DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

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30 July 2015

Americas/United States

Equity Research

Accounting & Tax

FX Translated ACCOUNTING

Accounting 101

Exhibit 1: The FX Two-Step

Source: Credit Suisse Accounting & Tax Research

■ Introducing the Accounting 101 (admit it, it was your favorite class) line

of reports. The focus will be on complex topics that are causing lots of

investor confusion. Our goal is simple: explain the accounting in Plain

English. So, if you're looking for a trading idea, stop reading. But if you want

to better understand the accounting to improve your models, analysis and

ability to uncover the underlying economics you've come to the right place.

■ FX impact on results continues to surprise even though we can all

follow changes in FX rates. Why? FX volatility, complex accounting,

opaque disclosures, FX hedging, intercompany transactions, etc. In the

piece we walkthrough FX accounting, including FX hedging and show how

FX changes impact financial statements. The cumulative FX translation loss

(S&P 500) is at a 15-year high over $240 billion (nearly 4% of book value).

■ Don't automatically ignore FX, use constant currency with caution.

There are just two questions that you need to ask yourself when trying to

analyze the impact of FX changes on the companies that you own and

follow: (1) What impact has FX had on the underlying business (e.g., has it

changed the future cash flow stream for the foreign business by affecting the

competitive landscape, cost base, product demand)? And (2) What impact

has FX had on the value of the business (e.g., has FX changed the U.S.

dollar value of the future cash flow stream from the foreign business)?

Research Analysts

David Zion, CFA, CPA

212 538 4837

david.zion@credit-suisse.com

Ravi Gomatam, CFA

212 325 8137

ravi.gomatam@credit-suisse.com

Ron Graziano, CPA

312 345 6169

ron.graziano@credit-suisse.com

30 July 2015

FX Translated 2

Table of contents Table of contents 2 FX Accounting Cheat Sheet 3 FX Translated 4

FX Continues to Surprise 6 FX Exposure from an Economic Perspective 6

If You're Happy and You Know it… 6 Accounting Can Disconnect from Underlying Economics 7 Boiling It Down 9

FX Accounting 10 Functional Currency Is the Key 10 The FX Two-Step 11

Step 1 – Get Everything Measured/Remeasured in the Functional Currency 12 Foreign Currency Transactions 13 If There Are Foreign Currency Books & Records, the Financial Statements Need to

Be Remeasured into Functional Currency Too 18 Step 2 – Translate from Functional Currency into Reporting Currency (FX Translation)

19 FX Translation Gain/Loss Reported in OCI within Shareholders' Equity 20 FX Translation Losses over $240 Billion in Aggregate for S&P 500 21 FX Translation Impacts Earnings Too 22 FX Translation Impacts Reported Cash Flows Too 23

FX Hedging 23 Au Naturale FX Hedges 23 Hedge Accounting, 1,000+ Pages of Fun and Excitement 24 Four Types of FX Hedges 26 1. Fair Value Hedge 26 2. Cash Flow Hedge 28 3. Net Investment Hedge 29 4. Standalone Derivative (Economic Hedge) 29 Where Can You Find Derivative Gains / Losses? 30

Appendix A – FX Remeasurement Example 31 Balance Sheet FX Remeasurement 31 Income Statement FX Remeasurement 32

FX Gain/Loss Reported on Income Statement 34 Appendix B – FX Translation Example 35

Balance Sheet FX Translation 35 FX Translation Gain/Loss Reported in OCI 36

Income Statement FX Translation 37 Cash Flow Statement FX Translation 38

Effect of FX Rate Changes on Cash 40

30 July 2015

FX Translated 3

FX Accounting Cheat Sheet In the midst of another earnings season chock full of FX related hits/misses, we decided to

try our hand at translating the accounting for FX translation. For those interested in the

quick and dirty version, we kick things off with our FX Accounting Cheat Sheet in Exhibit 2.

Print it out and tack it up on the cork board (near the kids art work and that signed Darryl

Dawkins poster), so the next time FX volatility rears its ugly head, you'll be prepared.

Exhibit 2: FX Accounting Cheat Sheet

Source: Credit Suisse Accounting & Tax Research Note: See Exhibit 17 for details on remeasuring foreign currency financial statements 1: Foreign Currency: any currency other than the functional currency 2: Functional Currency: the currency in which the company/subsidiary does most of its business 3: OCI = Other comprehensive income (OCI) 4: Monetary assets/liabilities include cash, receivables, payables, etc. (cash or items expected to be settled in cash) 5: Non-monetary assets/liabilities include inventory, PP&E, deferred revenue etc. 6: FX rate on transaction date, in practice weighted average FX rates are used.

30 July 2015

FX Translated 4

FX Translated With this piece we introduce our Accounting 101 line of reports (we figured why not go

with everyone's favorite class from school). The focus will be on complex topics that are

causing lots of investor confusion. Our goal is simple: explain the accounting in Plain

English. So, if you're looking for a trading idea, we'll save you some time, stop reading. But

if you want to better understand the accounting to improve your models, analysis and

ability to uncover the underlying economics you've come to the right place.

Foreign Currency sure has been a hot topic over the last few earnings seasons (nearly as

hot as the New York Yankees). It seems like FX related hits and misses have been

popping up in every other earnings call, from the nine point drag on second quarter

revenue for IBM, to DuPont's $0.80 per share currency headwind for 2015, to Omnicom's

FX related revenue drop of more than 6%, the list goes on and on, including a few more

examples in Exhibit 3.

Exhibit 3: The FX Impact – Some Company Examples

Source: Company transcripts, Credit Suisse Research

Of course the culprit behind most of the FX related noise is the strong dollar. The U.S.

dollar went on quite a run appreciating 22% against a basket of major currencies from

June 30th 2014 through March 31, 2015 see Exhibit 4 and that had a big (generally

negative) impact on reported results for U.S. companies. The last time we saw the dollar

come close to strengthening like that over such a short period of time was back in 2009,

when it was up nearly 20% over the nine months ending March 31, 2009.

But since the beginning of April the dollar had been hit pretty hard, it dropped by nearly 5%

at one point during the quarter and was down about 2.3% against a basket of major

currencies through June 30th (it has since gained back those losses and then some). So

are we now seeing an FX tailwind in the second quarter? Depends upon how you look at

30 July 2015

FX Translated 5

things, maybe on a quarter-over-quarter basis FX is providing a little bit of help. But if your

focus is year-over-year, we continue to see significant FX headwinds. That's a result of the

U.S. dollar being up 19% over the past year through June 30th, see Exhibit 5. In fact the

recent year-over-year strength in the U.S. dollar is among the most significant in the past

thirty years.

Exhibit 4: Trade Weighted U.S. Dollar Index: Major Currencies Exhibit 5: Year-Over-Year Change U.S. Dollar Index

Source: Board of Governors of the Federal Reserve System (US), Credit Suisse estimates Note: Major currencies include currencies of the Euro Area, Canada, Japan, the United Kingdom, Switzerland, Australia, and Sweden. Trade Weighted U.S. Dollar Index: March 1973 = 100

Source: Board of Governors of the Federal Reserve System (US), Credit Suisse estimates Note: Major currencies include currencies of the Euro Area, Canada, Japan, the United Kingdom, Switzerland, Australia, and Sweden. Trade Weighted U.S. Dollar Index: March 1973 = 100

The FX ups and downs can wreak havoc on analyst estimates, earnings, balance sheets

etc. and FX volatility hit a five year high early this year (remember that's when the Swiss

National Bank removed the cap on the Swiss franc and it shot up), see Exhibit 6.

Exhibit 6: Average USD FX 1m realized volatility (%)

Source: Bloomberg, Credit Suisse estimates Note: Simple average of 1-month realized volatility of currencies of the Euro Area, Canada, Japan, the United Kingdom, Switzerland, Australia, and Sweden.

30 July 2015

FX Translated 6

FX Continues to Surprise

But you knew that already. So if everyone knows what's going on with FX rates, why do

FX impacts (negative and positive) continue to catch analysts and investors by surprise?

We think there are a number of factors: the FX volatility is difficult to deal with, tack on top

the complex accounting, confusing terminology (is it translation or transaction?),

exposures to multiple currencies, varying FX exposures (currency mismatches),

differences in how companies manage the risk (are they hedged or not?), opaque

disclosures (which currencies and cross currencies are they exposed to?), intercompany

transactions, etc. As a result FX is a tough topic for investors and analysts to wrap their

heads around (companies struggle with it too).

What's not a surprise is that we have been getting a steady stream of FX related questions.

Investors want to know how FX flows through the financial statements to tighten up their

models. In addition, to get at the underlying economics of a multinational business

(including, what's driving the results, is it the business or currency fluctuations?) you need

to understand the accounting for FX (which doesn’t always match the economics).

In this piece, we try to translate foreign currency accounting into Plain English (it’s a

struggle) and show how FX movements impact the financial statements. Our plan is to

eventually follow up with a piece that focuses on examining FX exposures and modeling

FX risk using the clues that companies sprinkle around their financial statements,

footnotes, earnings releases, etc.

FX Exposure from an Economic Perspective

Before we dive into the accounting and all that translation/transaction mumbo jumbo, let's

quickly review FX exposures from an economic perspective. There are plenty of

companies with varying degrees and types of FX exposure, that's why we decided to write

this report and probably why you have made it this far (congratulations you are on page

six). Yes, FX exposure comes in lots of different flavors, but if you take a step back and

focus on the underlying economics it can be narrowed down to three simple perspectives,

is the company a net (1) importer, (2) exporter or (3) purely domestic. Just to be clear an

importer / exporter would include the import / export of goods, services, labor, capital, etc.

If You're Happy and You Know it…

In Exhibit 7, we summarize FX exposures for a U.S. company to a stronger/weaker dollar

from these three perspectives (apply it to a foreign company by replacing the U.S. dollar

with their local currency). For example, a stronger dollar is good news (hence the smiley

face) if you're importing stuff from overseas (all else equal) as it would cost less in U.S.

dollars but bad news (hence the frown) if you're an exporter as your product/service would

cost your customers more in their local currency.

An interesting twist on that last point was provided by Royal Caribbean CFO Jason Liberty

during the Q1 2015 Earnings Call: "The majority of our onboard offering are denominated

in U.S. dollars and the significant strengthening of the dollar has slightly weakened the

purchasing power of many of our international guests." In other words Royal Caribbean is

effectively an exporter of its "onboard offering" to its passengers.

