May 29, 2014
General Background
News published in Venezuelan and international media, have informed that subsidiaries of transnational entities have reported foreign currency losses when their financial statements are to be consolidated into the financial statements of the parent company, due to the intricate and complicated exchange rate system now in force. Information is confusing, but the most common news refers to the reporting of losses due to the application of different exchange rates in comparison with the former official CADIVI rate.
Details of some of the news published by private media address these issues while showing different patterns (no particular order or relevance with respect to copying and omitted details of the story that are not relevant to this work):
News 1:
Coca Cola announced that, based on recent changes in the Venezuelan exchange devices: “We changed the exchange rate used to prepare the financial statements of our Venezuelan subsidiary into U.S. dollars."
They explained that from March 28, 2014, the company will be using the Supplementary System Administration of Foreign Exchange # 1 (SICAD I).
Coca Cola declared that during the first quarter, the Company recorded US$247 million on charges related to the devaluation of the bolivar and by using current projections the Company anticipates that the modification of the exchange rates will impact its profit adversely for the rest of 2014. Besides,... (Reported by Business Insider Website).
News 2:
Brink´s, the parent company of Servicio Pan Americano de Protección, announced it would reduce the value of its assets in Venezuela, causing a 12% stock drop in the New York Stock Exchange.
Brink´s decision may indicate similar action by DirecTV and MercadoLibre, companies with big amounts of money trapped in Venezuela, because the modification of the exchange rate to SICAD II (about Bs50 per US dollar) would diminish the income, said co-founder of hedge fund Newfoundland Capital Management, Jonathan Rosenthal. ”Now is crystal clear for bankers that those businesses will not create the same amount of cash as they thought,” said Rosenthal, whose hedge fund is based in the Cayman Islands....
Bloomberg noted that Brink´s is the first company to adopt the SICAD II exchange rate for its first quarter earnings. ”Meanwhile, Procter & Gamble, Colgate-Palmolive and Telefonica have said they will adopt SICAD I, created last year for the imports of non-essential items” they said.
News 3:
DirecTV and MercadoLibre are prepared to remeasure their accounts with the exchange rate SICAD II, so that their profits in Venezuela could drop up to 50%.
The satellite operator DirecTV could see their cash holdings reduced by 26% while earning per share would decline between 9% and 11% if measured at Bs50 per dollar, said the co-founder of hedge fund Newfoundland Capital Management.
"There are U. S. companies where any income between 10-50% can disappear even though Venezuela is totally off the radar,” he said. His hedge fund "is looking for ways to monetize this” which includes betting on the decline in DirecTV, he added.
MercadoLibre should reduce its operating income by 31% if remeasures its assets in Venezuela using the rate of SICAD II, according to data compiled by Bloomberg.
Reuven Yaron, President Reuven Capital Investments LP, said they are betting that the shares of the company will be reduced. ”These companies reported fictitious profits and soon they´ll start to really report losses. Those bolivars are useless”, he said.
News 4:
In this example, Estee Lauder has not recognized any loss, although, according to the news, a ”hypothetical devaluation of 45%” could induce a remeasurement of the results causing a loss of between US$20 and US$27 million after tax, depending on the timing and size of the devaluation.
In short, to sum things up, that news reflects the drama currently faced by multinational companies with Venezuelan subsidiaries. The worst thing about the situation is the chaotic way the companies are performing. It is observed that in some cases it was announced that certain entities decided to apply the exchange rate SICAD I for the translation of its financial statements; others commented that they are considering the exchange rate SICAD II; and another announced it will continue using the preferential rate CENCOEX (old CADIVI), since it assumes that there is no official devaluation in Venezuela.
At first glance, a reckless reader without accounting knowledge would not understands how the same problem can be treated in various ways, as if there were not accounting principles and rules to address this matter. The truth is these rules and/or principles do exist, but to apply them is necessary to implement an extreme use of judgment and careful application of professional standards, as well as deep knowledge of the economic and financial situation happening in Venezuela at the present time.
