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Chapter 14

Management ofTranslation Exposure

Management 3460Institutions and Practices in

International Finance

Fall 2003Greg Flanagan

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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 haveon the consolidated financialstatements of the multinational

company.

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Chapter Objectives

discuss and differentiate varioustranslation methods:

lcurrent/noncurrent

lmonetary/nonmonetaryltemporal

lcurrent rate

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Chapter Objectives (continued)

summarize the FASB statement 52discuss the management of

translation exposure.

evaluate the empirical analysis of thechange 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 potentialthat the firms consolidated financialstatements can be affected bychanges in exchange rates.

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Why do we Care aboutTranslation?

managers, analysts and investors need someidea about the importance of the foreignbusiness a translated accounting data give anapproximate idea of this.

performance measurement for bonus plans,hiring, firing, and promotion decisions.

accounting value serves as a benchmark toevaluate valuation.

for income tax purposes. legal requirement to consolidate financial

statements.

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Current/Noncurrent Method

The underlying principal is that assets andliabilities should be translated based ontheir maturity.lcurrent assets translated at the spot rate.

lnoncurrent assets translated at thehistorical rate in effect when the item wasfirst recorded on the books.

generally accepted in the US from the 1930s

-1975, at which time FAS8 becameeffective.Short-term gains/losses will be recognized

long term will not be.

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Current/Noncurrent Method

Current assets/liabilitiestranslated atthe spot rate.

i.e. 2=$1 Noncurrent

assets/liabilitiestranslated at

the historicalrate in effectwhen the itemwas firstrecorded on the

books. i.e.3=$1

Balance Sheet Local Currency

Current/Noncurrent

Cash 2,100 $1,050

Inventory 1,500 $750

Net fixed assets 3,000 $1,000

Total Assets 6,600 $2,800Current liabilities 1,200 $600

Long-Term debt 1,800 $600

Common stock 2,700 $900

Retained earnings 900 $700

CTA -------- --------

Total Liabilities an

Equity

6,600 $2,800

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Monetary/NonmonetaryMethod

The underlying principle is that monetary accountshave a similarity because their value represents asum of money whose value changes as theexchange rate changes.

All monetary balance sheet accounts (cash,marketable securities, accounts receivable, etc.)of a foreign subsidiary are translated at the currentexchange rate.

All other (nonmonetary) balance sheet accounts(owners equity, land) are translated at the

historical exchange rate in effect when theaccount was first recorded. i.e. PPP

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Monetary/NonmonetaryMethod

All monetarybalance sheetaccounts aretranslated at thecurrent exchange

rate. i.e. 2=$1 All other balance

sheet accountsare translated atthe historical

exchange rate ineffect when theaccount was firstrecorded. i.e.

3=$1

Balance Sheet Local

Currency

Monetary/

Nonmonetary

Cash 2,100 $1,050

Inventory 1,500 $500

Net fixed assets 3,000 $1,000

Total Assets 6,600 $2,550Current liabilities 1,200 $600

Long-Term debt 1,800 $900

Common stock 2,700 $900

Retained earnings 900 $0

CTA -------- --------

Total Liabilities andEquity

6,600 $2,400

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Temporal Method

The underlying principal is that assets andliabilities should be translated based onhow they are carried on the firms books.

Balance sheet account are translated at the

current spot exchange rate if they arecarried on the books at their current value.

Items that are carried on the books at

historical costs are translated at thehistorical exchange rates in effect at thetime the firm placed the item on the books.

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Temporal Method Items carried on

the books at theircurrent value aretranslated at thespot exchangerate. i.e. 2=$1

Items that arecarried on thebooks athistorical costsare translated atthe historical

exchange rates.i.e. 3=$1

Balance Sheet Local Currency

Temporal

Cash 2,100 $1,050

Inventory 1,500 $900

Net fixed assets 3,000 $1,000

Total Assets 6,600 $2,950

Current liabilities 1,200 $600Long-Term debt 1,800 $900

Common stock 2,700 $900

Retained earnings 900 $0

CTA -------- --------

Total Liabilities and

Equity

6,600 $2,400

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Current Rate Method

All balance sheet items (except forstockholders equity) are translated at thecurrent exchange rate.

Very simple method in application.

A plug equity account named cumulativetranslation adjustment is used to makethe balance sheet balance.

