Measuring accounting exposure
The general concept of exposure refers to the degree to which a company is
affected by exchange rate changes. Accounting exposure arises from the need, for
purposes of reporting and consolidation, to convert the financial statements of
foreign operations from the local currencies (LC) involved to the home currency
(HC). If exchange rates have changed since the previous reporting period, this
translation, or restatement, of those assets, liabilities, revenues, expenses, gains,
and losses that are denominated in foreign currencies will result in foreign
exchange gains or losses. The possible extent of these gains or losses is measured
by the translation exposure figures. The rules that govern translation are devised by
an accounting association such as the Financial Accounting Standards Board in the
United States, the parent firm's government, or the firm itself.
ALTERNATIVE CURRENCY TRANSLATION METHODS
Companies with international operations will have foreign currencydenominated assets and liabilities, revenues, and expenses. However, because
home-country investors and the entire financial community are interested in home
currency values, the foreign currency balance sheet accounts and income statement
must be assigned HC values. In particular, the financial statements of an MNC's
overseas subsidiaries must be translated from local currency to home currency
prior to consolidation with the parent's financial statements.
If currency values change, foreign exchange translation gains or losses may
result. Assets and liabilities that are translated at the current (postchange) exchange
rate are considered to be exposed; those translated at a historical (prechange)
exchange rate will maintain their historic HC values and, hence, are regarded as
not exposed. Translation exposure is simply the difference between exposed assets
and exposed liabilities. The controversies among accountants center on which
assets and liabilities are exposed and on when accounting-derived foreign
exchange gains and losses should be recognized (reported on the income
statement). A crucial point to realize in putting these controversies in perspective is
that such gains or losses are of an accounting nature—that is, no cash flows are
necessarily involved.
Four principal translation methods are available: the current/noncurrent
method, the monetary/nonmonetary method, the temporal method, and the current
rate method. In practice, there are also variations of each method.
Current/Noncurrent Method
At one time, the current/noncurrent method, whose underlying theoretical
basis is maturity, was used by almost all U.S. multinationals. With this method, all
the foreign subsidiary's current assets and liabilities are translated into home
currency at the current exchange rate. Each noncurrent asset or liability is
translated at its historical exchange rate; that is, at the rate in effect at the time the
asset was acquired or the liability incurred. Hence, a foreign subsidiary with
positive local currency working capital will give rise to a translation loss (gain)
from a devaluation (revaluation) with the current/noncurrent method, and vice
versa if working capital is negative.
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The income statement is translated at the average exchange rate of the
period, except for those revenues and expense items associated with noncurrent
assets or liabilities. The latter items, such as depreciation expense, are translated at
the same rates as the corresponding balance sheet items. Thus, it is possible to see
different revenue and expense items with similar maturities being translated at
different rates.
Monetary/Nonmonetary Method
The monetary/nonmonetary method differentiates between monetary assets
and liabilities—that is, those items that represent a claim to receive, or an
obligation to pay, a fixed amount of foreign currency units—and nonmonetary, or
physical, assets and liabilities. Monetary items (for example, cash, accounts
payable and receivable, and long-term debt) are translated at the current rate;
nonmonetary items (for example, inventory, fixed assets, and long-term
investments) are translated at historical rates.
Income statement items are translated at the average exchange rate during
the period, except for revenue and expense items related to nonmonetary assets and
liabilities. The latter items, primarily depreciation expense and cost of goods sold,
are translated at the same rate as the corresponding balance sheet items. As a
result, the cost of goods sold may be translated at a rate different from that used to
translate sales.
Temporal Method
The temporal method appears to be a modified version of the
monetary/nonmonetary method. The only difference is that under the
monetary/nonmonetary method, inventory is always translated at the historical rate.
Under the temporal method, inventory is normally translated at the historical rate,
but it can be translated at the current rate if the inventory is shown on the balance
sheet at market values. Despite the similarities, however, the theoretical bases of
the two methods are different. The choice of exchange rate for translation is based
on the type of asset or liability in the monetary/nonmonetary method; in the
temporal method, it is based on the underlying approach to evaluating cost
(historical versus market). Under a historical cost accounting system, as the United
States now has, most accounting theoreticians would probably argue that the
temporal method is the appropriate method for translation.
