Chapter 13

Translation Exposure

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Overview of Translation
Translation exposure, also called accounting exposure, arises because financial statements of foreign subsidiaries which are stated in foreign currency must be restated in the parents reporting currency for the firm to prepare consolidated financial statements. The accounting process of translation, involves converting these foreign subsidiaries financial statements into US dollar-denominated statements.
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Overview of Translation
Translation exposure is the potential for an increase or decrease in the parents net worth and reported net income caused by a change in exchange rates since the last translation.

While the main purpose of translation is to prepare consolidated statements, management uses translated statements to assess performance (facilitation of comparisons across many geographically distributed subsidiaries).
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Overview of Translation
Translation in principle is simple:
Foreign currency financial statements must be restated in the parent companys reporting currency
If the same exchange rate were used to remeasure each and every line item on the individual statement (I/S and B/S), there would be no imbalances resulting from the remeasurement What if a different exchange rate were used for different line items on an individual statement (I/S and B/S)? An imbalance would result

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Overview of Translation
Why would we use a different exchange rate in remeasuring different line items?
Translation principles in many countries are often a complex compromise between historical and current market valuation. Historical exchange rates can be used for certain equity accounts, fixed assets, and inventory items, while current exchange rates can be used for current assets, current liabilities, income, and expense items.
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Overview of Translation
Most countries today specify the translation method used by a foreign subsidiary based on the subsidiarys business operations (subsidiary characterization). For example, a foreign subsidiarys business can be categorized as either an integrated foreign entity or a selfsustaining foreign entity. An integrated foreign entity is one that operates as an extension of the parent, with cash flows and business lines that are highly interrelated. A self-sustaining foreign entity is one that operates in the local economic environment independent of the parent company.

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Overview of Translation
A foreign subsidiarys functional currency is the currency of the primary economic environment in which the subsidiary operates and in which it generates cash flows. In other words, it is the dominant currency used by that foreign subsidiary in its day-to-day operations. The US, requires that the functional currency of the foreign subsidiary be determined based on the nature and purpose of the subsidiary.
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Overview of Translation
Two basic methods for the translation of foreign subsidiary financial statements are employed worldwide: The current rate method The temporal method Regardless of which method is employed, a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured, but also designate where any imbalance is to be recorded (current income or an equity reserve account).

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Overview of Translation
The current rate method is the most prevalent in the world today.
Assets and liabilities are translated at the current rate of exchange Income statement items are translated at the exchange rate on the dates they were recorded or an appropriately weighted average rate for the period Dividends (distributions) are translated at the rate in effect on the date of payment

Common stock and paid-in capital accounts are translated at historical rates

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Overview of Translation
Gains or losses caused by translation adjustments are not included in the calculation of consolidated net income. Rather, translation gains or losses are reported separately and accumulated in a separate equity reserve account (on the B/S) with a title such as cumulative translation adjustment (CTA). The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings).

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Overview of Translation
Under the temporal method, specific assets are translated at exchange rates consistent with the timing of the items creation. This method assumes that a number of individual line item assets such as inventory and net plant and equipment are restated regularly to reflect market value. Gains or losses resulting from remeasurement are carried directly to current consolidated income, and not to equity reserves (increased variability of consolidated earnings).

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Overview of Translation
If these items were not restated but were instead carried at historical cost, the temporal method becomes the monetary/nonmonetary method of translation. Monetary assets and liabilities are translated at current exchange rates Nonmonetary assets and liabilities are translated at historical rates Income statement items are translated at the average exchange rate for the period Dividends (distributions) are translated at the exchange rate on the date of payment Equity items are translated at historical rates

