Chapter 14 Management of Translation Exposure Management 3460 Institutions and Practices in...
-
Upload
beryl-cobb -
Category
Documents
-
view
222 -
download
0
Transcript of Chapter 14 Management of Translation Exposure Management 3460 Institutions and Practices in...
Chapter 14 Management of
Translation Exposure
Management 3460 Institutions and Practices in
International Finance
Fall 2003Greg Flanagan
Nov 27, 2003 2
Chapter Objectivesdefine 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.
Nov 27, 2003 3
Chapter Objectivesdiscuss and differentiate various
translation methods:current/noncurrentmonetary/nonmonetarytemporalcurrent rate
Nov 27, 2003 4
Chapter Objectives (continued)summarize the FASB statement 52discuss 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
Nov 27, 2003 5
Definition
Translation Exposure – the potential that the firm’s consolidated financial statements can be affected by changes in exchange rates.
Nov 27, 2003 6
Why do we Care about Translation?
managers, analysts and investors need some idea about the importance of the foreign business 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.
Nov 27, 2003 7
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.
Nov 27, 2003 8
Current/Noncurrent Method
Current assets /liabilities translated at the spot rate.i.e. €2=$1
Noncurrent assets /liabilities translated at the historical rate in effect when the item was first recorded 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 $2,800 Current liabilities € 1,200 $600 Long-Term debt € 1,800 $600 Common stock € 2,700 $900 Retained earnings € 900 $700CTA -------- --------Total Liabilities and
Equity€ 6,600 $2,800
Nov 27, 2003 9
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
Nov 27, 2003 10
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
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 $2,550 Current liabilities € 1,200 $600 Long-Term debt € 1,800 $900 Common stock € 2,700 $900 Retained earnings € 900 $0CTA -------- --------Total Liabilities and
Equity€ 6,600 $2,400
Nov 27, 2003 11
Temporal Method The underlying principal is that assets and
liabilities should be translated based on how they are carried on the firm’s 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.
Nov 27, 2003 12
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 Local Currency
Temporal
Cash € 2,100 $1,050 Inventory € 1,500 $900Net fixed assets € 3,000 $1,000
Total Assets € 6,600 $2,950 Current liabilities € 1,200 $600 Long-Term debt € 1,800 $900 Common stock € 2,700 $900 Retained earnings € 900 $0CTA -------- --------Total Liabilities and
Equity€ 6,600 $2,400
Nov 27, 2003 13
Current Rate MethodAll balance sheet items (except for
stockholder’s 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.
Nov 27, 2003 14
Current Rate Method All balance sheet
items (except for stockholder’s 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
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 $3,300 Current 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
Nov 27, 2003 15
How Various Translation Methods Deal 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 $360CTA -------- -------- -------- -------- $540
Total Liabilities and Equity
€6,600 $2,800 $2,550 $2,950 $3,300
Spot exchange rate
Nov 27, 2003 16
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 $360CTA -------- -------- -------- -------- $540
Total Liabilities and Equity
€6,600 $2,800 $2,550 $2,950 $3,300
How Various Translation Methods Deal with a Change from €3 to €2 = $1
Book value of inventory at spot exchange rate
Book value of
inventory historic
rate
Current value of inventory at spot exchange rate.
