Intercompany loans are often a source of exposure to financial risk. We encounter cases where affiliate companies provide loans from one to the other, believing that “it cancels out in the consolidated report”. This isn’t always the case, especially when the loan is denominated in a currency other than the functional currency of one of the parties. The exchange rate differences will be reflected as revenue/expenses in the consolidated report. These loans are not visible in the consolidated balance sheet as the mutual balances eliminate each other, but the exchange rate differences reflect genuine economic risk and may result in undesirable fluctuations in in the P&L report.
Take for example a parent company whose functional currency is the Israeli Shekel, giving a loan in US Dollars to a subsidiary whose functional currency is the USD. When consolidating the reports of the companies, financial expenses in the parent company’s solo report are included, and are not offset. This problem may be handled by one of the following solutions:
- Cross Currency Swap: This solution is best suited for hedging this exposure, if reimbursements from the subsidiary are likely.
- A series of forward transactions, and / or currency options: in case the loan is expected to be repaid, but in an uncertain time.
- Receiving Dollar credit: If the subsidiary is expected to repay the loan, but start only in a few years, the parent can make use of a Dollar credit to hedge.
- Accounting treatment: Classifying the loan as “net investment in foreign activity”. This action does not eliminate the financial exposure, but reduces undesired fluctuations in the financing section in the P&L statement.
This is only a general description. In practice, it is highly important to analyze each case individually and match specific solutions to a company, according to its perception of risk, accounting needs, financial capabilities and other technical.
Written by Moran Shtainberg, Economist, Ofakim Group.