Management of Translation Exposure

Chapter Objective:

Chapter Ten

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This chapter discusses the impact that unanticipated changes in exchange rates may have on the consolidated financial statements of the multinational company.

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Chapter Outline

Translation Methods FASB Statement 8 FASB Statement 52 International Accounting Standards Management of Translation Exposure Empirical Analysis of the Change from FASB 8 to FASB 52

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Translation Methods

Current/Noncurrent Method Monetary/Nonmonetary Method Temporal Method Current Rate Method

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Current/Noncurrent Method

The underlying principal is that assets and liabilities should be translated based on their maturity.

Current assets translated at the spot rate. Noncurrent assets translated at the historical rate in effect when the item was first recorded on the books.

This method of foreign currency translation was generally accepted in the United States from the 1930s until 1975, at which time FASB 8 became effective.

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Current/Noncurrent Method

Current assets translated at the spot rate.

Balance Sheet

Cash e.g. 2 = $1 Inventory Noncurrent assets Net fixed assets Total Assets translated at the historical rate in Current liabilities effect when the Long-Term debt Common stock item was first recorded on the Retained earnings CTA books. Total Liabilities and e.g. 3 = $1 Equity

Local Current/ Currency Noncurrent 2,100 $1,050 1,500 $750 3,000 $1,000 6,600 $2,800 1,200 $600 1,800 $600 2,700 $900 900 $700 -------------- 6,600 $2,800

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Monetary/Nonmonetary Method

The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes. All monetary balance sheet accounts (cash, marketable securities, accounts receivable, etc.) of a foreign subsidiary are translated at the current exchange rate. All other (nonmonetary) balance sheet accounts (owners equity, land) are translated at the historical exchange rate in effect when the account was first recorded.

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Monetary/Nonmonetary Method

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All monetary balance sheet accounts are translated at the current exchange rate. e.g. 2 = $1 All other balance sheet accounts are translated at the historical exchange rate in effect when the account was first recorded. e.g.3 = $1

Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity

Local Monetary/ Currency Nonmonetary 2,100 $1,050 1,500 $500 3,000 $1,000 6,600 $2,550 1,200 $600 1,800 $900 2,700 $900 900 $0 -------------- 6,600 $2,400

Temporal Method

The underlying principal is that assets and liabilities should be translated based on how they are carried on the firms books. Balance sheet account are translated at the current spot exchange rate if they are carried on the books at their current value. Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books.

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Temporal Method

Balance Sheet Items carried on the books at their current value are Cash Inventory translated at the spot exchange rate. Net fixed assets Total Assets e.g. 2 = $1 Current liabilities Items that are Long-Term debt carried on the Common stock books at historical Retained earnings costs are translated CTA Total Liabilities and at the historical Equity exchange rates. e.g. 3 = $1

Local Currency 2,100 1,500 3,000 6,600 1,200 1,800 2,700 900 ------- 6,600

Temporal $1,050 $900 $1,000 $2,950 $600 $900 $900 $0 -------$2,400

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Current Rate Method

All balance sheet items (except for stockholders equity) are translated at the current exchange rate. Very simple method in application. A plug equity account named cumulative translation adjustment is used to make the balance sheet balance.

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Current Rate Method

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All balance sheet items (except for stockholders equity) are translated at the current exchange rate. A plug equity account named cumulative translation adjustment is used to make the balance sheet balance

Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity

Local Currency 2,100.00 1,500.00 3,000.00 6,600.00 1,200.00 1,800.00 2,700.00 900.00 -------6,600.00

Current Rate $1,050 $750 $1,500 $3,300 $600 $900 $900 $360 $540 $3,300

How Various Translation Methods Deal with a Change from 3 = $1 to 2 = $1

Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Current/ Monetary/ Temporal Currency Noncurrent Nonmonetary 2,100 $1,050 $1,050 $1,050 1,500 $750 $500 $900 3,000 $1,000 $1,000 $1,000 6,600 $2,800 $2,550 $2,950 1,200 $600 $600 $600 1,800 $600 $900 $900 2,700 $900 $900 $900 900 $700 $150 $550 ----------------------------6,600 $2,800 $2,550 $2,950
Spot exchange rate
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Current Rate $1,050 $750 $1,500 $3,300 $600 $900 $900 $360 $540 $3,300

How Various Translation Methods Deal with a Change from 3 to 2 = $1

Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Current/ Monetary/ Temporal Currency Noncurrent Nonmonetary 2,100 $1,050 $1,050 $1,050 1,500 $750 $500 $900 3,000 $1,000 $1,000 $1,000 6,600 $2,800 $2,550 $2,950 Book $600 1,200 $600 $600 1,800 $600 value of $900 $900 inventory $900 2,700 $900 $900 900 $700 historic $150 $550 --------------- rate --------------6,600 $2,800 $2,550 $2,950 Current Rate $1,050 $750 $1,500 $3,300 $600 $900 $900 $360 $540 $3,300

Book value of inventory at spot exchange rate

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Current value of inventory at spot exchange rate.

