Translation Exposure
(or chapter 10)
1
Agenda
 How translation exposure arises?
 Functional currency?
 Current Rate Method vs. Temporal Method.
 Balance Sheet Hedge?
 Earnings Management.
2


Translation Exposure
Potential for increase/ decrease in parent’s net worth &
reported income due to forex change.
Translation method differ:
• based on operation
– Integrated Foreign Entity: cash flow integrated w/ parent
– Self-sustaining Foreign Entity –independent of parent
• based on functional currency (currency of economic activity)
• Which currency is functional? Not a discretionary management
decision!
–
–
–
–
–
–
Cash flow
Sales prices
Sales market
Expenses
Financing
Intercompany tranactions
3
Translation Methods
Current (Closing) Rate Method
Temporal Method
Assets & Liabilities: translate @ current rate Assets & Liabilities:
(as of balance sheet date).
-Monetary: translate @ current rates.
-Non-monetary (inventory & fixed assets):
@ historical rates
Income statement Items: translate @ actual
rate when items incurred.
Income Statement Items: translated @
average rates except for depreciation & cost
of goods sold (@ historical rates)
Distributions: dividends translated @ the
rate on date of payment.
Distributions: dividends translated @ the
rate on date of payment.
Equity Items: Common stock & Paid-in
capital translated @ historical rates.
Retained earnings +/- income/loss for the
year.
Equity Items: Common stock & Paid-in
capital translated @ historical rates.
Retained earnings +/- income/loss +/imbalance from translation.
Translation Adjustments: not included into
consolidated income but in equity reserve
account.
Translation Adjustments: unrealized forex
gains/ losses included in primary earnings.
4
US Translation Procedures
Purpose: Need to translate foreign subs statement into US$
If subs financial statements kept in $,
no need for translation.
Is local currency
functional currency?
Yes
No
Is US$
functional currency?
1. Remeasure from foreign
currency to functional
by temporal method
2. Translate to US$
by current rate method
Use current rate method
No
Yes
Remeasure to US$
by temporal method
5
Hyperinflation Countries
 FAS #52: US subs in countries where cumulative
inflation 100%+ over 3 years use temporal method
• Why? B/c if current rate method, depreciation
understated & profits overstated => book value of PP&E
would disappear.
 International Practices:
• Integrated subsidiaries: re-measure using temporal
method.
• Self-sustaining subsidiaries: translate by current rate
method.
6
Translation Example







Suppose EUR depreciated 16.67% from $1.2/EUR to
$1.0/EUR
Functional currency EUR, Parent: US$
PP&E, common stock acquired @ $1.276/EUR
Inventory purchased/manufactured @ $1.218/EUR
Exposed assets:asset whose value drops w/ depreciation of
functional currency & rises w/ appreciation of functional
currency.
Net exposed assets: exposed assets – exposed liability
Implications:
• Appreciation -> increase net exposed assets.
• Depreciation -> decrease net exposed assets.
7
BALANCE SHEET TRANSLATION
CURRENT RATE METHOD
Assets
Cash
Accounts receivable
Inventory
Net plant & equipment
Total
Dec-02
EUR
($/EUR)
€ 1,600,000
1.20
3,200,000
1.20
2,400,000
1.20
4,800,000
1.20
€ 12,000,000
Liabilities & Net Worth
Accounts payable
€ 800,000
Short-term bank loan
€ 1,600,000
Lont-term debt
€ 1,600,000
Common stock
€ 1,800,000
Retained earnings
€ 6,200,000
CTA account
Total
€ 12,000,000
TEMPORAL METHOD
Assets
Cash
Accounts receivable
Inventory
Net plant & equipment
Total
1.20
1.20
1.20
1.28
1.20
Dec-02
EUR
($/EUR)
€ 1,600,000
1.20
3,200,000
1.20
2,400,000
1.22
4,800,000
1.28
€ 12,000,000
Liabilities & Net Worth
Accounts payable
€ 800,000
Short-term bank loan
€ 1,600,000
Lont-term debt
€ 1,600,000
Common stock
€ 1,800,000
Retained earnings
€ 6,200,000
CTA account (loss)
Total
€ 12,000,000
1.20
1.20
1.20
1.28
Jan-03
$
($/EUR)
1,920,000
1.00
3,840,000
1.00
2,880,000
1.00
5,760,000
1.00
14,400,000
$
$
$
$
$
$
1,600,000
3,200,000
2,400,000
4,800,000
12,000,000
$
960,000
1,920,000
1,920,000
2,296,800
7,440,000
(136,800)
14,400,000
$
$
$
$
$
$
$
800,000
1,600,000
1,600,000
2,296,800
7,440,000
(1,736,800)
12,000,000
$
$
$
$
$
Jan-03
$
($/EUR)
1,920,000
1.00
3,840,000
1.00
2,923,200
1.22
6,124,800
1.28
14,808,000
$
$
$
$
$
$
1,600,000
3,200,000
2,923,200
6,124,800
13,848,000
$
$
$
$
$
$
$
800,000
1,600,000
1,600,000
2,296,800
7,711,200
(160,000)
8
13,848,000
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
960,000
1,920,000
1,920,000
2,296,800
7,711,200
$
14,808,000
1.00
1.00
1.00
1.28
1.20
1.00
1.00
1.00
1.28
1.20
How to manage accounting exposure?

Balance Sheet Hedge –requires equal amount of exposed
forex assets & liabilities on consolidated balance sheet
• Termed monetary balance under temporal method
• Cost:


– Costly if borrowing cost of parent higher.
How to manage it if depreciation expected?
• Reduce EUR exposed assets, no change on EUR exposed liab.
• Increase EUR exposed liabilities, no change on EUR exposed
assets.
When balance sheet hedge justified?
• Subs to be liquidated
• Firm has debt covenants to maintain debt/equity ratios
• Management evaluated on basis of certain income statement and
•
balance sheet measures
Subs operating in hyperinflationary country
9
For example…
10
Earnings Management
EARNINGS INCRASING
EARNINGS SMOOTHING
LOSS AVOIDANCE
LOSS AVOIDANCE
11
Things to remember…
 How translation exposure arises?
 Functional currency?
 Current Rate Method vs. Temporal Method.
 Balance sheet hedge
 Earnings Management.
12