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:
current/noncurrent
monetary/nonmonetary
temporal
current 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
4
Nov 27, 2003
Definition
Translation Exposure – the potential
that the firm’s consolidated financial
statements can be affected by
changes in exchange rates.
5
Nov 27, 2003
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.
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.
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.
7
Nov 27, 2003
Current/Noncurrent Method
Balance Sheet
 Current assets
/liabilities
Cash
translated at the
Inventory
spot rate.
Net fixed assets
i.e. €2=$1
Total Assets
 Noncurrent assetsCurrent liabilities
/liabilities
Long-Term debt
translated at the
historical rate in Common stock
effect when the Retained earnings
CTA
item was first
recorded on the Total Liabilities and
books. i.e. €3=$1
Equity
8
Local
Current/
Currency
Noncurrent
€ 2,100
$1,050
€ 1,500
$750
€ 3,000
$1,000
€ 6,600
$2,800
€ 1,200
$600
€ 1,800
$600
€ 2,700
$900
€ 900
$700
--------------€ 6,600
$2,800
Nov 27, 2003
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
accounts are
translated at the
current exchange
rate. i.e. €2=$1
 All other balance
sheet accounts are
translated at the
historical exchange
rate in effect when
the account was first
recorded. i.e.€3=$1
10
Balance Sheet
Cash
Inventory
Net fixed assets
Total Assets
Current liabilities
Long-Term debt
Common stock
Retained earnings
CTA
Total Liabilities and
Equity
Monetary/
Local
Nonmonetary
Currency
$1,050
€ 2,100
$500
€ 1,500
$1,000
€ 3,000
$2,550
€ 6,600
$600
€ 1,200
$900
€ 1,800
$900
€ 2,700
$0
€ 900
--------------$2,400
€ 6,600
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.
11
Nov 27, 2003
Temporal Method
 Items carried on the
books at their
current value are
translated at the
spot exchange rate.
i.e. €2=$1
 Items that are
carried on the
books at historical
costs are translated
at the historical
exchange rates.
i.e. €3=$1
12
Balance Sheet
Cash
Inventory
Net fixed assets
Total Assets
Current liabilities
Long-Term debt
Common stock
Retained earnings
CTA
Total Liabilities and
Equity
Local
Currency
€ 2,100
€ 1,500
€ 3,000
€ 6,600
€ 1,200
€ 1,800
€ 2,700
€ 900
-------€ 6,600
Temporal
$1,050
$900
$1,000
$2,950
$600
$900
$900
$0
-------$2,400
Nov 27, 2003
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.
13
Nov 27, 2003
Current Rate Method
 All balance sheet
items (except for
stockholder’s equity)
are translated at the
current exchange
rate. i.e. €2=$1
 A “plug” equity
account named
cumulative
translation
adjustment is used
to make the balance
sheet balance
14
Balance Sheet
Cash
Inventory
Net fixed assets
Total Assets
Current liabilities
Long-Term debt
Common stock
Retained earnings
CTA
Total Liabilities
and Equity
Local
Currency
€2,100.00
€1,500.00
€3,000.00
€6,600.00
€1,200.00
€1,800.00
€2,700.00
€900.00
-------€6,600.00
Current
Rate
$1,050
$750
$1,500
$3,300
$600
$900
$900
$360
$540
$3,300
Nov 27, 2003
How Various Translation Methods
Deal with a Change
from €3 to €2 = $1
Balance Sheet
Cash
Inventory
Net fixed assets
Total Assets
Current liabilities
Long-Term debt
Common stock
Retained earnings
CTA
Total Liabilities
and Equity
15
Local
Current/
Monetary/
Temporal Current
Currency
Noncurrent Nonmonetary
Rate
€2,100
$1,050
$1,050
$1,050
$1,050
€1,500
$750
$500
$900
$750
€3,000
$1,000
$1,000
$1,000
$1,500
€6,600
$2,800
$2,550
$2,950
$3,300
€1,200
$600
$600
$600
$600
€1,800
$600
$900
$900
$900
€2,700
$900
$900
$900
$900
€900
$700
$150
$550
$360
----------------------------$540
€6,600
$2,800
$2,550
$2,950
$3,300
Spot exchange rate
Nov 27, 2003
How Various Translation Methods
Deal with a Change from €3 to €2
= $1
Balance Sheet
Cash
Inventory
Net fixed assets
Total Assets
Current liabilities
Long-Term debt
Common stock
Retained earnings
CTA
Total Liabilities
and Equity
Local
Current/
Monetary/
Temporal Current
Currency
Noncurrent Nonmonetary
Rate
€2,100
$1,050
$1,050
$1,050
$1,050
€1,500
$750
$500
$900
$750
€3,000
$1,000
$1,000
$1,000
$1,500
€6,600
$2,800
$2,550
$2,950
$3,300
€1,200
$600 Book $600
$600
$600
€1,800
$600 value of $900
$900
$900
€2,700
$900inventory $900
$900
$900
€900
$700 historic $150
$550
$360
rate
----------------------------$540
€6,600
$2,800
$2,550
$2,950
$3,300
Book value of inventory
at spot exchange rate
16
Current value of inventory
at spot exchange rate.
