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Management 3460

Institutions and Practices in


International Finance
Fall 2003
Greg Flanagan

Chapter 14
Management of
Translation Exposure
Chapter Objectives
¢define translation exposure.
¢explain why we care about translation
¢explain the impact that unanticipated
changes in exchange rates may have
on the consolidated financial
statements of the multinational
company.
¢

2 Nov 27, 2003


Chapter Objectives
¢discuss and differentiate various
translation methods:
lcurrent/noncurrent
lmonetary/nonmonetary
ltemporal
lcurrent rate

3 Nov 27, 2003


Chapter Objectives (continued)
¢summarize the FASB statement 52
¢discuss the management of
translation exposure.
¢evaluate the empirical analysis of the
change from FAS8 to FAS52.
¢discuss the importance of translation
exposure in comparison with
economic and transaction exposure

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Definition

¢Translation Exposure – the potential


that the firm’s consolidated financial
statements can be affected by
changes in exchange rates.

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Why do we Care about
Translation?
¢ managers, analysts and investors need some
idea about the importance of the foreign
business a translated accounting data give an
approximate idea of this.
¢ performance measurement for bonus plans,
hiring, firing, and promotion decisions.
¢ accounting value serves as a benchmark to
evaluate valuation.
¢ for income tax purposes.
¢ legal requirement to consolidate financial
statements.
6 Nov 27, 2003
Current/Noncurrent Method
¢The underlying principal is that assets and
liabilities should be translated based on
their maturity.
lcurrent assets translated at the spot rate.
lnoncurrent assets translated at the
historical rate in effect when the item was
first recorded on the books.
¢generally accepted in the US from the 1930s
-1975, at which time FAS8 became
effective.
¢Short-term gains/losses will be recognized
long term will not be.
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Current/Noncurrent Method
Balance Sheet Local Current/
¢ Current assets Currency Noncurrent
/liabilities Cash € 2,100 $1,050
translated at Inventory € 1,500 $750
the spot rate. Net fixed assets € 3,000 $1,000
 i.e. €2=$1 Total Assets € 6,600 $2,800
Current liabilities € 1,200 $600
¢ Noncurrent
Long-Term debt € 1,800 $600
assets Common stock € 2,700 $900
/liabilities Retained earnings € 900 $700
translated at
the historical CTA -------- --------
rate in effect Total Liabilities and € 6,600 $2,800
Equity
when the item
was first
recorded on the
books.8 i.e. Nov 27, 2003

€3=$1
Monetary/Nonmonetary
Method
¢ 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.
¢ All monetary balance sheet accounts (cash,
marketable securities, accounts receivable, etc.)
of a foreign subsidiary are translated at the current
exchange rate.
¢ All other (nonmonetary) balance sheet accounts
(owners’ equity, land) are translated at the
historical exchange rate in effect when the
account was first recorded. i.e. PPP
9 Nov 27, 2003
Monetary/Nonmonetary
Method
¢ All monetary
balance sheet Balance Sheet Local Monetary/
Currency Nonmonetary
accounts are
Cash € 2,100 $1,050
translated at the Inventory € 1,500 $500
current exchange Net fixed assets € 3,000 $1,000
rate. i.e. €2=$1 Total Assets € 6,600 $2,550
¢ All other balance Current liabilities € 1,200 $600
sheet accounts Long-Term debt € 1,800 $900
are translated at Common stock € 2,700 $900
Retained earnings € 900 $0
the historical
exchange rate in CTA -------- --------
Total Liabilities and € 6,600 $2,400
effect when the Equity
account was first
recorded. i.e.
€3=$1
¢ 10 Nov 27, 2003
Temporal Method
¢The underlying principal is that assets and
liabilities should be translated based on
how they are carried on the firm’s books.
¢Balance sheet account are translated at the
current spot exchange rate if they are
carried on the books at their current value.
¢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.

