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Chapter 10 Chapter 10

Translation Exposure Translation Exposure
ƒ Learning Objectives
• Demonstrate how translation practices result in a foreign
exchange exposure for the multinational enterprise
• Explain the meaning behind the designation of a foreign
subsidiary’s “functional currency”
• Illustrate both the theoretical and practical differences between
two primary methods of converting foreign currency
denominated financial statements into the reporting currency of
the parent company
Prepared by Shafiq Jadallah
• Compare translation exposure with operating exposure
To Accompany • Analyze the costs and benefits of managing translation exposure
Fundamentals of Multinational Finance
Michael H. Moffett, Arthur I. Stonehill, David K. Eiteman
Copyright © 2003 Pearson Education, Inc. Slide 10-1 Copyright © 2003 Pearson Education, Inc. Slide 10-2

Translation Exposure Subsidiary Characterization
ƒ Translation exposure, also called accounting exposure, arises ƒ Most countries specify the translation method to be
because the financial statements of foreign subsidiaries must used by a foreign subsidiary based upon its operations
be restated in the parent’s reporting currency for the firm to
prepare its consolidated financial statements ƒ A foreign subsidiary can be classified as
ƒ Translation exposure is the potential for an increase or • Integrated Foreign Entity – one which operates as an
decrease in the parent’s net worth and reported income caused extension of the parent company, with cash flows and
by a change in exchange rates since the last transaction line items that are highly integrated with the parent
ƒ Translation methods differ by country along two dimensions • Self-sustaining Foreign Entity – one which operates
• One is a difference in the way a foreign subsidiary is in the local economy independent of its parent
characterized depending on its independence
• The other is the definition of which currency is most important
ƒ The foreign subsidiary should be valued in terms of
for the subsidiary the currency that is the basis of its economic viability

Copyright © 2003 Pearson Education, Inc. Slide 10-3 Copyright © 2003 Pearson Education, Inc. Slide 10-4

Functional Currency Translation Methods
ƒ A foreign affiliate’s functional currency is the ƒ There are two basic methods for the translation of
currency of the primary economic environment in foreign subsidiary financial statements
which the subsidiary operates • The current rate method
ƒ The geographic location of a subsidiary and its • The temporal method
functional currency can be different ƒ Regardless of which is used, either method must
designate
• Example: US subsidiary located in Singapore may find
that its functional currency could be • The exchange rate at which individual balance sheet
and income statement items are remeasured
– US dollars (integrated subsidiary)
• Where any imbalances are to be recorded
– Singapore dollars (self-sustaining subsidiary)
– This can affect either the balance sheet or the income
– British pounds (self-sustaining subsidiary) statement

Copyright © 2003 Pearson Education, Inc. Slide 10-5 Copyright © 2003 Pearson Education, Inc. Slide 10-6

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year end retained earnings consist of year-beginning plus or minus any income or foreign subsidiary translation loss on the year plus or minus any imbalance from translation ƒ Under the temporal method. Slide 10-9 Copyright © 2003 Pearson Education. rather than through the ƒ Income statement items – all items are translated at either the company’s consolidated income statement actual exchange rate on the dates the various revenues. Inc. then the temporal method becomes exchange rate for the period except for depreciation and cost of goods sold which are associated with non- the monetary/non-monetary method monetary items. Slide 10-10 Temporal Method US Translation Procedures ƒ Line items included in this method are ƒ The US differentiates foreign subsidiaries on the • Distributions – dividends paid are translated at the basis of functional currency. Inc. ƒ These cumulative gains and losses from expenses. Slide 10-8 Temporal Method Temporal Method ƒ Under this method. Slide 10-11 Copyright © 2003 Pearson Education. specific assets and liabilities are ƒ Line items included in this method are translated at exchange rates consistent with the timing • Monetary assets (primarily cash. gains and losses were incurred or at a weighted remeasurement are only recognized in current average exchange rate for the period income under the current rate method when the ƒ Distributions – dividends paid are translated at the rate in foreign subsidiary giving rise to that gain or loss is effect on the date of payment liquidated ƒ Equity items – common stock and paid-in capital are translated at historical rates. Inc. Inc. following are the procedures for translated at historical rates. any gains or losses from remeasurement are carried directly to current consolidated income and not to equity reserves Copyright © 2003 Pearson Education. year end retained earnings consist of year-beginning plus or minus any income or loss on the year Copyright © 2003 Pearson Education. Slide 10-7 Copyright © 2003 Pearson Education. accounts receivable. Inc. these items are translated at their historical rate Copyright © 2003 Pearson Education. Current Rate Method Current Rate Method ƒ Under this method all financial statement items are translated at the “current” exchange rate ƒ Any gain or loss from re-measurement is closed to ƒ Assets & liabilities – are translated at the rate of exchange in an equity reserve account entitled the cumulative effect on the balance sheet date translation adjustment. Inc. not subsidiary exchange rate in effect the date of payment characterization • Equity items – common stock and paid-in capital are ƒ Under US GAAP. of the item’s creation and long-term receivables) and all monetary liabilities are translated at current exchange rates ƒ The temporal method assumes that a number of line • Non-monetary assets (primarily inventory and plant items such as inventories and net plant and equipment and equipment) are translated at historical exchange are restated to reflect market value rates ƒ If these items were not restated and carried at • Income statement items – are translated at the average historical costs. Slide 10-12 2 .

