In some circumstances, a monetary liability may be hedged with a non-monetary asset or a future reucnlu stream designated in the same currency. The main requirement seems to be that there has to be a ‘reasonable assurance’ that therewas aconscious decision that the monetary item was originally inten- ded as a foreign currency hedge and that it continues to function as one.

if the auditors accept that the monetary liability was created as a hedge of a foreign cutrency asset or revenue stream, then all foreign exchange gains and losses can be completely deferred until settlement, i.e., they do not cvrn have to mortised. Moreover, Section 1650 introduces the possibility that renegotiation of the debt and/or its settlement by debt replacement can defer the foreign exchange gain or loss indefinitely. This would occur as long as the substance of the original transaction occurred, so that the natural asset or revenue hedge is continued.

As long as a company has foreign currency assets or revenues its foreign currency liabilities may not be exposed to exchange-rate changes under this new rule. This implication has not been lost on Canada Development Corporation and its auditors Thorne RiddelL2 They w e d that CDC pur- chased its Canadian assets with vs dollar debt only because those assets gave rise to a us dollar revenue stream. Hence, there was an implicit rmentle hedge. CDC’S long-term debt at current exchange rates is about $5 billion, but in its financial statements it reports its historicvalue of $4.6 billion. The $400 million loss caused by the depreciation of the Canadian dollar is deferred until the revenue hedge is unwound.

Similarly, Abitibi-Rice reports “unrealised gains or losses on translation of long term debt payable in us funds, which is deferred on the balance sheet and is hedged by an income stream denominated in us funds.” Clearly, given the significance of the export sector of the Canadian economy and the fact that many of those exports are denominated in us dollars, tremendous scope exists for the creation of revenue hedges. The implication is

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that foreign currency debt will cease to be ‘exposed’ to foreign exchange rate changes.

In this paper we will examine the appropriate accounting treatment of revenue hedges. We will not consider the complete translation problem for self-sustaining or integrated operations, since that has been dealt with else where.’ Instead, we consider the simple question: if a firm issues foreign currency debt because it believes that this is a hedge of foreign currency revenues, how should any resulting foreign exchange gains and losses be treated? Note that although this is only a s m a l l part of the oanslation problem, it looms large for Canadian firms because of the volume of export business denominated in us dollars and the value of us dollar debt financing.

The paper is organised in three analysis sections where we stan with the simplest possible case and then progressively add more descriptors of a practical problem. This is done for two reasons: first, pedagogically there is much to be gained since it helps bring out different aspects of economic theory, and second it helps explain the differences of opinion that exist on this problem. Our basic analytical tool is a simple worked example fol- lowed up by mathematical formulation.

Pure Exchange Rate Uncertainty Assumea firm as in Table 1. It has net assets o f t 100 million financed by $50 million in equity and $50 million in debt. Its turnover ratio is one, generat- ing $100 million in revenues with $90 million in costs. For simplicity, we assume that all revenues are generated in us dollars, costs in Canadian dollars and that the current exchange rate is lc$ = lusS.‘With a 50 per cent tax rate and a zero interest rate on foreign debt, the firm’s net income is $5 million for a 1 0 per cent return on equity. We will explain the choice ofthese particular numbers later.

Suppose it is equally likely that the Canadian dollar appreciates or dep- reciates by 10 per cent. What will happen now? In column B, the Canadian dollar depreciates by 10 per cent. Hence, revenues increase by S 10 million, since they are denominated in us dollars, and net income by $5 million. However, the $50 million of us debt now has a Canadian value of $55 million, so the firm has a foreign exchange loss of $5 million. It will have to pay another $5 million to retire its us debt. The result is that the adjusted net income, that is net income inclusive offoreign exchangegains and losses, is constant at $ 5 million. Alternatively, in column C the Canadian dollar appreciates by 10 per cent. In this case, revenues decline to $90 million and net income is reduced to zero. However, now it will only cost $45 million to retire the $50 million of us debt. Hence, there is a foreign exchange gain of $5 million and adjusted net income is again constant at $5 million.

The example in Table 1 illustrates perfectly the idea behind a revenue hedge. Remember a hedge is defined as “to bet on both sides so as to guard against loss.” In this case, the gain or loss on the foreign debt perfectly offsets the fluctuating dollar value of us revenues. An alternative to the revenue hedge would have been to finance with Canadian dollar debt

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(again at a zero interest cost) and to have used the futures market to hedge the revenue stream. In this case, if the company could have sold a us dollar futures contract for t 100 million at the expected exchange rate of 1 : 1, then it would have locked in the income statement of A.' Moreover, in account- ing for this decision the gainfloss on the futures contract is included in the income statement with the realised revenue stream. In this excample the two hedges are perfect substitutes for each other.