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Temporal Method
¢ Items carried on
Balance Sheet Local Temporal
the books at their Currency
current value are Cash € 2,100 $1,050
translated at the Inventory € 1,500 $900
spot exchange Net fixed assets € 3,000 $1,000
rate. i.e. €2=$1 Total Assets € 6,600 $2,950
¢ Items that are Current liabilities € 1,200 $600
carried on the Long-Term debt € 1,800 $900
books at Common stock € 2,700 $900
historical costs Retained earnings € 900 $0
are translated at CTA -------- --------
the historical Total Liabilities and € 6,600 $2,400
exchange rates. Equity
i.e. €3=$1

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Current Rate Method
¢All balance sheet items (except for
stockholder’s equity) are translated at the
current exchange rate.
¢Very simple method in application.
¢A “plug” equity account named cumulative
translation adjustment is used to make
the balance sheet balance.

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Current Rate Method
Balance Sheet Local Current
¢ All balance sheet Currency Rate
items (except for
stockholder’s Cash €2,100.00 $1,050
equity) are Inventory €1,500.00 $750
translated at the Net fixed assets €3,000.00 $1,500
current exchange Total Assets €6,600.00 $3,300
rate. i.e. €2=$1 Current liabilities €1,200.00 $600
¢ A “plug” equity Long-Term debt €1,800.00 $900
account named
cumulative Common stock €2,700.00 $900
translation Retained earnings €900.00 $360
adjustment is CTA -------- $540
used to make the Total Liabilities €6,600.00 $3,300
balance sheet and Equity
balance
14 Nov 27, 2003
How Various Translation Methods
Deal with a Change
from €3 to €2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash €2,100 $1,050 $1,050 $1,050 $1,050
Inventory €1,500 $750 $500 $900 $750
Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500
Total Assets €6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities €1,200 $600 $600 $600 $600
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
Retained earnings €900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540
Total Liabilities €6,600 $2,800 $2,550 $2,950 $3,300
and Equity

15 Spot exchange rate Nov 27, 2003


How Various Translation
Methods Deal with a Change
from €3 to €2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash €2,100 $1,050 $1,050 $1,050 $1,050
Inventory €1,500 $750 $500 $900 $750
Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500
Total Assets €6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities €1,200 $600 $600 $600 $600
Long-Term debt €1,800 $600 Book
$900 $900 $900
Common stock €2,700 $900 value
$900 of $900 $900
Retained earnings €900 $700 inventory
$150 $550 $360
CTA -------- -------- historic --------
-------- $540
Total Liabilities €6,600 $2,800 rate $2,950
$2,550 $3,300
and Equity

Book value of inventory Current value of inventory


at spot exchange rate at spot exchange rate.
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How Various Translation
Methods Deal with a Change
from €3 to €2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash €2,100 $1,050 $1,050 $1,050 $1,050
Inventory €1,500 $750 $500 $900 $750
Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500
Total Assets €6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities €1,200 $600 $600 $600 $600
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
Retained earnings €900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540
Total Liabilities €6,600 $2,800 $2,550 $2,950 $3,300
and Equity

historic rate spot exchange rate


Nov 27, 2003
17
How Various Translation
Methods Deal with a Change
from €3 to €2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash €2,100 $1,050 $1,050 $1,050 $1,050
Inventory €1,500 $750 $500 $900 $750
Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500
Total Assets €6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities €1,200 $600 $600 $600 $600
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
Retained earnings €900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540
Total Liabilities €6,600 $2,800 $2,550 $2,950 $3,300
and Equity

spot rate
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How Various Translation
Methods Deal with a Change
from €3 to €2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash €2,100 $1,050 $1,050 $1,050 $1,050
Inventory €1,500 $750 $500 $900 $750
Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500
Total Assets €6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities €1,200 $600 $600 $600 $600
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
Retained earnings €900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540
Total Liabilities €6,600 $2,800 $2,550 $2,950 $3,300
and Equity

historical rate spot rate Nov 27, 2003


19
How Various Translation
Methods Deal with a Change
from €3 to €2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash €2,100 $1,050 $1,050 $1,050 $1,050
Inventory €1,500 $750 $500 $900 $750
Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500
Total Assets €6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities €1,200 $600 $600 $600 $600
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
Retained earnings €900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540
Total Liabilities €6,600 $2,800 $2,550 $2,950 $3,300
and Equity

historical rate
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How Various Translation
Methods Deal with a Change
from €3 to €2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash €2,100 $1,050 $1,050 $1,050 $1,050
Inventory €1,500 $750 $500 $900 $750
Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500
Total Assets €6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities €1,200 $600 $600 $600 $600
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
Retained earnings €900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540
Total Liabilities €6,600 $2,800 $2,550 $2,950 $3,300
and Equity

