Eun7e CH 010

Management of Translation Exposure
Chapter Ten
Copyright © 2014 by the McGraw-Hill Companies,
Inc. All rights reserved.
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

Inc. All rights reserved. 10-2
Translation Methods
• Current/Noncurrent Method
• Monetary/Nonmonetary Method
• Temporal Method
• Current Rate Method

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.

Current/Noncurrent Method
• Current assets Balance Sheet Local Current/
translated at the spot Currency Noncurrent
rate. Cash € 2,100 $1,050
e.g. €2 = $1 Inventory € 1,500 $750
• Noncurrent assets Net fixed assets € 3,000 $1,000
Total Assets € 6,600 $2,800
translated at the
Current liabilities € 1,200 $600
historical rate in effect
Long-Term debt € 1,800 $600
when the item was first
Common stock € 2,700 $900
recorded on the books.
Retained earnings € 900 $700
e.g. €3 = $1 CTA -------- --------
Total Liabilities and € 6,600 $2,800
Equity
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, etc.) are translated at the historical exchange rate
in effect when the account was first recorded.

Monetary/Nonmonetary Method
• All monetary balance Balance Sheet Local Monetary/
sheet accounts are Currency Nonmonetary
translated at the current Cash € 2,100 $1,050
exchange rate. e.g. €2 = Inventory € 1,500 $500
$1 Net fixed assets € 3,000 $1,000
• All other balance sheet Total Assets € 6,600 $2,550
accounts are translated Current liabilities € 1,200 $600
at the historical Long-Term debt € 1,800 $900
exchange rate in effect Common stock € 2,700 $900
when the account was Retained earnings € 900 $0
first recorded. e.g. €3 =
CTA -------- --------
$1
Equity

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.

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

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 balance the
balance sheet.

Current Rate Method
• All balance sheet items
(except for stockholder’s Balance Sheet Local Current
equity) are translated at the Currency Rate
current exchange rate. Cash €2,100.00 $1,050
• A “plug” equity account Inventory €1,500.00 $750
named cumulative Net fixed assets €3,000.00 $1,500
translation adjustment is Total Assets €6,600.00 $3,300
used to balance the balance
sheet. Current liabilities €1,200.00 $600
Long-Term debt €1,800.00 $900
Common stock €2,700.00 $900
Retained earnings €900.00 $360
CTA -------- $540
Total Liabilities €6,600.00 $3,300
and Equity
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

from €3 = $1 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 Book $2,550 $2,950 $3,300
Current liabilities €1,200 $600 value of $600 $600 $600
Long-Term debt €1,800 $600 inventory$900 $900 $900
Common stock €2,700 $900 historic $900 $900 $900
Retained earnings €900 $700 rate $150 $550 $360
CTA -------- -------- -------- -------- $540
and Equity
Book value of inventory Current value of inventory
at spot exchange rate at spot exchange rate
from €3 = $1 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
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
from €3 = $1 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
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
from €3 = $1 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
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
CTA -------- -------- -------- -------- $540
and Equity
Spot rate Copyright © 2014 by the McGraw-Hill Companies,

from €3 = $1 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
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

from €3 = $1 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
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)

from €3 = $1 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
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 balances the balance sheet.
from €3 = $1 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 the average exchange rate over the period, €2.50 = $1
from €3 = $1 to €2 = $1
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

from €3 = $1 to €2 = $1
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

from €3 = $1 to €2 = $1
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 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 (loss) by differencing profit after tax and net income:
$700 – $400 = $300. Copyright © 2014 by the McGraw-Hill Companies,
10-23
Inc. All rights reserved.
from €3 = $1 to €2 = $1
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
$2,550 – $600 –$900 –$900 = $150 = addition to retrained earnings
Add back on dividends to get net income. Then solve for forex gain (loss) by differencing profit after tax and net income:
$150 – $700 = –$550. Inc. All rights reserved. 10-24
from €3 = $1 to €2 = $1
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
$2,950 – $600 –$900 – $900 = $550 = addition to retrained earnings
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. Copyright © 2014 by the McGraw-Hill Companies,
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.
FASB Statement 52
• The mechanics of the FASB 52 translation
process
– Function currency
– Reporting currency
• Highly inflationary economies

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.

• 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.

Parent’s currency
Foreign
Nonparent Functional
entity’s books
kept in? Currency? Third currency
Currency
Local currency Temporal
Remeasurement
Currency
Parent’s
Current Rate
Translation
Parent’s Currency
Highly Inflationary Economies
• Foreign entities are required to remeasure
financial statements using the temporal
method “as if the functional currency were the
reporting currency.”

International Accounting Standards
• Since January 2005, all companies doing business in the
European Union must use the accounting standards
distributed 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).
• 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.

• In 2009 IASB and FASB issued a
memorandum of understanding to achieve
substantial convergence of accounting
standards by 2011.
• Consequently, most countries may soon follow
a common standard for foreign currency
translation.

Management of Translation Exposure
• Translation exposure vs. transaction exposure
• Hedging translation exposure
– Balance sheet hedge
– Derivatives hedge
• Translation exposure vs. operating exposure

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.

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

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

Derivatives Hedge
• An example would be the use of a forward
contract 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.

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.

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

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Balance Sheet Local Current/ Monetary/ Temporal Current

Spot exchange rate

Balance Sheet Local Current/ Monetary/ Temporal Current

Spot rate Copyright © 2014 by the McGraw-Hill Companies,

Historical rate Spot rate

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

Local Current/ Monetary/ Temporal Current

Translate at €2.50 = $1 Translate at old exchange rate, €3.00 = $1

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

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

Copyright © 2014 by the McGraw-Hill Companies,

• The effect that unanticipated changes in

Copyright © 2014 by the McGraw-Hill Companies,

• There did not appear to be a revaluation of firms’ values

Copyright © 2014 by the McGraw-Hill Companies,

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