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Management of Translation Exposure

INTERNATIONAL FINANCIAL MANAGEMENT
Fourth Edition EUN / RESNICK

Chapter Objective:

This chapter discusses the impact that unanticipated changes in exchange rates may Fourth Edition have on the consolidated financial statements of the multinational company. EUN / RESNICK
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INTERNATIONAL FINANCIAL MANAGEMENT

Chapter Ten

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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline
z z z z z

Translation Methods
z z z z

Translation Methods FASB Statement 8 FASB Statement 52 Management of Translation Exposure Empirical Analysis of the Change from FASB 8 to FASB 52

Current/Noncurrent Method Monetary/Nonmonetary Method Temporal Method Current Rate Method

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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Current/Noncurrent Method
z

Current/Noncurrent Method
z

The underlying principal is that assets and liabilities should be translated based on their maturity.
„ „

Current assets translated at the spot rate.
e.g. €2=$1

Balance Sheet

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.

z

z

This method of foreign currency translation was generally accepted in the United States from the 1930s until 1975, at which time FASB 8 became effective.
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Cash Inventory Noncurrent assets Net fixed assets Total Assets translated at the Current liabilities historical rate in Long-Term debt effect when the Common stock item was first Retained earnings recorded on the CTA books. Total Liabilities and e.g. €3=$1 Equity
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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

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

000 $1.00 €1. Temporal Method z Temporal Method z z z The underlying principal is that assets and liabilities should be translated based on how they are carried on the firm’s books. All rights reserved.100 $1.00 €1.600 $2. accounts receivable.400 Copyright © 2007 by The McGraw-Hill Companies.700 € 900 -------€ 6. marketable securities. Very simple method in application.000 $2.00 €900.00 -------€6. All other (nonmonetary) balance sheet accounts (owners’ equity.000. e.g. All rights reserved. Inc. 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.800 $900 € 2. e. Inc. €3=$1 10-9 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. 10-8 Copyright © 2007 by The McGraw-Hill Companies. Balance sheet account are translated at the current spot exchange rate if they are carried on the books at their current value. z Items carried on the books at their current value are translated at the spot exchange rate.g.700.600 Temporal $1.000 € 6. 10-6 Copyright © 2007 by The McGraw-Hill Companies.400 Copyright © 2007 by The McGraw-Hill Companies.100. .200 $600 € 1.300 10-10 Copyright © 2007 by The McGraw-Hill Companies.€3=$1 10-7 Local Monetary/ Currency Nonmonetary € 2.500 € 3. A “plug” equity account named cumulative translation adjustment is used to make the balance sheet balance. Inc.00 €6.000 € 6.g.500.Monetary/Nonmonetary Method z Monetary/Nonmonetary Method z z z 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.200 € 1. All rights reserved. z All monetary Balance Sheet balance sheet Cash accounts are Inventory translated at the current exchange Net fixed assets Total Assets rate.500 $3.g.950 $600 $900 $900 $0 -------$2.300 $600 $900 $900 $360 $540 $3.050 € 1.600 $2.800. e.00 €2. €2=$1 Current liabilities All other balance sheet accounts are Long-Term debt Common stock translated at the historical exchange Retained earnings rate in effect when CTA the account was first Total Liabilities and Equity recorded. A “plug” equity account named cumulative translation adjustment is used to make the balance sheet balance 10-11 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 €2.550 € 1.100 € 1.600. Inc. All rights reserved.00 €1. e.500 $500 € 3.200.600 € 1.00 Current Rate $1. Current Rate Method z Current Rate Method z z z All balance sheet items (except for stockholder’s equity) are translated at the current exchange rate. All rights reserved. Inc.050 $900 $1.050 $750 $1. Copyright © 2007 by The McGraw-Hill Companies. etc.800 € 2. All rights reserved. land) are translated at the historical exchange rate in effect when the account was first recorded. z All balance sheet items (except for stockholder’s equity) are translated at the current exchange rate. €2=$1 Items that are carried on the books at historical costs are translated at the historical exchange rates. All monetary balance sheet accounts (cash.00 €3.) of a foreign subsidiary are translated at the current exchange rate.700 $900 € 900 $0 --------------€ 6.600. Inc.