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Current Rate Method

All balance sheetitems (except forstockholdersequity) aretranslated at the

current exchangerate. i.e.2=$1 A plug equity

account namedcumulative

translationadjustment isused to make thebalance sheetbalance

Balance Sheet Local

Currency

Current

Rate

Cash 2,100.00 $1,050

Inventory 1,500.00 $750

Net fixed assets 3,000.00 $1,500

Total Assets 6,600.00 $3,300Current liabilities 1,200.00 $600

Long-Term debt 1,800.00 $900

Common stock 2,700.00 $900

Retained earnings 900.00 $360

CTA -------- $540

Total Liabilities

and Equity

6,600.00 $3,300

H V i T l i M h d

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How Various Translation MethodsDeal with a Changefrom 3 to 2 = $1

Balance Sheet Local

Currency

Current/

Noncurrent

Monetary/

Nonmonetary

Temporal Current

Rate

Cash 2,100 $1,050 $1,050 $1,050 $1,050

Inventory 1,500 $750 $500 $900 $750

Net fixed assets 3,000 $1,000 $1,000 $1,000 $1,500

Total Assets 6,600 $2,800 $2,550 $2,950 $3,300

Current liabilities 1,200 $600 $600 $600 $600

Long-Term debt 1,800 $600 $900 $900 $900

Common stock 2,700 $900 $900 $900 $900

Retained earnings 900 $700 $150 $550 $360

CTA -------- -------- -------- -------- $540Total Liabilities

and Equity

6,600 $2,800 $2,550 $2,950 $3,300

Spot exchange rate

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Balance Sheet Local

Currency

Current/

Noncurrent

Monetary/

Nonmonetary

Temporal Current

Rate

Cash 2,100 $1,050 $1,050 $1,050 $1,050

Inventory 1,500 $750 $500 $900 $750

Net fixed assets 3,000 $1,000 $1,000 $1,000 $1,500

Total Assets 6,600 $2,800 $2,550 $2,950 $3,300

Current liabilities 1,200 $600 $600 $600 $600

Long-Term debt 1,800 $600 $900 $900 $900

Common stock 2,700 $900 $900 $900 $900

Retained earnings 900 $700 $150 $550 $360

CTA -------- -------- -------- -------- $540

Total Liabilities

and Equity

6,600 $2,800 $2,550 $2,950 $3,300

How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1

Book value of inventoryat spot exchange rate

Bookvalue of

inventoryhistoric

rate

Current value of inventoryat spot exchange rate.

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Balance Sheet Local

Currency

Current/

Noncurrent

Monetary/

Nonmonetary

Temporal Current

Rate

Cash 2,100 $1,050 $1,050 $1,050 $1,050

Inventory 1,500 $750 $500 $900 $750

Net fixed assets 3,000 $1,000 $1,000 $1,000 $1,500Total Assets 6,600 $2,800 $2,550 $2,950 $3,300

Current liabilities 1,200 $600 $600 $600 $600

Long-Term debt 1,800 $600 $900 $900 $900

Common stock 2,700 $900 $900 $900 $900

Retained earnings 900 $700 $150 $550 $360

CTA -------- -------- -------- -------- $540Total Liabilities

and Equity

6,600 $2,800 $2,550 $2,950 $3,300

How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1

historic rate spot exchange rate

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Balance Sheet Local

Currency

Current/

Noncurrent

Monetary/

Nonmonetary

Temporal Current

Rate

Cash 2,100 $1,050 $1,050 $1,050 $1,050

Inventory 1,500 $750 $500 $900 $750

Net fixed assets 3,000 $1,000 $1,000 $1,000 $1,500Total Assets 6,600 $2,800 $2,550 $2,950 $3,300

Current liabilities 1,200 $600 $600 $600 $600

Long-Term debt 1,800 $600 $900 $900 $900

Common stock 2,700 $900 $900 $900 $900

Retained earnings 900 $700 $150 $550 $360

CTA -------- -------- -------- -------- $540Total Liabilities

and Equity

6,600 $2,800 $2,550 $2,950 $3,300

How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1

spot rate

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Balance Sheet Local

Currency

Current/

Noncurrent

Monetary/

Nonmonetary

Temporal Current

Rate

Cash 2,100 $1,050 $1,050 $1,050 $1,050

Inventory 1,500 $750 $500 $900 $750

Net fixed assets 3,000 $1,000 $1,000 $1,000 $1,500Total Assets 6,600 $2,800 $2,550 $2,950 $3,300