Income statement items are normally translated at an average rate for the
reporting period. However, cost of goods sold and depreciation and amortization
charges related to balance sheet items carried at past prices are translated at
historical rates.
Current Rate Method
The current rate method is the simplest; all balance sheet and income items
are translated at the current rate. Under this method, if a firm’s foreign currencydenominated assets exceed its foreign currency-denominated liabilities, a
devaluation must result in a loss and a revaluation, in a gain. One variation is to
translate all assets and liabilities except net fixed assets at the current rate.
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Table 1 - ALTERNATIVE CURRENCY TRANSLATION METHODS
Balance sheet items
Current
Methods
1. Current/
Noncurrent
2. Monetary/
Nonmonetary
3. Temporal
4. Current
Noncurrent
Monetary
Nonmonetary
(Long-term
(Fixed assets,
debt)
Equity)
Monetary
(Cash, AR,
STL, AP)
Nonmonetary
(Inventories)
C
C
H
C
H
C
C
H
(C – at market
value)
C
C
Income statement items
All revenues +
All expenses –
(CGS + A/D)
Cost of
goods sold
(CGS)
Depreciation /
Amortization
(D/A)
H
A
A
H
H
A
H
H
H
C
C
H
A
H
(C – at market
value)
C
C
(H – for
Capital
Stock)
C
C
C – current rate exchange; H – historical rate exchange; A – average rate exchange.
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Table 2 – Financial statement impact of translation alternatives (in USA $ thousands)
Total liabilities plus equity
Current liabilities
Long-term debt
Deferred income taxes
TOTAL current liabilities
Capital stock
Retained earnings
TOTAL equity
Translation gain (loss)
After REVALUATION
of local currency (LC 2,5 = $1)
Current
MoneCurrates for
try/
Temrnt/
all assets
Nonmooral
Noncuand
etary
rent
liabilities
3 140
3 680
3 710
4 400
$1 040
$1 040$
$1 040
$1 040
11 000
LC 2 600
3 600
200
6 400
3 600
1 000
4 600
900
50
1 600
900
250
1 150
900
50
1 470
900
250
1 150
720
50
1 290
900
250
1 150
720
40
1 280
900
250
1 150
720
40
1 280
720
200
920
900
50
1 990
900
250
1 150
1 440
50
2 530
900
250
1 150
1 440
80
2 560
900
250
1 150
1 440
80
2 560
1 440
400
1 840
11 000
3 400
3 000
500
6 900
1 500
2 600
4 100
2 750
850
750
125
1 725
375
650
1 025
2 620
680
600
100
1 380
375
865
1 240
2 440
680
600
100
1 380
375
685
1 060
2 430
680
750
125
1 555
375
500
875
2 200
680
600
100
1 380
375
445
820
3 140
1 360
1 200
200
2 760
375
5
380
3 680
1 360
1 200
200
2 760
375
545
920
3 710
1 360
750
125
2 235
375
1 100
1 475
4 400
1 360
1 200
200
2 760
375
1 265
1 640
-
-
$215
$35
$(150)
$(205)
$(645)
$(105)
$450
$615
Local
currency
Assets
Cash, marketable securities
and receivables
Inventory (at market)
Prepaid expenses
TOTAL current assets
Net fixed assets
Goodwill
TOTAL fixed assets
After DEVALUATION
of local currency (LC 5 = $1)
Current
MoneCurrates for
try/
Temrnt/
all assets
Nonmooral
Noncuand
etary
rent
liabilities
2 620
2 440
2 430
2 200
$520
$520
$520
$520
USA $
prior to
exchange
rate
change
(LC 4 =
$1)
2 750
$650
Assets = Total liabilities plus equity
Total equity = Assets - Total liabilities
Retained earnings include sum of translation gain (loss)
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Table 3 – Impact of translation methods
Methods
DEVALUATION
of Local Currency
REVALUATION
of Local Currency
1. Current/ Noncurrent
2. Monetary/ Nonmonetary
3. Temporal
4. Current
LOSS
GAIN
GAIN
LOSS
GAIN
LOSS
LOSS
GAIN
TYPES OF CURRENCY IN MNC
An affiliate’s functional currency is the currency of the primary economic
environment in which the affiliate generates and expends cash. If the enterprise's
operations are relatively self-contained and integrated within a particular country,
the functional currency would generally be the currency of that country. An
example of this case would be an English affiliate that both manufactures and sells
most of its output in England. Alternatively, if the foreign affiliate's operations are
a direct and integral component or extension of the parent company's operations,
the functional currency would be the U.S. dollar. An example would be a Hong
Kong assembly plant for radios that sources the components in the United States
and sells the assembled radios in the United States. It is also possible that the
functional currency is neither the local currency nor the dollar but, rather, is a third
currency.