The choice between the two hedges depends on a number of factors. First, there may not even be a futures market. Second, the futures market may not be efficient, in the sense that the futures rate may deviate from the expected exchange rate. In this latter case, the futures market may be regarded as a relatively expensive method of hedging the firm's revenue stream. In either of these two cases, the firm may opt for the revenue hedge. However, for some firms it may be difficult to establish. In creating the example in Table 1 it was assumed that only the revenue

stream and the foreign debt were exposed. The exact amount of debt was determined from the following equation:

( 1 )

where ll is net income, A net assets, t the corporate tax rate, Q the turnover ratio, P the debt ratio, C the Canadian dollar costs and E the exchange rate. The subscripts represent time periods and, with our definitions, QA is sales fevmue and PA the firm's debt. Net income will thus vary with the exchange rate as,

n = (QAEI-C) (1-t) - BA(EI-Eo)

-- dn - aA( 1 -t) - PA dE, A hedged position thus requires dII/dE, = 0 and Q( 1 -t) = p, that is a debt ratio equal to one minus the AX rate times the turnover ratio. This condi- tion is satisfied by the example in Table 1 .6

Suppose, however, that the turnover ratio was not one, but two. In this case, the debt ratio has to be 100 per cent, which is clearly not feasible. Hence, there is a constraint placed on the ability to create a revenue hedge. If the turnover ratio or the share of foreign revenues is relatively low, then the revenue hedge may be a feasible alternative to the futures market hedge.

In accounting for the revenue hedge, note that in columns B and C we include the foreign exchange gain or loss in adjusted net income. This is con- trary to Section 1650, where the foreign exchange gain or loss is deferred under the assumption that it is hedged by the revenue stream. The only condition under which such deferral seems defensible is the condition that the change in revenue also be deferred. That is, the expected revenue of S 100 million is recognised and not the actual revenue of $ 1 10 million or $90 million. Remember that the hedge creates two offsetting flows. To account for them requires consistency; either they are both included or they are both excluded. I t is inconsistent to include the realised revenues

'

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and then exclude the foreign exchange gain or loss on the grounds that it is ‘hedged’ by the revenue stream. Conversely, the logical grounds for allow- ing a revenue hedge of foreign debt are that the revenues arc not calculated using current exchange rates. Since revenues are almost always valued at the exchange rates at the time that they are received, i.e., in our example the current rate, it follows that the foreign exchange gain or loss has to be included as well. In this case, the defend or even the amonisation of such gains and losses on the grounds that there is a revenue hedge makes no sense whatsoever.

Clearly, if the foreign debt is undertaken to hedge the foreign revenue stream, then fluctuations in its value are required to offset fluctuations in the value of the revenue stream. Hence, it makes sense to include the foreign exchange gain or loss on foreign currency liabilities in the income state- ment. Note that this would also mandate complete inclusion, that is, no deferral over the life of the investment. In Table 1 including 10 per cent of the foreign exchange gain or loss on the assumption that it is ten-year foreign debt makes little sense since i t is tantamount to exclusion.

Exchange Rate Changes Caused by Inflation The problem with the example in Table 1 is that exchangerate changes nor- mally do not occur in a vacuum. The exchange rate is just the relative price of two national currencies, so it is hard to believe that this price will not vary with the relative supplies of these two monies and their respective pur- chasing powers. Suppose in Table l , columns D and E, there is 10 per cent domestic inflation and 10 per cent domestic deflation, respectively, with domestic debt. In this case, the net income is constant in real terms andjust varies with the domestic inflation rate. We call this a real hedge, because real adjusted net income is constant. .

In modifying equation 1 we get

ll = (aAP,E, - P,C)(I-t) - @A(EI-Eo) (3 1 where P, and P, are the foreign and domestic price levels respectively. With no foreign debt (@A = 0), profits will change according to dIl = (aAP,dE, - cdP,)( 1 -t), so that a real hedge will exist when dE, = d f , and profits only change in nominal, not real terms. The intuition is simply that the Canadian cost stream increases to partly offset the domestic value of foreign revenues. With the foreign revenues also increasing due to foreign inflation we would have a complete statement of thepurchosingpownpanty (PPP) theorm, which states that on a relative basis the exchange rate merely offsets difierences in inflation between two different money supplies. In our example, PPP holds exactly.

The economic insight is that if PPP holds we already have a real hedge. In essense, the foreign currency exposure ofthe revenue stream is offset by the inflation exposure ofthe Canadian dollar cost stream. To hedge completely with foreign debt merely creates double hedging. In this case, net income would be 0.5 and 9.5 respectively, since i t is no longer the revenue but the

net income stream that is exposed. A nominal hedge in this case could be accomplished by solving (3) with foreign debt, i.e.,

For a nominal hedge dn/dEl = 0, so that if PPP holds (dC/dE, = 1) the amount of foreign debt required is $5 million, yielding exchange gains and losses of $0.5 million. In the example there is no real exposure to exchange rate changes since

PPP essentially convens the foreign revenue stream into a Canadian dollar revenue stream. Intuitively, it states that if the price of a commonly traded commodity like paper is $X a ton in Canada and us SY in the us then the exchange rate must be E = X/Y, otherwise paper would command two dif- ferent real prices. If this did happen then commodity arbifrage would occur; if X > EY then Canadian exporters would be unable to sell paper into the us market, if X < EY they would be flooded with orders.’

