Working with clients in other countries opens you up to the world of foreign exchange differences. These differences can arise in many ways. Take two simple examples:

1. A small firm with just one UK office provides services to a European client, which wants to be billed in euros. If the bill for, say, €100,000 is recorded in the books when the sterling/euro exchange rate is €1.30/£1 and settled when the rate is €1.40/£1, an exchange difference has arisen. In this case, it is a loss
of £5,495. 

2. An international firm invests £1m in setting up a new office in Spain when the exchange rate is €1.40/£1 (investing €1.4m in local currency). One year later the euro has moved to €1.20/£1 and the first set of consolidated accounts including the new Spanish office are produced. The value of the original investment is now worth £1,166,667, purely because of the currency movement – a gain of £166,667.

In practice, a large international firm will have thousands of foreign exchange differences arising every day. At the end of each year, the results of each foreign operation will need to be translated into the reporting currency of the firm's head office.

There are many ways of managing foreign exchange exposures. Exposures arising from transactions (like example 1) can be managed by forward foreign exchange deals, currency options or various derivative transactions built on these trades. These transactions can be effective, but they are relatively costly in terms of bid/offer spreads, fees and other costs. And it can be controversial to sign large cheques to offset paper gains on the other side of a transaction. Exposures arising from investment in foreign operations are perhaps best hedged by funding the underlying assets in the same currency (either as loans or partner capital), creating the 'natural hedge' that firms talk about.

Many firms take the philosophical view that their business is naturally well hedged, because their revenues from international offices are in the same currency as the costs of those offices. Any foreign exchange exposure is only to the profit element, and even that is shared with the partners in the international offices. 

However you manage and account for foreign exchange exposures, perhaps the most difficult thing to address happens when a currency in which you bill a large part of your fees loses a lot of its value. This is what we have seen recently with the euro, which has lost 12% against sterling over the last year, going from around €1.25/£1 to around €1.40/£1.

But some words of warning on constant currency figures:

1. They are not real, in the sense that the underlying net assets of the firm have not increased by the constant currency figure. The cash collected from these bills will
be the amount at today's exchange rate. The boost seen by constant currency is a theoretical figure.  And you can't spend theoretical revenue.

2. The constant currency figures are not typically included in the annual financial statements, and so they are not likely to be audited.
 
As some firms become more global it is legitimate to ask what the reporting currency should be. For example, less than half of Allen & Overy's partners are UK-based. I sometimes wonder if it would be more realistic to report to them in terms of a basket of currencies, representing the currencies we do business in. This basket would be approximately 35% sterling, 35% euros, 25% dollars and 5% other currencies. This might reflect the real nature of our business and ownership structure more accurately than reporting in sterling alone, which is just the currency of the country we happened to start in. Of course, the accounting standards do not allow for such a thing, but it may be the best way of thinking about a truly global business.

Jason Haines is finance and operations director at Allen & Overy. This article reflects his personal opinion.