Technical Background
The issue is relatively simple, but is somehow complex for the manner certain events have developed in Venezuela in recent times. Some of the questions any unqualified person without accounting knowledge would made are: 1) Why does these companies lose money if they have a good performance in Venezuela and make so much money?; 2) Is it not true that the national government is forcing a control of prices because these companies and many others are selling at exorbitant prices and are producing large profits for their shareholders?; 3) How the SICAD and/or the CADIVI exchange rate affects these matters?
An accountant with experience in reporting to the parent company of his Venezuelan employer perfectly knows the answers: 1) Many transnational (and national) corporations earn money, but their results are measured in local currency, in Venezuelan bolivars; 2) Prices are based, mainly, on imported goods and raw materials and companies has to pay it in foreign currency; 3) The foreign exchange rate, whichever the company uses, is used to account for foreign currency transactions in the Venezuelan books and for translation of the financial statements for purposes of consolidation into the financial statements of the parent company.
Companies quoted in previous section, generally correspond to USA entities and only one is a European corporation. All of them have the same problem. The USA entities should manage it applying the US GAAP; Europeans using the IFRS. Generally, Asian companies, Latin American and entities of other regions are using IFRS. Starting from this distribution, a comparative approach could be framed. The next table shows the main elements of the accounting rules which should be evaluated (and were probably used) by these entities:
Comparative Table
# | Accounting Standard / Principle / Guide | Under IFRS | Under US GAAP |
1 | Venezuela is considered a hyperinflationary economy[1] | Yes | Yes |
2 | The functional currency is the Venezuelan bolivar [2] | Yes | Yes |
3 | Transactions in foreign currency are recognized at the exchange rate of the market or another representative transaction rate[3] | Yes | Yes |
4 | Financial statements are translated into the reporting currency | Yes | Yes |
5 | The reporting currency, when it relates to an entity located in a hyperinflationary economy, is the currency of the parent company | Yes | Yes |
6 | Financial statements of the entity must be remeasured before they are translated into the reporting currency[4] | Yes | Yes |
7 | Translation of the financial statements is performed using the exchange rate of >>>>>>>[5] | ??? | ??? |
8 | Translation results are recognized in income of the period | Yes | Yes |
Point 7 concentrates the problems foreign entities are facing. I will try to summarize the origin of the differences between companies. However, there are other issues related to the management of foreign currency transactions that would cause additional losses to national entities, which will not be discussed in this article. For more details, read the article quoted at the start of the Foreign Exchange Background Section below.
Analysis under IFRS
IAS 21 ”The Effects of Changes in Foreign Exchange Rates” contains the requirements that a company must complete to translate its financial statements into a foreign currency when the entity is located in a hyperinflationary economy, which is the case of Venezuela. The following paragraphs are a true excerpt from the original text of IAS 21 (underlines are mine):
Definition
8 The following terms are used in this Standard with the meanings specified:
• Closing rate is the spot exchange rate at the end of the reporting period.
......
• Spot exchange rate is the exchange rate for immediate delivery.
Translation to the presentation currency
38 An entity may present its financial statements in any currency (or currencies). If the presentation currency differs from the entity’s functional currency, it translates its results and financial position into the presentation currency. For example...
42 The results and financial position of an entity whose functional currency is the currency of a hyperinflationary economy shall be translated into a different presentation currency using the following procedures:
(a) All amounts (i.e. assets, liabilities, equity items, income and expenses, including comparatives) shall be translated at the closing rate at the date of the most recent statement of financial position, except that...
43 When an entity’s functional currency is the currency of a hyperinflationary economy, the entity shall restate its financial statements in accordance with IAS 29 before applying the translation method set out in paragraph 42, except for comparative amounts.....
Text above copied is summarized in the Comparative Table. Therefore, it only remains to determine the exchange rate to be applied in Venezuela as under IAS 21, because that's where the problem originates. IAS 21 was the result of a thorough review of the rule and others that existed before its enactment in 1993. Reproduced definitions should solve the problem but this is not possible due to the situation discussed in Foreign Exchange Issues section.
