What effects do exchange rate differences have on profit and loss statements?

Financial statements are currently prepared without taking into consideration the most dangerous risks associated with exchange rate differences, and this can result in inaccurate representations of the financial condition of companies. From an accounting standpoint, positive or negative exchange rate differences reflect the fluctuations in the ruble exchange rate relative to foreign currencies when organizations have entered into export or import contracts in foreign currency. For accounting purposes, exchange rate differences are recorded in other revenues and other expenses. And if goods or services are paid by 100% currency advances, no revaluation is required, and they are recorded in accounting at the exchange rate of the Central Bank of Russia on the date of the relevant transaction. In addition to export or import of goods, the following transactions in foreign currency are also subject to revaluation: bank account cash balances, financial investments, settlements with suppliers (except advance payments), settlements with customers (except advance payments), loan and credit payments. The effect of exchange rate difference is also felt when contributions to share capitals are made in foreign currency.

What are the most obvious risks associated with exchange rate differences?

One of the risks associated with exchange rate differences arises from the different dates at which cash or payments are received and income/expenses are recorded in accounting.

The second risk, which is perhaps the most obvious, arises upon purchase or sale of currency in conditions of sharp fluctuations in the ruble exchange rate. In most cases, this is a short-term risk, and companies can use various hedging tools offered by banks to minimize this risk. In some cases, a sharp fall in the ruble exchange rate may result in adverse consequences in the long term, but company executives have time to negotiate new contract terms and take other steps.

What is the most underestimated risk that can affect most companies?

It arises when company executives focus more on profit and loss statements rather than changes in cash flows. However, its effect can also be observed on the changes in revenues and expenses. The difficulty is that this effect is not reflected separately so executives cannot see the real picture, and they can therefore make incorrect management decisions. This risk remains minor when companies make all their transactions exclusively in local currency or when their share of import/export transactions in foreign currency is not significant. Conversely, this is a much greater risk when the share of transactions in foreign currency is significant. This risk is related to the structure of expenses and income in place in a particular company.

Any practical examples?

For example, a Russian company purchases raw materials in the United States, which represent a significant part of the company’s expenses, and this company sells its products in Russia. So, when the USD exchange rate grows, the company’s sales margin decreases, and when USD exchange rate grows and sales decline, the company can even record losses.

Exchange rate USD 1= RUB 50 

RUB                    USD               Total, RUB          
RUB revenue 10 000 000 10 000 000
USD expenses* 140 000 7 000 000
RUB expenses 2 000 000 2 000 000
Gross profit* 1 000 000
Sales margin** 10

Same scenario but exchange rate USD 1= RUB 55

RUB                    USD               Total, RUB          
RUB revenue 10 000 000 10 000 000
USD expenses* 140 000 7 700 000
RUB expenses 2 000 000 2 000 000
Gross profit* 300 000
Sales margin** 0.03

Unfavorable scenario – exchange rate growth USD 1= RUB 57 and 20% fall in revenue

RUB                    USD               Total, RUB          
RUB revenue 8 000 000 8 000 000
USD expenses* 112 000 6 384 000
RUB expenses 1 600 000 1 600 000
Gross profit* 16 000
Sales margin** 0

* USD part of expenses is the USD amount multiplied by exchange rate.
** Gross profit is RUB revenue minus RUB expenses and USD expenses recalculated with the ruble exchange rate.
*** Sales margin is RUB revenue divided by gross profit.

What strategies are used by companies to minimize the risks associated with exchange rate differences?

Many companies focus on hedging tools offered by various financial institutions to minimize currency risks. This also includes special exchange rates offered by banks. One of the most common measures under contracts in foreign currency between Russian companies was to switch to rubles. However, a successful strategy does not consist of a single method. A strategy is optimal when it is based not only on accounting, but also on the understanding of how exchange rate fluctuations can affect future profits and expenses. Such approach also gives investors a clear picture of the risks that might be incurred by companies and how to overcome them.

Are there various ways of recording the effect of exchange rate differences?

In addition to other classifications of exchange rate differences, it is also possible to divide exchange rate differences into completed and outstanding. The difference between them is that completed exchange rate differences are those resulting from the revaluation of mutual settlements, and outstanding exchange rate differences are those resulting from the revaluation of items in foreign currency at the end of a particular period.

Additional items separately reflecting exchange rate differences in accounts receivable, accounts payable, loan arrears, etc. may be used for management accounting purposes. This approach helps understand the reason for changes in financial statements during the period of exchange rate fluctuations.