International: Financial Management

INTERNATIONAL
FINANCIAL
MANAGEMENT
Fifth Edition
EUN / RESNICK
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Management of
Translation Exposure 10
Chapter Ten
Chapter Objective:
This chapter discusses the impact that

unanticipated changes in exchange rates may have
on the consolidated financial statements of the
multinational company.
10-2
Chapter Outline
 Translation Methods
 FASB Statement 8
 FASB Statement 52
 International Accounting Standards
 Management of Translation Exposure
 Empirical Analysis of the Change from FASB 8 to
FASB 52
10-3
Translation Methods
 Current/Noncurrent Method
 Monetary/Nonmonetary Method
 Temporal Method
 Current Rate Method
10-4
Current/Noncurrent Method
 The underlying principal is that assets and
liabilities should be translated based on their
maturity.
 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.
 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.
10-5
Current/Noncurrent Method
 Current assets Balance Sheet Local Current/
translated at the Currency Noncurrent
spot rate. Cash € 2,100 $1,050
e.g. €2 = $1 Inventory € 1,500 $750
 Noncurrent assets Net fixed assets € 3,000 $1,000
translated at the Total Assets € 6,600 $2,800
historical rate in Current liabilities € 1,200 $600
effect when the Long-Term debt € 1,800 $600
item was first Common stock € 2,700 $900
recorded on the Retained earnings € 900 $700
books. CTA -------- --------
e.g. €3 = $1 Total Liabilities and € 6,600 $2,800
Equity
10-6
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.
10-7
Monetary/Nonmonetary Method
 All monetary Balance Sheet Local Monetary/
balance sheet 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
Total Assets € 6,600 $2,550
rate. e.g. €2 = $1
Current liabilities € 1,200 $600
 All other balance Long-Term debt € 1,800 $900
sheet accounts are Common stock € 2,700 $900
translated at the Retained earnings € 900 $0
historical exchange CTA -------- --------
rate in effect when Total Liabilities and € 6,600 $2,400
the account was Equity
first recorded. e.g.
10-8
€3 = $1
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.
10-9
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 rate. Net fixed assets € 3,000 $1,000
Total Assets € 6,600 $2,950
e.g. €2 = $1 Current liabilities € 1,200 $600
 Items that are Long-Term debt € 1,800 $900
carried on the Common stock € 2,700 $900
books at historical Retained earnings € 900 $0
costs are translated CTA -------- --------
at the historical Total Liabilities and € 6,600 $2,400
exchange rates. Equity
e.g. €3 = $1
10-10
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.
10-11
Current Rate Method
 All balance sheet Balance Sheet Local Current
items (except for Currency Rate
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. Current liabilities €1,200.00 $600
 A “plug” equity Long-Term debt €1,800.00 $900
Common stock €2,700.00 $900
account named
Retained earnings €900.00 $360
cumulative
CTA -------- $540
translation
Total Liabilities €6,600.00 $3,300
adjustment is
and Equity
used to make the
balance sheet
10-12 balance
How Various Translation Methods Deal with
a Change from €3 = $1 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 exchange rate
10-13
a Change from €3 to €2 = $1

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 Book $600 $600 $600
Long-Term debt €1,800 $600 value of $900 $900 $900
Common stock €2,700 $900inventory $900 $900 $900
Retained earnings €900 $700 historic $150 $550 $360
CTA -------- -------- rate -------- -------- $540
and Equity
Book value of inventory Current value of inventory

at spot exchange rate at spot exchange rate.
10-14

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
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
CTA -------- -------- -------- -------- $540
and Equity
historic rate spot exchange rate
10-15

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
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
CTA -------- -------- -------- -------- $540
and Equity
Cash + Inventory + Net Fixed Assets

10-16

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
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
CTA -------- -------- -------- -------- $540
and Equity
spot rate
10-17

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
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
CTA -------- -------- -------- -------- $540
and Equity
historical rate spot rate
10-18

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
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
CTA -------- -------- -------- -------- $540
and Equity
Requires income statement data (see slides 23, 24, 25)

10-19
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
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
CTA -------- -------- -------- -------- $540
and Equity
Under the current rate method, a “plug” equity account named
cumulative translation adjustment makes the balance sheet balance.
10-20
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
For notes, see Exhibit 14.1
10-21
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
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Earnings € 900 $700 $150 $550 $360
Translate at
€2.50 = $1 Translate at old exchange rate, €3.00 = $1
For notes, see Exhibit 14.1
10-22
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
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Earnings € 900 $700 $150 $550 $360
Translate at €3 = $1 Translate at average exchange rate,