Analysis under US GAAP
Section 830 "Foreign Currency Matters” basically contains all the elements for an entity to translate its financial statements into a foreign currency. Copied below are some paragraphs which will orient the reader to understand what sets this body of rules, which basically is the same as set out in IFRS, with certain minor differences. Underlines are mine:
830-10-45 Other Presentation Matters
General
45-1 The guidance in this Section relates to how a reporting entity determines the functional currency of a foreign entity (including of a foreign entity in a highly inflationary economy), remeasures the books of record (if necessary), and characterizes transaction gains and losses. The guidance is organized as follows:
· The functional currency
· The functional currency in highly inflationary economies
· Remeasurement of books of record into the functional currency
· Transaction gains and losses not extraordinary.
The Functional Currency in Highly Inflationary Economies
45-11 The financial statements of a foreign entity in a highly inflationary economy shall be remeasured as if the functional currency were the reporting currency. Accordingly, the financial statements of those entities shall be remeasured into the reporting currency according to the requirements of paragraph 830-10-45-17. For the purposes of this requirement, a highly inflationary economy is one that has cumulative inflation of approximately 100 percent or more over a 3-year period.
Remeasurement of the Books of Record into the Functional Currency
45-17 If an entity’s books of record are not maintained in its functional currency, remeasurement into the functional currency is required. That remeasurement is required before translation into the reporting currency. If a foreign entity’s functional currency is the reporting currency, remeasurement into the reporting currency obviates translation..…The remeasurement process is intended to produce the same result as if the entity’s books of record had been maintained in the functional currency. To accomplish that result, it is necessary to use historical exchange rates between the functional currency and another currency in the remeasurement process for certain accounts (the current rate will be used for all others), and this guidance identifies those accounts. To accomplish that result, it is also necessary to recognize currently in income all exchange gains and losses from remeasurement of monetary assets and liabilities that are not denominated in the functional currency (for example, assets and liabilities that are not denominated in dollars if the dollar is the functional currency).
830-30-45 Other Presentation Matters
General
45-1 The guidance in this Section discusses how a reporting entity translates foreign currency statements and analyzes changes in the cumulative translation adjustment. It also addresses two related reporting matters.
Translation Using Current Exchange Rate
45-3 All elements of financial statements shall be translated by using a current exchange rate as follows:
a. For assets and liabilities, the exchange rate at the balance sheet date shall be used.
b. For revenues, expenses, gains, and losses, the exchange rate at the dates on which those elements are recognized shall be used.
45-4 For purposes of translation of financial statements referred to in this Subtopic, the current exchange rate is the rate as of the end of the period covered by the financial statements or as of the dates of recognition in those statements in the case of revenues, expenses, gains, and losses.
45-6 In the absence of unusual circumstances, the exchange rate applicable to conversion of a currency for purposes of dividend remittances shall be used to translate foreign currency statements.
Analyzing the preceding paragraphs, it is observed that coincide quite closely with the transcripts of IAS 21, although US GAAP’s are more specific than IFRS. In that regard, paragraph 45.6 provides for the possibility of using a special, designated exchange rate: the dividend rate, which is not taken into account by IFRS. That has led to the great diversity of positions elected by entities required to report under US GAAP and possibly also those reporting under IFRS since for these entities there is no an so specific standard.
Foreign Exchange Issues
In my recent work in spanish language ”Multiple Exchange Rates in Venezuela - An Accounting Problem” (click here to read it), I explained the current situation affecting all Venezuelan entities, but I didn't refer to the translation of financial statements into a foreign currency issue. It is mandatory to summarize the exchange rate environment to understand the origin of the problem here studied.
To date, there are the following legal exchange rate systems in Venezuela:
1. CADIVI (CENCOEX today) Fixed Exchange Rate – Bs6.30/US$1;
2. SICAD I Variable Exchange Rate – Bs10/US$1; and
3. SICAD II Variable Exchange Rate – Bs50/US$1.
1. CADIVI (CENCOEX today) Fixed Exchange Rate
This system is only available to individuals and/or entities receiving Authorization for Settlement of Foreign Exchange (ALD’s) which CADIVI grants at the fixed preferential exchange of Bs6.30/US$1. In April 2014, CENCOEX replaced CADIVI as the office responsible for managing foreign exchange issues. From the date of such substitution, entities entitled to receive ALD from CENCOEX, should be engaged in the importation of essential goods and services. ALD would be subsequently liquidated by the BCV of Venezuela (BCV) at the official preferred exchange rate, so that the entity can demand its suppliers to complete orders based on that premise. As it is known at present, very few entities are receiving foreign currency under this system.