The empirical evidence in support of PPP is quite voluminous. For indivi- dual products, quite large discrepancies can persist due to restrictions on commodity arbitrage such as import quotas, tariffs, orderly marketing agreements, and quality and performance differences between products. However, even in the face of such barriers, the fendency towards PPP is strong, witness the recent growth of ‘grey’ markets for many products such as cameras and Mercedes-Benz. For price indexes asa whole, representing the purchasing power of national monies, the empirical evidence is much stronger, particularly in the longer term.8

The implication of PPP holding on average as a long run tendency is that the firm’s domestic cost stream implicitly acts as a real hedge for its revenue stream. The problem remains, however, of short run deviations from PPP. Suppose that the Canadian dollar depreciates by plus or minus 10 per cent, but Canadian inflation is only plus or minus 5 per cent respectively, i.e., PPP is onlypartially holding. In these cases, (Fand GofTable l ) , the real hedge is imperfect and there is still real variability in net income. However, financ- ing with foreign debt does not help resolve this problem.

If foreign debt of $50 million is raised then in F and G , there are foreign exchange losses and gains of $5 million respectively. In neither case, is net income variability removed, i.e., neither a real nor a nominal hedge is created. The reason is simply that we now have a partial ond a perfect hedge against the foreign revenue stream. Although we don’t have two perfect hedges, as we would have if PPP held, we still have more than one hedge.9

The upshot of this argument is that we have two extreme positions. Ifwe have pure foreign exchange uncextainty, then the revenue hedge by foreign debt is identical to a futures hedge. However, if PPP holds the foreign exchange uncer- tainty is created by differential inflation rates. In this case we have a real hedge created by the firm’s cost stream. This makes the revenue hedge of foreign debt partly redundant. In between is the realistic case of short run deviations from PPP where the foreign debt is imperfectly hedging the net inrome stream.

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A B C D E F G H I J E(ct = ustj 1.0 1.1 0.9 1.1 0.9 1.1 0.9 1.1 1.15 1.05 Revenues 100 110 90 110 90 110 90 110 115 105 OperadngCosu 90 90 90 99 81 94.5 85.5 99 99 99 Net Operating

Income 10 20 0 I 1 9 15.5 4.5 1 1 16 6 Interest 0 0 0 0 0 0 0 0 0 0 Ta (50%) 5 10 0 5.5 4.5 7.75 2.25 5.5 8 3 Net Income 5 10 0 5.5 4.5 7.75 2.25 5.5 8 3 Forexgainfloss - (5) 5 - - 15) 5 (5) (7.5) (2.5) Adjusted Net

Income 5 5 5 5.5 4.5 2.25 7.75 0.5 0.5 0.5 Note: negative values are in parentheses

In this realistic case, the firm must determine its net income exposure rather than its revenue exposure. In our simple example, this would start with a domestic inflation or cost forecast. Suppose, domestic inflation is forecast at 10 per cent and foreign inflation at zero, then PPP would predict 10 percent devaluation. This is column H in Table 1. The revenue uncer- tainty can be hedged with foreign debt, so that if the exchange rate is actually 1.05 or 1.15 and inflation is realised at 10 per cent we have a hedged position with adjusted net income of 0.5 regardless of the exchange rate. Note that as before the foreign exchange gain or loss has to be included in adjusted net income to reflect the hedge.

The reason why the revenue hedge works in columns I and J and fails in columns rand G is that expected inflation is realised even though pppworks imperfectly. Hence, we are in essence back to a pure exchange rate uncer- tainty model. Given that expectations are only rarely realised in practice, the firm has to hedge the cost uncertainty in order for the revenue hedge to work. The only way to do this is to sell the cost stream forward at the expected price level. Unfortunately, neither forward, futures nor options markets exist for most of the specific price indexes included in the firm’s cost stream. However, a futures market is being encouraged on the consumer price index (CPI) . Hence, if the firm’s cost stream is highly correlated with the CPI, the firm should buy futures contracts at the expected index value in the amount of its nominal cost stream. If inflation then exceeds that ex- pected, the firm’s profit on its futures contract will offset its losses in its cost stream.’”

We thus have the following conclusions. Empirical evidence indicates that exchange rate changes are linked to differential inflation rates. If PPP holds perfectly then a real hedge exists and there is no need to issue foreign debt; indeed it compounds the problem by double hedging. If PPP holds imperfectly then this double hedging problem is only mitigated not removed. Hence, the only solution is to remove the hedging properties of either the firm’s cost stream or its foreign liabilities. The cost stream itself can be hedged by futures contracts on the CPI thus making the ‘revenue’ hedge operable again. Alternatively, the debt can be repatriated and the cost stream left as a long run real hedge. This latter solution, of course, would

1s1

leave the short run uncertainty of PPP holding imperfectly to flow through the income statement.

Exchange Rate Changes with Interest Rate Differentials So far in the analysis we have assumed a zero interest rate on domestic and foreign debt. This assumption may be defensible in the pure exchange rate uncertainty scenario, where there was price stability. It is not, however, defensible once we get inflation, since there is abundant empirical evidence that nominal interest rates adjust on an approximately equal basis with inflation. That is, the simple Fisher e fed holds." If we additionally assume that, absent exchange conuoles, real interest rates are constant across the domestic and foreign capital market," then we must modify our example to include domestic interest rates of 10 per cent and foreign interest rates of 0 per cent, since we have assumed those rates of inflation and a zero real interest cost.

