Where exchange rates enter the financial statements twice

Accounting standards give two names to the currencies a company deals with: the functional currency and the presentation currency.

The functional currency is the currency of the environment in which the company actually operates. The test is which currency its product prices are mainly set in, and which currency it pays wages and materials in. The presentation currency is the choice of which currency the financial statements are printed in.

The two can be the same or different. A Korean company that operates in won and reports in won uses the same currency for both. A company with an overseas subsidiary has a subsidiary whose functional currency is the local currency, while the presentation currency of the parent's consolidated financial statements is the won.

The distinction matters because once the currencies differ, an exchange rate has to be applied somewhere, and the way it is applied differs from item to item.

Start with transactions the company carries out in foreign currency. If it makes a sale in dollars, it records the amount in won using the exchange rate on the date of the transaction. So far, this is intuitive.

The issue is balances where no money has changed hands by the closing date. If dollars are still receivable, that balance has to be remeasured at the exchange rate on the closing date. If the rate moved between the date of sale and the closing date, the amount in won changes, and the difference is booked as a gain or loss.

A difference locked in when money is actually received or repaid is called a foreign exchange transaction gain or loss, and a difference that arises from remeasuring a balance not yet settled is called a foreign currency translation gain or loss. The former is already realized; the latter has moved only on the books.

Both items usually sit below operating income. So in a year of big exchange rate swings, operating income can barely change while net income moves sharply. The company did not make more or fewer sales; the won value of the foreign currency balances it held changed.

Consolidating an overseas subsidiary into the consolidated financial statements works differently again. The subsidiary's entire set of financial statements must be converted into won, and different exchange rates are used for different items.

Assets and liabilities are converted at the exchange rate on the closing date. Since this measures what they are worth as of the closing date, that day's rate is the right one. Revenue and expenses, by contrast, are converted at the rates on the dates those transactions took place. Because going through a full year of transactions one by one is impractical, in practice the average rate for the period is usually used as an approximation.

A mismatch is inevitable here. Assets carry the period-end rate while revenue carries the average rate, so the numbers do not tie out exactly. On top of that, net assets already converted at last year's end are remeasured at this year's closing rate, which creates another difference to the extent the rate moved in between. Accounting standards send the resulting difference not to the income statement but to other comprehensive income.

Amounts sent to other comprehensive income accumulate as a separate item within equity. In Korean financial statements they commonly appear under a name meaning translation gains and losses on overseas operations. They build up year after year without appearing in net income, and are moved into profit or loss only when the overseas business is actually disposed of.

Return on equity is affected first, because the cumulative translation gains and losses sit inside equity, its denominator. Even if the company's business is unchanged, if exchange rates have moved in one direction over several years, equity will have swelled or shrunk, and a ratio calculated on top of it does not reflect only the profitability of the business.

The debt ratio moves for the same reason. Its denominator is also equity, and overseas assets and liabilities are each remeasured at the period-end rate. In a year of big exchange rate moves, the debt ratio can change even if the company borrowed nothing new.

Operating margin and net margin can go separate ways. Because exchange-related gains and losses usually sit outside operating income, there are years when operating margin is calm while net margin moves sharply. When the two ratios do not move in the same direction, the exchange-related items are a good first place to check.

Revenue growth is a little more subtle. For a company with a large share of overseas sales, last year's sales carry last year's average rate, and this year's sales carry this year's average rate. Even if local unit volumes are exactly the same, sales in won appear to grow or shrink when the two years' average rates differ.

Jupick takes the financial metrics of Korean stocks from annual reports filed on DART, Korea's electronic disclosure system, and gives priority to consolidated financial statements. In other words, the values on the screen are the numbers the company disclosed after completing every step described above.

Jupick does not strip out the effect of exchange rates from them. Doing so would require knowing each company's mix of overseas businesses and its balances by currency, but that information is scattered in narrative form through the notes to the disclosures, and its format differs from company to company, so it is not data that can be read mechanically.

So Jupick's debt ratio and return on equity include a part created by exchange rates. This is hard to call an error. The financial statements the company disclosed are built that way, and they are the company's actual financial position. Still, when looking at the metrics of a company with a large overseas share, it is better to know that part of them comes from exchange rates.

One more thing should be made clear. Grades are assigned from a fixed table of score bands, not from each stock's position relative to others. So in a year of big exchange rate moves, the scores of companies with large overseas shares can be pushed in the same direction together. If a grade moved within a year, the right order is to look at what happened at the company and also at how exchange rates behaved over that period.

The bottom line of the income statement alone does not show how much exchange rates were involved. The clues are further back: the statement of changes in equity, which few readers open, and the notes that follow it.

The statement of changes in equity shows on a single line how much other comprehensive income rose or fell that year. A big move there means that translating overseas operations shook equity that year.

Foreign exchange transaction gains and losses and foreign currency translation gains and losses sit lower on the income statement, in items such as other income and other expenses, or finance income and finance costs. If the amounts are not negligible relative to net income, that year's net income cannot be explained by the results of the business alone.

The notes also often include a disclosure of sensitivity to exchange rate changes. It is a table the company prepared showing how much profit and equity would change if exchange rates moved by a given amount. It is the part where the company itself states how exposed it is to exchange rates.

One last point: a large exchange rate effect is not in itself a good or bad sign. A company that earns a lot abroad is naturally exposed to exchange rates, and some companies take steps in advance to reduce that exposure. What matters is not whether exposure exists but whether the company knows about it and manages it.

This content is for information only and is not investment advice. Jupick does not suggest trading any particular stock and does not forecast the future direction of exchange rates or earnings, and the fact that a company's exchange rate exposure is large or small is not advice of any kind. Investment decisions and responsibility for them rest with the user.