Nov 27, 2003
How Various Translation Methods
Deal with a Change from €3 to €2
= $1
Balance Sheet
Cash
Inventory
Net fixed assets
Total Assets
Current liabilities
Long-Term debt
Common stock
Retained earnings
CTA
Total Liabilities
and Equity
17
Local
Current/
Monetary/
Temporal Current
Currency
Noncurrent Nonmonetary
Rate
€2,100
$1,050
$1,050
$1,050
$1,050
€1,500
$750
$500
$900
$750
€3,000
$1,000
$1,000
$1,000
$1,500
€6,600
$2,800
$2,550
$2,950
$3,300
€1,200
$600
$600
$600
$600
€1,800
$600
$900
$900
$900
€2,700
$900
$900
$900
$900
€900
$700
$150
$550
$360
----------------------------$540
€6,600
$2,800
$2,550
$2,950
$3,300
historic rate
spot exchange
rate
Nov 27, 2003
How Various Translation Methods
Deal with a Change from €3 to €2
= $1
Balance Sheet
Cash
Inventory
Net fixed assets
Total Assets
Current liabilities
Long-Term debt
Common stock
Retained earnings
CTA
Total Liabilities
and Equity
18
Local
Current/
Monetary/
Temporal Current
Currency
Noncurrent Nonmonetary
Rate
€2,100
$1,050
$1,050
$1,050
$1,050
€1,500
$750
$500
$900
$750
€3,000
$1,000
$1,000
$1,000
$1,500
€6,600
$2,800
$2,550
$2,950
$3,300
€1,200
$600
$600
$600
$600
€1,800
$600
$900
$900
$900
€2,700
$900
$900
$900
$900
€900
$700
$150
$550
$360
----------------------------$540
€6,600
$2,800
$2,550
$2,950
$3,300
spot rate
Nov 27, 2003
How Various Translation Methods
Deal with a Change from €3 to €2
= $1
Balance Sheet
Cash
Inventory
Net fixed assets
Total Assets
Current liabilities
Long-Term debt
Common stock
Retained earnings
CTA
Total Liabilities
and Equity
19
Local
Current/
Monetary/
Temporal Current
Currency
Noncurrent Nonmonetary
Rate
€2,100
$1,050
$1,050
$1,050
$1,050
€1,500
$750
$500
$900
$750
€3,000
$1,000
$1,000
$1,000
$1,500
€6,600
$2,800
$2,550
$2,950
$3,300
€1,200
$600
$600
$600
$600
€1,800
$600
$900
$900
$900
€2,700
$900
$900
$900
$900
€900
$700
$150
$550
$360
----------------------------$540
€6,600
$2,800
$2,550
$2,950
$3,300
historical rate
spot rate
Nov 27, 2003
How Various Translation Methods
Deal with a Change from €3 to €2
= $1
Balance Sheet
Cash
Inventory
Net fixed assets
Total Assets
Current liabilities
Long-Term debt
Common stock
Retained earnings
CTA
Total Liabilities
and Equity
Local
Current/
Monetary/
Temporal Current
Currency
Noncurrent Nonmonetary
Rate
€2,100
$1,050
$1,050
$1,050
$1,050
€1,500
$750
$500
$900
$750
€3,000
$1,000
$1,000
$1,000
$1,500
€6,600
$2,800
$2,550
$2,950
$3,300
€1,200
$600
$600
$600
$600
€1,800
$600
$900
$900
$900
€2,700
$900
$900
$900
$900
€900
$700
$150
$550
$360
----------------------------$540
€6,600
$2,800
$2,550
$2,950
$3,300
historical rate
20
Nov 27, 2003
How Various Translation Methods
Deal with a Change from €3 to €2
= $1
Balance Sheet
Cash
Inventory
Net fixed assets
Total Assets
Current liabilities
Long-Term debt
Common stock
Retained earnings
CTA
Total Liabilities
and Equity
21
Local
Current/
Monetary/
Temporal Current
Currency
Noncurrent Nonmonetary
Rate
€2,100
$1,050
$1,050
$1,050
$1,050
€1,500
$750
$500
$900
$750
€3,000
$1,000
$1,000
$1,000
$1,500
€6,600
$2,800
$2,550
$2,950
$3,300
€1,200
$600
$600
$600
$600
€1,800
$600
$900
$900
$900
€2,700
$900
$900
$900
$900
€900
$700
$150
$550
$360
----------------------------$540
€6,600
$2,800
$2,550
$2,950
$3,300
From income statement
Nov 27, 2003
How Various Translation Methods
Deal with a Change from €3 to €2
= $1
Balance Sheet
Cash
Inventory
Net fixed assets
Total Assets
Current liabilities
Long-Term debt
Common stock
Retained earnings
CTA
Total Liabilities
and Equity
Local
Current/
Monetary/
Temporal Current
Currency
Noncurrent Nonmonetary
Rate
€2,100
$1,050
$1,050
$1,050
$1,050
€1,500
$750
$500
$900
$750
€3,000
$1,000
$1,000
$1,000
$1,500
€6,600
$2,800
$2,550
$2,950
$3,300
€1,200
$600
$600
$600
$600
€1,800
$600
$900
$900
$900
€2,700
$900
$900
$900
$900
€900
$700
$150
$550
$360
----------------------------$540
€6,600
$2,800
$2,550
$2,950
$3,300
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
23
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
Translate at €2.50 = $1
24
Translate at new exchange rate, €2.00 = $1
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
Translate at €3 = $1
25
Translate at average exchange rate, €2.5 = $1
Nov 27, 2003
How Various Translation Methods