Before we include the foreign debt option we should consider the case of domestic debt financing. For simplicity, we first assume no taxes. In column A of Table 2 the net income is 6 reflecting the deduction of the nominal interest cost. However, a purchasing power gain is realised, since the nominal debt outstanding is fixed whereas prices have risen due to infla- tion. It is important to realise that in an efficient market this is expected by both borrowers and lenders, so that the nominal interest costjust offsets the purchasing power gain. As Modigliani and Cohn ( 1979)13 point out, in- creases in expected inflation will decrease accounting net income even though the real interest rate may be unchanged and both borrowers and lenders have protected themselves from its effects.

The problem is that GAAP does not recognise purchasing power gains and losses as components of income, even though in an inflationary period their expectations are implicitly incorporated in the firm's interest cost. Both with SFAS 33 and the CICA Handbook, purchasing power gains and losses may be included only as information in the supplementary notes to the finan- cial statements." Hence, in Table 2 we include two additional definitions of

TABLE 2

A B C D E F G H I E[ct : ustl 1 . 1 1 . 1 1 . 1 1 . 1 1 . 1 1.15 1.05 1.15 1.05 Revenues 110 110 110 110 110 115 105 115 105

NctOpcraunglncomc I 1 1 1 I 1 1 1 1 1 16 6 16 6 Interest 5 0 0 5 0 0 0 5 5 lh 0 0 0 3 5 . 5 8 3 5.5 0.5 Net lncomc 6 I 1 1 1 3 5.5 8 3 5.5 0.5 Forex gainfloss 0 0 (5) 0 ( 5 ) (7.5) (2.5) - - Purchasing Power

Adjusted Net Income 6 6' 6 3 0.5 0.5 0.5 5.5 0.5 Hicksian Net Income I 1 1 1 I I 8 5.5 5 .5 5.5 10.5 5 .5

Would have to include incrcascd indrxed value of debt as a COSI 10 be ronsisrrnt Note: negative values are in parcnrhrscs

Operating Cosu 99 99 99 99 99 99 99 99 99

gainlloss 5 ( 5 ) 0 5 0 - - 5 5

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net income: adjusted net income which is exclusive of purchasing power gains and losses, and Hicksian net income which includes them. Adjusted net income can be thought of as net income that includes the equiualenf of the nominal interest cost in the firm’s income statement, and thus is consis- tent with current CMP, whereas Hicksian income includes the real interest cost in the income statement and is thus consistent with areal definition of income.’)

In column ATable 2, issuing normal debt with 10 per cent expected infla- tion produces expected adjusted net income of 6 and expected Hicksian income of I 1. This latter result could also be achieved by issuing inflation- indexed debt. In this case, both the real interest cost and the principal are linked to the rate of inflation. In column B, the firm’s Hicksian income would be 1 1, but its adjusted net income would onh be 6, if the inflationary increase in the nominal value of debt outstanding is treated as an expense. I t is the treatment oftheincreased nominalvalueofthefirm’sdebt, both for tax and reporting purposes that accounts for its unpopularity relative to normal debt financing, since if it is an expense for the issuer it must also be income to the holder. Hence, it gives rise to taxes even though no cash has been received.

The tax and reporting problems of indexed debt account for its unpopu- larity. However, conceptually it is equivalent to normal debt, where the firm maintains its real debt outstanding by refinancing the purchasing power gain each period. lfwe include foreign debt in column C, the 10 per cent depreciation automatically increases the Canadian value of foreign debt and causes a foreign exchangeloss. To account for this situation it is impor- tant to realise that the foreign debt is behaving identically to inflation- indexed debt. In both cases, there is an increase in the value of the debt outstanding. The problem is to correctly account for it.

Ifwe exclude the foreign exchange loss from the income statement then we are implicitly calculating Hicksian net income in the same way as in A, when we added back the purchasing power gain on domestic debt, or in B where we excluded the inflationary increase in the nominal value of the indexed debt. In all three cases, we only include the real interest cost in the income statement. However, to be consistent with the CMP treatment of domestic debt in B, we have to include the increase in the nominal value of the firm’s debt. Hence, in adjusted net income in C we have to include the foreign exchange gain or loss on foreign debt to produce a result compar- able with the CMP treatment of domestic debt.

In columns D and E ofTable 2 we introduce taxes. In the domestic debt option (D), the inclusion of nominal interest costs lowers the firm’s tax bill, since the inflationary component of nominal interest costs is regarded as a tax deductible expense. In column E, the equivalent foreign exchange loss is not tax deductjble unless short-term debt is issued and the loss is ‘realised’ for tax purposes. With long-term debt, the loss is simply accumulated until the debt is retired. Hence, current period net income is higher for the foreign debt option, even though the firm is paying more taxes and the

effects of the inflation and depreciation have been fully anticipated. How- ever, Hicksian or real net income is higher for the domestic debt option reflecting a decline in average taxes paid from 50 per cent to 27.5 per cent. The adjusted net income would show this effect for the foreign debt option by subtracting out the foreign exchange loss and correctly recording the fact that the debt choice simply affects taxes paid.”