Exhibit 7: Economic Impact of Stronger/Weaker Dollar on a U.S. Company

Source: Credit Suisse Accounting & Tax Research

Lots of incoming questions

on FX translation

In this piece we focus on the

accounting, we plan to

follow up on FX exposures

What impact has FX had on

the underlying business?

30 July 2015

FX Translated 7

How would our thought process apply to a U.S. company with foreign subsidiaries? Well, if

you are looking at it from the U.S. parent perspective, it's effectively a net exporter of

capital. It has invested its capital in a business that generates cash flows in a foreign

currency. If for example the U.S. dollar strengthens that's bad news (all else equal) as the

return that it receives on its investment (the foreign currency cash flows) are worth less in

U.S. dollars. If you expected FX rates to remain at those levels it could impact the

valuation of the foreign subsidiary and therefore the company as a whole (unless there

was some offsetting currency effect on the underlying business).

FX Can Even Impact A Purely Domestic Company

A stronger dollar may even be bad news for a U.S. company that does all of its business

domestically. Why? Because it could hurt the company's competitive positions by allowing

the foreign competition to cut pricing in the U.S. or it might invite new foreign competition.

This point was addressed several times in the Q1 2015 Earnings Call for Harley Davidson

by the CFO John Olin: "Given the levels of competitive inventories in the retail channel

coupled with foreign exchange that was favorable for our competitors, we expect

aggressive discounting from the competition will continue for some time…Our competitors

are largely Japanese and European. They're certainly realizing a strong benefit when they

sell in the United States."

Accounting Can Disconnect from Underlying Economics

Too bad the accounting for FX exposure doesn’t always match the underlying economics

(that'd be too easy). For example, take FX translation (which we explain in more detail

below), if the dollar is strengthening, the earnings of a foreign subsidiary could appear to

weaken when they are translated into U.S. dollars, even if the foreign business is

performing well. So have things gotten worse (that year's U.S. dollar earnings are lower) or

better (the foreign business is performing well)?

But if the U.S. company has invested in a business that generates cash flows in a different

currency, it’s the results in that currency you should care about most (too bad you don't

tend to get that information, though constant currency may get you in the ballpark).

Especially if the U.S. company was truly reinvesting the foreign currency profits back into

the foreign business (i.e., not converting the foreign currency profits into dollars) for the

long-term.

Before you Ignore FX Translation…

Does that mean you can simply ignore the impacts of FX translation, stop reading this

report and ride off into the sunset? Not so fast cowboy/cowgirl. First off, every line item on

the financial statements could be impacted by FX translation and as a result key metrics

that the market pays attention to (like revenues, earnings, margins, etc.) can all be

affected by FX swings. And in order to gauge the quality of earnings/revenues/cash flows

you must be able to distinguish between the sustainable/core drivers of the results and

those that are not sustainable and non-core (that's why companies provide results in

constant currency).

So, is FX translation more of an accounting risk (that's temporary / non-core) which you

can fuhgeddabout? Should you simply pay attention to the results in constant currency

and ignore the FX impacts? Probably not, remember the company has invested in a

business with foreign currency cash flows that at some point it will want to turn into U.S.

dollars. FX rates will play a part in determining how many dollars it gets.

Before you ignore FX translation because it doesn't really capture the economic exposure

that a company has to FX rates and jump on the constant currency bandwagon, we'd

suggest using FX translation as a signal of FX risk. Start off by evaluating the materiality of

FX translation gains and losses along with the impact of FX translation on individual line

items (like revenues, etc.). Compare the FX translation gain/loss to book value, market

cap, against peers, etc. (see Exhibit 20 for some benchmarks by sector). As for the impact

U.S. company investment in

a foreign business is net

export of capital

FX Translation represents

FX exposure on investments

in foreign businesses

FX Translation could impact

every line item in the

financial statements

Constant currency shows

year-over-year changes in

revenue and other line items

assuming no change in FX

rates, proceed with caution

30 July 2015

FX Translated 8

on specific line items, materiality is in the eye of the beholder, for example, if FX is causing

the top line to move by 50 basis points is that material?

If material, it could signal that FX is a significant risk that you should think long and hard

about when valuing the company. You might consider running sensitivities, for example,

how would different FX rates impact the value of the foreign currency cash flow stream in

U.S. dollars, have FX movements really changed the value of the foreign business?

Turning a Longer-Term Valuation Risk into Shorter-Term Cash Flow Problem

But how much attention you give to FX will depend in part upon your time horizon (long-

term investors may be able to live with some FX related noise assuming it's not a

structural shift in FX rates, heck it might even create some buying/selling opportunities if

the market overreacts to an FX driven earnings surprise).

It will also depend upon how dependent the company is on monetizing its overseas

investment, in other words is it reliant upon turning the foreign currency cash flow stream

into U.S. dollars to pay dividends, buyback stock, pay down U.S. based debt or to support

the U.S. business? That will vary from company to company. Some companies are not

dependent upon it and as a result are able to truly reinvest the foreign profits overseas. On

the other hand there are companies that need to get their hands on the foreign cash,

transforming a longer-term valuation risk into one that has near-term cash implications.

There are a couple of ways that foreign investments can be monetized, first off the U.S.

company could simply sell its foreign business, realizing FX related losses if the dollar has

strengthened or FX gains if it's weakened. Another way that this stuff gets monetized is if

instead of the foreign currency profits being reinvested back into the foreign subsidiary

they are repatriated back to the U.S. or the foreign profits are converted into U.S. dollars.

In other words the foreign currency profits are actually being turned into less

($ strengthens) or more ($ weakens) dollars depending upon FX rate changes.

That may be happening more than you realize, in our March 17, 2015 report, Parking A-

Lot Overseas, At Least $690 Billion in Cash and Over $2 Trillion in Earnings, we found

that companies appear to be repatriating more of their foreign profits and even those

companies that are not repatriating may be storing their foreign profits in U.S. dollars

(sometimes in the U.S.A). We'd suggest that you ask the companies that you own and

follow exactly what they are doing with their foreign profits and in what currency they are

storing them (the disclosure here is pretty vague). Their answer may cause you to look at

FX risks differently from company to company.

Take Avon Products for example, in its most recent 10-K the company discussed how the

"strengthening of the U.S. dollar reduced the expected dividends and royalties that could

be remitted to the U.S. by its foreign subsidiaries, particularly Russia, Brazil, Mexico and

Colombia." In addition to less cash coming to the U.S. from its overseas business the

stronger dollar caused a significant drop in Avon's expected foreign source income. As a

result, the company might not generate enough taxable income to use its deferred tax

assets so it wrote them down by recording a $441 million valuation allowance.

What About FX Transactions?

On the other hand, FX transactions (see below) may reflect a real currency mismatch (e.g.,

revenues in one currency and costs in another) that can result in immediate cash flow

consequences as the transactions are settled in the foreign currency. The related FX gains

and losses may not be sustainable but they could reflect FX risks that need to be taken

into account when valuing a company. Of course they could just be more accounting noise

too. If for example, the assets and liabilities are denominated in the same currency but one

side is required to be remeasured by the accounting rules for changes in FX rates (e.g.,

payables) but you are not allowed to remeasure the corresponding assets (e.g., inventory)

the accounting could provide the appearance of an FX exposure when the assets and

liabilities really are matched.

What impact has FX had on

the value of the business?

Is the company dependent

upon the foreign currency

cash flows to pay dividends,

buyback stock, support the

U.S. parent, etc.?

FX Transaction represents

FX exposure on regular

business activity

30 July 2015

FX Translated 9

Should You Worry About FX?

They say a picture is worth a thousand words, in Exhibit 8 we include a simple framework

to help you determine whether you should worry about the FX translation and FX

transaction exposures for the companies that you own and follow (keep in mind this is a

work-in-progress for us that we expect to fine tune in the future).

Exhibit 8: Should You Worry About FX or Not?

Source: Credit Suisse Accounting & Tax Research

Boiling It Down

There are really two sets of questions that you need to ask yourself, when trying to

analyze the impact of FX changes on the companies that you own and follow:

(1) What impact has FX had on the underlying business? Has it changed the future

cash flow stream for the business (by affecting the competitive landscape, cost

base, product demand, etc.)? See Exhibit 7.

(2) What impact has FX had on the value of the business? Has FX changed the U.S.

dollar value of the future cash flow stream from the foreign business? See Exhibit

8.

30 July 2015

FX Translated 10

FX Accounting The year was 1981, Rick Springfield (when he wasn’t hanging out at General Hospital)

topped the charts with Jessie's Girl, Olivia Newton John was getting physical and the

FASB released FAS 52, Foreign Currency Translation. FAS 52 (now known as ASC 830)

replaced the much maligned FAS 8, Accounting for the Translation of Foreign Currency

Transactions and Foreign Currency Financial Statements, and the accounting for FX

translation has been pretty much the same ever since.

Nowadays companies regularly enter into transactions denominated in a wide variety of

currencies and have subsidiaries spread around the globe. Of course all that information

needs to be pulled together and for a U.S. company eventually translated back into U.S.

dollars so that it can provide you with a set of consolidated financial statements reported in

one currency. But what exchange rate should they use? Where do the FX related gains

and losses get reported? These questions and others are answered by ASC 830.

This stuff can get complicated, but keep in mind there's really just two things (besides

currency hedging) that companies need to account for in FX land (1) transactions and (2)

financial statements, see Exhibit 9.

Exhibit 9: Two Things to Account for in FX Land

Source: Credit Suisse Accounting & Tax Research

Functional Currency Is the Key

The key to applying ASC 830 is the functional currency; in fact the rules are built around

the concept (it’s the sun in the FX solar system, the eye of the FX hurricane, you get the

point). The functional currency will drive what exchange rate companies use and whether

you are dealing with FX translation or FX transaction gains/losses and where they should

be reported.

So, what the heck is the functional currency? It's simply the currency of the main economic

environment that the company operates in. In other words: it’s the currency in which the

company does most of its business (which may or may not be the local currency).

Determining which functional currency a company uses is a management judgment call,

that's based on which currency things like cash flows, sales prices, sales market, costs

and financing are denominated in along with the volume of intercompany transactions. The

company must determine its own functional currency along with the functional currency for

each of its subsidiaries and equity method investees (i.e., each foreign subsidiary of a

Functional Currency:

currency in which the

company does most of its

business

Each foreign subsidiary of a

U.S. company could have a

different functional currency

30 July 2015

FX Translated 11

multinational company could have a different functional currency). Generally companies

don’t provide too much detail about their functional currencies, here's a few random

examples of what they disclose:

■ Coca-Cola (2014 10-K) – In 2014, we used 71 functional currencies. Due to our global

operations, weakness in some of these currencies might be offset by strength in

others.

