Management 3460

Institutions and Practices in International Finance

Fall 2003
Greg Flanagan

Chapter 14 Management of Translation Exposure

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Chapter Objectives
define translation exposure.

explain why we care about translation

explain the impact that unanticipated changes in exchange rates may have on the consolidated financial statements of the multinational company.
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Chapter Objectives
discuss and differentiate various translation methods: current/noncurrent monetary/nonmonetary temporal current rate

Chapter Objectives (continued)

summarize the FASB statement 52

discuss the management of translation exposure.

evaluate the empirical analysis of the change from FAS8 to FAS52. discuss the importance of translation exposure in comparison with economic and transaction exposure
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Definition
Translation Exposure the potential that the firms consolidated financial statements can be affected by changes in exchange rates.

Why do we Care about Translation?

managers, analysts and investors need some idea about the importance of the foreign business a translated accounting data give an approximate idea of this. performance measurement for bonus plans, hiring, firing, and promotion decisions. accounting value serves as a benchmark to evaluate valuation. for income tax purposes. legal requirement to consolidate financial statements.
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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.

generally accepted in the US from the 1930s -1975, at which time FAS8 became effective. Short-term gains/losses will be recognized long term will not be.
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Current/Noncurrent Method
Current assets /liabilities Cash translated at the Inventory spot rate. Net fixed assets i.e. 2=$1 Total Assets Noncurrent assets Current liabilities /liabilities Long-Term debt translated at the historical rate in Common stock effect when the Retained earnings CTA item was first recorded on the Total Liabilities and books. i.e. 3=$1 Equity
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Balance Sheet

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

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. i.e. PPP
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Monetary/Nonmonetary Method
All monetary balance sheet accounts are translated at the current exchange rate. i.e. 2=$1 All other balance sheet accounts are translated at the historical exchange rate in effect when the account was first recorded. i.e.3=$1
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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
Items carried on the books at their current value are translated at the spot exchange rate. i.e. 2=$1 Items that are carried on the books at historical costs are translated at the historical exchange rates. i.e. 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 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

All balance sheet items (except for stockholders equity) are translated at the current exchange rate. i.e. 2=$1 A plug equity account named cumulative translation adjustment is used to make the balance sheet balance
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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 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
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Local Current/ Monetary/ Temporal Current Currency Noncurrent Nonmonetary Rate 2,100 $1,050 $1,050 $1,050 $1,050 1,500 $750 $500 $900 $750 3,000 $1,000 $1,000 $1,000 $1,500 6,600 $2,800 $2,550 $2,950 $3,300 1,200 $600 $600 $600 $600 1,800 $600 $900 $900 $900 2,700 $900 $900 $900 $900 900 $700 $150 $550 $360 ----------------------------$540 6,600 $2,800 $2,550 $2,950 $3,300
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 Current Currency Noncurrent Nonmonetary Rate 2,100 $1,050 $1,050 $1,050 $1,050 1,500 $750 $500 $900 $750 3,000 $1,000 $1,000 $1,000 $1,500 6,600 $2,800 $2,550 $2,950 $3,300 1,200 $600 Book $600 $600 $600 1,800 $600 value of $900 $900 $900 2,700 $900inventory $900 $900 $900 900 $700 historic $150 $550 $360 rate ----------------------------$540 6,600 $2,800 $2,550 $2,950 $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
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Local Current/ Monetary/ Temporal Current Currency Noncurrent Nonmonetary Rate 2,100 $1,050 $1,050 $1,050 $1,050 1,500 $750 $500 $900 $750 3,000 $1,000 $1,000 $1,000 $1,500 6,600 $2,800 $2,550 $2,950 $3,300 1,200 $600 $600 $600 $600 1,800 $600 $900 $900 $900 2,700 $900 $900 $900 $900 900 $700 $150 $550 $360 ----------------------------$540 6,600 $2,800 $2,550 $2,950 $3,300
historic rate 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
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Local Current/ Monetary/ Temporal Current Currency Noncurrent Nonmonetary Rate 2,100 $1,050 $1,050 $1,050 $1,050 1,500 $750 $500 $900 $750 3,000 $1,000 $1,000 $1,000 $1,500 6,600 $2,800 $2,550 $2,950 $3,300 1,200 $600 $600 $600 $600 1,800 $600 $900 $900 $900 2,700 $900 $900 $900 $900 900 $700 $150 $550 $360 ----------------------------$540 6,600 $2,800 $2,550 $2,950 $3,300
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
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Local Current/ Monetary/ Temporal Current Currency Noncurrent Nonmonetary Rate 2,100 $1,050 $1,050 $1,050 $1,050 1,500 $750 $500 $900 $750 3,000 $1,000 $1,000 $1,000 $1,500 6,600 $2,800 $2,550 $2,950 $3,300 1,200 $600 $600 $600 $600 1,800 $600 $900 $900 $900 2,700 $900 $900 $900 $900 900 $700 $150 $550 $360 ----------------------------$540 6,600 $2,800 $2,550 $2,950 $3,300
historical rate
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
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Local Current/ Monetary/ Temporal Current Currency Noncurrent Nonmonetary Rate 2,100 $1,050 $1,050 $1,050 $1,050 1,500 $750 $500 $900 $750 3,000 $1,000 $1,000 $1,000 $1,500 6,600 $2,800 $2,550 $2,950 $3,300 1,200 $600 $600 $600 $600 1,800 $600 $900 $900 $900 2,700 $900 $900 $900 $900 900 $700 $150 $550 $360 ----------------------------$540 6,600 $2,800 $2,550 $2,950 $3,300
historical 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
21

