Accounting Exposure
Overview of Translation
 Accounting exposure, also called translation exposure, arises because financial
statements of foreign subsidiaries – which are stated in foreign currency – must be
restated in the parent’s reporting currency for the firm to prepare consolidated
financial statements.
 The accounting process of translation, involves converting these foreign
subsidiaries financial statements into US dollar-denominated statements.
 Translation exposure is the potential for an increase or decrease in the parent’s net
worth and reported net income caused by a change in exchange rates since the last
translation.
 Translation in principle is simple:
 Foreign currency financial statements must be restated in the parent company’s
reporting currency
 If the same exchange rate were used to remeasure each and every line item on the
individual statement (I/S and B/S), there would be no imbalances resulting from
the remeasurement
 What if a different exchange rate were used for different line items on an
individual statement (I/S and B/S)? An imbalance would occur
 Why would we use a different exchange rate in remeasuring different line items?
 Translation principles in many countries are often a complex compromise
between historical and current market valuation
 Historical exchange rates can be used for certain equity accounts, fixed assets, and
inventory items, while current exchange rates can be used for current assets,
current liabilities, income, and expense items.
 Two basic methods for the translation of foreign subsidiary financial statements are
employed worldwide:
 The current rate method: The current rate method is the most prevalent in the
world today.
 Assets and liabilities are translated at the current rate of exchange
 Income statement items are translated at the exchange rate on the dates they
were recorded or an appropriately weighted average rate for the period
 Dividends (distributions) are translated at the rate in effect on the date of
payment
 Common stock and paid-in capital accounts are translated at historical rates
 Gains or losses caused by translation adjustments are not included in the
calculation of consolidated net income.
 Rather, translation gains or losses are reported separately and accumulated in
a separate equity reserve account (on the B/S) with a title such as cumulative
translation adjustment (CTA).
 The biggest advantage of the current rate method is that the gain or loss on
translation does not pass through the income statement but goes directly to a
reserve account (reducing variability of reported earnings).
 The temporal method
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
Under the temporal method, specific assets are translated at exchange rates
consistent with the timing of the item’s creation.
 This method assumes that a number of individual line item assets such as
inventory and net plant and equipment are restated regularly to reflect market
value.
 Gains or losses resulting from remeasurement are carried directly to current
consolidated income, and not to equity reserves (increased variability of
consolidated earnings).
 If these items were not restated but were instead carried at historical cost, the
temporal method becomes the monetary/nonmonetary method of translation.
 Monetary assets and liabilities are translated at current exchange rates
 Nonmonetary assets and liabilities are translated at historical rates
 Income statement items are translated at the average exchange rate for the
period
 Dividends (distributions) are translated at the exchange rate on the date of
payment
 Equity items are translated at historical rates
 The US differentiates foreign subsidiaries on the basis of functional currency, not
subsidiary characterization.
 A foreign subsidiary’s functional currency is the dominant currency used by that
foreign subsidiary in its day-to-day operations.
 The US, requires that the functional currency of the foreign subsidiary be
determined based on the nature and purpose of the subsidiary.
 If the financial statements of the foreign subsidiary are maintained in US dollars,
translation is not required
 If the statements are maintained in the local currency, and the local currency is the
functional currency, they are translated by the current rate method
 If the statements are maintained in local currency, and the US dollar is the
functional currency, they are remeasured by the temporal method
 If the statements are in local currency and neither the local currency or the US
dollar is the functional currency, the statements must first be remeasured into the
functional currency by the temporal method, and then translated into US dollars
by the current rate method
Managing Translation Exposure
 The main technique to minimize translation exposure is called a balance sheet hedge
 A balance sheet hedge requires an equal amount of exposed foreign currency
assets and liabilities on a firm’s consolidated balance sheet.

If this can be achieved for each foreign currency, net translation exposure
will be zero.

If a firm translates by the temporal method, a zero net exposed position is
called monetary balance.

Complete monetary balance cannot be achieved under the current rate
method.

The cost of a balance sheet hedge depends on relative borrowing costs.
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 If a firm’s subsidiary is using the local currency as the functional currency, the
following circumstances could justify when to use a balance sheet hedge:
 The foreign subsidiary is about to be liquidated, so that the value of its CTA
would be realized
 The firm has debt covenants or bank agreements that state the firm’s
debt/equity ratios will be maintained within specific limits
 Management is evaluated on the basis of certain income statement and
balance sheet measures that are affected by translation losses or gains
 The foreign subsidiary is operating in a hyperinflationary environment
 Management will find it almost impossible to offset both translation and transaction
exposure at the same time.
 As a general matter, firms seeking to reduce both types of exposure usually
reduce transaction exposure first
 Transaction losses are considered “realized” and are deductible from pre-tax
income while translation losses are only “paper” losses and are not deductible
from pre-tax income.
Examples (next class)
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