The reporting currency is the currency in which the parent firm prepares
its own financial statements; that is, U.S. dollars for a U.S. firm. At each balance
sheet date, any assets and liabilities denominated in a currency other than the
functional currency of the recording entity must be adjusted to reflect the current
exchange rate on that date. Transaction gains and losses that result from adjusting
assets and liabilities denominated in a currency other than the functional currency,
or from settling such items, generally must appear on the foreign unit's income
statement. The only exceptions to the general requirement to include transaction
gains and losses in income as they arise are listed as follows:
1. Gains and losses attributable to a foreign currency transaction that is
designated as an economic hedge of a net investment in a foreign entity must be
included in the separate component of shareholders' equity in which adjustments
arising from translating foreign currency financial statements are accumulated. An
example of such a transaction would be a Deutsche mark borrowing by a U.S.
parent. The transaction would be designated as a hedge of the parent's net
investment in its German subsidiary. See, for example, the statement in Dow's
1989 Annual Report.
2. Gains and losses attributable to intercompany foreign currency
transactions that are of a long-term investment nature must be included in the
separate component of shareholders' equity. The parties to the transaction in this
case are accounted for by the equity method in the reporting entity's financial
statements.
3. Gains and losses attributable to foreign currency transactions that hedge
identifiable foreign currency commitments are to be deferred and included in the
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measurement on the basis of the related foreign transactions.
Table 4 – Functional currency
Types of affiliates
Functional currency
Integrated within a country of staying
Local currency
Component or extension of parent company
Parent country currency
Acts in country with hyperinflation
Parent country currency
Self-acting and nonintegrating within a country of
Currency of major
staying
operations
After all financial statements have been converted into the functional
currency, the functional currency statements are then translated into dollars, with
translation gains and losses flowing directly into the parent's foreign exchange
equity account.
If the functional currency is the parent country currency, the unit's local
currency financial statements must be remeasured in parent country currency. The
objective of the remeasurement process is to produce the same results that would
have been reported if the accounting records had been kept in parent country
currency rather than the local currency.
A large majority of firms have opted for the local currency as the functional
currency for most of their subsidiaries. The major exceptions are those
subsidiaries operating in Latin American and other highly inflationary countries
that must use the parent country currency as their functional currency.
THE EFFECTS OF FOREIGN-EXCHANGE EXPOSURE
Translation Exposure
A Mexican subsidiary reports cash in the bank of 900 000 pesos at a time
when 9,5 pesos will but AU$1; thus its Australian parent translated the net in
pesos in AU$94 737. When the exchange rate changes, however, and 10 pesos are
required to by AU$1, the total of 900 000 pesos must be retranslated from
AU$94 737 into AU$90 000.
Table 5 – The effect of foreign-exchange translation exposure
Index
Australian company bank account in Mexico
Initial exchange rate
Initial bank account worth
Subsequent exchange rate
Subsequent bank account worth
Amount
900 000 pesos
9,5 pesos/AU$
AU$94 737
10 pesos/AU$
AU$90 000
Calculation
= 900 000 / 9,5
= 900 000 / 10
Transaction exposure
If an Australian company denominates its sales in AU$, it has no transaction
exposure. If it denominates the sale in British pounds, the AU dollar value of the
receivable rises or falls as the exchange rate changes, as illustrated in table 5.