The implication ofTable 2 is that on an ex ante basis, even though inflation and depreciation have been hl ly anticipated by both borrowers and lenders, the location of debt decision affects the expected corporate tax bill and hence the firm’s market value. The result is well known to any multinational treasurer; finance in weak currencies to minimise taxes. In our example, the weak currency is the home currency. The problem is that this conflicts with the use of foreign currency debt as a hedge of foreign currency revenues!

So far we have not introduced uncertainty, since we wanted to examine the expected financing costs of different financial instruments. However, in columns F and G we introduce exchange rate uncertainty with the foreign debt choice. As before, adjusted net income is hedged once we include the foreign exchange loss. Hence, the ‘revenue’ hedge works if the domestic cost stream is sold forward. However, with the same exchange rate uncer- tainty the domestic debt choice in columns H and I produces both higher adjusted and Hicksian net income, even though both are uncertain.

In examining columns F and G relative to H and I we see that the reduc- tion in Hicksian income is a function of the increase in income taxes and the realised exchange rate. In column F when the exchange rate depreciates more than expected, the unexpectedly high foreign exchange loss aggra- vates the fact that income taxes are higher. In column G, the unexpectedly low foreign exchange loss offsets the effect of paying higher taxes. Ex ante the domestic debt choice is superior, but ex post it is conceivable that the exchange rate realisation may offset the higher tax bill.

The upshot of introducing nominal interest costs and taxes is to intro- duce the location of debt decision as part of the firm’s cost minimisation and value maximisation decision. It then soon becomes apparent that the location of debt decision to maximise value may conflict with the desire to use foreign debt as a revenue hedge. If we introduce real interest cost dif- ferentials, then the likelihood of such a conflict increases.

If futures markets exist, then the logical decision is to separate the financ- ing decision from the hedging decision. Debt can be located where the financing cost is minimised, and the futures markets can be used to hedge both the firm’s cost and revenue stream. If no futures markets exist, then the firm is faced with locating debt in a foreign currency to create a hedge, while ignoring opportunities to lower its financing costs. This may be sensible if the value of hedging exceeds the financing cost. However, there is no evidence that hedging aflects the value of the lirm, ips0 facto the lirm should not use foreign debt as a hedging tool.

The accounting implication of introducing the location of debt decision as a value maximisation is to cast doubt on the required assumption that

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debt is located in a foreign currency in order to hedge foreign revenues. All financial theory and practice suggest that this is not the case. Firms raise foreign currency debt to minimise financing costs and maximise market value. Ex post, they might tell their auditors a different story to claim a pre- ferred accounting treatment, but only rarely, when the financing costs are identical, will this story be true.

Integrated Model To include the ideas discussed in previous sections we have to extend equa- tion (1) to include nominal interest costs, price level changes and a choice between domestic and foreign debt. Doing so gives

fl= (aAP, i - F<C-R,P,,,BA( 1 -y) - r,P,,BAyg)(l-t) - P,,BAy(~-E,) ( 5 )

where terms are as previously defined plus P, and P, are the US (foreign) and Canadian price levels respectively, y is a currency of denomination para- meter and the subscript o means the initial value. For simplicity, we assume that the foreign price level is stable. Hence, rr is the real interest rate on foreign debt, while

R, = (l+rl)(Fc/Plo) - 1 (6) is the nominal domestic interest cost determined by Fisher parity on real domestic interest costs and expected changes in the domestic price level (Ft/Pco). A bar indicates an expected value.

Note that with zero nominal interest costs and no price changes, such that the price levels can be arbitrarily set to one, equation ( 5 ) collapses to equation (1). Moreover, by varying the currency of denomination para- meter (y) we can move to 100 per cent foreign debt (y = I ) , 100 per cent domestic debt (y = 0) or any position in between (0 < y < 1). In all cases, total debt (PA) remains constant. With 100 per cent domestic debt, borrow- ing costs are simply &P,,BA( 1 - 1). With 190 pe_r cent foreign denominated debt, borrowing costs are P,,BA(r,( 1 -t)E + E - EJ, where the foreign interest costs are subject to exchange risk as well as the principal amount borrowed.

We can differentjate in our hedging decision from our financing decision by rewriting ( 5 ) as n= fi + E' where E' is a mean zero random variable. With this structure the objective of the hedging decision is to minimise E' whereas the objective of the financing decision, given the unsystematic nature of exchange rate changes, is to maximise nl* To add structure to (4) we can first write our uncertain PPP assumption as

PsE = P, + ( 7 ) where PPP is expected to hold (P,E=fi,) but there are mean zero random deviations @,). Moreover, the uncertainty in the domestic price level can be written as

(8) 6, = Fc + &

where& is the mean zero deviation from the expected price level. If (7 ) and (8) are substituted into ( 5 ) , after grouping terms we get

rf = (aAF, - CF, - &P,,PA(l-y) - r,FcPAy)(l-t) - PAy(P,-P,,) (9) E' = (aA(1-t) - (l+r,(l-t))PAy)& + ( (a-C)( l - t ) - (l+r,(l-t))PAyb (10)

and to solve the hedging problem we have to choose values in (1 0) to remove the bracketed terms magnifying&, the deviation from PPP, and E2 the uncertain domestic price level.