How Various Translation Methods Deal with a Change from 3 to 2 = $1

Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Current/ Monetary/ Temporal Currency Noncurrent Nonmonetary 2,100 $1,050 $1,050 $1,050 1,500 $750 $500 $900 3,000 $1,000 $1,000 $1,000 6,600 $2,800 $2,550 $2,950 1,200 $600 $600 $600 1,800 $600 $900 $900 2,700 $900 $900 $900 900 $700 $150 $550 ----------------------------6,600 $2,800 $2,550 $2,950 Current Rate $1,050 $750 $1,500 $3,300 $600 $900 $900 $360 $540 $3,300

historic rate
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spot exchange rate

How Various Translation Methods Deal with a Change from 3 to 2 = $1

Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Current/ Monetary/ Temporal Currency Noncurrent Nonmonetary 2,100 $1,050 $1,050 $1,050 1,500 $750 $500 $900 3,000 $1,000 $1,000 $1,000 6,600 $2,800 $2,550 $2,950 1,200 $600 $600 $600 1,800 $600 $900 $900 2,700 $900 $900 $900 900 $700 $150 $550 ----------------------------6,600 $2,800 $2,550 $2,950 Current Rate $1,050 $750 $1,500 $3,300 $600 $900 $900 $360 $540 $3,300

Cash + Inventory + Net Fixed Assets

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How Various Translation Methods Deal with a Change from 3 to 2 = $1

Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Current/ Monetary/ Temporal Currency Noncurrent Nonmonetary 2,100 $1,050 $1,050 $1,050 1,500 $750 $500 $900 3,000 $1,000 $1,000 $1,000 6,600 $2,800 $2,550 $2,950 1,200 $600 $600 $600 1,800 $600 $900 $900 2,700 $900 $900 $900 900 $700 $150 $550 ----------------------------6,600 $2,800 $2,550 $2,950 Current Rate $1,050 $750 $1,500 $3,300 $600 $900 $900 $360 $540 $3,300

spot rate
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How Various Translation Methods Deal with a Change from 3 to 2 = $1

Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Current/ Monetary/ Temporal Currency Noncurrent Nonmonetary 2,100 $1,050 $1,050 $1,050 1,500 $750 $500 $900 3,000 $1,000 $1,000 $1,000 6,600 $2,800 $2,550 $2,950 1,200 $600 $600 $600 1,800 $600 $900 $900 2,700 $900 $900 $900 900 $700 $150 $550 ----------------------------6,600 $2,800 $2,550 $2,950 Current Rate $1,050 $750 $1,500 $3,300 $600 $900 $900 $360 $540 $3,300

historical rate
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spot rate

How Various Translation Methods Deal with a Change from 3 to 2 = $1

Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Current/ Monetary/ Temporal Currency Noncurrent Nonmonetary 2,100 $1,050 $1,050 $1,050 1,500 $750 $500 $900 3,000 $1,000 $1,000 $1,000 6,600 $2,800 $2,550 $2,950 1,200 $600 $600 $600 1,800 $600 $900 $900 2,700 $900 $900 $900 900 $700 $150 $550 ----------------------------6,600 $2,800 $2,550 $2,950 Current Rate $1,050 $750 $1,500 $3,300 $600 $900 $900 $360 $540 $3,300

Requires income statement data (see slides 23, 24, 25)

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How Various Translation Methods Deal with a Change from 3 to 2 = $1

Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Current/ Monetary/ Temporal Currency Noncurrent Nonmonetary 2,100 $1,050 $1,050 $1,050 1,500 $750 $500 $900 3,000 $1,000 $1,000 $1,000 6,600 $2,800 $2,550 $2,950 1,200 $600 $600 $600 1,800 $600 $900 $900 2,700 $900 $900 $900 900 $700 $150 $550 ----------------------------6,600 $2,800 $2,550 $2,950 Current Rate $1,050 $750 $1,500 $3,300 $600 $900 $900 $360 $540 $3,300

Under the current rate method, a plug equity account named cumulative translation adjustment makes the balance sheet balance.
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How Various Translation Methods Deal with a Change from 3 to 2 = $1