Deal with a Change from €3 to €2
= $1
Temporal Current
Monetary/
Current/
Local
Rate
Noncurrent Nonmonetary
Currency
Income Statement
$4,000
$4,000
$4,000
$4,000
€ 10,000
Sales
$3,000
$3,000
$2,500
$3,000
€ 7,500
COGS
$400
$333
$333
$333
€ 1,000
Depreciation
$600
$667
$1,167
$667
€ 1,500
Net operating income
$240
$267
$467
$267
€ 600
Income tax (40%)
$360
$400
$700
$400
€ 900
Profit after tax
$150
-$550
$300
Foreign exchange gain (loss)
$360
$550
$150
$700
€ 900
Net income
$0
$0
$0
$0
€0
Dividends
Addition to Retained
$360
$550
$150
$700
€ 900
Earnings
Note the effect on after-tax profit.
26
14.1
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 that foreign exchange gains (losses) has on net income.
14.1
27
Nov 27, 2003
FAS8 – superseded
Essentially the temporal method, with some
subtleties,
such 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).
28
Nov 27, 2003
The Mechanics of FAS52
Function Currency
The currency that the business is
conducted in.
Reporting Currency
The currency in which the MNC
prepares its consolidated financial
statements.
29
Nov 27, 2003
The Mechanics of FAS52
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.
30
Nov 27, 2003
The Mechanics of FAS52
Parent’s currency
Foreign
entity’s books
kept in?
Nonparent
Currency
Functional
Currency?
Parent’s
Currency
Local currency
Third currency
Temporal
Remeasurement
Current Rate
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”.
32
Nov 27, 2003
Management of Translation
Exposure
Translation Exposure vs. Transaction
Exposure
Hedging Translation Exposure
Balance Sheet Hedge
Derivatives Hedge
Translation Exposure vs. Operating
Exposure
33
Nov 27, 2003
Translation Exposure versus
Transaction Exposure
Translation Exposure
The effect that unanticipated changes in exchange
rates has on the firm’s consolidated financial
statements a accounting issue.
Transaction Exposure
A 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.
Balance Sheet Hedge
Derivatives Hedge
35
Nov 27, 2003
Balance Sheet Hedge
Eliminates the mismatch between net
assets and net liabilities denominated
in the same currency.
May create transaction exposure,
however.
36
Nov 27, 2003
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.
37
Nov 27, 2003
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.
38
Nov 27, 2003
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.
39
Nov 27, 2003
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.
40
Nov 27, 2003
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.
41
Nov 27, 2003
The (Ir)relevance of Translation
Exposure*
Economic exposure is far more
relevant!
*P. Sercu and R. Uppal, International Financial Markets and the Firm, 1994
42
Nov 27, 2003
ECONOMIC EXPOSURE:
ACCOUNTING EXPOSURE:
1. A forward looking concept: it focuses on
future cashflows.
1. A backward-looking concept: it reflects past
decisions as reflected in the subsidiary's assets
and liabilities.
2. Involves real cashflows, not just
accounting figures.
3. Relates to changes in the economic value
(or, in an efficient market, the market
value) of the firm.
4. Contractual exposure depends on the
firm’s portfolio of FC engagements
undertaken in the past. Operating exposure
depends on the environment (especially the
market structure and the input-output mix)
and on the firm's strategic response (e.g.,
relocation of production, changes in the
marketing mix or financial structure, etc.).
5. Also exists for firms without foreign
subsidiaries, such as exporting firms,
import-competing firms, and notably
potential import-competing firms.
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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
possibly through taxation effects.
3. Changes the firm's accounting value, but not
necessarily its market value.
4. Depends on the accounting rules chosen. This
is because the subsidiary's own internal rules
affect its accounting values (e.g., type of
depreciation, or inventory valuation methods)
and also because the translation process itself can
be done in different ways (see below).
5. Accounting exposure only exists in the case of
foreign direct investment, since pure exporting or
import-substituting firms have no foreign
subsidiaries.
Nov 27, 2003