■ Murphy Oil (2014 10-K) – Local currency is the functional currency in Canada and for

former refining and marketing activities in the UK. The U.S. dollar is the functional

currency used to record all other operations.

■ Williams Sonoma (10-K for fiscal ending 2/1/2015) – Some of our foreign operations

have a functional currency different than the U.S. dollar, such as those in Canada

(Canadian dollar), Europe (euro or British pound) and Australia (Australian dollar).

■ EMC Corporation (2014 10-K) – The local currency is the functional currency of the

majority of our subsidiaries.

A company must use the reporting currency (US$) as its functional currency when a

foreign sub operates in a highly inflationary environment (i.e., the cumulative inflation is

100% or more over the past three years) like in Venezuela.

If all of a company's transactions are denominated in the functional currency and that also

happens to be the reporting currency, the currency in which the financial statements

presented to investors are denominated (e.g., for a U.S. company the reporting currency is

the US$), there is no FX exposure from an accounting perspective.

However, there may still be FX exposure from an economic perspective as we highlighted

above (remember our purely domestic company from Exhibit 7).

The FX Two-Step

Yes, the accounting for FX can be complex but when you break it all down it’s just a two-

step process. The first step is to measure/remeasure all foreign currency transactions and

foreign currency financial statements into the functional currency followed by step two

where the functional currency financial statements are translated into the reporting

currency. See Exhibit 10 for the FX Two-Step.

Exhibit 10: The FX Two-Step

Source: Credit Suisse Accounting & Tax Research

Reporting Currency:

currency in which the

financial statements

presented to investors are

denominated

Foreign Currency: any

currency other than the

functional currency

30 July 2015

FX Translated 12

Before we take you on a spin through the FX Two-Step see Exhibit 11 for a good real

world description provided by Procter & Gamble CFO Jon Moeller of the various ways that

FX movements can impact a company's reported results:

Exhibit 11: FX Two-Step – A Real World Example

Source: Company transcripts. Credit Suisse Accounting & Tax Research

Step 1 – Get Everything Measured/Remeasured in

the Functional Currency

This step involves initially measuring foreign currency transactions in the functional

currency for the company and each of its foreign subsidiaries and then at each period end

remeasuring FX transactions that remain on the balance sheet (or for those transactions

that have settled remeasuring them at the settlement date). It also involves remeasuring

the financial statements of a foreign subsidiary if the books and records happen to be

maintained in a currency other than the functional currency.

In order to run you through how FX accounting works in this report we'll use a fictional

multinational company with the following key characteristics:

Parent: Uncle Sam Inc, domiciled in the U.S., functional currency and reporting

currency are the U.S. Dollar

o UK subsidiary: God Save the Queen (GSTQ) Plc

Euro is the functional currency

Transactions in foreign currencies (such as Russian ruble)

Books and records maintained in British pounds

30 July 2015

FX Translated 13

Foreign Currency Transactions

A foreign currency transaction is any transaction denominated in a currency other than the

functional currency and includes the import or export of goods, services, capital etc. (see

Exhibit 12). They can be transactions entered into by the U.S. parent (e.g., Uncle Sam Inc.

issues debt in Swiss francs) or its foreign subsidiaries (e.g., the UK sub GSTQ has a

payable in Russian rubles to a supplier in Russia or a receivable in Japanese yen from a

customer in Japan) and it even includes intercompany transactions.

Exhibit 12: FX Transactions for a UK Subsidiary with Euro Functional Currency, Some Examples

Source: Credit Suisse Accounting & Tax Research

Note how the same transaction can have a very different accounting result for a company,

depending upon the functional currency. For example, let's say GSTQ issues debt

denominated in euros (that is not an FX transaction since the debt is denominated in the

functional currency) but if the U.S. parent issued that same debt it would be treated as an

FX transaction (since the debt is in euros and the functional currency for the U.S. parent is

U.S. dollars) and in that case changes in the US$/Euro exchange rate would result in FX

transaction gains/losses that impact earnings.

Measure / Remeasure

Foreign currency transactions are initially measured in the functional currency using the

exchange rate in effect on the date of the transaction (in practice a weighted average rate

is typically used for income statement stuff, like revenue and expenses). If the FX

transactions remain on the balance sheet at the end of the quarter or in future quarters

they may need to be remeasured at the FX rate in effect on the balance sheet date (or for

those transactions that have settled, remeasured at the settlement date), depending on

whether the asset or liability is monetary or non-monetary. Check out Exhibit 13 for the FX

rates used to measure/remeasure a foreign currency transaction.

Exhibit 13: Foreign Currency Transaction Timeline - FX Rates Used to Measure/Remeasure

Source: Credit Suisse Accounting & Tax Research Note: Examples of monetary assets/liabilities include cash, payables, receivables etc. (cash or items expected to be settled in cash). Non-monetary assets/liabilities include inventory, PP&E, deferred revenue etc. 1: When transaction is settled or removed from the balance sheet

Foreign Currency

Transaction: transaction

denominated in a currency

other than the functional

currency

30 July 2015

FX Translated 14

An FX transaction is only remeasured if it’s a monetary asset or liability (see Exhibit 14 for

some examples). That's because those transactions will need to be settled in a foreign

currency at some point in the future (e.g., paying off a payable) and that can have

functional currency cash flow consequences (see our example below for a further

discussion).

Exhibit 14: Monetary and Non-Monetary Assets and Liabilities, Some Examples

Source: Credit Suisse Accounting & Tax Research

On the other hand non-monetary assets and liabilities (see Exhibit 14) are initially

measured at the FX rate on the transaction date but are not subsequently remeasured (i.e.,

they are not adjusted for changes in FX rates), in other words they are held at historical FX

rates. That's because those assets and liabilities don't need to be settled in the future. The

related income statement item (e.g., COGS, depreciation, amortization) is also determined

using the historical FX rate.

That said, you could still argue that there are FX holding gains/losses on non-monetary

assets and liabilities that are eventually recognized even though those assets and

liabilities are not remeasured for FX rate changes. Take inventory as an example,

changing FX rates can change the amount of cash (in functional currency) that the

company will receive on the sale of the inventory but that gets buried in the profit margin

when the sale is recognized (cutting margins if the functional currency strengthens and

boosting margins if it weakens). In other words the margin really has two components, the

margin in the underlying foreign currency and an FX piece due to changes in exchange

rates.

Impact of FX Rate Changes on Initial Measurement of Foreign Currency Transactions

You can see the effects on the financial statements of a stronger or weaker functional

currency against the currency in which the FX transaction is denominated in Exhibit 15.

Notice how we split the exhibit into two parts, measure and remeasure, both of which can

impact earnings.

Let's start with the initial measurement of FX transactions, if the functional currency is

strengthening against the foreign currency, new layers of FX transaction related revenues,

expenses, assets and liabilities will fall (all else equal). On the other hand, if the functional

currency weakens, new amounts of foreign currency transaction related revenues,

expenses, assets and liabilities would increase (all else equal). That appears to be what

happened to Procter & Gamble in Russia as explained by CFO Jon Moeller during its Q2

2015 earnings call, changes in the Euro/Ruble exchange rate increased the Russian unit's

costs of razors which it imports from Germany reducing its profit.

In other words (our own) if the Russian unit buys 100 euros worth of razors in Q1 when the

Euro/Ruble exchange rate was 75 (1 Euro = 75 Rubles) the cost of those razors when

measured in rubles was 7,500. If the ruble weakens in Q2 and the FX rate goes to 85 and

it buys another 100 euros worth of razors the cost of those razors in ruble now jumps to

8,500. The cost of razors goes up in the functional currency (Russian ruble) driving profits

down when the razors are sold assuming they can't pass the higher costs along to their

customers. Just to be clear this is the result of new layers of inventory getting measured at

different FX rates and those layers flowing through the income statement driving up COGS,

not FX related remeasurement which we discuss next (inventory is not remeasured).

Only monetary assets and

liabilities are remeasured

Non-monetary assets and

liabilities are not

remeasured (i.e., held at

historical FX rates)

Changes in exchange rates

impact initial measurement

of FX transactions, earnings

too

30 July 2015

FX Translated 15

Exhibit 15: FX Transactions - Impact of FX Rate Changes on Functional Currency Financial Statements

Source: Credit Suisse Accounting & Tax Research Note: Examples of monetary assets/liabilities include cash, payables, receivables etc. (cash or items expected to be settled in cash). Non-monetary assets/liabilities include inventory, PP&E, deferred revenue etc. Monetary assets and liabilities are remeasured using end of period exchange rates. Non-monetary assets/liabilities are not remeasured, the historical (i.e., transaction) FX rate is used.

Impact of FX Rate Changes, Remeasuring Foreign Currency Transactions

Certain FX transactions (i.e., monetary assets and monetary liabilities) that linger on the

balance sheet must be remeasured from the foreign currency into the functional currency.

The change in the value of the monetary asset or liability in functional currency due to

changes in exchange rates from the remeasurement process results in a foreign currency

transaction gain or loss that's run through the income statement impacting earnings. Or as

Kansas City Southern described it in its 10-K "The difference between the exchange rate

on the date of the transaction and the exchange rate on the settlement date, or balance

sheet date if not settled is included in the income statement as foreign exchange gain or

loss."

FX Transaction Gains & Losses Hit Earnings (Usually)

As you can see in the bottom half of Exhibit 15 a stronger functional currency will drive the

value of the monetary assets and liabilities down as they are remeasured, resulting in FX

transaction related losses/(assets) and gains/(liabilities), while a weaker functional

currency will have the opposite effect increasing the value of the monetary assets and

liabilities resulting in FX transaction related gains and losses respectively. Note that

there's no accounting impact on non-monetary assets/liabilities from FX rate changes

since they are not remeasured.

FX transaction gain/loss:

Change in value of net

monetary asset or liability

due to changes in FX rates

30 July 2015

FX Translated 16

To sum up, it’s the monetary assets/liabilities multiplied by the change in exchange rates

(functional currency / foreign currency) that determine the FX transaction gain or loss

reported on the income statement. That gain or loss reflects expected/actual functional

currency cash flow consequences that changing FX rates have on these transactions (e.g.,

an FX transaction loss indicates a company has paid (or will pay) more or received less (or

will receive less) in functional currency on a foreign currency transaction and vice versa for

an FX transaction gain) which is why it's generally reported in earnings. Keep in mind that

it includes both remeasurement (unrealized) and settlement (realized) gains and losses.