2. SICAD I Variable Exchange Rate – Bs10/US$1
This new exchange system was organized in the first quarter of 2013 and would grant corporations and individuals with a higher exchange rate than the old CADIVI fixed rate, but its value is determined by auctions organized by CENCOEX with the collaboration of BCV. This system would benefit some importers who previously received CADIVI currency at the fixed exchange rate of that system. According to legal terms, entities and individuals registered in the auctions would receive foreign currency at the variable exchange rate decided by BCV, after they make advanced payment of their positions before the auctions. Therefore, entities benefited by this system get foreign currency only for payment of imports and/or services, and BCV is responsible for delivering the currency once the process is complete.
The last known exchange rate of SICAD I, published by BCV on April 7th, 2014 was Bs10/US1. That amount was posted in BCV web page without providing any other detail, and appears to be the result from an average of awards approved in several completed auctions in one day. It should be noted that this rate is constantly fluctuating and entities must plan in advance for purchasing foreign currency, but the final outcome depends on the decisions of BCV at the time of the award. Taking into account what has been published in the press, CENCOEX would be using this system to deliver currencies that were not fulfilled by CADIVI; for payment of new imports of non-essential goods and services; and for other purposes.
3. SICAD II Variable Exchange Rate – Bs50/US$1
This is the latest exchange system introduced after the enforcement of the Law of the Exchange Rate System and its Illicit Issues. This system is different to SICAD I and the exchange rate is set from offerings of individuals and corporations interested in buying or selling foreign currency through BCV. It is not a full-fledged auction and the value of foreign currency is determined on the basis of the tenders submitted to BCV and decisions made under their control. The final, averaged exchange rate published by the BCV as a result of these transactions is higher than SICAD I.
The last known exchange change of SICAD II, published by BCV on May 20, 2014, was Bs49,99/US$1. As with SICAD I, that amount was issued without giving additional details and appears to be the result from the average value of selected deals to buy and sell currencies in one day. In these journeys, those who buy and those who sell present their offers or requests for foreign currency and the prices at which they are willing to settle it. Then, BCV decides who and who cannot participate. Each entity interested in offering or purchasing foreign currency through this system must send it through a bank and await for the outcome of the BCV decisions. Based on these decisions, purchasing entities know the exact exchange rate at which they acquire foreign currency and that is the value they will use to measure the correspondent foreign currency asset.
Payment of Dividends
To date there is no clear evidence that local subsidiaries of foreign entities may remit dividends using any of the three above mentioned systems. The remittance of dividends is legally covered under the Exchange Agreement No. 1 of February 2003, which in part provides:
Article 29. To acquire foreign currency for the remittance of dividends, capital gains and interest, if applicable, as a result of foreign direct investment, as well as.....
The Authorization for Purchasing of Foreign Currency must be requested by the concerned duly registered with the competent national body office. CADIVI will provide its determination to fulfill this process expeditiously.
Applications filed by interested entities, had somehow been processed by CADIVI, and since 2003 these entities had been receiving foreign currency at the exchange rates existing under the regime of then existing exchange agreements. The latest news addressing this issue is from March 7, 2012 and reports, regarding the delivering of foreign currency during 2011, the following information:
“Official figures released by the Report and Accounts of the Ministry of Planning and Finance reveal that only 45 applications were approved related to repatriation of dividends.
A total of 13 companies in the industrial sector have benefited from a greater amount in currency adopted by 31 million dollars, followed by 11 companies in the business area to which they are settled in the amount of US$25,7 million and 2 companies in the sector food with US$13,2 million. Seven companies in the banking area, health and telecommunications were authorized a total of US$11,6 million.”
