Chap. 10(a) Measuring
Accounting Exposure
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Accounting or Translation Exposure
Operating or Economic Exposure
Transaction Exposure is both
The Problem of Finding a Standard Accounting
Measure
• FASB 52
• Nov. 20, 2002
by William Pugh
Accounting/ Translation Exposure
• Motivation: Until now, we have assumed that
any currency exposure was short-term and
associated with some aspect of foreign trade.
• This is Transaction Exposure . This exposure
is usually associated with extension of trade
credit by the seller to the buyer. Listed
under accounts receivable (for the seller) or
accounts payable (for the buyer).
• More realistically, a MNC will have other
assets and liabilities in another currency
Accounting/ Translation Exposure
Accounting/ Translation Exposure
• Exposed Assets and Liabilities: those that
will have valuation changes if currency rates
change.
• The chain also has peso liabilities: it owes its
Mexican suppliers for 60 days worth of goods
already shipped, and a Mexican bank is holding
a (peso) mortgage on some of the buildings.
• Motivation: Before we even decide whether
to hedge exposure, we need to understand
what the level of exposure is.
• Example: McD’s (USA) has a Mexican
subsidiary (McDonald's of Mexico). The
Mexican chain's assets include real estate,
inventory, cash (all valued in pesos).
Accounting/ Translation Exposure
• An easier example: You manage the Mex$
1billion Mexico Fund. All of your assets are
exposed to a depreciation as they are fully
invested in Mexican stock and thus the peso.
Your exposure is the total NAV of the fund.
• Translation or Accounting Exposure: equals
the difference between exposed assets and
liabilities. The trick is to decide what is
exposed and what is not. Sometimes called
balance sheet risk.
• What is at risk if the peso falls?
• Assets fall after translating them into dollars:
Certainly the pesos you are holding. Probably
the inventory. What about the buildings?
• Liabilities (payables and bank debt) fall in dollar
terms, so it performs like a natural hedge.
Operating/ Economic Exposure
• Changes in the economic value of an
enterprise as a result of an exchange rate
change. This exposure is usually correlated
to accounting exposure, but sometimes there
is an inverse relationship. These gains or
losses are often measured by estimating the
impact on future cash flow.
• Note that Transaction Exposure is usually
found to be equally an example of both
accounting and economic exposure
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The Problem of Measurement
• Consider the McDonald's above, with the
following balance sheet: (in Mex$ Billions)
Assets
Claims
Cash Equiv.. 10
payables 20
Inventory
30
S.t. Debt 50
Plant/Equip. 160
L.t. Debt 80
• Thus net worth is Mex$ 50 billion
• Income Statement In Pesos (Mex$ Billions)
Revenues 20
Expenses (10) thus net income is Mex$10
The Problem of Measurement
• Translating the new net worth, and getting $4
billion, indicates a loss on the total investment
of $1 billion. Here, the economic loss (cash
flow) and accounting loss (net worth) are the
same (20 percent).
• 2) Suppose the Peso falls to eight cents over
one year, but this time reflecting Mexican
inflation of 25%. None assumed in case (1)
• PPP would predict the new spot to be eight
cents. (assume no U.S. inflation).
The Problem of Measurement
• The net worth, if maintained at historical cost
stays the same in pesos, but is devalued in
dollar terms. So in this example, we have no
economic losses, but our accountants say the
value of our Mexican assets is down by 20%.
• 3) Suppose the Peso crashes to eight cents in
one day as in (1), but the subsidiary is not a
McDonald's but "El Dorado Silver Mining
Company". Does your Mexican investment
lose 20 percent as in (1)?
The Problem of Measurement
• Assume the peso is worth 10 cents at first, and
all monetary assets and liabilities are in pesos.
Thus net worth is Mex$50 billion or $5 billion
(U.S.) and net income is $1 billion (U.S.)
• 1) Suppose the Peso crashes to eight cents in
one day. Does your Mexican investment lose 20
percent as well? In the short term, probably
yes: your revenues, expenses, and net income
should stay the same in peso terms, but when
translated to dollars, should fall to $0.8 billion.
The Problem of Measurement
• Here the real exchange rate is unchanged.
Do we use the same accounting procedure as
in scenario (1)? Is there a dramatic loss to
the American parent MNC?
Maybe not. We assume your revenues,
expenses, and net income will rise in peso
terms, by the rate of inflation, to give a net
income of 12.5 billion pesos. Converting the
pesos to USD gives $1 billion, unchanged from
a year ago.
The Problem of Measurement
• Assume most of the costs (labor, transport,
interest payments are unchanged in pesos and
thus fall in dollar terms. The difference this
time is that revenues should hold steady in
dollar terms since silver is sold on the world
market. Thus, USD revenues hold at $20
billion, costs fall to $8 billion, net income rises
from $10 to $12 billion!
Here, you have an economic gain, but still an
accounting loss.