Current liabilities 1,200 $600 $600 $600 $600

Long-Term debt 1,800 $600 $900 $900 $900

Common stock 2,700 $900 $900 $900 $900

Retained earnings 900 $700 $150 $550 $360

CTA -------- -------- -------- -------- $540Total Liabilities

and Equity

6,600 $2,800 $2,550 $2,950 $3,300

How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1

spot ratehistorical rate

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Balance Sheet Local

Currency

Current/

Noncurrent

Monetary/

Nonmonetary

Temporal Current

Rate

Cash 2,100 $1,050 $1,050 $1,050 $1,050

Inventory 1,500 $750 $500 $900 $750

Net fixed assets 3,000 $1,000 $1,000 $1,000 $1,500Total Assets 6,600 $2,800 $2,550 $2,950 $3,300

Current liabilities 1,200 $600 $600 $600 $600

Long-Term debt 1,800 $600 $900 $900 $900

Common stock 2,700 $900 $900 $900 $900

Retained earnings 900 $700 $150 $550 $360

CTA -------- -------- -------- -------- $540Total Liabilities

and Equity

6,600 $2,800 $2,550 $2,950 $3,300

How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1

historical rate

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Balance Sheet Local

Currency

Current/

Noncurrent

Monetary/

Nonmonetary

Temporal Current

Rate

Cash 2,100 $1,050 $1,050 $1,050 $1,050

Inventory 1,500 $750 $500 $900 $750

Net fixed assets 3,000 $1,000 $1,000 $1,000 $1,500Total Assets 6,600 $2,800 $2,550 $2,950 $3,300

Current liabilities 1,200 $600 $600 $600 $600

Long-Term debt 1,800 $600 $900 $900 $900

Common stock 2,700 $900 $900 $900 $900

Retained earnings 900 $700 $150 $550 $360

CTA -------- -------- -------- -------- $540Total Liabilities

and Equity

6,600 $2,800 $2,550 $2,950 $3,300

How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1

From income statement

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Balance Sheet Local

Currency

Current/

Noncurrent

Monetary/

Nonmonetary

Temporal Current

Rate

Cash 2,100 $1,050 $1,050 $1,050 $1,050

Inventory 1,500 $750 $500 $900 $750

Net fixed assets 3,000 $1,000 $1,000 $1,000 $1,500

Total Assets 6,600 $2,800 $2,550 $2,950 $3,300Current liabilities 1,200 $600 $600 $600 $600

Long-Term debt 1,800 $600 $900 $900 $900

Common stock 2,700 $900 $900 $900 $900

Retained earnings 900 $700 $150 $550 $360

CTA -------- -------- -------- -------- $540

Total Liabilities

and Equity

6,600 $2,800 $2,550 $2,950 $3,300

How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1

Under the current rate method, a plug equity account namedcumulative translation adjustment makes the balance sheet balance.

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How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1

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

Income StatementLocal

CurrencyCurrent/

NoncurrentMonetary/

NonmonetaryTemporal Current

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 incom 1,500 $667 $1,167 $667 $600

Income tax (40%) 600 $267 $467 $267 $240Profit after tax 900 $400 $700 $400 $360

$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

Foreign exchange gain (loss)

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Income Statement

Local

Currency

Current/

Noncurrent

Monetary/

Nonmonetary

Temporal Current

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 incom 1,500 $667 $1,167 $667 $600

Income tax (40%) 600 $267 $467 $267 $240

Profit after tax 900 $400 $700 $400 $360

$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

Foreign exchange gain (loss)

How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1

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

How Various Translation

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Income Statement

Local

Currency

Current/

Noncurrent

Monetary/

Nonmonetary

Temporal Current

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 incom 1,500 $667 $1,167 $667 $600

Income tax (40%) 600 $267 $467 $267 $240

Profit after tax 900 $400 $700 $400 $360

$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

Foreign exchange gain (loss)

How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1

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

How Various Translation

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Income Statement

Local

Currency

Current/

Noncurrent

Monetary/

Nonmonetary

Temporal Current

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 incom 1,500 $667 $1,167 $667 $600Income tax (40%) 600 $267 $467 $267 $240

Profit after tax 900 $400 $700 $400 $360

$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

Foreign exchange gain (loss)

How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1

14.1Note the effect on after-tax profit.

How Various Translation

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Income Statement

Local

Currency

Current/

Noncurrent

Monetary/

Nonmonetary

Temporal Current

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 incom 1,500 $667 $1,167 $667 $600

Income tax (40%) 600 $267 $467 $267 $240

Profit after tax 900 $400 $700 $400 $360

$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

Foreign exchange gain (loss)

How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1

14.1

Note the effect that foreign exchange gains (losses) has on net income.

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FAS8 superseded

Essentially the temporal method, with somesubtleties,

lsuch as translating inventory athistorical rates (a hassle).

Required taking foreign exchange gains andlosses through the income statement.