From income statement


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How Various Translation
Methods Deal with a Change
from €3 to €2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash €2,100 $1,050 $1,050 $1,050 $1,050
Inventory €1,500 $750 $500 $900 $750
Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500
Total Assets €6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities €1,200 $600 $600 $600 $600
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
Retained earnings €900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540
Total Liabilities €6,600 $2,800 $2,550 $2,950 $3,300
and Equity

Under the current rate method, a “plug” equity account named


cumulative translation adjustment makes the balance sheet balance.
Nov 27, 2003
22
How Various Translation
Methods Deal with a Change
from €3 to €2 = $1
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales € 10,000 $4,000 $4,000 $4,000 $4,000
COGS € 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation € 1,000 $333 $333 $333 $400
Net operating income € 1,500 $667 $1,167 $667 $600
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Addition to Retained
Earnings € 900 $700 $150 $550 $360

Sales translate at average exchange rate over the period, €2.50 = $1

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How Various Translation
Methods Deal with a Change
from €3 to €2 = $1
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales € 10,000 $4,000 $4,000 $4,000 $4,000
COGS € 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation € 1,000 $333 $333 $333 $400
Net operating income € 1,500 $667 $1,167 $667 $600
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Addition to Retained
Earnings € 900 $700 $150 $550 $360

Translate at €2.50 = $1 Translate at new exchange rate, €2.00 = $1


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How Various Translation
Methods Deal with a Change
from €3 to €2 = $1
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales € 10,000 $4,000 $4,000 $4,000 $4,000
COGS € 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation € 1,000 $333 $333 $333 $400
Net operating income € 1,500 $667 $1,167 $667 $600
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Addition to Retained
Earnings € 900 $700 $150 $550 $360

Translate at €3 = $1 Translate at average exchange rate, €2.5 = $1

25 Nov 27, 2003


How Various Translation
Methods Deal with a Change
from €3 to €2 = $1
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales € 10,000 $4,000 $4,000 $4,000 $4,000
COGS € 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation € 1,000 $333 $333 $333 $400
Net operating income € 1,500 $667 $1,167 $667 $600
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Addition to Retained
Earnings € 900 $700 $150 $550 $360

Note the effect on after-tax profit.


14.1
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How Various Translation
Methods Deal with a Change
from €3 to €2 = $1
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales € 10,000 $4,000 $4,000 $4,000 $4,000
COGS € 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation € 1,000 $333 $333 $333 $400
Net operating income € 1,500 $667 $1,167 $667 $600
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Addition to Retained
Earnings € 900 $700 $150 $550 $360

Note the effect that foreign exchange gains (losses) has on net income.
14.1
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FAS8 – superseded
¢Essentially the temporal method, with some
subtleties,
lsuch as translating inventory at
historical rates (a hassle).
¢Required taking foreign exchange gains and
losses through the income statement.
¢This lead to variability in reported earnings
(irritated corporate executives).

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The Mechanics of FAS52
¢Function Currency
lThe currency that the business is
conducted in.
¢Reporting Currency
lThe currency in which the MNC
prepares its consolidated
financial statements.

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The Mechanics of FAS52
Two-Stage Process
¢First, determine in which currency the foreign
entity keeps its books.
lIf the local currency in which the foreign entity
keeps its books is not the functional
currency, remeasurement into the functional
currency is required.
¢Second, when the foreign entity’s functional
currency is not the same as the parent’s
currency, the foreign entity’s books are
translated using the current rate method.
30 Nov 27, 2003
The Mechanics of FAS52
Parent’s currency
Foreign Nonparent
entity’s books Functional Third currency
kept in? Currency?
Currency
Local currency Temporal
Remeasurement
Currency

Current Rate
Parent’s

Translation

Parent’s Currency
14-31 Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
Highly Inflationary
Economies
¢Highly inflationary economies—over
100% over three years
¢Foreign entities are required to
remeasure financial statements
using the temporal method “as if the
functional currency were the
reporting currency”.