050 $750 $1.000 $1.300 Local Current/ Monetary/ Temporal Currency Noncurrent Nonmonetary €2.500 $3.100 $1.050 $1.300 $600 $900 $900 $360 $540 $3.700 $900 $900 $900 €900 $700 $150 $550 ----------------------------€6. All rights reserved.200 $600 $600 $600 €1.950 €1.000 €6.800 $600 $900 $900 €2.800 $600 $900 $900 €2. All rights reserved.950 €1.050 €1.000 $1.950 €1. Inc.000 €6.300 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 Local Current/ Monetary/ Temporal Currency Noncurrent Nonmonetary €2.800 $2.800 $600 inventory $900 $900 €2.000 $1. Copyright © 2007 by The McGraw-Hill Companies.100 $1. All rights reserved.000 $1. All rights reserved.000 $1.050 €1.600 $2.950 Current Rate $1.000 €6.500 $3.550 $2.550 $2.800 $2. 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 Currency Noncurrent Nonmonetary €2.050 €1.500 $3.700 $900 $900 $900 €900 $700 $150 $550 ----------------------------€6.600 $2.800 $2.600 $2.700 $900 $900 $900 €900 $700 $150 $550 ----------------------------€6.050 €1.600 $2.950 Current Rate $1.500 $750 $500 $900 €3.050 $1.800 $2.500 $750 $500 $900 €3.200 $600 $600 $600 value of €1.800 $2.550 $2.000 $1. Copyright © 2007 by The McGraw-Hill Companies.550 $2.300 $600 $900 $900 $360 $540 $3. 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 Currency Noncurrent Nonmonetary €2.000 $1.100 $1.950 Current Rate $1.050 $750 $1.300 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 Local Current/ Monetary/ Temporal Currency Noncurrent Nonmonetary €2.550 $2.550 $2.050 $1.000 $1.100 $1.600 $2. All rights reserved.500 $750 $500 $900 €3.050 $1.800 $2.700 $900 $900 $900 €900 $700 $150 $550 ----------------------------€6.800 $2.950 Current Rate $1. Copyright © 2007 by The McGraw-Hill Companies.000 €6.600 $2.550 $2.550 $2.050 €1.950 €1.000 $1.550 $2.200 $600 $600 $600 €1.950 €1.950 Book €1.600 $2. .300 $600 $900 $900 $360 $540 $3.050 $1.000 $1.200 $600 $600 $600 €1.000 €6.300 historical rate 10-16 spot rate 10-17 historical rate Copyright © 2007 by The McGraw-Hill Companies. Inc.300 $600 $900 $900 $360 $540 $3.050 $750 $1.000 $1.100 $1.300 $600 $900 $900 $360 $540 $3.050 $750 $1. Inc.550 $2.300 historic rate 10-14 spot exchange rate 10-15 spot rate Copyright © 2007 by The McGraw-Hill Companies.600 $2.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 10-12 How Various Translation Methods Deal with a Change from €3 to €2 = $1 Balance Sheet Local Current/ Monetary/ Temporal Currency Noncurrent Nonmonetary €2. All rights reserved.050 $750 $1.000 $1.050 $1.800 $600 $900 $900 €2.800 $2. Inc.300 $600 $900 $900 $360 $540 $3.000 €6.000 $1.800 $2.000 $1.050 $750 $1.100 $1. Current value of inventory at spot exchange rate.600 $2.000 $1.050 $1.050 $1.500 $3.000 $1.500 $750 $500 $900 €3.600 $2.050 $1.000 $1.500 $3.950 Spot exchange rate Current Rate $1.550 $2.800 $600 $900 $900 €2.000 $1.300 Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Book value of inventory at spot exchange rate 10-13 Copyright © 2007 by The McGraw-Hill Companies.800 $2.550 $2.800 $2.500 $750 $500 $900 €3.950 Current Rate $1.200 $600 $600 $600 €1.050 $1.800 $600 $900 $900 €2.200 $600 $600 $600 €1.050 $1.800 $2.500 $3.050 €1.600 $2.700 $900 $900 $900 €900 $700 $150 $550 ----------------------------€6.500 $750 $500 $900 €3.600 $2. Inc.700 $900 historic $900 $900 €900 $700 rate $150 $550 ----------------------------€6. Inc.050 $1.