Local Current/ Monetary/ Temporal Current Currency Noncurrent Nonmonetary Rate 2,100 $1,050 $1,050 $1,050 $1,050 1,500 $750 $500 $900 $750 3,000 $1,000 $1,000 $1,000 $1,500 6,600 $2,800 $2,550 $2,950 $3,300 1,200 $600 $600 $600 $600 1,800 $600 $900 $900 $900 2,700 $900 $900 $900 $900 900 $700 $150 $550 $360 ----------------------------$540 6,600 $2,800 $2,550 $2,950 $3,300
From income statement

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 Current Currency Noncurrent Nonmonetary Rate 2,100 $1,050 $1,050 $1,050 $1,050 1,500 $750 $500 $900 $750 3,000 $1,000 $1,000 $1,000 $1,500 6,600 $2,800 $2,550 $2,950 $3,300 1,200 $600 $600 $600 $600 1,800 $600 $900 $900 $900 2,700 $900 $900 $900 $900 900 $700 $150 $550 $360 ----------------------------$540 6,600 $2,800 $2,550 $2,950 $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 Current Income Statement Currency Noncurrent Nonmonetary Rate Sales 10,000 $4,000 $4,000 $4,000 $4,000 COGS 7,500 $3,000 $2,500 $3,000 $3,000 Depreciation 1,000 $333 $333 $333 $400 Net operating income 1,500 $667 $1,167 $667 $600 Income tax (40%) 600 $267 $467 $267 $240 Profit after tax 900 $400 $700 $400 $360 Foreign exchange gain (loss) $300 -$550 $150 Net income 900 $700 $150 $550 $360 Dividends 0 $0 $0 $0 $0 Addition to Retained Earnings 900 $700 $150 $550 $360

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

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

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

Translate at 2.50 = $1
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Translate at new exchange rate, 2.00 = $1

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

Local Current/ Monetary/ Temporal Current Income Statement Currency Noncurrent Nonmonetary Rate Sales 10,000 $4,000 $4,000 $4,000 $4,000 COGS 7,500 $3,000 $2,500 $3,000 $3,000 Depreciation 1,000 $333 $333 $333 $400 Net operating income 1,500 $667 $1,167 $667 $600 Income tax (40%) 600 $267 $467 $267 $240 Profit after tax 900 $400 $700 $400 $360 Foreign exchange gain (loss) $300 -$550 $150 Net income 900 $700 $150 $550 $360 Dividends 0 $0 $0 $0 $0 Addition to Retained Earnings 900 $700 $150 $550 $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 Current Income Statement Currency Noncurrent Nonmonetary Rate Sales 10,000 $4,000 $4,000 $4,000 $4,000 COGS 7,500 $3,000 $2,500 $3,000 $3,000 Depreciation 1,000 $333 $333 $333 $400 Net operating income 1,500 $667 $1,167 $667 $600 Income tax (40%) 600 $267 $467 $267 $240 Profit after tax 900 $400 $700 $400 $360 Foreign exchange gain (loss) $300 -$550 $150 Net income 900 $700 $150 $550 $360 Dividends 0 $0 $0 $0 $0 Addition to Retained Earnings 900 $700 $150 $550 $360
Note the effect on after-tax profit.
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14.1