This lead to variability in reported earnings

(irritated corporate executives).

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The Mechanics of FAS52

Function CurrencylThe currency that the business is

conducted in.

Reporting CurrencylThe currency in which the MNC

prepares its consolidated

financial statements.

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The Mechanics of FAS52Two-Stage Process

First, determine in which currency the foreignentity keeps its books.lIf the local currency in which the foreign entity

keeps its books is not the functionalcurrency, remeasurement into the functionalcurrency is required.

Second, when the foreign entitys functional

currency is not the same as the parentscurrency, the foreign entitys books aretranslated using the current rate method.

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

Current Rate

Translation

Parents Currency

Foreignentitys books

kept in?

Pare

nts

Currency

FunctionalCurrency?

Local currency TemporalRemeasurement

Parents currency

Nonparent

Currency

Third currency

The Mechanics of FAS52

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Highly InflationaryEconomies

Highly inflationary economiesover100% over three years

Foreign entities are required toremeasure financial statementsusing the temporal method as if thefunctional currency were the

reporting currency.

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Management of TranslationExposure

Translation Exposure vs. TransactionExposure

Hedging Translation Exposure

lBalance Sheet Hedge

lDerivatives Hedge

Translation Exposure vs. OperatingExposure

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Translation Exposure versusTransaction Exposure

Translation ExposurelThe effect that unanticipated changes in

exchange rates has on the firms consolidatedfinancial statements a accounting issue.

Transaction ExposurelA effect that unanticipated changes in

exchange rates has on the firms cash flowsa

finance issue.It is generally not possible to eliminate both

translation exposure and transaction exposure.

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Hedging TranslationExposure

If the managers of the firm wish tomanage their accounting numbers aswell as their business, they have two

methods for dealing with translationexposure.

lBalance Sheet Hedge

lDerivatives Hedge

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Balance Sheet Hedge

Eliminates the mismatch between netassets and net liabilitiesdenominated in the same currency.

May create transaction exposure,however.

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Derivatives Hedge

An example would be the use offorward contracts with a maturity ofthe reporting period to attempt to

manage the accounting numbers.However, using a derivatives hedge

to control translation exposure really

involves speculation about foreignexchange rate changes.

T l ti E

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Translation Exposure versusOperating Exposure

The effect that unanticipated changesin exchange rates has on the firmsongoing operations.

Operating (economic) exposure is asubstantive issue with which themanagement of the firm should

concern itself with.

E i i l A l i f th

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Empirical Analysis of theChange from FAS8 to FAS52

There did not appear to be a revaluation offirms values following the change.

This suggests that market participants do

not react to cosmetic earnings changes.Other researchers have found similar

results when investigating otheraccounting changes.

This highlights the futility of attempting tomanage translation gains and losses.

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Relevance of Translation(Accounting) Exposure

Should the exchange rate effect be shownas part of the reporting period, or shouldit just be mentioned on the balancesheet, as an unrealized gain or loss?

Most of the gains are not realized a keepgains/losses out of income statement.

Translation sounds great, but none of the

three methods produces the trueeconomic value.

f

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Relevance of Translation(Accounting) Exposure

Should we worry about translation exposureat 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 valueanyway

a simplicity/consistency: Current rate method.

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ECONOMIC EXPOSURE: ACCOUNTING EXPOSURE:

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ECONOMIC EXPOSURE:

1. A forward looking concept: it focuses onfuture cashflows.2. Involves real cashflows, not just accounting

figures.

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 firmsportfolio of FC engagements undertaken inthe past. Operating exposure depends on theenvironment (especially the market structureand the input-output mix) and on the firm'sstrategic response (e.g., relocation ofproduction, changes in the marketing mix orfinancial structure, etc.).

5. Also exists for firms without foreignsubsidiaries, such as exporting firms, import-competing firms, and notablypotentialimport-competing firms.

ACCOUNTING EXPOSURE:

1. A backward-looking concept: it reflects pastdecisions as reflected in the subsidiary's assets andliabilities.

2. A change in an accounting value due totranslation is not a "realized" gain or loss; nochange in the cash situation is involved exceptpossibly through taxation effects.3. Changes the firm's accounting value, but notnecessarily its market value.

4. Depends on the accounting rules chosen. This isbecause the subsidiary's own internal rules affectits accounting values (e.g., type of depreciation, orinventory valuation methods) and also because thetranslation process itself can be done in differentways (see below).

5. Accounting exposure only exists in the case offoreign direct investment, since pure exporting orimport-substituting firms have no foreignsubsidiaries.