Since then (probably since 2011), the entities which submitted new applications to pay dividends have not received responses from CADIVI (CENCOEX today) and it is unknown whether that agency will do it at some point. The fact is: there is no guarantee that such requests will be processed and less, which exchange rate, if any, would be granted being it positively decided. Additionally, with the recent elimination of CADIVI, questions have arisen regarding how applications of foreign currency for payment of dividends will be conducted and, also, how the requests made by entities will finally be resolved. One of the institutions grouping multinational companies in Venezuela revealed the following in a press release dated April 8, 2014:
“The commercial debt of companies affiliated within the Venezuelan-American Chamber of Commerce and Industry (Venamcham) amounts to 13 billion dollars, said CEO Carlos Tejera.
He explained that is required a dialogue between the government and industry in regard to the limitations that have arisen in the supply of foreign currency, is required. He affirmed that Venamcham estimated at 10 billion dollars repatriation of dividends by affiliated companies. He recalled that the camera has 1,054 member companies (74% are Venezuelan, 15% U.S. and 11% from different countries), reported El Universal.”
Summarizing, up to date it is not possible to assert which is the applicable dividend remission exchange rate, which would be the applicable rate by US GAAP reporting entities, if strictly they aim to adhere to the provisions of paragraph 45.6 of Section 830.30.
The same does not apply to entities reporting under IFRS since these rules do not contain a provision on a dividend exchange rate and because IAS 21 mandate to using the closing exchange rate. In Venezuela it is very difficult to establish which is the closing exchange rate as we have seen that there are at least three different systems (apart from the parallel rate) whereby entities could buy foreign currency. It could be strongly argued that corporations have no chance of receiving foreign currency under the CADIVI - CENCOEX system (Bs6.30/US$1). That leaves the possibilities of SICAD I and II SICAD, and the parallel rate. According to information from the Internet, the parallel exchange rate at the date of this article was approximately Bs69.50/US$1.
Through different information in the Internet, it has been known that several audit firms of Venezuelan subsidiaries of USA corporations are recommending (some with discretion) that the exchange rate to be applied instead of the dividend remittance exchange rate, should be that of SICAD I because there is a provision in the Exchange Agreement No. 25 of January 2014, supplemented by Providence CADIVI No. 056, which would support that position.
Article 1 of Exchange Agreement No. 25 provides as follows (underlines mine):
Article 1 -. Starting from the effective date of this Exchange Agreement, the settlement of transactions for sale of foreign currency for the concepts below, governed by the relevant rules of the system of administration of foreign currency, will be made to rate resulting from the latest foreign exchange allocation through Supplementary on Foreign Exchange Administration System (SICAD I), which will be published on the website of the Institute:
........
f) International investments and royalty payments, use and exploitation of patents, trademarks, licenses and franchises, as well as technology import contracts and technical assistance.
In turn, Providence CADIVI No. 056 of August 2004 (apparently not superseded), which is applied to implement the provisions of Exchange Agreement No. 25, states the following (underlines mine):
Article 1. This Providence sets out rules for the authorization to purchase foreign currency required to honor commitments under international investment activities in the Bolivarian Republic of Venezuela by companies duly incorporated or domiciled in the country, who are receiving of such investments.
Article 2. The foreign exchange authorized by the Administration Commission (CADIVI) in accordance with the provisions of this Providence only is affected for the following purposes:
......
c) Remittance of profits, rents, interest and dividends from international investment.
So the decision to apply the exchange rate of SICAD I would be sufficiently justified if we attach to the above commented. If it would be so simple, why, then, some of the entities mentioned in the first section have indicated that they would use the exchange rate of SICAD II and another entity informs that they will continue to applying the exchange rate of CADIVI (CENCOEX today)? The answer is frankly: because there is no sufficient, legal or institutional confidence to assure that it is logical to apply the SICAD I exchange rate; but it is less fortunate, in my opinion, to continue in the position of the last and extremely conservative to apply the SICAD II exchange rate. In either case, the problem is not easy to solve because it doesn’t depend on accounting or legal evaluations; because it depends on the Venezuela national executive disposition to comply with their commitments; because it depends on what should be interpreted in the current circumstances on the legality of the laws and resolutions of CADIVI (CENCOEX today). In short, for many other reasons different than those resulting from a purely accounting evaluation.