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Overview of Translation
The US differentiates foreign subsidiaries on the basis of functional currency, not subsidiary characterization. If the financial statements of the foreign subsidiary are maintained in US dollars, translation is not required If the statements are maintained in the local currency, and the local currency is the functional currency, they are translated by the current rate method If the statements are maintained in local currency, and the US dollar is the functional currency, they are remeasured by the temporal method If the statements are in local currency and neither the local currency or the US dollar is the functional currency, the statements must first be remeasured into the functional currency by the temporal method, and then translated into US dollars by the current rate method
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Exhibit 13.2 Procedure Flow Chart for United States Translation Practices

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Overview of Translation
Many of the worlds largest industrial countries as well as the relatively newly formed International Accounting Standards Committee (IASC) follow the same basic translation procedure:
A foreign subsidiary is an integrated foreign entity or a self-sustaining foreign entity Integrated foreign entities are typically remeasured using the temporal method Self-sustaining foreign entities are translated at the current rate method, also termed the closing-rate method.

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Translation Example: Trident Europe

The functional currency of Trident Europe is the euro, and the reporting currency of its parent, Trident Corporation, is the U.S. dollar
Plant and equipment and long-term debt and common stock issued some time in the past when the exchange rate was $1.2760/ Inventory currently on hand was purchased or manufactured during the immediately prior quarter when the average exchange rate was $1.2180/

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Exhibit 13.4 Trident Europe: Translation Loss Just after Depreciation of the Euro

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Exhibit 13.5 Trident Europe: Translation Loss or Gain: Comparison of Current Rate and Temporal Methods

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Translation Example: Trident Europe

As seen in exhibit 13.4 and 13.5, the translation loss or gain is larger under the current rate method because inventory and net plant and equipment, as well as all monetary assets, are deemed exposed The managerial implications of this fact are very important Depending on accounting method of the moment, management might select different assets and liabilities for reduction or increase as a result impacting real decisions
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Managing Translation Exposure

The main technique to minimize translation exposure is called a balance sheet hedge. A balance sheet hedge requires an equal amount of exposed foreign currency assets and liabilities on a firms consolidated balance sheet. If this can be achieved for each foreign currency, net translation exposure will be zero. If a firm translates by the temporal method, a zero net exposed position is called monetary balance. Complete monetary balance cannot be achieved under the current rate method.

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Managing Translation Exposure

The cost of a balance sheet hedge depends on relative borrowing costs. These hedges are a compromise in which the denomination of balance sheet accounts is altered, perhaps at a cost in terms of interest expense or operating efficiency, to achieve some degree of foreign exchange protection.

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Managing Translation Exposure

If a firms subsidiary is using the local currency as the functional currency, the following circumstances could justify when to use a balance sheet hedge: The foreign subsidiary is about to be liquidated, so that the value of its CTA would be realized The firm has debt covenants or bank agreements that state the firms debt/equity ratios will be maintained within specific limits Management is evaluated on the basis of certain income statement and balance sheet measures that are affected by translation losses or gains The foreign subsidiary is operating in a hyperinflationary environment

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Mini-Case Questions: La Jolla Engineering Services Do you believe Meaghan OConnor should spend time and resources attempting to manage translation losses, which many consider to be purely an accounting phenomenon? How would you characterize or structure your analysis of each of the individual country threats to La Jolla? What specific features of their individual problems seem to be intertwined with currency issues? What would you recommend Meaghan do?
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Chapter 13

Additional Chapter Exhibits

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Exhibit 13.1 Economic Indicators for Determining the Functional Currency

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Exhibit 13.3 Comparison of Translation Methods Employed in Selected Countries

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Exhibit 13.6 Comparison of Translation Exposure with Operating Exposure, Depreciation of Euro from $1.200/ to $1.0000/ for Trident Europe

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Exhibit 13.7 Trident Europe, Balance Sheet Exposure

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Exhibit 1 Monthly Average Exchange Rates: Jamaican Dollars per U.S. Dollar

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Exhibit 2 Monthly Average Exchange Rates: Mexican Pesos per U.S. Dollar

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Exhibit 3 Monthly Average Exchange Rates: Venezuelan Bolivars per U.S. Dollar

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