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Table 6 – The effect of foreign-exchange transaction exposure
Index
Total price of merchandise on Exporter’s books
Initial exchange rate
Initial underlying value of sale
Amount received by Exporter
Subsequent exchange rate
Subsequent payment value of collected
receivable
Loss to Exporter
Amount
AU$500 000
1,9 AU$/£
£263 158
£263 158
1,88 AU$/£
AU$494 737
Calculation
= AU$500 000 / 1,9
AU$5 263
= AU$500 000 - AU$494 737
= AU$500 000 / 1,88
Economic (or Operating) exposure
The transaction is the same as in Transaction exposure, but this the British
importer must pay the Australian Exporter in dollars.
The first calculation shows how many British pounds the Importer must
come up with to convert to AU dollars to pay the Exporter. That amount is then
marked up 10% for sale in the United Kingdom.
The next calculation assumes that the British pound weakens to AU$1,88
per pound, meaning that the Importer has to come up with more pounds to convert
to AU dollars to pay the Exporter. The higher amount is then marked up by 10%,
and we show how much more the Importer would have to charge in the market
and how much the Importer’s profit margin would be at the higher price.
However, the economic exposure is that the Importer may not be able to sell
the products at a higher price, so there are two options:
1. One is for the Importer to sell the product for the same price as before
and accept a lower profit margin (£23 517) or
2. For the Exporter to charge only AU$494 737, which would allow the
Importer to pay the same amount in British pounds as before the
exchange rate change and still be able to keep the price the same in the
United Kingdom and earn the same profit margin as before.
The difference between the last two calculations is that the Importer suffers
a drop in profits in the first case and the Exporter suffers a drop in profits in the
second case.
Table 7 – The effect of foreign-exchange economic exposure
Index
Total price of merchandise on Exporter’s books
Initial exchange rate
Initial underlying value of sale
Amount charged by Importer after 10% markup
Subsequent exchange rate
Subsequent underlying value of sale
Amount charged by Importer after 10% markup
Difference in sales price before and after rate change
Profit to Importer if Importer charged higher price
Profit to Importer if Importer absorbs cost increase
Price charged by Exporter for constant cost to
Importer
Amount
AU$500 000
1,9 AU$/£
£263 158
£289 474
1,88 AU$/£
£265 957
£292 553
£3 079
£26 596
£23 517
AU$494 737
Calculation
= AU$500 000 / 1,9
= £263 158 * (1 + 0,1)
= AU$500 000 / 1,88
= £265 957 * (1 + 0,1)
= £292 553 - £289 474
= £292 553 - £265 957
= £289 474 - £265 957
= £263 158 * 1,88
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Problems
1. Suppose that on January 1, American Golf's French subsidiary, Golf du
France, had a balance sheet that showed current assets of FF 1 million; current
liabilities of FF 300,000; total assets of FF 2.5 million; and total liabilities of FF
900,000. On December 31, Golf du France's balance sheet in francs was
unchanged from the figures given above, but the franc had declined in value from
$0.1270 at the start of the year to $0.1180 at the end of the year. Under FASB-52,
what is the translation amount to be shown on American Golf’s equity account for
the year if the franc is the functional currency? How would your answer change if
the dollar were the functional currency?
2. Suppose that at the start and at the end of the year, Bell U.K. had current
assets of £.1 million, fixed assets of £2 million, and current liabilities of £1 million.
Bell has no long-term liabilities. If the pound depreciated during that year from
$1.50 to $1.30, what will be the FASB-52 translation gain (loss) to be included in
the equity account of Bell's U.S. parent?
3. Zapata Auto Parts, the Mexican affiliate of American Diversified, Inc.,
had the following balance sheet on January 1, 1992:
ASSETS (PS MILLIONS)
LIABILITIES (PS MILLIONS)
Cash, marketable securities
Ps 1 000 Current liabilities
Ps 47 000
Accounts receivable
50 000 Long-term debt
12 000
Inventory
32 000 Equity
135 000
Net fixed assets
111 000
Ps 194 000
Ps 194 000
The exchange rate on January 1, 1992, was Ps 8,000 = $1.
a. What is Zapata's FASB-52 peso translation exposure on January 1, 1992?
b. Suppose the exchange rate on December 31, 1992, is Ps 12,000. What will
be Zapata's translation loss for the year?
c. Zapata can borrow an additional Ps 15,000. What will happen to its
translation exposure if it uses the funds to pay a dividend to its parent? If it uses the
funds to increase its cash position?
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