The FX transaction gain/loss must be disclosed either on the face of the income statement

or in the footnotes. However, the specific location on the income statement can vary, for

example:

■ Mattel (in its 2014 10-K) reported $44 million of 2014 currency transaction gains in

operating income and the remaining $2.8 million in other non-operating income.

■ Procter & Gamble disclosed in its 10-Q for the quarter ending March 31, 2015, that

total FX transaction charges added approximately 50 basis points to SG&A as a

percentage of net sales, (due to revaluing receivables and payables from transactions

denominated in a currency other than a local entity’s functional currency).

■ Avon disclosed in its 10-Q that foreign currency transaction losses were recorded

within cost of sales and selling, general & administrative expenses, which had an

unfavorable impact to adjusted operating profit of an estimated $45 million for the

three months ended March 31, 2015.

Keep in mind there are exceptions to running the FX transaction gain or loss through

earnings for foreign currency transactions that have been designated as a hedge and

intercompany transactions that are of a long-term investment nature which are treated as

part of the net investment in the foreign subsidiary. In both cases the FX gains and losses

would be reported in other comprehensive income (in shareholders' equity) instead of the

income statement.

FX Transaction Example

To hammer home all this FX transaction stuff let's run through a simple example, say

Uncle Sam's UK sub, God Save the Queen's functional currency is the euro and it has a

payable to a Russian supplier in rubles. Since the payable is denominated in a currency

(ruble) that differs from the functional currency (euro) it’s a foreign currency transaction

that must first be measured in the functional currency and then remeasured (since it’s a

monetary liability).

Let’s assume that the payable remains outstanding for two quarters until it's paid. In

Exhibit 16 you can see how the payable in rubles stays the same from period to period but

the amount in euro changes as it is remeasured using different exchange rates (resulting

in an FX transaction gain in the first period followed by an FX transaction loss). Notice how

this example, differs from the P&G case discussed above because of different functional

currencies, here the functional currency is the euro and the foreign currency transaction is

in rubles (it’s the opposite for P&G).

FX Transaction gain/loss

reflects expected/actual

cash flow consequences of

changing FX rates

30 July 2015

FX Translated 17

Exhibit 16: FX Transaction Gain/(Loss) Example - Russian Ruble Payable, Functional Currency is Euro

Source: Credit Suisse Accounting & Tax Research 1: Drop in the value of the liability in the functional currency results in an FX transaction gain. 2: Increase in the value of the liability in the functional currency results in an FX transaction loss.

By settling the payable at the end of Q2 the company would need to rustle up €167 to pay

off the 10,000 rubles that it owes. Relative to the €133 when the transaction was first

entered into, that's €34 more than would have been needed initially, or a €34 FX

transaction loss. That loss was reported on the income statement over two quarters, a €15

gain in Q1 (as the euro strengthened initially) followed by a €49 loss in Q2 (due to the euro

weakening). FX transaction gains and losses are included in earnings because they

eventually impact functional currency cash flows (in this case an FX transaction loss

because more euros were needed to settle the ruble payable).

Intercompany FX Risk?

Have you ever come across companies discussing FX exposure related to intercompany

transactions (some companies even hedge this "intercompany" risk) and wondered what

the heck they were talking about, like in the following examples?

■ Mattel (2014 10K) – The company uses foreign currency forward contracts to hedge

intercompany loans and advances denominated in foreign currencies. Due to the

short-term nature of the contracts involved, Mattel does not use hedge accounting for

these contracts.

■ Keurig Green Mountain Inc (3/28/2015 10Q) - We have certain assets and liabilities

that are denominated in Canadian currency. During the 2015 YTD period, we incurred

a net foreign currency loss of $17.9 million as compared to a net loss of $19.3 million

during the prior YTD period. The net foreign currency losses were primarily attributable

to re-measurement of certain intercompany notes with our foreign subsidiaries which

fluctuate due to the relative strength or weakness of the U.S. dollar against the

Canadian dollar.

■ Baxter (3/30/2015 10Q) - In 2015, other income, net included $89 million of income

related to foreign currency fluctuations, principally relating to intercompany

receivables, payables and monetary assets denominated in a foreign currency. The

company also enters into derivative instruments to hedge certain intercompany and

third-party receivables and payables and debt denominated in foreign currencies.

Yes, even though intercompany transactions are eliminated in consolidation they can still

leave behind FX transaction gains and losses. How you ask? Best way to explain it is with

an example.

30 July 2015

FX Translated 18

Let's say our UK sub has a loan from its U.S. parent denominated in U.S. dollars. Since

the functional currency of GSTQ is the euro, the U.S. dollar loan payable is a foreign

currency transaction (from GSTQ's perspective) and must be remeasured each period into

euros (since it’s a monetary liability). So if the euro weakens against the U.S. dollar, that

will cause the payable to increase in euros (even though the dollar amount has stayed the

same) resulting in an FX transaction loss (larger liability = loss). Despite the fact that the

payable is eliminated in consolidation (along with the parent company's corresponding

loan receivable) the FX transaction loss survives. It is reported on GSTQ's euro

denominated income statement, driving down the net income in functional currency. So

that loss along with everything else on GSTQ's income statement gets translated into U.S.

dollars and becomes part of the consolidated financial statements.

If There Are Foreign Currency Books & Records, the Financial Statements Need to

Be Remeasured into Functional Currency Too

Another scenario where we see an FX gain or loss reported on the income statement is

when a company happens to have a foreign subsidiary where the books and records are

denominated in a currency that differs from the functional currency. For example, if GSTQ

maintained its books and records in British pounds it would need to remeasure its British

pound financial statements into the functional currency (euro).

As with FX transactions, monetary assets/liabilities on the balance sheet are remeasured

using FX rates in effect on the balance sheet date, while non-monetary assets/liabilities

and equity are kept at historical FX rates. On the income statement revenues and

expenses are typically remeasured using weighted average FX rates for the period

(technically they should use the FX rate when the transactions are recognized, but in

practice a weighted average rate is used). Unless the income statement items relate to

non-monetary assets/liabilities like depreciation (PP&E), amortization (intangibles), COGS

(inventory) or recognizing deferred revenues. In that case historical exchange rates are

used.

Exhibit 17 provides an overview of the FX rates used to remeasure foreign currency

financial statements into the functional currency along with the impact of a

stronger/weaker functional currency.

Intercompany transactions

can result in FX transaction

gains/losses

Accounting Geek Alert -

This paragraph describes

the "Temporal Method"

30 July 2015

FX Translated 19

Exhibit 17: Remeasure Foreign Currency Financial Statements – FX Rates Used and Impact on Functional

Currency Financial Statements

Source: Credit Suisse Accounting & Tax Research 1: FX rate on transaction date, in practice weighted average FX rates are used. 2: Even though non-monetary assets/liabilities are not remeasured for FX rate changes new purchases of PP&E, inventory, intangibles, etc. along with new bookings of deferred revenue are initially measured using FX rates on the transaction date. As a result if the functional currency strengthens/weakens new amounts of foreign currency PP&E, inventory, intangibles and deferred revenue will be measured into lower/higher functional currency amounts relative to prior purchases and bookings. When those amounts flow through the income statement it will drive COGS, depreciation, amortization, revenue, etc. down/up respectively. 3: FX rate on balance sheet date. 4: Even though shareholders' equity is not remeasured for FX rate changes, new layers of equity (e.g., net income) are measured using FX rates for the period. As a result if the functional currency is strengthening/weakening it will generally result in lower/higher net income in functional currency relative to the prior period which will drag/boost shareholders' equity.

In Appendix A – FX Remeasurement Example we run you through an example that

remeasures the balance sheet and income statement of our hypothetical UK subsidiary

(GSTQ) from British pounds into the functional currency, euro. The Appendix includes

Exhibit 32 which shows the math behind the FX gain or loss from remeasurement that's

reported on the income statement.

Keep in mind that the FX gain or loss is not the only impact that changing FX rates have

on earnings. In our example in Exhibit 31 you can see that the same amount of British

pound revenues results in different amounts in euros from period to period due to FX rate

changes, less euros when the pound weakens and more euros when the pound

strengthens. Notice also how the gross margins change as COGS are kept at historical FX

rates but the FX rate used to measure revenues changes from period to period.

Step 2 – Translate from Functional Currency into

Reporting Currency (FX Translation)

After getting everything measured in the functional currency the next step is to translate

those functional currency financial statements for each and every subsidiary into the

reporting currency (e.g., US$ for a U.S. company). Sticking with our example, we'd need to

translate the euro denominated GSTQ financial statements into U.S. dollars.

In Exhibit 18 you can see that all of the assets and liabilities on the balance sheet are

translated at the current FX rates in effect on the balance sheet date (notice that the

translation process ignores whether the assets/liabilities are monetary or non-monetary),

while historical rates are used for shareholders' equity. Both the income statement and

Accounting Geek Alert –

This paragraph describes

the "Current Rate Method"

30 July 2015

FX Translated 20

cash flow statement are translated at the rates in effect when the items are recognized but

in practice companies use a weighted average exchange rate for the period instead. The

weighting is supposed to reflect when the transactions take place, for example, if a

company tends to book most of its sales in the last week of the quarter the average

exchange rate for the quarter should be heavily weighted toward that time frame.

Exhibit 18: Translation – FX Rates Used and Impact on Reporting Currency Financial Statements

Source: Credit Suisse Accounting & Tax Research 1: FX rate on transaction date, in practice weighted average FX rates are used. 2: FX rate on balance sheet date. 3: Reported in Other Comprehensive Income within shareholders' equity.

FX Translation Gain/Loss Reported in OCI within Shareholders' Equity

Because the FX translation process involves the use of different exchange rates, (e.g.,

current exchange rates for assets and liabilities, weighted average rates on the income

statement and historical rates for equity) the balance sheet would be out of balance if not

for the FX translation gain/loss (i.e., accounting plug).

An FX translation gain/loss for a given period reflects the impact of FX rate changes on (1)

the net investment in the foreign subsidiary (i.e., net asset or net liability) at the beginning

of the period and on (2) the net investment arising during the period (e.g., net income).

