Management of
Translation Exposure
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Chapter Fourteen
Chapter Objective:
• This chapter discusses the impact that unanticipated
changes in exchange rates may have on the
consolidated financial statements of the multinational
company.
Chapter Outline
 Translation Methods
 Management of Translation Exposure
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Translation Exposure
 Translation exposure, (also called accounting exposure), results
from the need to restate foreign subsidiaries’ financial
statements, usually stated in foreign currency, into the parent’s
reporting currency when preparing the consolidated financial
statements.
 Restating financial statements may lead to changes in the
parent’s net worth or net income.
 Two methods


Current rate method
Temporal Approach
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The Current Rate Method
1. All assets and liabilities are translated at the rate in effect on the
balance sheet date.
2. All items on the income statement are translated at an appropriate
average exchange rate or at the rate prevailing when the various
revenues, expenses, gains and losses were incurred (historical
rate).
3. Dividends paid are translated at the rate in effect on the payment
date.
4. Common stock and paid-in capital accounts are recorded at
historical rates. Year-end retained earnings consist of Beginning
RE plus or minus any income or loss for the year.
 Gains and losses resulting from translation are reported in a
special reserve account on the consolidated balance sheet with
such title as cumulative translation adjustment (CTA).
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The Current Rate Method
 Advantages of CTA


Eliminates the variability of net earnings due to translation
gains or losses.
The relative proportions of individual balance sheet
accounts remain the same (debt-to-equity ratio, for
example).
 Main disadvantage of CTA

violates the accounting principle of carrying balance sheet
accounts at historical cost.
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The Current Rate Method: An Example
 Foreign Subsidiary, Inc., (FSI) has been acquired on
December 31, 2000 when the exchange rate was LC1.25/$
(LC stands for FSI’s local currency).
 On December 31, 2001, the exchange rate was LC1.15/$.
The average exchange rate during 2001 was LC1.18/$.
 On December 31, 2002, the exchange rate was LC1.22/$.
The average exchange rate during 2002 was LC1.20/$.
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The Current Rate Method: An Example
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The Current Rate Method: An Example
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The Current Rate Method: An Example
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The Current Rate Method: An Example
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The Current Rate Method: An Example
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The Current Rate Method: An Example
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The Current Rate Method: An Example
12
Temporal Method
 Monetary assets (cash, marketable securities, AR) and monetary
liabilities (current liabilities and LTD) are translated at the current ER
(exchange rate at the balance sheet date).
 Non-monetary assets (inventory, fixed assets, etc.) and non-monetary
liabilities are translated at their historical rate.
 Income statement items are translated at the average ER over the
period, except for items that are associated with non-monetary assets or
liabilities, such as COGS (inventory) and depreciation (fixed assets),
which are translated at their historical rate.
 Dividends paid are translated at the rate in effect on the payment date.
 Equity items are translated at their historical rate, and include any
imbalance.
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Temporal Method
 Logic behind differentiating monetary and non-monetary
assets:
 Translation gains and losses on monetary accounts are
presumed meaningful components of expenses or revenue
because monetary accounts closely approximate market
values.
 Translation gains and losses on non-monetary accounts are
less meaningful since non-monetary accounts reflect
historical costs.
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Temporal Method
 Gains and losses resulting from translation are carried
directly to current consolidated income
 Unlike the current rate method these gains and losses do not
go to an equity reserve account.
 FX gains and losses introduce volatility of consolidated
earnings.
 This volatility is damped to the extent that many items in the
temporal approach are translated at their historical costs.
 The main advantage of this method is that it complies with
the accounting principle of carrying balance sheet accounts
at historical cost.
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The Temporal Method: An Example
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The Temporal Method: An Example
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The Temporal Method: An Example
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The Temporal Method: An Example
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The Temporal Method: An Example
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The Temporal Method: An Example
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Hedging Translation Exposure
The managers have two methods for dealing with translation
exposure.
1. Balance Sheet Hedge
Eliminates the mismatch between net assets and net liabilities
denominated in the same currency.
May create transaction exposure, however.
2. 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.
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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
 It is generally not possible to eliminate both
translation exposure and transaction exposure.
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