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

Local Current/ Monetary/ Temporal Current Income Statement Currency Noncurrent Nonmonetary Rate Sales 10,000 $4,000 $4,000 $4,000 $4,000 COGS 7,500 $3,000 $2,500 $3,000 $3,000 Depreciation 1,000 $333 $333 $333 $400 Net operating income 1,500 $667 $1,167 $667 $600 Income tax (40%) 600 $267 $467 $267 $240 Profit after tax 900 $400 $700 $400 $360 Foreign exchange gain (loss) $300 -$550 $150 Net income 900 $700 $150 $550 $360 Dividends 0 $0 $0 $0 $0 Addition to Retained Earnings 900 $700 $150 $550 $360
Note the effect that foreign exchange gains (losses) has on net income.
14.1
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FAS8 superseded
Essentially the temporal method, with some subtleties, such as translating inventory at historical rates (a hassle). Required taking foreign exchange gains and losses through the income statement. This lead to variability in reported earnings (irritated corporate executives).
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The Mechanics of FAS52

Function Currency The currency that the business is conducted in. Reporting Currency The currency in which the MNC prepares its consolidated financial statements.
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The Mechanics of FAS52

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 FAS52

Parents currency
Foreign entitys books kept in?

Nonparent
Currency

Functional Currency?

Third currency

Local currency

Temporal Remeasurement

Parents Currency

Current Rate Translation

Parents Currency
14-31 Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved.

Highly Inflationary Economies

Highly inflationary economiesover 100% over three years 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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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 a accounting issue.

Transaction Exposure
A effect that unanticipated changes in exchange rates has on the firms cash flows a finance issue. 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. However, using a derivatives hedge to control translation exposure really involves speculation about foreign exchange rate changes.
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Translation Exposure versus Operating Exposure

The effect that unanticipated changes in exchange rates has on the firms ongoing operations. Operating (economic) 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 FAS8 to FAS52

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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Relevance of Translation (Accounting) Exposure

Should the exchange rate effect be shown as part of the reporting period, or should it just be mentioned on the balance sheet, as an unrealized gain or loss? Most of the gains are not realized a keep gains/losses out of income statement. Translation sounds great, but none of the three methods produces the true economic value.
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Relevance of Translation (Accounting) Exposure

Should we worry about translation exposure at all? If so, should we worry what the best translation method is? choice doesn't affect any real cashflow except for taxes. only correct method is economic value anyway a simplicity/consistency: Current rate method.
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The (Ir)relevance of Translation Exposure*

Economic exposure is far more relevant!

*P. Sercu and R. Uppal, International Financial Markets and the Firm, 1994
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ECONOMIC EXPOSURE:

ACCOUNTING EXPOSURE:

1. A forward looking concept: it focuses on future cashflows.

2. Involves real cashflows, not just accounting figures.

1. A backward-looking concept: it reflects past decisions as reflected in the subsidiary's assets and liabilities.
2. A change in an accounting value due to translation is not a "realized" gain or loss; no change in the cash situation is involved except possibly through taxation effects. 3. Changes the firm's accounting value, but not necessarily its market value.

3. Relates to changes in the economic value (or, in an efficient market, the market value) of the firm.
4. Contractual exposure depends on the firms portfolio of FC engagements undertaken in the past. Operating exposure depends on the environment (especially the market structure and the input-output mix) and on the firm's strategic response (e.g., relocation of production, changes in the marketing mix or financial structure, etc.). 5. Also exists for firms without foreign subsidiaries, such as exporting firms, import-competing firms, and notably potential import-competing firms.
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4. Depends on the accounting rules chosen. This is because the subsidiary's own internal rules affect its accounting values (e.g., type of depreciation, or inventory valuation methods) and also because the translation process itself can be done in different ways (see below).
5. Accounting exposure only exists in the case of foreign direct investment, since pure exporting or import-substituting firms have no foreign subsidiaries.