Inc.2760/€ “disappearing asset” ƒ Inventory on hand was purchased or manufactured during the • If the current rate method were used. common stock. Slide 10-17 Copyright © 2003 Pearson Education. depreciation would immediately prior quarter when the average exchange rate was be overstated in real terms and the book value of the $1. and long-term debt were acquired by • The rationale is to correct the problem of the Trident Europe at a past rate of $1. the following determinations need to be made. Inc.3200/€ Copyright © 2003 Pearson Education. Translation Is the local currency the functional currency? Procedures No Yes Is the dollar the Translated to dollars functional currency? (current rate method) Remeasure from foreign currency to functional No Yes Remeasure to dollars (temporal method) (temporal method) and translate to dollars (current rate method) Copyright © 2003 Pearson Education. dollars If the financial statements of the foreign subsidiary US are expressed in a foreign currency. US Translation Procedures Purpose: Foreign currency financial statements must be translated into U.2180/€ physical assets would disappear from the balance sheet ƒ The example will also look at the consequences had the euro appreciated to $1. Inc. Inc. Slide 10-15 Copyright © 2003 Pearson Education. Slide 10-13 Copyright © 2003 Pearson Education. Inc. we now shift from Trident’s operating exposure to its statements of US subsidiaries operating in countries translation exposure where cumulative inflation has been approximately ƒ Recall that the euro depreciated by 16. Slide 10-14 Hyperinflation Countries Translation Example – Trident Europe ƒ As we continue with our Trident example from the previous ƒ FAS #52 has a special provision for translating chapter.S. Inc. Slide 10-16 Trident Europe: Current Method Trident Europe: Temporal Method Copyright © 2003 Pearson Education.000/€ in January 2003 ƒ Financial statements of these subsidiaries must be ƒ The functional currency of the subsidiary is the euro and the currency of the parent is US dollars translated using the temporal method ƒ PP&E. Slide 10-18 3 .200/€ in December 2002 to $1.67% or moved from 100% or more for over a three-year period $1.

it could minimize translation exposure by reducing net exposed assets • If management expects appreciation. under these same circumstances shows Case 1: Depreciation of euro ($1. Inc. Inc.914) Loss on operations that Germany is more desirable location because of the Case 2: Volume doubles $2. Slide 10-19 Copyright © 2003 Pearson Education.892 Gain on operations • This illustrates the importance of focusing decisions on operating consequences and not accounting based consequences Copyright © 2003 Pearson Education.033. Inc. it should increase net exposed assets to benefit from the gain Copyright © 2003 Pearson Education. not only in magnitude but in sign Translation Exposure ƒ A manager focusing only on translation losses might avoid Current rate method ($1. Slide 10-21 Copyright © 2003 Pearson Education. Inc.106 Gain on operations operating consequences Case 3: Sales price increase $3.000) Loss on translation • The manager might fear losses tied to reported profits Operating Exposure ƒ Operating exposure.866. Trident Europe: Comparison Managerial Implications ƒ In the previous slides. Slide 10-24 4 .600. the translation loss or gain is larger under the current rate method because inventory and PP&E as well as monetary assets are deemed exposed ƒ The managerial implications are • If management expects a currency to depreciate. Inc. Inc. Slide 10-20 Comparing Translation Exposure Comparing Translation Exposure to Operating Exposure to Operating Exposure ƒ Translation gains or losses can be different from operating Exposure Amount Gain or Loss gains or losses. Slide 10-23 Copyright © 2003 Pearson Education.742. Slide 10-22 Managing Translation Exposure Managing Translation Exposure ƒ Balance Sheet Hedge – this requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet • A change in exchange rates will change the value of exposed assets but offset that with an opposite change in liabilities • This is termed monetary balance • The cost of this method depends on relative borrowing costs in the varying currencies Copyright © 2003 Pearson Education.000) Loss on translation countries because of likelihood of such losses Temporal method ($160.

Inc. Inc. this calls for having an equal amount of exposed foreign currency assets and liabilities ƒ Even if management chooses to follow an active policy of hedging translation exposure. Slide 10-28 Summary of Learning Objectives ƒ The main technique for managing translation exposure is a balance sheet hedge. Slide 10-26 Summary of Learning Objectives Summary of Learning Objectives ƒ Translation exposure results from translating foreign ƒ Technical aspects of translation include questions currency denominated financial statements into the about when to recognize gains or losses in the income parent’s consolidated reporting currency statement. Inc. Managing Translation Exposure Choosing Which Exposure to ƒ When is a balance sheet hedge justified? Minimize • The foreign subsidiary is about to be liquidated so that ƒ As a general matter. not only in which it operates magnitude but in direction. the distinction between functional and ƒ Translation exposure is the potential for loss or gain reporting currency and the treatment of subsidiaries from this translation process in hyperinflation countries ƒ A foreign subsidiary’s functional currency is the ƒ Translation gains and losses can be quite different currency of the primary economic environment in from operating gains and losses. Slide 10-27 Copyright © 2003 Pearson Education. firms seeking to reduce both the value of its CTA would be realized types of exposures typically reduce transaction • The firm has debt covenants or bank agreements that exposure first state the firm’s debt/equity ratios will be maintained within specific limits ƒ They then recalculate translation exposure and then • Management is evaluated on the basis of certain decide if any residual translation exposure can be income statement and balance sheet measures that are reduced without creating more transaction exposure affected by translation losses or gains • The foreign subsidiary is operating in a hyperinflationary environment Copyright © 2003 Pearson Education. Slide 10-25 Copyright © 2003 Pearson Education. Slide 10-29 5 . Inc. Inc. most managers will choose to reduce transaction exposure first and then translation exposure Copyright © 2003 Pearson Education. management may need to ƒ The two basic procedures for translation used in most determine which is of greater significance countries today are the current rate and the temporal method Copyright © 2003 Pearson Education. it is nearly impossible to offset both transaction and translation exposure simultaneously. if forced.