€2.5 = $1
10-23
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
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Earnings € 900 $700 $150 $550 $360
First Solve for retained earnings so as Total Assets = Total Liabilities:
Total Assets – current liabilities – long-term debt – common stock
$2,800 – $600 –$600 –$900 = $700 = addition to retrained earnings
Add back on dividends to get net income. Then solve for forex gain
10-24 (loss) by differencing profit after tax and net income $700 – $400 =
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
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Earnings € 900 $700 $150 $550 $360
Add back on dividends to get net income. Then solve for forex gain
10-25
(loss) by differencing profit after tax and net income $150 – $700 = –
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
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Earnings € 900 $700 $150 $550 $360
Add back on dividends to get net income. Then solve for forex gain (loss) by
differencing profit after tax and net income $550 – $400 = $150
10-26
FASB Statement 8
 Essentially the temporal method, with some
subtleties.
 Such as translating inventory at historical rates, which is
a hassle.
 Requires taking foreign exchange gains and losses
through the income statement.
 This leads to variability in reported earnings.
 Which leads to irritated corporate executives.
10-27
FASB Statement 52
 The Mechanics of the FASB 52 Translation
Process
 Function Currency
 Reporting Currency
 Highly Inflationary Economies
10-28
The Mechanics of FASB Statement 52
 Function Currency
 The currency that the business is conducted in.
 Reporting Currency
 The currency in which the MNC prepares its
consolidated financial statements.
10-29
 Two-Stage Process
 First, determine in which currency the foreign entity
keeps its books.
 If 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.
10-30
Parent’s currency
Foreign Nonparent
entity’s books Functional
Currency? Third currency
kept in? Currency
Local currency Temporal
Remeasurement
Currency
Current Rate
Parent’s
Translation
Parent’s Currency
10-31
Highly Inflationary Economies
 Foreign entities are required to remeasure
financial statements using the temporal method
“as if the functional currency were the reporting
currency”.
10-32
International Accounting Standards
 Since January 2005, all companies doing business in the
European Union have to use the accounting standards
promulgated by the International Accounting Standards
Board (IASB).
 Similar to the American FASB, the IASB publishes it
standards in a series of pronouncements called
International Financial Reporting Standards.
 It also adopted and maintains the pronouncements of the
predecessor body, the IASC, called International
Accounting Standards (IAS).
10-33
International Accounting Standards
 IAS 21, The Effects of Changes in Foreign
Exchange Rates is the European standard for
handling foreign currency translation.
 IAS 21 most closely resembles the
monetary/nonmonetary translation method
discussed earlier in the chapter.
 Thus, in the European Union, a different
translation method is used than in the United
States.
10-34
Management of Translation Exposure
 Translation Exposure vs. Transaction Exposure
 Hedging Translation Exposure
 Balance Sheet Hedge
 Derivatives Hedge
 Translation Exposure vs. Operating Exposure
10-35
Translation Exposure versus
Transaction Exposure
 Translation Exposure
 The effect that unanticipated changes in exchange rates
has on the firm’s consolidated financial statements.
 An accounting issue.
 Transaction Exposure
 The effect that unanticipated changes in exchange rates
has on the firm’s cash flows.
 A finance issue and the subject of Chapter 8.
 It is generally not possible to eliminate both
translation exposure and transaction exposure.
10-36
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.
 Balance Sheet Hedge
 Derivatives Hedge
10-37
Balance Sheet Hedge
 Eliminates the mismatch between net assets and
net liabilities denominated in the same currency.
 May create transaction exposure, however.
10-38
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.
10-39
Translation Exposure versus
Operating Exposure
 The effect that unanticipated changes in exchange
rates has on the firm’s ongoing operations.
 Operating exposure is a substantive issue with
which the management of the firm should concern
itself with.
10-40

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INTERNATIONAL

This chapter discusses the impact that

Balance Sheet Local Current/ Monetary/ Temporal Current

Balance Sheet Local Current/ Monetary/ Temporal Current

Book value of inventory Current value of inventory

Balance Sheet Local Current/ Monetary/ Temporal Current

Balance Sheet Local Current/ Monetary/ Temporal Current

Cash + Inventory + Net Fixed Assets

Balance Sheet Local Current/ Monetary/ Temporal Current

Balance Sheet Local Current/ Monetary/ Temporal Current

Balance Sheet Local Current/ Monetary/ Temporal Current

Requires income statement data (see slides 23, 24, 25)

Sales translate at average exchange rate over the period,

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

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