In other words, the problem will not be resolved by applying accounting standards to a situation that has become an institutional problem, a political problem, a problem of lack of foreign currency, a problem of unwillingness to meet its commitments by the Venezuelan government. Foreign entities, meanwhile, do not risk the reporting of exaggerated losses if they can use an exchange rate even though it is not sufficiently supported. Apparently, their approach to a final decision is not to deny the possibility that someday they could pay dividends or repatriate their investments in Venezuela. Possibly they would have no choice but to do it with SICAD II exchange rate or to go to the parallel market to acquire the necessary foreign currency, either for payments of dividends or for repatriation of their investments in Venezuela. The cost of the decision is bigger than ever.
Conclusion
The lack of reliable information and the lack of legal certainty in relation to exchange events in Venezuela have created a problem for national entities translating its financial statements to a foreign currency that is not really an accounting problem. But, also, it is not a legal issue, as some have asserted.
As I have shown in this article, the accounting principles contain all provisions to handle this matter since long time ago. Obviously, subsidiaries of USA companies (US GAAP) confront the lack of clear information regarding the exchange rate for the payment of dividends, but subsidiaries of other countries (IFRS) are also facing a similar situation because they cannot decide what the closing exchange rate is. In a nutshell, all foreign entities are in the same conditions regardless of the accounting framework that regulates it.
Some readers may argue that in Venezuela there has not been a formal devaluation and, therefore, foreign entities should not apply a rate different from that of the CADIVI (CENCOEX) exchange rate system. That statement cannot be refuted from a legal point of view because, in fact, there is no official devaluation. Others may argue that although there is no official devaluation, all signals sent by the Venezuelan government (SICAD I and SICAD II exchange systems) indicate that devaluation, in fact, has already been implemented but it´s not yet “legalized”. Most radicals justify the devaluation commenting that in the near future there will be only a legal exchange rate close to the parallel exchange rate, because the lack of international reserves and the decreasing of the income from sales of the oil industry.
If we are to believe the latest news, which are based on statements by leading representatives of the national government, the country is heading towards a single exchange rate system by the removal of all of the existing exchange rates and by the implementation of a new unique system close to the parallel market. However, these statements may be pondered as ”interested statements”, who knows for what purposes.
In any case, the accounting effects of all this matter will be of great impact. Devaluation representing three current exchange rates relative to the CADIVI (CENCOEX) rate can be seen in the table below and could be used to compute the amount of potential losses:
Exchange
System | Exchange
Rate | Implicit Devaluation |
CADIVI (CENCOEX) | 6.30 | NA |
SICAD I | 10.00 | 58.73% |
SICAD II | 50.00 | 693.65% |
Parallel rate | 69.50 | 1,103.17% |
The entities that already apply rate SICAD I have anticipated some of the effects of these losses. Those applying SICAD II, if any has actually taken that step, seem more realistic although it is possible that the effect of losses in the financial statements of the parent company may be immaterial. But entities sticking to the CADIVI (CENCOEX) exchange rate are simply delaying, wrongly in my opinion, and without accounting supports, the recognition of true losses. This could be contested or challenged by any interested third party.
Accounting principles contains key provisions to guide accountants in their application and users in their review of the financial statements. The IFRS Framework provides:
QC12 Financial reports represent economic phenomena in words and numbers. To be useful, financial information must not only represent relevant phenomena, but it must also faithfully represent the phenomena that it purports to represent. To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and free from error. Of course, perfection is seldom, if ever, achievable. The Board’s objective is to maximize those qualities to the extent possible
QC13 A complete depiction includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations.........
QC14 A neutral depiction is without bias in the selection or presentation of financial information.........
QC15 Faithful representation does not mean accurate in all respects. Free from error means there are no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process......
4.38 An item that meets the definition of an element should be recognized if:
(a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and
(b) the item has a cost or value that can be measured with reliability.
Facts and conditions are known. The accounting decisions must be based on facts and convictions. Corporations should consult their auditors, lawyers and other financial and economic advisors to adequately support any decision. The more time goes by without these decisions are taken, the greater and deeper the consequences will be for all those involved.
