Chapter 10
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.
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Overview of Translation
• 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.
• While the main purpose of translation is to
prepare consolidated statements, management
uses translated statements to assess
performance (facilitation of comparisons across
many geographically distributed subsidiaries).
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Overview of 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 reslult
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Overview of Translation
• 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.
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Overview of Translation
• Most countries today specify the translation method
used by a foreign subsidiary based on the subsidiary’s
business operations (subsidiary characterization).
• For example, a foreign subsidiary’s business can be
categorized as either an integrated foreign entity or a
self-sustaining foreign entity.
• An integrated foreign entity is one that operates as an
extension of the parent, with cash flows and business
lines that are highly interrelated.
• A self-sustaining foreign entity is one that operates in
the local economic environment independent of the
parent company.
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Overview of Translation
• A foreign subsidiary’s functional currency is
the currency of the primary economic
environment in which the subsidiary operates
and in which it generates cash flows.
• In other words, it is the dominant currency
used by that foreign subsidiary in its day-today operations.
• The US, requires that the functional currency
of the foreign subsidiary be determined based
on the nature and purpose of the subsidiary.
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Overview of Translation
• Two basic methods for the translation of foreign
subsidiary financial statements are employed
worldwide:
– The current rate method
– The temporal method
• Regardless of which method is employed, a translation
method must not only designate at what exchange rate
individual balance sheet and income statement items
are remeasured, but also designate where any
imbalance is to be recorded (current income or an
equity reserve account).
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Overview of Translation
• 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
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Overview of Translation
• 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).
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Overview of Translation
• 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).
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Overview of Translation
• 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
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Overview of Translation
• The US differentiates foreign subsidiaries on the basis of
functional currency, not subsidiary characterization.
– 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
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Exhibit 10.2 Procedure Flow Chart for United States
Translation Practices
Purpose: Foreign currency financial statements must be translated into U.S. dollars
If the financial statements of the foreign subsidiary
are expressed in a foreign currency, the following
determinations need to be made.
Is the local currency the
functional currency?
Yes
No
Is the dollar the
functional currency?
Remeasure from foreign
currency to functional
(temporal method)
and translate to dollars
(current rate method)
Translated to dollars
(current rate method)
No
Yes
Remeasure to dollars
(temporal method)
* The term “remeasure” means to translate, as to change the unit of measure, from a foreign
currency to the functional currency.
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Overview of Translation
• Many of the world’s largest industrial countries –
as well as the relatively newly formed
International Accounting Standards Committee
(IASC) follow the same basic translation
procedure:
– A foreign subsidiary is an integrated foreign entity
or a self-sustaining foreign entity
– Integrated foreign entities are typically remeasured
using the temporal method
– Self-sustaining foreign entities are translated at the
current rate method, also termed the closing-rate
method.
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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.
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Managing Translation Exposure
• The cost of a balance sheet hedge
depends on relative borrowing costs.
• These hedges are a compromise in which
the denomination of balance sheet
accounts is altered, perhaps at a cost in
terms of interest expense or operating
efficiency, to achieve some degree of
foreign exchange protection.
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Managing Translation Exposure
• 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
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Managing Translation Exposure
• 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.
• Taxes complicate the decision to seek protection against
transaction or translation exposure.
• 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.
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Evaluation of Performance
• An MNE must be able to set specific financial
goal, monitor progress by all units of the
enterprise towards those goals, and evaluate
results.
• An MNE must be able to measure the
performance of each of its subsidiaries on a
consistent basis, and managers of subsidiaries
must be given unambiguous objectives against
which they will be judged.
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Evaluation of Performance
• The MNE must determine for itself the proper
balance between three operating financial
objectives:
– Maximization of consolidated after-tax income
– Minimization of the firm’s effective global tax
burden
– Correct positioning of the firm’s income, cash
flows, and available funds
• These goals are frequently inconsistent.
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Evaluation of Performance
• Managers of foreign subsidiaries must be able
to run their own operations efficiently
according to achievable objectives.
• All firms expand and modify their domestic
profitability measures when applying them to
foreign subsidiaries.
• In addition, some firms establish foreign
subsidiaries for objectives not related to normal
corporate profit-oriented goals.
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Evaluation of Performance
• There are four purposes of an internal
evaluation system:
– To ensure adequate profitability
– To have an early warning system if
something is wrong
– To have a basis for allocating resources
– To evaluate individual managers
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Evaluation of Performance
• International financial evaluation of foreign
subsidiaries is both unique and difficult.
• Use of one foreign exchange translation
method, in an attempt to measure results in the
home currency, will present a different measure
of success or of compliance with
predetermined goals than use of some other
translation method.
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Evaluation of Performance
• The results of any control system must be
judged against distortions of performance
caused by widely differing national
business environments.
• International measurement systems are
distorted by decisions to benefit the
world system (MNE) at the expense of a
specific local subsidiary.
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Evaluation of Performance
• The impact of exchange rate movements on the
measured performance of foreign subsidiaries
is one of the single largest dilemmas facing
management of the MNE.
• The evaluation of the performance of an MNE
subsidiary involves three different evaluation
dimensions:
– Management evaluation
– Subsidiary evaluation
– Strategic evaluation
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