CHAPTER TEN
10
GFS 750: International
Financial Management
Management of Translation Exposure
Outline
 Translation Methods
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Current/Noncurrent Method
Monetary/Nonmonetary Method
Temporal Method
Current Rate Method
 Financial Accounting Standards Board
Statement 8
 Financial Accounting Standards Board
Statement 52

The Mechanics of the FASB 52
Outline


Translation Process
Highly Inflationary Economies
 Management of Translation Exposure
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Translation Exposure versus Transaction
Exposure
Hedging Translation Exposure
Balance Sheet Hedge
Derivatives Hedge
Translation Exposure versus Operating
Exposure
Introduction
 Translation exposure, also frequently called
accounting exposure, refers to the effect that
an unanticipated change in exchange rates
will have on the consolidated financial
reports of a MNC.
Translation Methods
1. Current/Noncurrent Method: assets and liabilities
should be translated based on their maturity.
 Current assets and liabilities are converted at
the current exchange rate.
 Noncurrent assets and liabilities are translated
at the historical exchange rate in effect at the
time the asset or liability was first recorded on
the books
Income statement items are translated at the
average exchange rate for the accounting period.
Translation Methods
2. Monetary/ Nonmonetary Method: all
monetary balance sheet accounts (cash,
marketable securities, accounts receivable, notes
payable, accounts payable) are translated at the
current exchange rate.
All other (nonmonetary) balance sheet accounts,
including stockholders’ equity, are translated at
the historical exchange rate in effect when the
account was first recorded.
Income statement accounts are translated at the
average exchange rate for the period
Translation Methods
3. Temporal Method: monetary accounts such
as cash, receivables, and payables (both
current and noncurrent) are translated at the
current exchange rate.
Other balance sheet accounts are translated at
current rate, if they are carried on the books at
current value; if they are carried at historical
costs, they are translated at the rate of exchange
on the date the item was placed on the books.
Most income statement items are translated at
the average exchange rate for the period.
Translation Methods
4. Current Rate Method: all balance sheet
accounts are translated at the current
exchange rate, except for stockholders’
equity.
The common stock account and any additional
paid-in capital are carried at the exchange rates
in effect on the respective dates of issuance.
Income statement items are to be translated at
the exchange rate at the dates the items are
recognized.
Effect of Translation Methods
on Financial Statement
Financial Accounting Standards
Board Statement 8
 Became effective on January 1, 1976.
 FASB 8 is essentially the temporal method of
translation as previously defined, but there
are some subtleties.
 FASB 8 ran into acceptance problems from
the accounting profession and MNCs from
the very beginning.
Financial Accounting Standards
Board Statement 52
 FASB 52 was issued in December 1981
1. Dissatisfaction with FASB No. 8 - true
profitability often disguised by exchange rate
volatility – temporal method
2. Balance sheet translation uses current rate
method.
3. Income statement uses:
i.
ii.
Weighted average rate during period or
The rate in effect when and expenses
incurred.
11
Financial Accounting Standards
Board Statement 52
4. Translation Gains or Losses
i.
Recorded in separate equity account on
balance sheet.
Known as cumulative translation
adjustment account.
5. New Distinction under FASB No. 52:
Functional vs. Reporting currency
ii.
i.
Functional currency: for foreign subsidiary =
the currency used in the primary economic
environment in which it operates.
Financial Accounting Standards
Board Statement 52
ii.
Reporting currency: the currency the parent
firm uses to prepare its financial statements.
The Mechanics of the FASB 52
Translation Process
 The actual translation process prescribed by FASB 52 is a
two-stage process.
i.
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. – use temporal method
ii.
When the foreign entity’s functional currency is not
the same as the parent’s currency, the foreign entity’s
books are translated from the functional currency into
the reporting currency using the current rate method.
The Mechanics of the FASB 52
Translation Process
Highly Inflationary Economies
 A highly inflationary economy is defined as
“one that has cumulative inflation of
approximately 100 percent or more over a 3year period.”
 FASB 52 requires that the foreign entity’s
financial statements be remeasured from the
local currency “as if the functional currency
were the reporting currency” using the
temporal translation method.
International Accounting
Standards
 Since January 2005, all companies doing
business in the European Union started using
the accounting standards promulgated by the
International Accounting Standards Board
(IASB).
 Similar to the FASB, the ISAB publishes its
standards in a series of pronouncements
called International Financial Reporting
Standards.
Hedging Translation Exposure
1. Balance Sheet Hedge: translation exposure is
not entity specific; rather, it is currency
specific. Its source is a mismatch of net assets
and net liabilities denominated in the same
currency. A balance sheet hedge eliminates
the mismatch.
2. Derivatives Hedge: a derivative product can
be used to attempt to hedge potential loss.
using a derivatives hedge to control
translation exposure involves speculation
about foreign exchange rate changes.
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END
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