Nov 27, 2003 17
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 $360CTA -------- -------- -------- -------- $540
Total Liabilities and Equity
€6,600 $2,800 $2,550 $2,950 $3,300
How Various Translation Methods Deal with a Change from €3 to €2 = $1
historic rate spot exchange rate
Nov 27, 2003 18
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 $360CTA -------- -------- -------- -------- $540
Total Liabilities and Equity
€6,600 $2,800 $2,550 $2,950 $3,300
How Various Translation Methods Deal with a Change from €3 to €2 = $1
spot rate
Nov 27, 2003 19
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 $360CTA -------- -------- -------- -------- $540
Total Liabilities and Equity
€6,600 $2,800 $2,550 $2,950 $3,300
How Various Translation Methods Deal with a Change from €3 to €2 = $1
spot ratehistorical rate
Nov 27, 2003 20
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 $360CTA -------- -------- -------- -------- $540
Total Liabilities and Equity
€6,600 $2,800 $2,550 $2,950 $3,300
How Various Translation Methods Deal with a Change from €3 to €2 = $1
historical rate
Nov 27, 2003 21
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 $360CTA -------- -------- -------- -------- $540
Total Liabilities and Equity
€6,600 $2,800 $2,550 $2,950 $3,300
How Various Translation Methods Deal with a Change from €3 to €2 = $1
From income statement
Nov 27, 2003 22
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 $360CTA -------- -------- -------- -------- $540
Total Liabilities and Equity
€6,600 $2,800 $2,550 $2,950 $3,300
How Various Translation Methods Deal with a Change from €3 to €2 = $1
Under the current rate method, a “plug” equity account named cumulative translation adjustment makes the balance sheet balance.
Nov 27, 2003 23
How Various Translation Methods Deal with a Change from €3 to €2 = $1
Sales translate at average exchange rate over the period, €2.50 = $1
Income StatementLocal
CurrencyCurrent/
Noncurrent Monetary/
NonmonetaryTemporal Current
RateSales € 10,000 $4,000 $4,000 $4,000 $4,000COGS € 7,500 $3,000 $2,500 $3,000 $3,000Depreciation € 1,000 $333 $333 $333 $400Net operating income € 1,500 $667 $1,167 $667 $600Income tax (40%) € 600 $267 $467 $267 $240Profit after tax € 900 $400 $700 $400 $360
$300 -$550 $150Net income € 900 $700 $150 $550 $360Dividends € 0 $0 $0 $0 $0Addition to Retained
Earnings € 900 $700 $150 $550 $360
Foreign exchange gain (loss)
Nov 27, 2003 24
Income StatementLocal
CurrencyCurrent/
Noncurrent Monetary/
NonmonetaryTemporal Current
RateSales € 10,000 $4,000 $4,000 $4,000 $4,000COGS € 7,500 $3,000 $2,500 $3,000 $3,000Depreciation € 1,000 $333 $333 $333 $400Net operating income € 1,500 $667 $1,167 $667 $600Income tax (40%) € 600 $267 $467 $267 $240Profit after tax € 900 $400 $700 $400 $360
$300 -$550 $150Net income € 900 $700 $150 $550 $360Dividends € 0 $0 $0 $0 $0Addition to Retained
Earnings € 900 $700 $150 $550 $360
Foreign exchange gain (loss)
How Various Translation Methods Deal with a Change from €3 to €2 = $1
Translate at €2.50 = $1 Translate at new exchange rate, €2.00 = $1
Nov 27, 2003 25
Income StatementLocal
CurrencyCurrent/
Noncurrent Monetary/
NonmonetaryTemporal Current
RateSales € 10,000 $4,000 $4,000 $4,000 $4,000COGS € 7,500 $3,000 $2,500 $3,000 $3,000Depreciation € 1,000 $333 $333 $333 $400Net operating income € 1,500 $667 $1,167 $667 $600Income tax (40%) € 600 $267 $467 $267 $240Profit after tax € 900 $400 $700 $400 $360
$300 -$550 $150Net income € 900 $700 $150 $550 $360Dividends € 0 $0 $0 $0 $0Addition to Retained
Earnings € 900 $700 $150 $550 $360
Foreign exchange gain (loss)
How Various Translation Methods Deal with a Change from €3 to €2 = $1
Translate at €3 = $1 Translate at average exchange rate, €2.5 = $1
Nov 27, 2003 26
Income StatementLocal
CurrencyCurrent/
Noncurrent Monetary/
NonmonetaryTemporal Current
RateSales € 10,000 $4,000 $4,000 $4,000 $4,000COGS € 7,500 $3,000 $2,500 $3,000 $3,000Depreciation € 1,000 $333 $333 $333 $400Net operating income € 1,500 $667 $1,167 $667 $600Income tax (40%) € 600 $267 $467 $267 $240Profit after tax € 900 $400 $700 $400 $360
$300 -$550 $150Net income € 900 $700 $150 $550 $360Dividends € 0 $0 $0 $0 $0Addition to Retained
Earnings € 900 $700 $150 $550 $360
Foreign exchange gain (loss)
How Various Translation Methods Deal with a Change from €3 to €2 = $1
14.1Note the effect on after-tax profit.