Local Current/ Monetary/ Temporal Income Statement Currency Noncurrent Nonmonetary Sales 10,000 $4,000 $4,000 $4,000 COGS 7,500 $3,000 $2,500 $3,000 Depreciation 1,000 $333 $333 $333 Net operating income 1,500 $667 $1,167 $667 Income tax (40%) 600 $267 $467 $267 Profit after tax 900 $400 $700 $400 Foreign exchange gain (loss) $300 -$550 $150 Net income 900 $700 $150 $550 Dividends 0 $0 $0 $0 Addition to Retained Earnings 900 $700 $150 $550 Current Rate $4,000 $3,000 $400 $600 $240 $360 $360 $0 $360

Sales translate at average exchange rate over the period, 2.50 = $1

For notes, see Exhibit 14.1
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How Various Translation Methods Deal with a Change from 3 to 2 = $1

Local Current/ Monetary/ Temporal Income Statement Currency Noncurrent Nonmonetary Sales 10,000 $4,000 $4,000 $4,000 COGS 7,500 $3,000 $2,500 $3,000 Depreciation 1,000 $333 $333 $333 Net operating income 1,500 $667 $1,167 $667 Income tax (40%) 600 $267 $467 $267 Profit after tax 900 $400 $700 $400 Foreign exchange gain (loss) $300 -$550 $150 Net income 900 $700 $150 $550 Dividends 0 $0 $0 $0 Addition to Retained Earnings 900 $700 $150 $550 Current Rate $4,000 $3,000 $400 $600 $240 $360 $360 $0 $360

Translate at 2.50 = $1
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Translate at old exchange rate, 3.00 = $1

For notes, see Exhibit 14.1

How Various Translation Methods Deal with a Change from 3 to 2 = $1

Local Current/ Monetary/ Temporal Income Statement Currency Noncurrent Nonmonetary Sales 10,000 $4,000 $4,000 $4,000 COGS 7,500 $3,000 $2,500 $3,000 Depreciation 1,000 $333 $333 $333 Net operating income 1,500 $667 $1,167 $667 Income tax (40%) 600 $267 $467 $267 Profit after tax 900 $400 $700 $400 Foreign exchange gain (loss) $300 -$550 $150 Net income 900 $700 $150 $550 Dividends 0 $0 $0 $0 Addition to Retained Earnings 900 $700 $150 $550 Current Rate $4,000 $3,000 $400 $600 $240 $360 $360 $0 $360

Translate at 3 = $1
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Translate at average exchange rate, 2.5 = $1

How Various Translation Methods Deal with a Change from 3 to 2 = $1

Local Current/ Monetary/ Temporal Income Statement Currency Noncurrent Nonmonetary Sales 10,000 $4,000 $4,000 $4,000 COGS 7,500 $3,000 $2,500 $3,000 Depreciation 1,000 $333 $333 $333 Net operating income 1,500 $667 $1,167 $667 Income tax (40%) 600 $267 $467 $267 Profit after tax 900 $400 $700 $400 Foreign exchange gain (loss) $300 -$550 $150 Net income 900 $700 $150 $550 Dividends 0 $0 $0 $0 Addition to Retained Earnings 900 $700 $150 $550 Current Rate $4,000 $3,000 $400 $600 $240 $360 $360 $0 $360

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First Solve for retained earnings so as Total Assets = Total Liabilities: Total Assets current liabilities long-term debt common stock $2,800 $600 $600 $900 = $700 = addition to retrained earnings Add back on dividends to get net income. Then solve for forex gain (loss) by differencing profit after tax and net income $700 $400 = $300

How Various Translation Methods Deal with a Change from 3 to 2 = $1

Local Current/ Monetary/ Temporal Income Statement Currency Noncurrent Nonmonetary Sales 10,000 $4,000 $4,000 $4,000 COGS 7,500 $3,000 $2,500 $3,000 Depreciation 1,000 $333 $333 $333 Net operating income 1,500 $667 $1,167 $667 Income tax (40%) 600 $267 $467 $267 Profit after tax 900 $400 $700 $400 Foreign exchange gain (loss) $300 -$550 $150 Net income 900 $700 $150 $550 Dividends 0 $0 $0 $0 Addition to Retained Earnings 900 $700 $150 $550 Current Rate $4,000 $3,000 $400 $600 $240 $360 $360 $0 $360

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First Solve for retained earnings so as Total Assets = Total Liabilities: Total Assets current liabilities long-term debt common stock $2,550 $600 $900 $900 = $150 = addition to retrained earnings Add back on dividends to get net income. Then solve for forex gain (loss) by differencing profit after tax and net income $150 $700 = $550