In Appendix B – FX Translation Example we translate the balance sheet, income

statement and cash flow statement of our imaginary UK sub from its functional currency

euro into the U.S. dollar, the reporting currency of its parent. As part of the translation

process we walkthrough the calculation of the FX translation gain/loss in Exhibit 36.

The FX translation gain or loss initially bypasses the income statement and is reported in

shareholders' equity as part of accumulated other comprehensive income (AOCI). It’s not

until the business is sold or liquidated that the cumulative FX translation gain or loss that

had been stored in equity is transferred to earnings.

Why are FX translation gains and losses tucked away in shareholders' equity? That's

because the translation related FX exposure is tied to the net investment (assets –

liabilities) in the foreign subsidiary. As a result FX translation might not have much of an

impact on a day to day basis. Take our fictional company as an example, the UK sub does

most of its business in euros and assuming the U.S. parent reinvests those euros in its UK

sub (though you do need to be careful with that assumption), how much those euros are

worth in dollars doesn’t really matter all that much for now (at least in theory).

30 July 2015

FX Translated 21

FX Translation Losses over $240 Billion in Aggregate for S&P 500

For the S&P 500 companies the cumulative FX translation losses have grown quite a bit

over the last couple of quarters as the U.S. dollar has strengthened and are now $244

billion in the aggregate, see Exhibit 19. That's the highest level in the past 15 years.

Exhibit 19: Cumulative FX Translation Gain/(Loss), S&P 500 (2007-3/31/2015)

Source: Compustat, Credit Suisse estimates Note: Data up to 3/31/2015. The last period in the chart contains data from the fiscal quarters ending between 1/1/2015 and 3/31/2015.

To help you put the FX translation gains and losses into perspective for the companies

you own and follow we provide benchmarks by sector. In Exhibit 20 we compare the

cumulative FX translation gain/loss by sector to book value and market cap. For those

companies that you follow which differ significantly from their peers you might want to do a

little digging to better understand why they appear to have more/less FX exposure (see

Exhibit 8).

Exhibit 20: Benchmarks - Cumulative FX Translation Gain/(Loss) as of 3/31/2015 by Sector, S&P 500

Source: Compustat, Credit Suisse estimates Note: Cumulative FX translation gain/loss, book value and market cap are as of the last fiscal quarter ending on or before 03/31/2015. Measures involving book value exclude companies with negative book values.

30 July 2015

FX Translated 22

FX Translation Impacts Earnings Too

Even though the FX translation gain/loss is not (initially) reported on the income statement

the FX translation process can still have an impact on earnings. As you saw in Exhibit 18,

the translated revenues and expenses will fall (all else equal) if the reporting currency is

strengthening against the functional currency and vice versa when the reporting currency

weakens. As a result the stronger dollar tends to cause reported revenues and earnings to

drop for many U.S. multinationals. Though the margins (in percentage terms) stay the

same (functional currency vs. reporting currency) bottom line earnings can be impacted.

That said the FX translation process can throw a monkey wrench into your ratio analysis

whenever the numerator and denominator of the ratio are translated at different FX rates.

For example, any ratios that involve both the income statement (weighted average FX

rates) and the balance sheet (period end FX rates) like a return on assets could be very

different after FX translation since you are comparing apples and oranges.

Lots of companies have highlighted the impacts of FX translation on the income statement

over the last couple of earnings seasons, here are a few examples:

■ Illinois Tool Works (Q1 2015 Earnings Call) – "Foreign currency translation reduced

revenues by 7%, resulting in total revenues declining 6%." Paul Lundstrom, Director,

Investor Relations. 4/21/2015.

■ United Technologies (Q1 2015 Earnings Call) - "Overall foreign exchange translation

was an 11-point earnings headwind and a nine-point sales headwind." Michael M.

Larsen, CFO. 4/21/2015.

■ Starbucks (Q2 2015 Earnings Call) – "Revenues grew to $4.6 billion, an 18% increase

over prior year, despite nearly two percentage points of headwind through foreign

currency translation. Revenue growth for fiscal 2015 remains targeted at 16% to 18%,

despite two points of headwind from foreign currency translation" Scott Maw, CFO.

4/23/2015.

■ Caterpillar (Q1 2015 Earnings Call) - (Q2 2015 Earnings Call) – "Foreign currency

translation is forecasted to reduce 2015 U.S. dollar sales by 6% to 7%, up from a

previous range of 4% to 5%." Nicholas C. Gangestad, CFO. 4/23/2015.

Companies Respond with Constant Currency

Some companies have responded to the spike in FX volatility by providing information in

constant currency (i.e., currency neutral), showing year-over-year changes in revenue and

other line items assuming no change in exchange rates. This information can be helpful to

get at the performance of the underlying business in the functional currency especially for

those companies that are reinvesting the functional currency profits back into their foreign

subs. But (as discussed earlier) constant currency info should be used with caution,

especially for those companies that are repatriating the foreign earnings or turning them

into U.S. dollars.

Constant currency comparisons can also hide the pricing pressure a company may be

facing. For example, take an industry where there is competition from around the world

and a supply chain that is also global. If the currency in a particular country weakens, that

may put pressure on all the companies operating in that country to increase the price of

their products to maintain their margins (remember they have costs in other now stronger

currencies). If a company were to blame the entire decline in revenues on FX translation,

that may not be the whole story. What if other companies were able to pass on the

additional costs to customers, but the company you are analyzing wasn't? They lost

pricing power on a relative basis and as a result their revenues were lower than what they

would have been if they were able to maintain it. So, pay attention to what is happening to

the peers with comparable FX exposures. If a company is impacted more than the rest,

there may be more to the story than just FX translation.

FX translation can throw a

monkey wrench into your

ratio analysis

30 July 2015

FX Translated 23

FX Translation Impacts Reported Cash Flows Too

Even though the FX translation process has no real impact on the cash flows in the

functional currency it can cause the numbers on the reported currency cash flow

statement to bounce around. Each line item on the cash flow statement is typically

translated into the reporting currency using weighted average FX rates for the period (like

on the income statement).

If that's the case you might be wondering what's that line item labeled something like:

"Effect of exchange rate changes on cash and cash equivalents" that you'll find at the

bottom of the cash flow statement? Well if you take all the line items on the cash flow

statement and translate them at a weighted average FX rate for the period you won't be

able to reconcile cash from the beginning of the period to the end of the period especially

when the beginning and ending cash balances are translated at different exchange rates.

So that line is a plug number to get it all to reconcile. See our example in Exhibit 43 of

Appendix B – FX Translation Example for the math. In other words the change in reported

cash has two components, (1) actual cash flows and (2) the impact of changing exchange

rates.

As with earnings this line item is not the only impact that FX translation has on the cash

flow statement. In our example, you can see that the change in inventory is €52 each

period, but the U.S. dollar amount fluctuates solely due to FX rate changes. A stronger

dollar results in weaker reported cash flows all else equal and vice versa for a weaker

dollar.

FX Translation Causes Disconnect Between Cash Flow Statement and Balance Sheet

The FX translation process can also create a disconnect between the changes in line

items in the reporting currency on the balance sheet and what you see on the cash flow

statement. That's because different exchange rates are used. Take inventory, in our

example it appears to fall by $176 on the balance sheet from 03/31/15 to 6/30/15 in Exhibit

35 while on the cash flow statement in Exhibit 42 it looks like inventory dropped by only

$62. That's similar to Archer Daniels Midland Co where on the balance sheet inventory

dropped by $1,002 million, but on the cash flow statement inventory dropped by only $739

million during the quarter ending 3/31/2015.

FX Hedging

Hopefully what you've read so far makes sense and has helped to alleviate some of the

confusion around the accounting for FX. Now we can really get the party started by

switching over to FX hedging.

Au Naturale FX Hedges

Some companies have natural currency hedges in place, for example they might localize

production in foreign markets (incurring labor, raw material costs, etc. in the same

currency that they are selling product), or by financing the foreign business in local

currencies (e.g., issuing debt in the same currency as their assets, etc.). Keep in mind that

just because revenues and costs are incurred by the same foreign subsidiary doesn’t

automatically mean there's a natural FX hedge in place as the revenues and costs could

still be denominated in different currencies.

Those natural hedges reduce the net exposure a company has to a particular currency, so

that currency related losses are offset to some extent by currency gains and vice versa

(though there may still be timing differences). That's one of the reasons why you'll see a

difference between the top line and bottom line impact of FX across companies; some

have the revenues and costs matched up while others have mismatches.

In Exhibit 21 we compare and contrast the impact of a 10% stronger/weaker dollar on the

results of three hypothetical companies, one with a natural hedge in place (revenues and

expenses are in the same currency) and two with currency mismatches (revenues and

FX is one of the reasons

why you can't tie out the

changes in the balance

sheet to the cash flow

statement

Natural Hedge - matching

currency revenues &

expenses, assets &

liabilities reduces FX

exposure

30 July 2015

FX Translated 24

expenses are in different currencies). Notice how when naturally hedged the margin

remains at 20% though it does fluctuate in dollars, from $20 to $22 when the dollar

weakens and from $20 to $18 when the dollar strengthens. Contrast that with both the

exporter and importer with currency mismatches (i.e., foreign currency transactions) where

both the margin % and dollars fluctuate.

Exhibit 21: FX Exposure – Natural Currency Hedge vs. Mismatch, Example

Source: Credit Suisse Accounting & Tax Research

There are plenty of companies with currency mismatches (e.g., revenues in one currency

and costs in another). Here's a couple of examples:

■ Ralph Lauren - in its Q4 conference call, the CFO Christopher Peterson discussed the

impact of a revenue / cost mismatch "so when we look at the FX impact on the top-line

of 5.5%, the flow-through of that to the bottom line is a little bit over 40%...which is

what leads to the $185 million headwind, because our cost structure is not

denominated in local currency."

■ McDonald's – from its Q4 conference call, CFO Pete Bensen addressed the weakness

in McDonald's Europe margins driven by Russia and the Ukraine "Over half of this

margin decline reflected a significant impact of weakening currencies on imported

commodity costs in these two markets. We expect this currency impact to significantly

pressure the segment's company-operated margins again in 2015, especially in the

first half."

As a result of a currency mismatch some companies may look to try and minimize that risk

by entering into FX hedging transactions. Hedging long-term structural mismatches might

make some sense (depending upon the costs involved) but hedging accounting risk is a

whole other ball of wax.

