III.2 TranslationAccounting Exposure MSE Ch. 10

1
III.2 Translation/Accounting Exposure (MSE Ch.
10)

• 6F130 International Finance
• Prof. David S. Bates
• Lecture 20

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Translation Exposure

• MNCs have FC-denominated
• assets liabilities
• revenues expenses
• HC investors, regulators want to know HC-valued
  balance sheet income statements
• The translation method used affects how the B/S
  I/S are affected by X-rate changes
• translation exposure
• Does it matter?
• Maybe.

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Translation exposure

• Approaches
• Temporal method
• Current rate method
• Issue 2 Where are exchange-rate related
  translation gains/losses reported?
• Income statement?
• Elsewhere in balance sheet?

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Temporal method

• (Premise historical-cost accounting)
• (Foreign) monetary assets and liabilities
• Cash, marketable securities, ARs, LT receivables
• Current liabilities (APs), LT debt
• translated at current market value current
  exchange rate
• Nonmonetary assets and liabilities
• fixed assets (plant equipment),
• inventory
• valued translated at historical cost
  historical exchange rate when acquired

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Current Rate Method

• (Foreign) monetary assets and liabilities
• Cash, marketable securities, ARs, LT receivables
• Current liabilities (APs), LT debt
• translated at current market value current
  exchange rate
• Nonmonetary assets and liabilities
• fixed assets (plant equipment),
• inventory
• valued translated at current market value (if
  possible) current exchange rate

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U.S. accounting practices

• Pre-71 fixed exchange rates
• 1975 FASB 8
• Temporal method
• Monetary AL _at_ current X-rate
• Fixed assets _at_ historical X-rate
• Translation gains losses reported in income
  statement, creating volatile reported earnings

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Example of FASB 8 problems

• U.S. parent firm
• issues DM bonds
• builds a German factory
• DM revenues cover DM coupon payments
• little operating exposure

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Example of FASB 8 problems

• FASB 8
• Factory is a fixed asset
• Evaluated at historical X-rate (3 DM/)
• B/S valuation unaffected by X-rate changes
• DM debt is a monetary liability
• Evaluated at current X-rate affected by X-rate
  changes
• Result
• Enormous translation exposure!!
• Highly volatile earnings statements!!!

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FASB 52

• Current rate method, mostly.
• Monetary AL _at_ current X-rate
• Fixed assets _at_ current X-rate
• Effects of X-rate changes on fixed asset
  valuation reported in balance sheet (cumulative
  translation adjustment). Not in income
  statement (until realized by sale of fixed
  asset).
• Transactions exposure (unhedged AR, AP) still
  affects income statement.

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U.S accounting standards
1975-81FASB 8
1981-todayFASB 52
TemporalMethod
Current rateMethod
Monetary(AR, debt, etc.)
CurrentX-rate
CurrentX-rate
Fixed(PE, inventory)
HistoricalX-rate
CurrentX-rate
Asset translationgains/losses reported
Incomestatement
separate equityacct in B/S
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U.S accounting standards

• Actually somewhat more complicated.
• FASB 52 current rate vs. temporal translation
  method depends on nature of foreign affiliate
• -based accounting no translation problem
• FC-based accounting/FC functional currency
  current rate method
• (self-sustaining foreign entity)
• FC-based accounting/ functional currency
  temporal method
• (integrated foreign entity -- extension of
  parent)
• hyperinflation countries -based accounting

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Managing Translation Exposure

• Should it be managed?
• FASB 8 volatile earnings from X-rate changes
  induced hedging of translation exposure (window
  dressing)
• altering currency of LT debt
• forward positions
• Less need under FASB 52

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Translation vs. Operating Exposure

• Translation/accounting exposure is retrospective
  
• focus on effect of currency changes upon result
  from past decisions of firm (assets
  liabilities)
• Operating/economic exposure is prospective
• focus on effect of currency changes upon future
  cash flows of firm
• The two measures can diverge.

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Translation vs. Operating Exposure

• Example Debt-financed factory producing a
  steady stream of FC revenues
• Operating exposure looks at the
• present value of all future expected revenues
  from the factory
• less the cost of the factory (debt liability)
• Translation exposure looks at
• the value of the factory
• the near-term contracted net revenues (ARs
  APs)
• less the debt liability
• Substantial overlap, but
• Accounting measures of factory value can diverge
  from the estimated PV of revenues from the factory

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Managing Translation Exposure

• Tax issues
• Gains/losses from transaction exposure affects
  corporate income, and taxes
• Gains/losses from other aspects of translation
  exposure are paper capital gains/losses.
• No tax impact until realized by a sale.
• Investors perception of firm
• Claim sophisticated institutional investors
  dont require/arent fooled by dressed-up
  balance sheet

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How do firms manage exposure?

• U.S. firms concerns
• Active concern about transaction exposure
• Directly affects income statement
• Many firms hedge short-term
• Some concern about operating exposure
• Relevant to firms competitiveness prospects
• Some use of financial hedges (LT debt, swaps)
• Strategic responses
• Little direct concern about translation exposure,
  apart from accounting earnings (transaction
  exposure)