000 COGS € 7.000 $4.000 Depreciation € 1.600 $2.1 Copyright © 2007 by The McGraw-Hill Companies.050 €1.000 $3.500 $667 $1.200 $600 $600 $600 €1. €2. All rights reserved.000 $1.600 $2.000 $1.167 $667 Income tax (40%) € 600 $267 $467 $267 Profit after tax € 900 $400 $700 $400 Foreign exchange gain (loss) $300 -$550 $150 Net income € 900 $700 $150 $550 Dividends €0 $0 $0 $0 Addition to Retained Earnings € 900 $700 $150 $550 Current Rate $4. 10-23 For notes.500 $3. How Various Translation Methods Deal with a Change from €3 to €2 = $1 Local Current/ Monetary/ Temporal Income Statement Currency Noncurrent Nonmonetary Sales € 10.000 $2.000 $333 $333 $333 Net operating income € 1.500 $3. Inc. Copyright © 2007 by The McGraw-Hill Companies. All rights reserved.500 $3.950 Current Rate $1.000 $333 $333 $333 Net operating income € 1.1 Copyright © 2007 by The McGraw-Hill Companies.000 $333 $333 $333 Net operating income € 1.000 $1.000 $333 $333 $333 Net operating income € 1.300 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 Local Current/ Monetary/ Temporal Currency Noncurrent Nonmonetary €2.050 $750 $1.800 $2.050 $1.1 Copyright © 2007 by The McGraw-Hill Companies.050 $750 $1.700 $900 $900 $900 €900 $700 $150 $550 ----------------------------€6.200 $600 $600 $600 €1.500 $3. Translate at €2.500 $3.600 $2. see Exhibit 14.950 €1. see Exhibit 14.000 $400 $600 $240 $360 $360 $0 $360 How Various Translation Methods Deal with a Change from €3 to €2 = $1 Local Current/ Monetary/ Temporal Income Statement Currency Noncurrent Nonmonetary Sales € 10.500 $750 $500 $900 €3.000 €6.000 $4.000 $4.00 = $1 For notes.550 $2.000 $1.800 $2.500 $667 $1.167 $667 Income tax (40%) € 600 $267 $467 $267 Profit after tax € 900 $400 $700 $400 Foreign exchange gain (loss) $300 -$550 $150 Net income € 900 $700 $150 $550 Dividends €0 $0 $0 $0 Addition to Retained Earnings € 900 $700 $150 $550 Current Rate $4. All rights reserved. .000 $3.000 €6.550 $2.050 $1.000 $4. Inc.800 $600 $900 $900 €2.000 $3.000 COGS € 7.800 $2.100 $1.000 $400 $600 $240 $360 $360 $0 $360 How Various Translation Methods Deal with a Change from €3 to €2 = $1 Local Current/ Monetary/ Temporal Income Statement Currency Noncurrent Nonmonetary Sales € 10.500 $3.000 $4.500 $750 $500 $900 €3.1 10-20 Copyright © 2007 by The McGraw-Hill Companies.000 $4.500 $667 $1. Note the effect on after-tax profit.800 $2.500 $3.000 $4.500 $3.000 $400 $600 $240 $360 $360 $0 $360 Sales translate at average exchange rate over the period.000 $1.50 = $1 10-21 Translate at new exchange rate.000 $3.950 Current Rate $1.000 $4.167 $667 Income tax (40%) € 600 $267 $467 $267 Profit after tax € 900 $400 $700 $400 Foreign exchange gain (loss) $300 -$550 $150 Net income € 900 $700 $150 $550 Dividends €0 $0 $0 $0 Addition to Retained Earnings € 900 $700 $150 $550 Current Rate $4. All rights reserved.000 Depreciation € 1. €2.000 COGS € 7.300 $600 $900 $900 $360 $540 $3.000 Depreciation € 1. Inc. All rights reserved. Inc. All rights reserved. see Exhibit 14.000 $2. Inc.50 = $1 For notes. a “plug” equity account named cumulative translation adjustment makes the balance sheet balance.700 $900 $900 $900 €900 $700 $150 $550 ----------------------------€6.167 $667 Income tax (40%) € 600 $267 $467 $267 Profit after tax € 900 $400 $700 $400 Foreign exchange gain (loss) $300 -$550 $150 Net income € 900 $700 $150 $550 Dividends €0 $0 $0 $0 Addition to Retained Earnings € 900 $700 $150 $550 Current Rate $4.000 $4. €2.050 $1.000 COGS € 7.300 From income statement 10-18 Copyright © 2007 by The McGraw-Hill Companies.000 $4.050 €1.000 $4.5 = $1 For notes.950 €1.000 $4. 10-19 Under the current rate method.050 $1.000 $400 $600 $240 $360 $360 $0 $360 Translate at €3 = $1 10-22 Translate at average exchange rate.600 $2.000 $2.800 $600 $900 $900 €2. How Various Translation Methods Deal with a Change from €3 to €2 = $1 Local Current/ Monetary/ Temporal Income Statement Currency Noncurrent Nonmonetary Sales € 10.500 $667 $1.500 $3.000 Depreciation € 1.550 $2.300 $600 $900 $900 $360 $540 $3. see Exhibit 14.550 $2.000 $1.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 Currency Noncurrent Nonmonetary €2.000 $2.100 $1. Inc.500 $3.