Hedge Accounting, 1,000+ Pages of Fun and Excitement

The accounting guidance for FX hedging is laid out in ASC 815, Derivatives and Hedging

(the standard formerly known as FAS No. 133). It allows companies to hedge the FX risk

on certain assets and liabilities, unrecognized firm commitments (legally binding

Is the company hedging a

structural FX mismatch or

an accounting risk?

30 July 2015

FX Translated 25

agreements that include, fixed price, timing, quantity, etc.), forecasted transactions (e.g.,

forecasted purchases and sales), net investments in foreign subsidiaries even certain

intercompany transactions (e.g., receivables and payables). All of these potential hedged

items must be denominated in a currency other than the functional currency in order to be

"hedgeable" from an accounting perspective.

Companies can use derivatives (FX forward, options, swaps, etc.) or in some cases non-

derivative financial instruments (e.g., debt) to hedge FX risks. We include a few examples

of what companies have to say about hedging FX risk in Exhibit 22.

Exhibit 22: FX Hedging – Company Examples

Source: Company filings and transcripts

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FX Translated 26

Four Types of FX Hedges

From an accounting perspective we can put these hedging transactions into four buckets:

(1) Fair Value Hedge

(2) Cash Flow Hedge

(3) Net Investment Hedge

(4) Standalone Derivative

Before we describe each in a bit more detail including journal entries (admit it now you're

excited), Exhibit 23 provides a high level overview of how each of the different ways to

account for an FX hedge impact the financial statements.

Exhibit 23: FX Hedge Accounting Summary

Source: Credit Suisse Accounting & Tax Research Note: I/S – Income Statement, OCI – Other Comprehensive Income 1: Changes in fair value of hedges that qualify for hedge accounting can be divided into effective and ineffective portions. 2: Generally represents the difference between change in fair value of hedge and change in fair value of hedged item due to FX risk. 3: Ineffectiveness on a cash flow hedge is recognized in earnings only with an "overhedge", that's when the cumulative change in the fair value of the hedge exceeds the cumulative change in the expected future cash flows of the hedged item. 4: Represents change in fair value of the hedged item due to FX risk 5: If hedged item is FX transaction monetary asset/liability then the impact of changes in FX rates will run through the income statement

1. Fair Value Hedge

A derivative that is being used to protect the fair value of an asset or liability on the

balance sheet or an unrecognized firm commitment from FX risk and that meets the

laundry list of hedge accounting requirements in ASC 815 is treated as a fair value hedge.

The derivative is reported on the balance sheet as an asset or liability at fair value.

Changes in fair value run through the income statement as a gain or loss on a quarterly

basis. That sounds a lot like the accounting for a stand-alone derivative (see below). The

difference is that gains and losses on the hedged item, as a result of the specific risk being

hedged are also reported in the income statement.

For example, in Exhibit 24 a U.S. company with a firm commitment to buy a piece of

machinery from a French manufacturer for €1,000,000 enters into a forward contract to

buy €1,000,000 for $1,250,000, hedging the fair value of its commitment against FX

fluctuations (i.e., it effectively locked in the price of the machine in dollars). It would report

a loss on the derivative and a gain on the firm commitment in earnings when the dollar

30 July 2015

FX Translated 27

strengthens and vice versa if the dollar weakens. The change in value of the derivative

and hedged item will offset each other to some extent in earnings. If the hedge is perfect

(as in our example) they will offset entirely and there will be no impact on earnings, if not

there will be some residual impact on earnings, that's known as hedge ineffectiveness.

In our example notice how the dollar has weakened over the course of the year and as a

result if there were no hedge in place the €1,000,000 piece of machinery would end up

costing $1,300,000. But our fictional U.S. company hedged the firm commitment with a

forward contract and as a result of the $50,000 gain on the forward (a successful hedge)

the machine ends up costing the company only $1,250,000. Of course if the dollar had

strengthened the forward contract would have gone against the company (an unsuccessful

hedge) and the machine would have ended up costing more in dollars than if unhedged.

Exhibit 24: Fair Value Hedge Example

The Journal Entries With the hedge On 3/31/2015 1. To recognize the change in the fair value of the forward contract and the firm commitment due to FX rate changes

DEBIT Gain/(Loss) on the Forward Contract $100,000 DEBT Firm Commitment Asset $100,000 CREDIT Forward Contract Payable $100,000 CREDIT Gain/(Loss) on the Firm Commitment $100,000

On 6/30/2015 2. To recognize the change in the fair value of the forward contract and the firm commitment due to FX rate changes

DEBIT Forward Contract Payable $100,000 DEBIT Forward Contract Receivable $50,000 DEBT Gain/(Loss) on the Firm Commitment $150,000 CREDIT Gain/(Loss) on the Forward Contract $150,000 CREDIT Firm Commitment Asset $100,000 CREDIT Firm Commitment Liability $50,000

On 12/31/2015 (continued on the next page)

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3. To record settling the forward contract (receive $50,000 in cash) DEBIT Cash $50,000 CREDIT Forward Contract Receivable $50,000

4. To recognize the purchase of the machine for €1,000,000 measured at $1,300,000 (the $50,000 gain from the forward contract offsets the price of the machine recorded on the balance sheet). DEBIT PP&E $1,250,000 DEBIT Firm Commitment Liability $50,000 CREDIT Cash $1,300,000

Without the hedge On 12/31/2015 5. To recognize the purchase of the machine for €1,000,000 measured at $1,300,000.

DEBIT PP&E $1,300,000 CREDIT Cash $1,300,000

Source: Credit Suisse Accounting & Tax Research Note: Example ignores taxes and time value. Assumes forward rates and spot rates move in lock-step.

2. Cash Flow Hedge

A derivative that is being used to protect a forecasted cash inflow or outflow from FX risk

and that meets another laundry list of hedge accounting requirements in ASC 815 is

treated as a cash flow hedge. Once again the derivative is reported on the balance sheet

as an asset or liability at fair value. The difference with a cash flow hedge is that changes

in the fair value of the derivative are reported in OCI within shareholders' equity. They will

remain there until the hedged forecast cash flow affects the income statement.

For example, a U.S. company has a forecasted sale of rubber ducks to a customer located

in Turkey for 1,000,000 Turkish lira. The company enters into a forward contract to sell

1,000,000 Turkish lira for $400,000 to lock in the price in dollars. The gains and losses on

the forward contract are initially reported in OCI. As a result the forward contract does not

impact earnings (assuming no ineffectiveness) until the rubber ducks are sold. When the

revenue is recognized on the sale of the rubber ducks the gain or loss on the forward

contract is moved out of AOCI and into earnings. Exhibit 25 runs through this example.

Exhibit 25: Cash Flow Hedge Example

The Journal Entries (continued on the next page)

30 July 2015

FX Translated 29

With the hedge On 3/31/2015 1. To recognize the change in the fair value of the forward contract due to FX rate changes

DEBIT Forward Contract Receivable $42,857 CREDIT AOCI $42,857

On 6/30/2015 2. To recognize the change in the fair value of the forward contract due to FX rate changes

DEBIT AOCI $142,857 CREDIT Forward Contract Receivable $42,857 CREDIT Forward Contract Payable $100,000

On 12/31/2015 3. To record settling the forward contract (by paying $100,000 in cash)

DEBIT Forward Contract Payable $100,000 CREDIT Cash $100,000

4. To reclassify the loss on the hedge from AOCI into earnings DEBIT Sales $100,000 CREDIT AOCI $100,000

5. To recognize selling rubber ducks worth 1,000,000 Turkish lira measured at $500,000 DEBIT Cash $500,000 CREDIT Sales $500,000

Without the hedge 6. To recognize selling rubber ducks worth 1,000,000 Turkish lira measured at $500,000

DEBIT Cash $500,000 CREDIT Sales $500,000

Source: Credit Suisse Accounting & Tax Research Note: Example ignores taxes and time value. Assumes forward rates and spot rates move in lock-step.

In our example notice how the dollar has weakened over the course of the year and as a

result if there were no hedge in place the 1,000,000 Turkish lira received on the sale of the

rubber ducks would have been reported as $500,000 in revenue. But our fictional U.S.

company hedged the forecasted sale with a forward contract and as a result of the

$100,000 loss on the forward contract (an unsuccessful hedge) the company only books

$400,000 in revenue. Of course if the dollar had strengthened the forward contract would

have gone in the company's favor (a successful hedge) and the revenue would have been

higher in dollars than if unhedged.

So if you don’t see revenue move in line with changes in exchange rates that could be a

sign that the company is hedging FX risk. Take Google as an example, in its Q4

conference call, CFO Patrick Pichette discussed the benefits of its FX hedge program

"Just as a reminder, we hedge profits right, we don't hedge revenue. It just happens that

we book the profits to revenue because of the accounting rules and so we have seen in

Q4 approximately $150 million of hedge benefits."

3. Net Investment Hedge

Companies can also hedge the FX risk associated with the net investments in their foreign

subsidiaries. In this case the derivative (or financial instrument) is reported on the balance

sheet as an asset or liability at fair value. As with a cash flow hedge the changes in the fair

value of the derivative are reported in OCI alongside the related FX translation gain or loss.

Both will remain in shareholders' equity until the foreign sub is sold or liquidated.

For example, a U.S. company with a subsidiary in Mexico that uses the Mexican Peso as

its functional currency has a net investment equal to 1 billion pesos. The company issues

1 billion pesos of debt to protect against the FX exposure on its net investment in the

Mexican sub. Normally the peso debt would be treated as an FX transaction, with FX

related gains and losses reported in earnings. However, since it's treated as a net

investment hedge, the gains and losses on the debt are reported in OCI (instead of

earnings) along with the FX translation loss/gain on the Mexican net investment. So when

you don't see the cumulative translation adjustment moving in line with changes in

exchange rates that may be a sign that the company is hedging that exposure too.

4. Standalone Derivative (Economic Hedge)

There is one other way to account for an FX derivative, if it does not qualify for special

hedge accounting it's treated as a stand-alone derivative. It is reported on the balance

sheet as an asset or liability at fair value. Changes in fair value run through the income

statement as a gain or loss on a quarterly basis (see below for where they might be

30 July 2015

FX Translated 30

reported). Just from an accounting perspective this type of treatment works if the FX risk

being hedged is already reported on the income statement (e.g., the company is

economically hedging a foreign currency transaction monetary asset/liability); as that

would result in the gain/loss from the derivative naturally offset in earnings against the

loss/gain on the monetary asset or liability.