Hedging Problem

Case 1, Pure exchange rate uncertainty From Section 2, & = 0, i.e., the domestic price level is constant and exchange rate exposure is removed by either hedging the revenue uncer- tainty directly with futures contracts and domestic debt financing, or by solving,

The only modification to (2) is the exposed foreign interest payments and the recognition that debt policy only allows the division of total debt into domestic and foreign, i.e., total debt itself could not vary from the firm's optimal capital structure. Note that the inclusion of foreign nominal or real interest payments does not fundamentaIly change the hedging problem. With our hypothetical numbers and a 10 per cent foreign interest rate, 95 per cent of the debt could be located offshore rather than the original 100 per cent.

Case 2. Perfect PPP and price level uncertainty From Section 3.3 = 0 with no deviations from PPP. Hence, the real hedge is created with y = 0 so that the net income stream (aA-C)( 1 - t) is exposed to domestic inflation uncertainty. The nominal hedge would be created with

As in Section 3, with a zero foreign interest cost y = 10 per cent or 5 and with positive foreign interest costs this amount is reduced. For example, with r, = 10 per cent, y = 9.5 per cent.

Case 3. Imperfect PPP and inflation uncertainty If we set 3 = 0 and solve for y we get,

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which is uncertain. Hence, ex ante the amount of foreign debt to hedge the net income stream cannot be determined and a hedge cannot be created, although the uncertainty can still be minimised.

To resolve the problem in (1 3) either the cost stream uncertainty has to be removed with CPI futures or more structure has to beadded to the problem. In the latter vein, suppose that the domestic equivalents of foreign prices are perfectly correlated with the domestic prices themselves, i.e., ‘sE2 = pZI where p is a sensitivity coefficient. With this assumption, as the domestic value of foreign revenues declines From that expected, so too does the value of the cost stream. However, as long as p # 1, the declines are not equally proportional so that PPP does not hold. Substituting this assumption into (1 0) gives the optimal debt location as,

aA( 1 - t)( 1 + p) - C( 1 - t)p Y =

(1 +rJ l -t)BA) which gives the solution in note 9.

The fact that we can create a hedge simply reflects the implication of% = el, that there is no independent cost uncertainty other than that which arises from exchange rate uncertainty. Hence, foreign debt can still remove what in essence becomes a pure exchange rate uncertainty problem. If we generalise the uncertainty toZ2 = pZI + Z3, we are back to the impossibility of hedging completely. However, (1 4) is still the optimal though imperfect hedge and uncertainty is reduced to; = [C( 1 - t)/( 1 +p)J&. In this case, if p is relatively large and the residual uncertainty small the hedge, though imper- fect, may be very good.

Financing Problem To solve the financing problem we differentiate (9) with respect to y, while acknowledging the Fisher equation of (6), to obtain,

(15) -- d’ - ( 1 - - t ~ ( ( l + r c ) ~ / P c 0 ) - 1) - ~/Pcol( l+rs( l - t ) ) + 1 dY

where the second term on the right hand side is the cost of the foreign debt, which given that PPP is expected to hold is also the cost of inflation-indexed debt, and the first term is the cost of ‘normal’ domestic debt under infla- tion. If we arrange (1 5) we get;

- pc - 1)t dfi - Fc -- - (l-t)(rc-rs) - ( -

dY pco pco Hence, ifthere are no real interest differentials, expected net incomedcclzncs with foreign debt. This is due to the loss of the tax shield, t(Fc/Pco- l) , that arises when the expected inflation component ofdomestic nominal interest rates is tax deductible and the foreign exchange gain or loss on foreign debt is n0t.1~ If there is a real interest rate differential, then the total effect depends on its sign and magnitude.

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There is no reason for the financing solution in (16) to coincide with the previous hedging solutions. Moreover, there is no reason for the hedging solutions to override the value maximisation solution.

Conclusions This paper has examined the use of ‘revenue hedges’ as a justification for deferring the foreign exchange gains and losses that result from foreign currency debt financing. The paper has had to examine both hedging prin- ciples and accounting principles, since Section 1650 explicitly introduces the hedging motive as a criterion for accounting treatment. The conclusions are summarised in a decision tree in Figure 1.

The use of foreign debt as a hedging tool only becomes important once the forward or futures market fails. This obvious result follows from the implication of the second Section, that without transaction costs, they are all perfect substitutes for each other. Given transactions costs, 2o usually the advice is to hedge using the interbank forward market, since this market generally has the lowest transaction costs. The only disadvantage is the necessity of constantly reviewing the forward market hedge. The foreign debt hedge, on the other hand, once issued only has to be changed if the amount of revenue uncertainty changes. The accounting treatment of these hedges should be identical. Since all of the hedges are designed to remove revenue uncertainty, the gains and losses on the foreign debt or the for- ward or future market contract, have to be included in the income statement.

If no forward or futures market exists, then the foreign currencv hedge may conflict with value maximisation. Ifthere is a conflict, the debt should be located where value is maximised, since there is no evidence that hedg- ing affects the value of the firm. In the Canada-us case, the weak currencv has been the Canadian dollar and most financial advice would be to finance with Canadian dollars to obtain the largest tax deductions. However, the close integration ofthe us and Canadian financial markets, both in terms of real interest rates and expected intlation rates, would tend to reduce the financial cost of us debt financing. In this case the foreign debt may be used as a hedge without serious conflict with the principle of value maximisation. However, in general the underlying presumption that foreign currency debt is issued for hedging reasons is at the least highly questionable.

