Insight to All Things Currency and Treasury Management

“Avoid self-inflicted wounds.” Sounds like good advice and just plain common sense doesn’t it? But after having listened to hundreds of treasury professionals describe their FX hedging process, we have found that companies sometimes engage in practices that are inefficient and even downright illogical. Of course this is not unique to Treasury, nor is it unique to FX management, but for today, we will limit the discussion to corporate foreign exchange risk management practices.

One example of a “self-inflicted wound”: Inconsistent application of ERP system rates

Inconsistent application of ERP system rates primarily affects companies that use daily FX rates to post activities in their ERP system. When we say “inconsistent” we mean that companies set up their ERP rate system in a way that causes them (and particularly the treasurer) a lot of grief.

Let us explain. When you set up a new ERP system, you make a choice regarding the FX rate convention to be used. One choice is a “single rate” environment, where a rate is set at the end of the period (typically month-end) and then used to post all transactions for the following month. Alternatively, companies may instead choose to implement a daily (or weekly) rate for posting transactions. Daily FX rates are quite common in today’s data-driven environment.

Assuming you have chosen daily rates (the choice of daily vs. monthly rates will be the topic of a future discussion), there is at least one more decision to be made that’s vital to the treasurer’s ability to successfully manage balance sheet exposure: deciding whether to use current daily rates for all new postings, or whether to use historical rates – the latter assuming that you would match the document date to the historical FX rate to post all transactions. Sounds reasonable, right?

Seldom has such an innocuous-sounding decision created so much complexity for the treasurer!

To clarify: by allowing historical rates, the treasurer now has to “forecast” how many invoices with stale dates might still be outstanding that have not yet been posted. When those invoices get posted, they create “new” exposures that are not yet hedged, with historical FX rates that are likely to be very different from current rates. In other words, newly posted transactions will carry a “locked” FX gain (or loss) that the treasurer cannot control. Treasury has no way of knowing how may invoices or bills are outstanding that have not yet been posted, potentially with dates going back 30 days (sometimes more).

This creates a terribly inefficient situation, as well as potentially large swings in hedge results. You cannot hedge what you cannot see. In our day-to-day contact with treasury professionals we see companies that use this type of convention desperately looking for solutions to help them analyze their FX gain/loss results.

You might argue that Treasury could estimate the number and volume of invoices and bills outstanding and hedge based on that forecast. That’s an example of a “workaround” that will ultimately lead to problems because of the inherent uncertainty around any forecasting process. Unfortunately, this is exactly what some companies choose to do. Yet the better solution is to go after the root cause of the problem; there is a simple policy change that will solve this issue!

How to avoid this self-inflicted wound

We said earlier that by “inconsistent” we mean that companies set up their ERP rate system in a way that causes them (and particularly the treasurer) a lot of grief. On one hand the CFO (and most likely the Board of Directors) has tasked the treasurer with reducing volatility caused by FX in the income statement, while at the same time inadvertently authorizing the controller to use a rate system (i.e., historical rates) that is entirely inconsistent with the CFO/treasurer’s goal.

To avoid this conflict, companies could adopt a policy requiring all new postings of bills and invoices to be done at the current exchange rate. That way, all new transactions posted in the ERP system will reflect the most current (and, for the treasurer, the most actionable) exposures. With a properly configured rate system, today’s data-mining technologies will allow Treasury to pick up exposures from the ERP system daily via query, facilitating a quick review of current exposures vis-à-vis hedge positions and adjust hedges, if necessary –simple and efficient with no forecasts required.

The last point we’ll make about inconsistency is that the result of allowing historical rates to be used in an ERP system is the FX gain/loss is pushed “below the line” (into the treasurer’s world) instead of being realized “above the line.” Most companies in the U.S. are focused on managing what we call “balance sheet risk.” However, the ERP rate policy discussed here significantly hinders the treasurer’s ability to do just that. For this reason it is important for the treasurer to have a seat at the table when ERP FX rate configuration is discussed.

Bringing it all together

The CFO, controller, and treasurer need to work toward understanding exactly how the ERP rate choice impacts Treasury’s ability to reduce volatility in the income statement. By doing so companies could adopt a booking policy that is more consistent with their overall objective of reducing FX volatility from the income statement.

Call for Comments

  1. What is your experience dealing with inconsistent ERP system rates?
  2. Are you currently working with inconsistent ERP system rates and want to change but think you can’t or don’t want to change even though it causes problems with FX volatility? Why?
  3. Have you eliminated past FX volatility using methods described in this article? Tell us your overall experience and how you’ve benefited.