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Management of Translation
Exposure
¢Translation Exposure vs. Transaction
Exposure
¢Hedging Translation Exposure
lBalance Sheet Hedge
lDerivatives Hedge
¢Translation Exposure vs. Operating
Exposure

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Translation Exposure versus
Transaction Exposure
¢Translation Exposure
lThe effect that unanticipated changes in
exchange rates has on the firm’s consolidated
financial statements a accounting issue.
¢Transaction Exposure
lA effect that unanticipated changes in
exchange rates has on the firm’s cash flows
a finance issue.
¢ It is generally not possible to eliminate both
translation exposure and transaction exposure.
34 Nov 27, 2003
Hedging Translation
Exposure
¢If the managers of the firm wish to
manage their accounting numbers as
well as their business, they have two
methods for dealing with translation
exposure.
lBalance Sheet Hedge
lDerivatives Hedge
¢

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Balance Sheet Hedge
¢Eliminates the mismatch between net
assets and net liabilities
denominated in the same currency.
¢May create transaction exposure,
however.
¢

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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.
¢However, using a derivatives hedge
to control translation exposure really
involves speculation about foreign
exchange rate changes.

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Translation Exposure versus
Operating Exposure
¢The effect that unanticipated changes
in exchange rates has on the firm’s
ongoing operations.
¢Operating (economic) exposure is a
substantive issue with which the
management of the firm should
concern itself with.

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Empirical Analysis of the
Change from FAS8 to FAS52
¢There did not appear to be a revaluation of
firms’ values following the change.
¢This suggests that market participants do
not react to cosmetic earnings changes.
¢Other researchers have found similar
results when investigating other
accounting changes.
¢This highlights the futility of attempting to
manage translation gains and losses.

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Relevance of Translation
(Accounting) Exposure
¢Should the exchange rate effect be shown
as part of the reporting period, or should
it just be mentioned on the balance
sheet, as an unrealized gain or loss?
¢Most of the gains are not realized a keep
gains/losses out of income statement.
¢Translation sounds great, but none of the
three methods produces the true
economic value.
¢
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Relevance of Translation
(Accounting) Exposure
¢Should we worry about translation exposure
at all?
¢If so, should we worry what the best
translation method is?
¢choice doesn't affect any real cashflow
except for taxes.
¢only correct method is economic value
anyway
a simplicity/consistency: Current rate method.

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The (Ir)relevance of Translation
Exposure*
¢Economic exposure is far more
relevant!

*P. Sercu and R. Uppal, International Financial Markets and the Firm, 1994
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ECONOMIC EXPOSURE: ACCOUNTING EXPOSURE:

1. A forward looking concept: it focuses on 1. A backward-looking concept: it reflects past


future cashflows. decisions as reflected in the subsidiary's assets and
liabilities.
2. Involves real cashflows, not just accounting
figures. 2. A change in an accounting value due to
translation is not a "realized" gain or loss; no
change in the cash situation is involved —except
3. Relates to changes in the economic value
possibly through taxation effects.
(or, in an efficient market, the market value)
of the firm.
3. Changes the firm's accounting value, but not
necessarily its market value.
4. Contractual exposure depends on the firm’s
portfolio of FC engagements undertaken in
4. Depends on the accounting rules chosen. This is
the past. Operating exposure depends on the
because the subsidiary's own internal rules affect
environment (especially the market structure
its accounting values (e.g., type of depreciation, or
and the input-output mix) and on the firm's
inventory valuation methods) and also because the
strategic response (e.g., relocation of
translation process itself can be done in different
production, changes in the marketing mix or
ways (see below).
financial structure, etc.).

5. Also exists for firms without foreign 5. Accounting exposure only exists in the case of
subsidiaries, such as exporting firms, import- foreign direct investment, since pure exporting or
competing firms, and notably potential import-substituting firms have no foreign
import-competing firms. subsidiaries.

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