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ECONOMIC AND TRANSLATION RISKS 1. Economic Risk This relates to the possibility that the value of the company (the present value of all future cash flows) will change due to unexpected changes in future exchange rates. Its magnitude is difficult to measure as it considers unexpected changes in exchange rates. Economic risk arises as soon as a business gets into overseas market. It is often categorized into two forms namely: (i) Transaction exposure/risk: which focus on the short term effects on cash flows E.g. through foreign trade activities? (ii) Real operating exposure; which focuses on the long term effects on cash flows and net present value after the effect of inflation has been removed. As economic exposure has a direct effect on the values of the firm, it is important for multinationals to try to hedge against such exposure. However, as the size and nature of the exposure is unknown, it is difficult to hedge against international diversification of sales, production, raw material sources; so financing is suggested as this will provide more flexibility to respond to adverse unexpected changes in exchange rates. Many companies hedge against potential cash flow loss of transaction exposure (a part of economic exposure) through forward markets, currency options, currency futures etc. 2. Translation Risk (i) Definition: Translation risk exists because of the need for multinational companies to periodically consolidate the financial statements of overseas subsidiaries with those of the parent company in order to assess the performance of the entire group. In order to achieve consolidation, the subsidiaries accounts need to be translated from a foreign currency (subsidiarys functional currency) basis into the currency of the parent company (reporting currency) Translation is not a physical exchange of currencies; it is the change in the monetary expression from one to another currency. The risk arises as soon as a firm owns a foreign subsidiary or becomes a foreign subsidiary. (ii) Terms used in connection with translation risk: (a) Functional currency:- This is the currency of primary economic environment in which the entity operates. It is the currency that is used in day to day activities with the following impacts on entitys operations: Mainly influences sales prices Mainly influences costs (b) (c) (d) (e) Presentation currency:- This is the currency in which the financial statements of the entire group (consolidated) are presented where the reference is the entire group. Foreign Operation: Is an entity that is a subsidiary, associate, joint venture or branch of a reporting entity, the activities of which are based or conducted in a currency or country other than the reporting entity. Exchange Difference: Is the difference resulting from translating a given number of units of one currency into another at different exchange rates. A currency of hyperinflationary economy: A currency of a country or region whose economy is highly inflationed not stable. Such currency is subject to devaluation at any time.

(iii)Translation Risk Measurement (Quantification) 1

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The translation of subsidiaries financial statements from their functional currencies into reporting currency give rise to translation gain or loss if there has been an exchange rate changes within the period covered by the translated financial statements. Such a gain or loss is the quantity of risk/exposure to which such a group is/was exposed. The requirement by IAS 21 is that such translation be done using the following rates: Assets and liabilities be translated using closing rate i.e. the rate in force at the balance sheet date. Income and expenses be translated using the rate existing during the transaction (actual), though in practice if the rate didnt fluctuate much (i.e. the currency being not of hyper inflationary economy) the average rate in the period covered by the financial statements is used. Additional notes on adoption of IFRS and IAS the effect on some specific items (a) Treatment of exchange difference: All exchange differences resulting from translating the functional currencies into reporting currency shall be recognized as separate component of equity IAS 21 Para 39. (b) Goodwill: IFRS 3 clarifies details concerning any goodwill arising from business acquisition. (i) The acquirer shall, at the acquisition date, Recognize goodwill acquired in a business, combination as an asset and Initially measure that goodwill at cost, being the exess of the cost of business combination over the acquirers interest in the net value of the identifiable assets, liabilities and contingent liabilities IFRS 3 Para 51. (ii) To this effect the net asset acquired and the price paid both being in the acquirees functional currency are compared. Any resulting Goodwill is regarded as one of the assets of the acquiree being acquired. (iii) If the net asset acquired is greater in value than the price paid, the acquirer shall; Reassess the identification and measure of the acquirees identifiable assets, liabilities and contingent liabilities and the measure of the price paid, and Recognize immediately in the profit or loss any excess remaining after such reassessment. (c) Inter-group transactions elimination An inter-group monitary Asset/liability elimination against corresponding inter-group liability/asset goes together with showing the result (effect) of currency fluctuation (exchange difference corresponding). Such exchange difference is recognised in profit or loss of consolidated financial statement. Steps involved in arriving at translation gain/loss (1) (a) Convert purchasing price (investment in subsidiary) from parents to subsidiarys functional currency. (b) Analyse the net asset acquired (c) (i) Compare the two; (a) and (b) above both being in subsidiarys functional currency, where (ii) If (a) > (b) then the difference is goodwill an asset of the acquiree. (iii) If (b) > (a), then the acquirer should recheck the correctness of net value figure and price paid and realize any balance after such recheck as gain on acquisition of subsidiary in profit or loss in consolidated Retained Earnings. (2) Translate the income statement of the subsidiary into reporting currency. 2

