Management of Translation Exposure

Chapter Objective:

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Chapter Fourteen

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

Chapter Outline
Translation Methods Management of Translation Exposure
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Translation Exposure
Translation exposure, (also called accounting exposure), results from the need to restate foreign subsidiaries financial statements, usually stated in foreign currency, into the parents reporting currency when preparing the consolidated financial statements. Restating financial statements may lead to changes in the parents net worth or net income. Two methods

Current rate method Temporal Approach

The Current Rate Method

1. All assets and liabilities are translated at the rate in effect on the balance sheet date. 2. All items on the income statement are translated at an appropriate average exchange rate or at the rate prevailing when the various revenues, expenses, gains and losses were incurred (historical rate). 3. Dividends paid are translated at the rate in effect on the payment date. 4. Common stock and paid-in capital accounts are recorded at historical rates. Year-end retained earnings consist of Beginning RE plus or minus any income or loss for the year. Gains and losses resulting from translation are reported in a special reserve account on the consolidated balance sheet with such title as cumulative translation adjustment (CTA).
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The Current Rate Method

Advantages of CTA

Eliminates the variability of net earnings due to translation gains or losses. The relative proportions of individual balance sheet accounts remain the same (debt-to-equity ratio, for example). violates the accounting principle of carrying balance sheet accounts at historical cost.
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Main disadvantage of CTA

The Current Rate Method: An Example

Foreign Subsidiary, Inc., (FSI) has been acquired on December 31, 2000 when the exchange rate was LC1.25/$ (LC stands for FSIs local currency). On December 31, 2001, the exchange rate was LC1.15/$. The average exchange rate during 2001 was LC1.18/$. On December 31, 2002, the exchange rate was LC1.22/$. The average exchange rate during 2002 was LC1.20/$.

The Current Rate Method: An Example

The Current Rate Method: An Example

The Current Rate Method: An Example

The Current Rate Method: An Example

The Current Rate Method: An Example

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The Current Rate Method: An Example

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The Current Rate Method: An Example

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Temporal Method
Monetary assets (cash, marketable securities, AR) and monetary liabilities (current liabilities and LTD) are translated at the current ER (exchange rate at the balance sheet date). Non-monetary assets (inventory, fixed assets, etc.) and non-monetary liabilities are translated at their historical rate. Income statement items are translated at the average ER over the period, except for items that are associated with non-monetary assets or liabilities, such as COGS (inventory) and depreciation (fixed assets), which are translated at their historical rate. Dividends paid are translated at the rate in effect on the payment date. Equity items are translated at their historical rate, and include any imbalance.
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Temporal Method
Logic behind differentiating monetary and non-monetary assets: Translation gains and losses on monetary accounts are presumed meaningful components of expenses or revenue because monetary accounts closely approximate market values. Translation gains and losses on non-monetary accounts are less meaningful since non-monetary accounts reflect historical costs.

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Temporal Method
Gains and losses resulting from translation are carried directly to current consolidated income Unlike the current rate method these gains and losses do not go to an equity reserve account. FX gains and losses introduce volatility of consolidated earnings. This volatility is damped to the extent that many items in the temporal approach are translated at their historical costs. The main advantage of this method is that it complies with the accounting principle of carrying balance sheet accounts at historical cost.

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The Temporal Method: An Example

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The Temporal Method: An Example

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The Temporal Method: An Example

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The Temporal Method: An Example

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The Temporal Method: An Example

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The Temporal Method: An Example

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Hedging Translation Exposure

The managers have two methods for dealing with translation exposure. 1. Balance Sheet Hedge Eliminates the mismatch between net assets and net liabilities denominated in the same currency. May create transaction exposure, however. 2. 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 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

Transaction Exposure

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