If foreign currency debt is issued for value maximisation reasons, we showed in the fourth section that the foreign currency gains and losses have to be included in the income statement in order to obtain results that can be compared with the domestic financing results. In general, to avoid the effects of fluctuating foreign exchange gains and losses, the expected foreign exchange change should be included in the income statement and actual deviations included with domestic purchasing power gains and losses in the notes to the financial statements. This would be consistent with the effects of SFAS 33 and the treatment suggested in the CICA Handbook of domestic debt under inflation.

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FIGURE I Decision Trw

\ J

If foreign currency debt has been issued for hedging reasons and PPP holds, then we have a double hedge, since the domestic cost stream is already acting to create a real hedge. In this case, the amount of foreign currency debt has to be drastically reduced to create a nominal hedge. However, the motivation for locking in nominal values, while the general price level changes, is somewhat obscure.

Only i f p p p i s holdingimperfectlycan theforeigncurrencydebtbeusedas a hedge. However, we still have the cost stream acting as an imperfect hedge. This raises two possibilities, either hedge the cost stream by usingcpi futures or hedge the residual risk by estimating the correlation structures. In the former case, if a CPI futures market exists as a feasible market for

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hedging the firm’s cost stream, then the debt can be located offshore to hedge the revenue uncertainty. However, once done we have to include the foreign exchange gains and losses in the income statement, or again, we are only including one half of the hedge!

If no CPI futures market exists, the firm will have to estimate ( 1 4) and bear the residual uncertainty of an imperfect hedge. However, again, the foreign exchange gains and losses have to be included in the income statement.

A) Debt is not located offshoreprimarily for hedging reasons. Hence, the motivation underlying Section 1650 Revenue hedges is lacking.

B) When foreign currency debt is used as a hedge, almost by definition, foreign currency gains and losses have to be included in the income state- ment to offset revenue changes. In this way, they should be treated den- ticalfy to futures or forward market hedges.

The implication of the above is that the justification for the current accounting treatment of foreign currency debt has nothing to do with foreign currency revenue hedges, but everything to do with vested interests wanting the firm to ‘look good.’ The revenue hedge is just being used as an excuse to avoid taking foreign exchange losses into the income statement and writing up the value of the firm’s debt during a period of adepreciating dollar. If accounting principles are to be determined on a normative basis, emphasising consistency and comparability, such latitude in deviating from sound accounting principles should be removed. If the hedging argu- ment is taken seriously, foreign exchange gains and losses should be recor- ded in the income statement in the way suggested in the original Section 1650 and SFAS no. 8.

l b o basic conclusions emerge:

Notes 1 See the Ernst and Whinney (1981) booklet on this. 2 See The Globe and Mail’s “Report on Business”, 23 September, 1985. 3 See Aliber and Stickney (1973), Booth (1981) and Beaver and Wolfson (1982). 4 For simplicity, we assume that revenues are translated at year-end exchange

rates along with foreign debt. Extending the framework to allow revenues to be exchanged at average exchange rates is straightforward.

5 The Interest Rate Parity condition, 1+R, = (S/F)(I +R,), relates domestic (c) and foreign (s) nominal interest rates (R) with the spot (S) and forward (F) exchange rates. This condition will always hold in subsequent refinements of our model. Note, with zero interest rates the forward rate is the expected rate, which is also the current rate.

6 By assumption the debt is long term so that the foreign exchange loss is nof realised for tax purposes.

7 Long-term contracting would of course mitigate these effects. 8 See the symposium in the May issue of the Journal oflnfcrnalwnal Economics or

the recent work by Adler and Lehman (1 983). Even the evidence against PPP in the short run does not deny the influence of inflation differentials, only that other factors are also relevant.

9 Note that in the example foreign currency debt of 27.5 would have hedged the adjusted net income stream by creating foreign exchange gains and losses of 2.75 respectively. This arises because in the example the inflation and the Canadian value of foreign revenues are perfectly correlated. This

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‘constraint’ on PPP is discussed in the more general model of our fifth section.

10 Note that the gains and losses on the cn futures contract would be included . in the income statement to offset the cost stream uncertainty. The effective- ness of this cross-hedging strategy obviously depends on the correlation of the firm’s specific price indexes with the CPI.

1 1 See Levi and M a k h ( I 979) for a sound empirical study that shows that the Fisher effect holds in practice, once we adjust for changes in the real interest rate over time.

12 See Mishkin (1984) for evidence on this. It appears that significant real interest rate differentials do persist due to capital barriers. However, no such differences were observed to exist benven the us and Canada, which are the main capital markets of concern to Canadian firms.

I3 Note that man of the foreign currency translation rules are the by-product of a failure to t h y adjust financial statements for inflation.

14 However, Beaver, Griffin and Landsmann ( 1 9 8 2 ) have shown that the infla- tion data does not seem to be used in the market to adjust historic cost earnings.