(d)

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(4) (5)

Consolidated Balance sheet and profit and loss adjustments/workings to get figures for items in need for workings such as the question may require. Examples of items to be worked for are: (a) Translation reserve (b) Consolidated retained earnings (c) Minority interest (d) Some revenue and expenses items (e) Unrealized profit on inventories. (f) Inter-company transactions eliminations e.g. Debtors and creditors (g) Groups share of post acquisition retained earnings to the beginning of the period covered. Etc. Prepare consolidated Balance Sheet. Prepare consolidated Profit and Loss account.

Working Example The following are the balance sheets of X Ltd Y Ltd. Y Ltd are a subsidiary of X Ltd as at 31 December 2004. Tangible fixed assets Investment in Y Ltd Current assets Current liabilities Ordinary share capital Retained earnings X Ltd (Tshs.) 16,000 13,860 5,340 (4,360) 30,840 25,000 5,840 30,840 Y Ltd (Kshs.) 2,320 1,080 (560) 2,840 2,000 840 2,840

X Ltd acquired all the ordinary shares of Y Ltd on 1 January, 2004 at which time the retained earnings of Y Ltd were Kshs. 400. Exchange rates at selected dates were as follows: 1 January 2004Tshs. 5.50 = Kshs. 1 31 January 2004 Tshs. 5.00 = Kshs. 1 Average for 2004 Tshs. 5.20 = Kshs. 1 Required: Prepare a consolidated balance sheet for the X Ltd group as at 31 December, 2004. Solution Tshs. (a) Purchase price Net asset acquired: 13,860 Rate Kshs . 5.50 2,520

Ordinary share capital Retained earnings Net asset acquired Price paid Goodwill

Total X Ltd Y Ltd 100% 100% 0% Kshs. Kshs. Kshs. 2,000 2,000 0 400 400 0 2,400 2,520 120 3

Apt Financial Consultants (b) Translation reserve Balance b/f as at 1/1/2004 Movement for the year 2004 Net asset 1/1/2004 Goodwill Other Net assets Ord. S. capital. R/E Net asset 1/1/2004 Add: R/E for the year = (440 x 5.2) Net asset as at 31 Dec 2004 Kshs. % Age 120 X 100% 2,000 X 100% 400 X 100% = 2,520 x 5.5

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Kshs = 120 = 2,000 = 400 = 13,860 2,288 16,148

Net asset as per closing Balance Sheet: Kshs. % Age Kshs Goodwill 120 X 100% = 120 Other Net assets Osc 2,000 X 100% = 2,000 R/E 840 X 100% = 840 Net asset 31/12/2004 = 2,960 x 5 = 14,800 Translation loss (Cummulative) (1,348) (c) Consolidated retained Earnings - R/E of X - Xs share in Ys R/E: Preacquisition R/E = R/E as at 31/12/2004 = Post acquisition R/E Cummulative R/E for group Tshs. 5,840 Kshs. 400 840 440 x 5.2

2,288 8,128

X Limited Consolidated Balance Sheet as at 31/12/2004 Tshs. Tangible Fixed Assets 16,000 + (2320 x 5) 27,600 Goodwill (120 x 5) 600 Current Assets 5,340 + (1080 x5) 10,740 Current Liabilities 4,360 + (560 x 5) (7,160) 31,780 OSC 25,000 R/E 8,128 Translation loss (1,348) 31,780 In the above example the translation risk measure is TShs. 1,348.

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Translation exposure management Translation exposure doesnt directly measure the cashflow implications of exchange rate changes or the impact of such changes to the value of multinational. Because of this many companies do not hedge against it. However if the exposure is expected to result into significant reported losses, this may negatively affect the share prices of the entity in an imperfect market. If such results are predicted hedging may be taken. Some techniques of hedging used to hedge against transaction exposure (already explained) such as netting, matching and invoicing in foreign currency are also applicable in hedging against translation exposure; matching being the most appropriate suggested one for this purpose.