Where Can You Find Derivative Gains / Losses?

Where oh where are the derivative gains and losses reported? Despite the 1,000 plus

pages of rules, there's not a lot of guidance in ASC 815 regarding the income statement

location of derivative gains/losses. But in practice most companies using derivatives that

have qualified as a hedge, tend to put the derivative gain or loss on the same line item as

the hedged item (e.g., COGS, revenues, interest expense, etc.). Some companies will

strip out the ineffective piece and include that in another line item, like "other

income/expense" (though the FASB might change that). We'd argue it’s a cost of hedging

so it shouldn’t be ignored.

As for derivatives that don't qualify for hedge accounting treatment the practical guidance

that we have come across from the big accounting firms says the gains and losses

(including any ineffectiveness) could go into a separate line item like "other

income/expense" or be reported in the same place as the economically hedged item.

That said, companies should disclose where this stuff is reported, take Google as an

example. The company has exposure to three different types of currency hedges that all

result in different accounting treatment (per the 2014 10-K):

■ Cash Flow Hedge – Google uses options designated as cash flow hedges to hedge

certain forecasted revenue transactions denominated in currencies other than the U.S.

dollar. The company reflects gain or loss on the effective portion of a cash flow hedge

as a component of AOCI and subsequently reclassifies cumulative gains and losses to

revenues or interest expense when the hedged transactions are recorded.

■ Fair Value Hedge - Google uses forward contracts designated as fair value hedges to

hedge foreign currency risks for our investments denominated in currencies other than

the U.S. dollar. Gains and losses on these forward contracts and interest rate swaps

are recognized in interest and other income net along with the offsetting losses and

gains of the related hedged items.

■ Standalone Derivative - Other derivatives not designated as hedging instruments

consist of forward and option contracts that we use to hedge intercompany

transactions and other monetary assets or liabilities denominated in currencies other

than the local currency of a subsidiary. Google recognizes gains and losses on these

contracts, as well as the related costs in interest and other income, net, along with the

foreign currency gains and losses on monetary assets and liabilities.

30 July 2015

FX Translated 31

Appendix A – FX Remeasurement Example

In order to run you through the process of remeasuring foreign currency financial

statements into the functional currency we're going to focus on our fictional British

subsidiary: God Save the Queen Plc (GSTQ). GSTQ happens to maintain its books and

records in British pounds. However, GSTQ uses the euro as its functional currency

(because the majority of its business is done in euros). As a result, at the end of each

reporting period the financial statements need to be remeasured from the foreign currency

- British pounds (even though it’s the local currency, it is treated as a foreign currency from

an accounting perspective since it differs from the functional currency) into the functional

currency - euros.

Balance Sheet FX Remeasurement

In Exhibit 26, we present the balance sheet of GSTQ in British pounds. The financial

statements have been simplified to contain fewer items and where possible fewer period

over period changes in order to make it easier for you to follow the FX impact (e.g., no

new inventory is purchased, the payable remains unpaid, no additional deferred revenue is

booked, etc.).

Exhibit 26: GSTQ's Balance Sheet in British Pounds

Source: Credit Suisse Accounting & Tax Research

Monetary assets and liabilities are remeasured each period using the exchange rates as of

the balance sheet date. So things like cash, receivables and payables are remeasured

using current exchange rates at the end of the reporting periods.

Non-monetary assets and liabilities are not remeasured, that is, the original transaction

date exchange rate sticks (i.e., the historical rate is used). For example, if GSTQ buys

£500 worth of inventory it's initially measured as €650 since the exchange rate is 1.30

GBP/EUR. Regardless of future FX rate changes that inventory (or whatever's left of it) will

continue to be measured using the same 1.30 GBP/EUR exchange rate. However, if the

company subsequently buys another batch of inventory and the FX rate has changed, the

new rate will be used to measure the new batch.

In Exhibit 27 we see the exchange rate over time and the rates used to

measure/remeasure each line item on the balance sheet from British pounds into euros.

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FX Translated 32

Exhibit 27: Exchange Rates Used to Remeasure GSTQ's Balance Sheet

Source: Credit Suisse Accounting & Tax Research

We arrive at the functional currency (euro) balance sheet for GSTQ in Exhibit 28 by

applying the FX rates in Exhibit 27 to the British pound balance sheet in Exhibit 26. For

example, the £1,000 of cash at 12/31/14 is remeasured into €1,300 (£1,000 x 1.30) when

the FX rate is 1.30 EUR/GBP.

Exhibit 28: GSTQ's Balance Sheet Remeasured in Euros – Functional Currency

Source: Credit Suisse Accounting & Tax Research 1: Each period's remeasured net income is added to retained earnings (check Exhibit 31)

We have discussed how the assets and liabilities are treated but what about shareholders'

equity? Similar to non-monetary assets and liabilities the components of equity are

measured once at the FX rate in effect when the common stock is issued, net income is

earned, etc. and are not subsequently remeasured for changes in FX rates. Let's take the

period ending 3/31/15, notice how the paid-in-capital remains at €520 as it's not

remeasured. As for retained earnings, it increased by €184 of net income (see Exhibit 31)

to arrive at the new retained earnings balance of €314.

Income Statement FX Remeasurement

Moving on, in Exhibit 29 you'll find the income statement of GSTQ in British pounds. For

simplicity it's identical for all three periods so that you can really see the FX effects of

remeasuring into euros (and it ignores taxes, don't you wish you could ignore taxes too).

30 July 2015

FX Translated 33

Exhibit 29: GSTQ's Income Statement in British Pounds

Source: Credit Suisse Accounting & Tax Research Note: Assumes income is not taxed (remember, this is fiction)

The line items on the income statement are typically remeasured using weighted average

FX rates for the period, unless they are associated with non-monetary assets/liabilities. As

a result items like COGS, depreciation, amortization, etc. use a historical FX rate (e.g., the

FX rate when the inventory was originally purchased). In Exhibit 30 we provide the

exchange rates used to remeasure the income statement from British pounds into euros.

Exhibit 30: Exchange Rates Used to Remeasure GSTQ's Income Statement

Source: Credit Suisse Accounting & Tax Research

We arrive at the functional currency (euro) income statement for GSTQ in Exhibit 31 by

applying the FX rates in Exhibit 30 to the British pound income statement in Exhibit 29. For

example, the £60 of SG&A at 12/31/14 is remeasured into €78 (£60 x 1.30), when the

weighted average FX rate is 1.30 GBP/EUR.

Exhibit 31: GSTQ's Income Statement Remeasured in Euros – Functional Currency

Source: Credit Suisse Accounting & Tax Research Note: Assumes income is not taxed 1: Exhibit 32 shows the math behind the FX Gain/(Loss)

30 July 2015

FX Translated 34

FX Gain/Loss Reported on Income Statement

There is one line item on the functional currency income statement that needs some

further explaining, the FX Gain/(Loss). It can be broken down into two parts: the impact of

FX rate changes on the (1) net monetary assets at the beginning of the period and on the

(2) net monetary assets arising during the period.

For example, here's how we came up with the €52 FX gain in the quarter ended

3/31/2015:

■ The net monetary assets of £500 (£1,000 of cash - £500 of payables) at the beginning

of the 3/31/2015 quarter were last remeasured using an FX rate of 1.30 GBP/EUR on

12/31/2014.

■ When they are subsequently remeasured on 3/31/2015, the exchange rate is up by 10

euro cents moving to 1.40 GBP/EUR. This results in an FX gain of €50 (£500 x 0.10).

■ Similarly, the net monetary assets arising during the quarter, £40 increase in cash

(£100 of cash revenue - £60 of SG&A) were first measured on the income statement

using a weighted average exchange rate of 1.35 GBP/EUR.

■ When they are remeasured at the end of the quarter using the 1.40 GBP/EUR

exchange rate at that time, it results in an additional FX gain of €2 (£40 x (1.40 –

1.35)).

■ The two components add up to a total FX gain of €52 for the 3/31/2015 quarter.

We show the math behind the FX gain/(loss) from each period in Exhibit 32.

Exhibit 32: FX Gain/(Loss)

Source: Credit Suisse Accounting & Tax Research

30 July 2015

FX Translated 35

Appendix B – FX Translation Example

Let's continue with our example of God Save the Queen Plc (GSTQ) and its U.S. parent

Uncle Sam Inc. As seen in Appendix A – FX Remeasurement Example, GSTQ now has a

set of financial statements denominated in its functional currency, the euro. However,

Uncle Sam Inc. reports its results in U.S. dollars, so the financial statements of GSTQ

need to be translated from the functional currency - euros into the reporting currency - U.S.

dollars.

Balance Sheet FX Translation

We start with the GSTQ balance sheet in euros in Exhibit 33 (it may look familiar, since it’s

the same as Exhibit 28).

Exhibit 33: GSTQ's Balance Sheet Remeasured in Euros – Functional Currency

Source: Credit Suisse Accounting & Tax Research

When it comes to FX translation, current FX rates (i.e., rates in effect as of the balance

sheet date) are used to translate all assets and liabilities. Historical FX rates are used for

shareholders' equity (i.e., paid-in capital, retained earnings, etc. are accumulated over

time at FX rates in effect when equity is raised, net income is earned, dividends are paid,

etc.) In Exhibit 34, you can see the exchange rates over time and the FX rates used to

translate each line item on the balance sheet from euros into U.S. dollars.

Exhibit 34: Exchange Rates Used to Translate GSTQ's Balance Sheet

Source: Credit Suisse Accounting & Tax Research

30 July 2015

FX Translated 36

We arrive at the reporting currency (U.S. dollar) balance sheet in Exhibit 35, by applying

the exchange rates in Exhibit 34 to the functional currency balance sheet in Exhibit 33. For

example, the €1,300 cash in the functional currency balance sheet as of 12/31/2014 when

the FX rate is 1.20 EUR/USD gets translated into $1,560 (€1,300 x 1.20).

Exhibit 35: GSTQ's Balance Sheet Translated in U.S. Dollars – Reporting Currency

Source: Credit Suisse Accounting & Tax Research Note: Numbers may not sum due to rounding 1: Each period's translated net income is added to retained earnings (see Exhibit 39). 2: FX translation gains/(losses) from each period are accumulated (see Exhibit 36)

FX Translation Gain/Loss Reported in OCI

There is one line item that shows up on the translated balance sheet which needs some

further explaining, the cumulative translation adjustment. It has two components: the

impact of FX rate changes on the (1) net investment in GSTQ at the beginning of the

period and on the (2) net investment arising during the period.