Nov 27, 2003 27
Income StatementLocal
CurrencyCurrent/
Noncurrent Monetary/
NonmonetaryTemporal Current
RateSales € 10,000 $4,000 $4,000 $4,000 $4,000COGS € 7,500 $3,000 $2,500 $3,000 $3,000Depreciation € 1,000 $333 $333 $333 $400Net operating income € 1,500 $667 $1,167 $667 $600Income tax (40%) € 600 $267 $467 $267 $240Profit after tax € 900 $400 $700 $400 $360
$300 -$550 $150Net income € 900 $700 $150 $550 $360Dividends € 0 $0 $0 $0 $0Addition to Retained
Earnings € 900 $700 $150 $550 $360
Foreign exchange gain (loss)
How Various Translation Methods Deal with a Change from €3 to €2 = $1
14.1Note the effect that foreign exchange gains (losses) has on net income.
Nov 27, 2003 28
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).
Nov 27, 2003 29
The Mechanics of FAS52
Function CurrencyThe currency that the business is
conducted in.Reporting Currency
The currency in which the MNC prepares its consolidated financial statements.
Nov 27, 2003 30
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 entity’s functional currency is not the same as the parent’s currency, the foreign entity’s books are translated using the current rate method.
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 14-31
Current Rate
Translation
Parent’s Currency
Foreign entity’s books
kept in?
Par
ent’
s C
urre
ncy
Functional Currency?
Local currency Temporal Remeasurement
Parent’s currency
Nonparent
Currency
Third currency
The Mechanics of FAS52
Nov 27, 2003 32
Highly Inflationary Economies
Highly inflationary economies—over 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”.
Nov 27, 2003 33
Management of Translation Exposure
Translation Exposure vs. Transaction Exposure
Hedging Translation ExposureBalance Sheet HedgeDerivatives Hedge
Translation Exposure vs. Operating Exposure
Nov 27, 2003 34
Translation Exposure versus Transaction Exposure
Translation ExposureThe effect that unanticipated changes in exchange
rates has on the firm’s consolidated financial statements accounting issue.
Transaction ExposureA effect that unanticipated changes in exchange
rates has on the firm’s cash flows finance issue. It is generally not possible to eliminate both
translation exposure and transaction exposure.
Nov 27, 2003 35
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 HedgeDerivatives Hedge
Nov 27, 2003 36
Balance Sheet Hedge
Eliminates the mismatch between net assets and net liabilities denominated in the same currency.
May create transaction exposure, however.
Nov 27, 2003 37
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.
Nov 27, 2003 38
Translation Exposure versus Operating Exposure
The effect that unanticipated changes in exchange rates has on the firm’s ongoing operations.
Operating (economic) exposure is a substantive issue with which the management of the firm should concern itself with.
Nov 27, 2003 39
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.
Nov 27, 2003 40
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 keep gains/losses out of income statement.
Translation sounds great, but none of the three methods produces the true economic value.
Nov 27, 2003 41
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
simplicity/consistency: Current rate method.
Nov 27, 2003 42
The (Ir)relevance of Translation Exposure*
Economic exposure is far more relevant!
*P. Sercu and R. Uppal, International Financial Markets and the Firm, 1994
Nov 27, 2003 43
ECONOMIC EXPOSURE:
1. A forward looking concept: it focuses on future 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 firm’s 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.
ACCOUNTING EXPOSURE:
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.
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.