How Various Translation Methods Deal with a Change from 3 to 2 = $1

Local Current/ Monetary/ Temporal Income Statement Currency Noncurrent Nonmonetary Sales 10,000 $4,000 $4,000 $4,000 COGS 7,500 $3,000 $2,500 $3,000 Depreciation 1,000 $333 $333 $333 Net operating income 1,500 $667 $1,167 $667 Income tax (40%) 600 $267 $467 $267 Profit after tax 900 $400 $700 $400 Foreign exchange gain (loss) $300 -$550 $150 Net income 900 $700 $150 $550 Dividends 0 $0 $0 $0 Addition to Retained Earnings 900 $700 $150 $550 Current Rate $4,000 $3,000 $400 $600 $240 $360 $360 $0 $360

First Solve for retained earnings so as Total Assets = Total Liabilities: Total Assets current liabilities long-term debt common stock $2,950 $600 $900 $900 = $550 = addition to retrained earnings Add back on dividends to get net income. Then solve for forex gain (loss) by differencing profit after tax and net income $550 $400 = $150
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FASB Statement 8

Essentially the temporal method, with some subtleties.

Such as translating inventory at historical rates, which is a hassle.

Requires taking foreign exchange gains and losses through the income statement. This leads to variability in reported earnings. Which leads to irritated corporate executives.

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FASB Statement 52

The Mechanics of the FASB 52 Translation Process

Function Currency Reporting Currency

Highly Inflationary Economies

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The Mechanics of FASB Statement 52

Function Currency

The currency that the business is conducted in. The currency in which the MNC prepares its consolidated financial statements.

Reporting Currency

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The Mechanics of FASB Statement 52

Two-Stage Process

First, determine in which currency the foreign entity keeps its books. If the local currency in which the foreign entity keeps its books is not the functional currency, remeasurement into the functional currency is required. Second, when the foreign entitys functional currency is not the same as the parents currency, the foreign entitys books are translated using the current rate method.

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The Mechanics of FASB Statement 52

Parents currency
Foreign entitys books kept in?

Nonparent Currency

Functional Currency?

Third

currency

Local currency

Temporal Remeasurement

Parents Currency

Current Rate Translation

Parents Currency
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Highly Inflationary Economies

Foreign entities are required to remeasure financial statements using the temporal method as if the functional currency were the reporting currency.

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International Accounting Standards

Since January 2005, all companies doing business in the European Union have to use the accounting standards promulgated by the International Accounting Standards Board (IASB). Similar to the American FASB, the IASB publishes it standards in a series of pronouncements called International Financial Reporting Standards. It also adopted and maintains the pronouncements of the predecessor body, the IASC, called International Accounting Standards (IAS).

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International Accounting Standards

IAS 21, The Effects of Changes in Foreign Exchange Rates is the European standard for handling foreign currency translation. IAS 21 most closely resembles the monetary/nonmonetary translation method discussed earlier in the chapter. Thus, in the European Union, a different translation method is used than in the United States.

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Management of Translation Exposure

Translation Exposure vs. Transaction Exposure Hedging Translation Exposure

Balance Sheet Hedge Derivatives Hedge

Translation Exposure vs. Operating Exposure

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Translation Exposure versus Transaction Exposure

Translation Exposure

The effect that unanticipated changes in exchange rates has on the firms consolidated financial statements. An accounting issue. The effect that unanticipated changes in exchange rates has on the firms cash flows. A finance issue and the subject of Chapter 8.

Transaction Exposure

It is generally not possible to eliminate both translation exposure and transaction exposure.

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Hedging Translation Exposure

If the managers of the firm wish to manage their accounting numbers as well as their business, they have two methods for dealing with translation exposure.

Balance Sheet Hedge Derivatives Hedge

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Balance Sheet Hedge

Eliminates the mismatch between net assets and net liabilities denominated in the same currency. May create transaction exposure, however.

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Derivatives Hedge

An example would be the use of forward contracts with a maturity of the reporting period to attempt to manage the accounting numbers. Using a derivatives hedge to control translation exposure really involves speculation about foreign exchange rate changes, however.

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Translation Exposure versus Operating Exposure

The effect that unanticipated changes in exchange rates has on the firms ongoing operations. Operating exposure is a substantive issue with which the management of the firm should concern itself with.

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Empirical Analysis of the Change from FASB 8 to FASB 52

There did not appear to be a revaluation of firms values following the change. This suggests that market participants do not react to cosmetic earnings changes. Other researchers have found similar results when investigating other accounting changes. This highlights the futility of attempting to manage translation gains and losses.

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End Chapter Ten

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