Translation Exposure

(or chapter 10)

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 Agenda
How translation exposure arises?

Functional currency?

Current Rate Method vs. Temporal Method.

Balance Sheet Hedge?

Earnings Management.

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 Translation Exposure
Potential for increase/ decrease in parents 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

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 Translation Methods
Current (Closing) Rate Method
Assets & Liabilities: translate @ current rate Assets & Liabilities:
(as of balance sheet date).
Income statement Items: translate @ actual
rate when items incurred.
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.
Translation Adjustments: not included into
consolidated income but in equity reserve
account.
Temporal Method
-Monetary: translate @ current rates.
-Non-monetary (inventory & fixed assets):
@ historical rates
Income Statement Items: translated @
average rates except for depreciation & cost
of goods sold (@ historical rates)
Distributions: dividends translated @ the
rate on date of payment.
Equity Items: Common stock & Paid-in
capital translated @ historical rates.
Retained earnings +/- income/loss +/-
imbalance from translation.
Translation Adjustments: unrealized forex
gains/ losses included in primary earnings.
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 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?

No Yes

Is US$
Use current rate method
functional currency?

1. Remeasure from foreign

currency to functional No Yes Remeasure to US$
by temporal method by temporal method
2. Translate to US$
by current rate method

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 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.

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 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.

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BALANCE SHEET TRANSLATION
CURRENT RATE METHOD
Dec-02 Jan-03
Assets EUR ($/EUR) $ ($/EUR) $
Cash 1,600,000 1.20 $ 1,920,000 1.00 $ 1,600,000
Accounts receivable 3,200,000 1.20 $ 3,840,000 1.00 $ 3,200,000
Inventory 2,400,000 1.20 $ 2,880,000 1.00 $ 2,400,000
Net plant & equipment 4,800,000 1.20 $ 5,760,000 1.00 $ 4,800,000
Total 12,000,000 $ 14,400,000 $ 12,000,000

Liabilities & Net Worth

Accounts payable 800,000 1.20 $ 960,000 1.00 $ 800,000
Short-term bank loan 1,600,000 1.20 $ 1,920,000 1.00 $ 1,600,000
Lont-term debt 1,600,000 1.20 $ 1,920,000 1.00 $ 1,600,000
Common stock 1,800,000 1.28 $ 2,296,800 1.28 $ 2,296,800
Retained earnings 6,200,000 1.20 $ 7,440,000 1.20 $ 7,440,000
CTA account (136,800) $ (1,736,800)
Total 12,000,000 $ 14,400,000 $ 12,000,000
TEMPORAL METHOD
Dec-02 Jan-03
Assets EUR ($/EUR) $ ($/EUR) $
Cash 1,600,000 1.20 $ 1,920,000 1.00 $ 1,600,000
Accounts receivable 3,200,000 1.20 $ 3,840,000 1.00 $ 3,200,000
Inventory 2,400,000 1.22 $ 2,923,200 1.22 $ 2,923,200
Net plant & equipment 4,800,000 1.28 $ 6,124,800 1.28 $ 6,124,800
Total 12,000,000 $ 14,808,000 $ 13,848,000

Liabilities & Net Worth

Accounts payable 800,000 1.20 $ 960,000 1.00 $ 800,000
Short-term bank loan 1,600,000 1.20 $ 1,920,000 1.00 $ 1,600,000
Lont-term debt 1,600,000 1.20 $ 1,920,000 1.00 $ 1,600,000
Common stock 1,800,000 1.28 $ 2,296,800 1.28 $ 2,296,800
Retained earnings 6,200,000 $ 7,711,200 1.20 $ 7,711,200
CTA account (loss) $ (160,000)
Total 12,000,000 $ 14,808,000 $ 8
13,848,000
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
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For example

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 Earnings Management
EARNINGS INCRASING
EARNINGS SMOOTHING

LOSS AVOIDANCE
LOSS AVOIDANCE

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 Things to remember
How translation exposure arises?

Functional currency?

Current Rate Method vs. Temporal Method.

Balance sheet hedge

Earnings Management.

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