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The Problem of Measurement
Summary:Prob. of Measurement
• 4) Finally, back to the McDonalds, suppose the
Peso holds at ten cents over one year, in spite
of Mexican inflation of 25%. Again, PPP
predicts a new spot to be eight cents. Since the
peso is still tens cents, the real exchange rate
of the peso has risen.
• Case Comp. e1 Infl. Reale1 NetInc. NetWorth
• Income in peso terms should rise by 25%, but
with a steady exchange rate, the return
translated to the USD also rises 25%. The
accountants see no change in book value: an
economic gain and no accounting change
• The point of the above, is to demonstrate the
difficulty of coming up with accurate
accounting methods that will work reasonably
well for different companies and different
exchange rate shifts.
The Problem of Measurement
• This difficulty, in essence, ultimately caused
the accountants to throws up their hands and
cry, "forget it, just bury the change in the
balance sheet": hence FASB 52 was born.
• 1) McDon. $.08 none drop -20%
-20%
• 2) McDon. $.08 25% same
same
-20%
• 3) Silver
+20%
-20%
+20%
same
$.08 none drop
• 4) McDon. $.10 25% rise
FASB 52
• Various Accounting Approaches
• Some U.S. Firms formerly used the
• 1) Current / Noncurrent Method: Firm
revalues only Current Assets and Liabilities.
• 2) Monetary / Nonmonetary: Only Monetary
items are readjusted (Cash, Accts. Receivables,
Debts). Real Assets are presumed to keep
previous value (inventory, fixed assets). Never
was widely used in the U.S.
FASB 52
FASB 52
• 3) Temporal Method: (basis of old FASB 8).
Similar to Monetary /Nonmonetary, based
on historical cost. Major difference is that
INVENTORY may be revalued to current
exchange rate. Under FASB-8, companies
revalued their monetary-based items, plus
inventories annually and then were required
to list net gains or losses in valuation in the
Income Statement. Made the income stream
appear overly volatile. Firms hated it.
• FASB 52 is based on the 4) Current Method,
where all Assets and Liabilities are
considered exposed and thus revalued
annually to the current exchange rates. This
is a very easy method: the only effect a
currency change has is on the assets that are not
offset by liabilities (such as debt), thus only net
assets (or equity) is affected.
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FASB 52
• Example: A French subsidiary of Exxon has FF
100 million in assets and FF 60 million in
liabilities: the net translation exposure is also
the net worth or FF 40 million. Suppose the FF
falls from 16 cents to 14 cents, then the
translation loss is $.02/FF times FF 40 million
or $800,000.
• Under the strict Current method, this loss
would be subtracted from the Income Statement
FASB 52
• British Firms usually use the current method
Unfortunately, volatile currencies probably
make the earnings stream look "noisier" than is
probably warranted.
• U.S. firms use FASB-52, where the loss is not
reported on the income statement. FASB-52
has changes in net worth entered as a Balance
Sheet item (not affecting net income),
sometimes called a "Cumulative Translation
Adjustment". Earnings are thus “smoothed”
FASB 52
FASB 52
• FASB 52 replaced FASB-8, and
1) Kept accounting risk on Balance sheet,
2) Used the simplest accounting method
(Current),
3) Reflects operating risk, in that foreign
currency income streams are translated into
the current exchange rate (sometimes using
an average rate). A lower peso would cause
net income (for McDonalds) to drop in dollar
terms. (and rise for El Dorado Silver).
• An advantage to the FASB-52 approach is that
if the rate change is simply "noise" or
temporary, the balance sheet item simply
reverses at some future time and the income
statement appears more stable than under, say
any of the other reporting approaches .
FASB 52
FASB 52
• Reporting Currency: This is the currency that
the MNC headquarters uses to consolidate its
global operations. Usually the currency of the
nation where the headquarters is located.
• Schlumberger is an exception (probably a lot of
others) as they use the dollar although the firm
is French.
• Functional Currency: the currency that the
subsidiary does most of its business. Each
subsidiary (in a different country) will have to
annually convert its accounting statement from
its currency into the reporting currency.
• McDonald’s (USA) will get income streams in
many currencies. On would be the McDonalds
in Mexico, where most activities are in Pesos.
• This forms the consolidated income statement.
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FASB 52
• If subsidiary does most of its business in the
local currency, then simply use the current
method under FASB 52 for translating the
balance sheets.
• In contrast, if most business is done in, say
USDs, keep the books in dollars - and use
FASB-8. Now translation gains (losses) now
show up on the income statement.
• E.g. assembly plant across the border in Mexico
"maquiladoras”: USD is functional currency.
FASB 52
• Second, if host country currency is
experiencing very high inflation, (where the
local currency is basically an unreliable
measure of value) use the dollar as functional
currency.
• Use the dollar, even if you are running a local
operation like a McDonalds (the workers
probably wish they were getting paid in
dollars). Again, use FASB 8.
• McDonald’s in Russia? Argentina?
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