For example, here's how we came up with the $74 FX translation gain for the quarter

ended 3/31/2015:

■ At the beginning of the 3/31/2015 quarter, Uncle Sam had a net investment in GSTQ

of €650, which was last translated using an exchange rate of 1.20 EUR/USD on

12/31/2014.

■ However, the exchange rate moved to 1.30 EUR/USD by the end of the quarter

resulting in an FX translation gain of $65 (€650 x 0.10).

■ The net income of €184 (was the only additional net investment during the quarter)

and it was originally translated at a weighted average exchange rate of 1.25

EUR/USD.

■ Translating it at the end of the quarter using the 1.30 EUR/USD exchange rate results

in an additional FX translation gain of $9 (€184 x (1.30-1.25)) after rounding.

■ The total FX translation gain for the 3/31/2015 quarter is $74 ($65 + $9).

We show the math behind the FX translation gain/(loss) from each period in Exhibit 36.

30 July 2015

FX Translated 37

Exhibit 36: FX Translation Gain/(Loss)

Source: Credit Suisse Accounting & Tax Research

Unlike the FX gain/(loss) due to remeasurement in Appendix A – FX Remeasurement

Example, the FX translation gain/(loss) does not (initially) hit the income statement. Given

the long term nature of the investments, these potentially temporary and possibly volatile

gains/losses will hang out in the Accumulated Other Comprehensive Income (AOCI)

section of shareholders' equity on the balance sheet. The FX translation gains/losses are

eventually reclassified into earnings when the foreign subsidiary is liquidated or sold.

Income Statement FX Translation

Next, in Exhibit 37 you'll find the income statement of GSTQ in its functional currency, the

euro (it should look familiar, since it’s the same as Exhibit 31).

Exhibit 37: GSTQ's Income Statement Remeasured in Euros – Functional Currency

Source: Credit Suisse Accounting & Tax Research Note: Assumes income is not taxed

30 July 2015

FX Translated 38

The line items on the income statement are supposed to be translated at the rates in effect

when the revenues/expenses are recognized but in practice companies typically use a

weighted average exchange rate for the period. In Exhibit 38 we provide the exchange

rates used to translate the income statement from euros into U.S. dollars.

Exhibit 38: Exchange Rates Used to Translate GSTQ's Income Statement

Source: Credit Suisse Accounting & Tax Research

We arrive at the reporting currency income statement for GTSQ in Exhibit 39 by applying

the FX rates from Exhibit 38 to the euro income statement in Exhibit 37. For example, the

€78 of SG&A for the period ended 12/31/2014 is translated into $94 (€78 x 1.20), when the

weighted average FX rate is 1.20 EUR/USD.

Exhibit 39: GSTQ's Income Statement Translated in U.S. Dollars – Reporting Currency

Source: Credit Suisse Accounting & Tax Research Note: Assumes income is not taxed

Cash Flow Statement FX Translation

In Exhibit 40 you'll find GSTQ's cash flow statement in its functional currency, euro. It's

been simplified and assumes that there were no investing or financing cash flows.

30 July 2015

FX Translated 39

Exhibit 40: GSTQ's Cash Flow Statement Remeasured in Euros – Functional Currency

Source: Credit Suisse Accounting & Tax Research

Exhibit 41 shows the exchange rates used to translate the different line items on the

GSTQ cash flow statement from euros into U.S. dollars. Beginning of period cash is

translated using beginning of period exchange rates and end of period cash is translated

using the end of period exchange rate. All cash inflows and outflows are supposed to be

translated using the FX rates when the cash flows occur. But in practice, weighted

average rates FX rates are used instead.

Exhibit 41: Exchange Rates Used to Translate GSTQ's Cash Flow Statement

Source: Credit Suisse Accounting & Tax Research

We arrive at the translated cash flow statement for GSTQ in U.S. dollars in Exhibit 42 by

applying the exchange rates shown in Exhibit 41 to the euro cash flow statement in Exhibit

40. For example, the €52 change in inventory for the period ended 6/30/14 is translated

into $62 (€52 x 1.20), when the weighted average FX rate is 1.20 EUR/USD.

30 July 2015

FX Translated 40

Exhibit 42: GSTQ's Cash Flow Statement Translated in U.S. Dollars – Reporting Currency

Source Credit Suisse Accounting & Tax Research Note: Numbers may not sum due to rounding

Effect of FX Rate Changes on Cash

Once again we have a line item that appears from out of nowhere and needs some

explaining, the Effect of FX Rate Changes on Cash. Well if you take all the line items on

the cash flow statement translated at a weighted average FX rate for the period you won't

be able to reconcile cash from the beginning of the period to the end of the period

especially when the beginning and ending cash balances are translated at different

exchange rates. You can think of it as a plug that allows the cash flow statement to

reconcile.

That plug has three components: the impact of FX rate changes on the (1) cash balance

from the beginning of the period and on the (2) cash flows during the period, plus any (3)

effect of FX rate changes on the functional currency cash flow statement that needed to be

translated into the reporting currency; we walkthrough the math in Exhibit 43.

Basically, you need to take each cash flow item and adjust it for the difference between

the FX rate at which it was translated earlier and the FX rate at the end of the period.

For example:

■ At the beginning of the 3/31/2015 quarter the €1,300 of cash was translated at a rate

of 1.20 EUR/USD.

■ However, by the end of the period, the rate was higher by 10 cents at 1.30 EUR/USD.

That results in an FX translation impact of $130 (€1,300 x 0.10).

■ Similarly cash flow from operations of €54 was earlier translated at the weighted

average rate of 1.25 EUR/USD, applying the end of period rate of 1.30 EUR/USD

results in another $3 of translation impact (€54 x (1.30-1.25)) after rounding.

■ Last but not least the €102 effect of FX rate changes from the functional currency cash

flow statement is translated into $133 (€102 x 1.30).

■ Those three components make up the $265 (after rounding) of effect of FX rates

changes on the 3/31/2015 cash flow statement.

30 July 2015

FX Translated 41

Exhibit 43: Effect of FX Rate Changes on Cash During Translation

Source: Credit Suisse Accounting & Tax Research Note: Numbers may not sum due to rounding

30 July 2015

FX Translated 42

Companies Mentioned (Price as of 28-Jul-2015)

Abbott Laboratories (ABT.N, $50.94) Archer Daniels Midland Inc. (ADM.N, $48.35) Avon Products Inc (AVP.N, $5.35) Baxter International Inc. (BAX.N, $38.09) Caterpillar Inc. (CAT.N, $77.78) E.I. du Pont de Nemours and Company (DD.N, $55.9) EMC Corp (EMC.N, $26.78) Google, Inc. (GOOGL.OQ, $659.66) Green Mountain (GMCR.OQ, $71.8) Harley-Davidson (HOG.N, $58.18) Hasbro (HAS.OQ, $79.57) Hexcel Corporation (HXL.N, $48.67) Honeywell International Inc. (HON.N, $104.2) Illinois Tool Works, Inc. (ITW.N, $88.74) International Business Machines Corp. (IBM.N, $160.05) McDonald's Corp (MCD.N, $97.33) Murphy Oil Corp. (MUR.N, $34.12) Nike Inc. (NKE.N, $113.47) Phillips-Van Heusen (PVH.N, $113.41) Procter & Gamble Co. (PG.N, $80.23) Ralph Lauren (RL.N, $126.61) Red Hat, Inc. (RHT.N, $78.73) Royal Caribbean Cruises (RCL.N, $82.7) Starbucks (SBUX.OQ, $57.14) The Coca-Cola Company (KO.N, $40.55) United Technologies Corp (UTX.N, $98.97) Williams-Sonoma (WSM.N, $81.77)

Disclosure Appendix

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Market Weight : The analyst’s expectation for the sector’s fundamentals and/or valuation is neutral over the next 12 months.

30 July 2015

FX Translated 43

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Restrictions on certain Canadian securities are indicated by the following abbreviations: NVS--Non-Voting shares; RVS--Restricted Voting Shares; SVS--Subordinate Voting Shares.

Individuals receiving this report from a Canadian investment dealer that is not affiliated with Credit Suisse should be advised that this report may not contain regulatory disclosures the non-affiliated Canadian investment dealer would be required to make if this were its own report.

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As of the date of this report, Credit Suisse acts as a market maker or liquidity provider in the equities securities that are the subject of this report.

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Important Credit Suisse HOLT Disclosures

With respect to the analysis in this report based on the Credit Suisse HOLT methodology, Credit Suisse certifies that (1) the views expressed in this report accurately reflect the Credit Suisse HOLT methodology and (2) no part of the Firm’s compensation was, is, or will be directly related to the specific views disclosed in this report.

The Credit Suisse HOLT methodology does not assign ratings to a security. It is an analytical tool that involves use of a set of proprietary quantitative algorithms and warranted value calculations, collectively called the Credit Suisse HOLT valuation model, that are consistently applied to all the companies included in its database. Third-party data (including consensus earnings estimates) are systematically translated into a number of default algorithms available in the Credit Suisse HOLT valuation model. The source financial statement, pricing, and earnings data provided by outside data vendors are subject to quality control and may also be adjusted to more closely measure the underlying economics of firm performance. The adjustments provide consistency when analyzing a single company across time, or analyzing multiple companies across industries or national borders. The default scenario that is produced by the Credit Suisse HOLT valuation model establishes the baseline valuation for a security, and a user then may adjust the default variables to produce alternative scenarios, any of which could occur.

Additional information about the Credit Suisse HOLT methodology is available on request.

The Credit Suisse HOLT methodology does not assign a price target to a security. The default scenario that is produced by the Credit Suisse HOLT valuation model establishes a warranted price for a security, and as the third-party data are updated, the warranted price may also change. The default variable may also be adjusted to produce alternative warranted prices, any of which could occur.

CFROI®, HOLT, HOLTfolio, ValueSearch, AggreGator, Signal Flag and “Powered by HOLT” are trademarks or service marks or registered trademarks or registered service marks of Credit Suisse or its affiliates in the United States and other countries. HOLT is a corporate performance and valuation advisory service of Credit Suisse.

For Credit Suisse disclosure information on other companies mentioned in this report, please visit the website at https://rave.credit-suisse.com/disclosures or call +1 (877) 291-2683.

30 July 2015

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