„ Such as translating inventory at historical rates. FASB Statement 52 z The Mechanics of FASB Statement 52 z The Mechanics of the FASB 52 Translation Process „ „ Function Currency „ The currency that the business is conducted in.1 Copyright © 2007 by The McGraw-Hill Companies. Which leads to irritated corporate executives.000 $2. 10-27 Copyright © 2007 by The McGraw-Hill Companies. The Mechanics of FASB Statement 52 z The Mechanics of FASB Statement 52 Parent’s currency Foreign entity’s books kept in? Two-Stage Process „ „ „ First.000 Depreciation € 1.000 $4. Second. All rights reserved. If the local currency in which the foreign entity keeps its books is not the functional currency. 10-28 . The currency in which the MNC prepares its consolidated financial statements. Inc.500 $3. which is a hassle.167 $667 Income tax (40%) € 600 $267 $467 $267 Profit after tax € 900 $400 $700 $400 Foreign exchange gain (loss) $300 -$550 $150 Net income € 900 $700 $150 $550 Dividends €0 $0 $0 $0 Addition to Retained Earnings € 900 $700 $150 $550 Current Rate $4. determine in which currency the foreign entity keeps its books.500 $667 $1. see Exhibit 14. All rights reserved.000 $4.500 $3.000 COGS € 7. All rights reserved. remeasurement into the functional currency is required. z z z Requires taking foreign exchange gains and losses through the income statement. 10-25 Copyright © 2007 by The McGraw-Hill Companies. when the foreign entity’s functional currency is not the same as the parent’s currency.How Various Translation Methods Deal with a Change from €3 to €2 = $1 Local Current/ Monetary/ Temporal Income Statement Currency Noncurrent Nonmonetary Sales € 10. 10-24 For notes. Inc. Inc. Inc.000 $333 $333 $333 Net operating income € 1. All rights reserved. Copyright © 2007 by The McGraw-Hill Companies. Nonparent Currency Functional Currency? Third currency Local currency Temporal Remeasurement Parent’s Currency Current Rate Translation Parent’s Currency 10-29 Copyright © 2007 by The McGraw-Hill Companies. the foreign entity’s books are translated using the current rate method.000 $4.000 $3. Note the effect that foreign exchange gains (losses) has on net income. Inc. All rights reserved. All rights reserved.000 $400 $600 $240 $360 $360 $0 $360 FASB Statement 8 z Essentially the temporal method. with some subtleties. Function Currency Reporting Currency z Reporting Currency „ z Highly Inflationary Economies 10-26 Copyright © 2007 by The McGraw-Hill Companies. This leads to variability in reported earnings. Inc.

Inc. Transaction Exposure Hedging Translation Exposure „ „ Balance Sheet Hedge Derivatives Hedge z Translation Exposure vs. 10-33 Copyright © 2007 by The McGraw-Hill Companies. Balance Sheet Hedge z Derivatives Hedge z z Eliminates the mismatch between net assets and net liabilities denominated in the same currency. All rights reserved. . Translation Exposure vs. The effect that unanticipated changes in exchange rates has on the firm’s cash flows. Inc. All rights reserved. z An example would be the use of forward contracts with a maturity of the reporting period to attempt to manage the accounting numbers. All rights reserved. Operating Exposure 10-30 Copyright © 2007 by The McGraw-Hill Companies. however. Translation Exposure versus Transaction Exposure z Hedging Translation Exposure z Translation Exposure „ „ The effect that unanticipated changes in exchange rates has on the firm’s consolidated financial statements. z Transaction Exposure „ „ If the managers of the firm wish to manage their accounting numbers as well as their business. All rights reserved. May create transaction exposure. Inc. 10-32 Copyright © 2007 by The McGraw-Hill Companies. they have two methods for dealing with translation exposure. „ „ Balance Sheet Hedge Derivatives Hedge z It is generally not possible to eliminate both translation exposure and transaction exposure. however. Inc. Using a derivatives hedge to control translation exposure really involves speculation about foreign exchange rate changes. A finance issue and the subject of Chapter 13. All rights reserved. All rights reserved. 10-31 Copyright © 2007 by The McGraw-Hill Companies.Highly Inflationary Economies z Management of Translation Exposure z z Foreign entities are required to remeasure financial statements using the temporal method “as if the functional currency were the reporting currency”. 10-35 Copyright © 2007 by The McGraw-Hill Companies. An accounting issue. 10-34 Copyright © 2007 by The McGraw-Hill Companies. Inc. Inc.

All rights reserved. This highlights the futility of attempting to manage translation gains and losses. Other researchers have found similar results when investigating other accounting changes. z z z There did not appear to be a revaluation of firms’ values following the change.Translation Exposure versus Operating Exposure z Empirical Analysis of the Change from FASB 8 to FASB 52 z z The effect that unanticipated changes in exchange rates has on the firm’s ongoing operations. This suggests that market participants do not react to cosmetic earnings changes. 10-36 Copyright © 2007 by The McGraw-Hill Companies. All rights reserved. Inc. . All rights reserved. Inc. 10-37 Copyright © 2007 by The McGraw-Hill Companies. End Chapter Ten 10-38 Copyright © 2007 by The McGraw-Hill Companies. Operating exposure is a substantive issue with which the management of the firm should concern itself with. Inc.