15 Real in this sense, jusf means piercing the monetary veil created by historic cost accounting principles.

16 Note that normal debt under inflation is in many ways the op osite to zero- coupon debt. Both instruments misclassify interest, the cost o P using capital, and principal. Tax problems arise when the misclassification is carried over for tax purposes. However, note that unlike index linked debt, interest is imputed in zero coupon debt at the nominal rate and deductible as such for tax PU’X oses. Comparability requires the same principle for “low interest” indexe debt and foreign currency debt.

when the debt is refinanced a foreign exchange loss will be recorded which is tax deductible. Hence, the present value of the tax shield is reduced because of deferral.

18 See Solnik (1974) for simple statistical evidence of the unsystematic nature of exchange rate uncertainty and any modem finance text for the valuation of unsystematic risk. Maximising expected income is consistent with value maximisation if income is a real perpetuity and all uncertainty is unsystematic.

19 I f the foreign exchange loss (BAy(Fc-Pc,) in equation (9) is tax deductible, then ( 1 5 ) becomes,

17 Note that current taxes are higher for the foreign debt options, but that

where 0 is the difference between the income tax rate and the cfecftbc tax ratc on foreign exchangc gains or losses. Normally, 0 < 0 either because the gain/loss is treated as a capital item, or simply because it is deferred until rcalisation. in either case, with constant real interest rates, debt is denominated in domestic currency to maximise the present value of tax shields.

20 The only explicit cost of using the interbank market is the bank’s bid-ask spread, which for large customers is very small. The futures market, on the other hand, leaves the firm under constant threat of margin calls as the con- tracts are marked to market each business day. The transactions costs involved with foreign debt would involve the continuous refinancing to maintain the optimal amount of debt required of the hedge. Direct com- parison of these costs will vary from firm to firm depending on size and the variability of the foreign revenue stream.

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References M. Adler & B. Lehman. “Deviations from Purchasing Power Parity in the Long

Run.”Joumd $Finance (Dec 1983) R. Aliber & C. Stickney. “Accounting Measures for Foreign Exchange: The

Long and Short of it.” Accounfing Review (Jan 1973) J. Amernic & B. Gdvin. “Translation of Foreign Business Activities: Some

Evidence in a Canadian Context.” University cf fironlo Working Paper (March 1985)

W. Beaver & M. Wolfson. “Foreign Currency Translation and Changing Prices in Perfect and Complete Markets.”Journal $Accounting Research (Autumn 1982)

W. Beaver, P. Griffin & W. Landsmann. “The Incremental Information Content of Replacement Cost Earnings.” Journal cfAccounfing and Economics 4 (1982):

L. Booth. “FAS 52 and the Market for Excuses.” Universify o/Toronlo working Paper (March 1981)

Ernst & Whinney. Foreign Currency Trans/afion: A Comparison of Infernafional Prarlices (March 1981)

T:Hall. “Inflation and Rates of Exchange: Support for SFAS No. 52.” Journal cf Accounfink Auditing and Finance (Summer 1983)

M. Levi & J. Makin. “Fisher, Phillips, Friedman and the Measured Impact of Inflation on Interest.” Journal ofFinance (March 1979)

F. Mishkin. “The Real Interest Rate: A Multi-Country Empirical Study.” Cana- dian Journal of Economics (May 1984)

F. Modigliani & R. Cohn. “Inflation. Rational Valuation and the Market.” Finam’al Analysfs Journal (March/April 1979)

B. Solnik “Why Not Diversify Internationally Rather than Domestically.” Anan- cia1 Analysts Journal Uuly-Aug 1974)

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RtsurnC L’anicle 1650 du manuel de I’ICCA permet le report des gains et pertes de chan e relatifs a une dene libellee en devises Ctrangeres, si cette dette a pour but d e couvrir une source continue de revenu en devises etrangeres ou un actif en devises ttrangeres. Le vaitement de la dette libellee en devises btrangeres cst relic aux raisons qui ont motive sa creation. La prksente etude analyse cette motivation et offre les conclusions suivantes.

En premier lieu, la dtcision d’arbitrage peut aller P I’encontre de la justification habituelle P la base d’une decision de financement qui a pour but de maximiser la valeur marchande de I’entreprisc. 11 est donc logique de separer la decision d’arbitrage de la decision de financement en utilisant d’autres procedes d’arbitrage comme le operations de changc A tcrmc. En dcuxiCmc licu. Ics opcra- tions d’arbitrage r k l doivcnt Strc differcnciecs dcs operations d’arbitrage noniinalcs puisque I’incertitude du change pcut simplcment rcflktcr I’inccrtitutc dcs colit domestiqucs due a la parite du pouvoir d’achat. En dcrnicr licu, riii.nic dans Ics cas les plus simplcs d’inccrtitudc dc change, llcs gains ct pcrtcs dc changc doivcnt i.trc inclus dans la declaration dc rcvcnus pour contrcbalanccr I’incrctitudc drs rcvcnus.

La conclusion principdc dc cctte Ctudc veut quc la justification dc I’usagc d’ar- bitrage dans Ic but de produirc unc dcttc en dcvisc CtrangCrccst enticrcnicnt tcnue et quc mcme lorsqu’cllc vaut. Ic traitcnicnt comptable dccrit dans I’articlc 1650 nc correspond pas A la dcfinition d’unc opkration d’arbitrage.

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