Translation Exposure
Chapter Ten
Eitman, Stonehill, and Moffett
July 17, 2016
ESM Chapter Ten - Translation
Exposure
1
Translation exposure
 foreign currency financial statements
 different line items translated at
different exchange rates
 term of different assets & liabilities
translated at
 historical rates
 current rates
July 17, 2016
ESM Chapter Ten - Translation
Exposure
2
Foreign subsidiaries
 Integrated foreign entity
 Extension of parent firm
 Cash flows denominated in functional currency
 Supplier to the parent firm
 Self-sustaining foreign entity




Operates independently in foreign environment
Cash flows denominated in foreign currency
Supplied by local economy
Supplies local economy
July 17, 2016
ESM Chapter Ten - Translation
Exposure
3
Functional currency
 Primary economic environment of the
firm
July 17, 2016
ESM Chapter Ten - Translation
Exposure
4
Balance sheet




cash
market securities
receivables
inventories
 fixed assets
July 17, 2016
 payables
 accruals
 fixed debt
 common stock
 pd in capital
 acc. Retained
earnings
ESM Chapter Ten - Translation
Exposure
5
Income statement
 Revenues
 (Costs)
 (COGS)
 (Operating costs)
 (Depreciation)
 (Taxes)
 Net Income
 retained
 distributed
July 17, 2016
ESM Chapter Ten - Translation
Exposure
6
Types of foreign firms
 integrated foreign entity
 one which operates as an extension of
the parent firm
 functional currency is that of the parent
firm
 self-sustaining foreign entity
 one which operates independently of the
parent firm
 functional currency is that of the foreign
country
July 17, 2016
ESM Chapter Ten - Translation
Exposure
7
Determining the functional
currency
 intercompany transactions
 large volume - use parent currency
 small volume - use foreign currency
 large volume determined by a large split
between revenues and costs
 sales price responsive more to exchange rate
changes
 costs due to importing components from parent
company
 interest costs on financing in home currency
July 17, 2016
ESM Chapter Ten - Translation
Exposure
8
Current method (Historical)
 balance sheet items at current rate
 income statement items
 exchange rate in effect on dates incurred
 average exchange rate over the period
 distributions - rate on date of payment
 equity
 equity & pd in capital historical rates
 retained earnings at historical
 cum translation adj - on consolidated BS
July 17, 2016
ESM Chapter Ten - Translation
Exposure
9
Rationale for using current
method
 if relative PPP holds
 real assets depreciate in foreign currency
terms
 real assets retain constant value in home
currency terms
 monetary (financial) assets do not have
time to depreciate
 if relative PPP does not hold
 case is the same as that of a firm in an
inflationary or deflationary climate
July 17, 2016
ESM Chapter Ten - Translation
Exposure
10
Temporal
 balance sheet items - stock statement
 monetary assets & liabilities current rate
 non-monetary assets & liabilities - historical
rate
 inventories may be assigned as current assets
 income statement items - flow statement
 most items average rate
 except cashflows associated with non-current
assets or liabilities translated - historical rate
 depreciation
July 17, 2016
ESM Chapter Ten - Translation
Exposure
11
Temporal
 Assets
 Liabilities
 Cash
 marketable
securities
 accounts receivable
 inventories
 fixed assets
July 17, 2016
 accounts payable
 notes payable
 accruals
 long-term
liabilities
 equity
ESM Chapter Ten - Translation
Exposure
12
Temporal






revenues
(cost of goods sold)
(operating costs)
(amortization)
(depreciation)
(Taxes)
 Net Income
July 17, 2016
ESM Chapter Ten - Translation
Exposure
13
Rationale for using temporal
method
 This reflects normal evaluation
 Book values are used
 monetary (financial) assets do not have
time to depreciate
 if relative PPP does not hold
 case is the same as that of a firm in an
inflationary or deflationary climate
July 17, 2016
ESM Chapter Ten - Translation
Exposure
14
Balance Sheet Hedge
 Must match foreign denominated
liabilities to assets
 Borrow the expected change in equity
 Based on an expected future spot
 Convert to home currency now
 Sell assets equivalent to change in
equity
 Convert to home currency now
July 17, 2016
ESM Chapter Ten - Translation
Exposure
15
Current




cash
market securities
receivables
inventories
 fixed assets
July 17, 2016
 payables
 accruals
 fixed debt
 common stock
 pd in capital
 acc. Retained
earnings
ESM Chapter Ten - Translation
Exposure
16
Temporal
 Assets
 Liabilities
 Cash
 marketable
securities
 accounts receivable
 inventories
 fixed assets
July 17, 2016
 accounts payable
 notes payable
 accruals
 long-term
liabilities
 equity
ESM Chapter Ten - Translation
Exposure
17
Justifying a Balance Sheet
Hedge
 Liquidation of current foreign
operations in the short to medium
term
 Maintenance of debt covenants
 Subsidiary operating under
hyperinflation
July 17, 2016
ESM Chapter Ten - Translation
Exposure
18