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 parent’s 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 parent’s 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 company’s 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 subsidiary’s business
operations (subsidiary characterization).
• For example, a foreign subsidiary’s business can be
categorized as either an integrated foreign entity or a self-
sustaining 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 subsidiary’s 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 item’s 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 world’s 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 firm’s 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 firm’s 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 firm’s 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 O’Connor 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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