INTERNATIONAL ACCOUNTIN

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Fall 2008
International Finance Faculty Professor Bernard
Dumas International Accounting
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Introduction

• What is the objective to be pursued when managing
  the foreign-exchange risk of a firm?
• There are basically two possibilities
• some corporations are concerned that their
  accounting statement should not show a large (and
  presumably highly fluctuating)entry under
  "Foreign Exchange Gains and Losses".
• Other corporations largely disregard this item
  and are mostly concerned with the value expressed
  in their home currency of the cash flows which
  they will ultimately collect.
• We need to clarify this choice by asking the
  question should the item labeled "Foreign
  Exchange Gains and Losses serve
• ex ante as a management goal
• and ex post as a measure of management's ability
  to handle the exchange risk dimension?

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Overview

• Three basic principles of international
  accounting
• Why accounting exposure is not the proper
  management tool
• Translation and consolidation of the financial
  statements of foreign subsidiaries

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Three basic principles of international accounting
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Foreign Currency Transactions

• A corporation is often involved in transactions
  whose amount is set and agreed to in a currency
  other than the one its keeps its books in.
  Examples of these are
• purchases and sales of goods invoiced in foreign
  currencies,
• the acquisition and holding of foreign-currency
  denominated nominalassets (cash and bonds and
  Treasury bills) and liabilities (long-termdebt)
• the holding of inventories abroad when they are
  carried at local market value
• These will all generate "Foreign Exchange Gains
  and Losses
• We wish to clarify how these are computed.
• The basic principle (Principle 1) of accounting
  is that foreign-currency transactions
• must be translated into home currency using the
  spot exchange rate prevailing on the date of the
  transaction, and recorded as they occur,
• are settled at spot exchange rate prevailing at
  settlement date
• FC gain or loss is recorded in income on the
  settlement date

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Let us write the entries corresponding to a sale
transaction

• Consider a firm that sells a good for 100 units
  of foreign currency
• Date of invoice t0
• Spot value of foreign currency at that date S0
• Date of settlement t1
• Spot value of foreign currency at that date S1 gt
  S0

This is the record keeping for a transaction
completed within the balance-sheet period. The
highlighted items enter income immediately, as
their sum represents the dollar receipts for the
sale.
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Entries on balance sheet date

• Consider a firm that sells a good for 100 units
  of foreign currency
• Date of invoice t0
• Spot value of foreign currency at that date S0
• Closing date of B/S tb
• Spot value of foreign currency at that date Sb
• Date of settlement t1
• Spot value of foreign currency at that date
  example Sb gt S1 gt S0

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Remeasurement

• The value of balance-sheet accounts is updated to
  reflect the spot exchange rate prevailing at that
  date (closing rate).
• Some balance sheet items are classified as
  nominal in foreign currency and exposed to
  currency fluctuations (accounts receivable and
  payable, cash and long-term debt) and are,
  therefore, completely adjusted to reflect the
  closing rate,
• while other items (mostly fixed assets) are
  deemed totally unexposed and carried at their
  historical values.
• ________
• Inventories located abroad are adjusted if
  carried at market, and are not adjusted if
  carried at cost.

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Principles contd

• Transactions gains and losses can only arise from
  transactions already booked as, for example,
  accounts payable or receivable, or from cash on
  hand or debt (Principle 2).
• Their calculation rests on a dichotomous
  distinction between exposed and unexposed
  balance-sheet items (Principle 3).
• Definition
• Accounting exposure exposed assets exposed
  liabilities

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Why accounting exposure is not the right
management tool
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Effects of Exchange Rates on the Firm

• Three sources of exchange rate impacts on firms
• Already booked foreign-currency transactions and
  investments/liabilities denominated in FC
• Foreign-currency transaction exposure
• Transactions whose terms have already been set
  (contract..) but not yet booked,
• Extension of foreign-currency transaction
  exposure
• Future revenues
• Operating exposure to exchange rates
• Current accounting methods only capture the first
  impact.
• A correction using the same method can take care
  of the second impact.
• Accounting does not consider the third impact.

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Why accounting exposure is not the right
management tool (Example 1)
credit period
time
0
1
2
invoicing
today
settlement
behavior of exchange rate
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Why accounting exposure is not the right
management tool (Example 2)
repayment of debt D
A
L
(for the sake of illustration, imagine that D
happens to be equal to X1 (1r) X2)
A/R X1
Debt D
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Accounting exposure vs. Operating exposure

• Contra accounting, pricing and invoicing in
  domestic currency does not insulate you from
  exchange risk.
• It does so only over the credit period after a
  sale has been made, shipment has taken place and
  one is waiting for the customer to pay.
• That this should be a complete cover is a
  misconception arising frequently because of
  accounting practices.
• In fact, pricing and invoicing in domestic
  currency leaves you fully exposed to volume
  effects
• linked to losses or gains in competitiveness
  resulting from exchange rate changes,
• during the long period of time which extends
  between now (when you can do something to hedge)
  and the moment of sale.
• This effect will be picked up by operating
  exposure

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Foreign subsidiaries
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Foreign subsidiaries

• Another category of exchange gains and losses --
  but one to which managers pay less and less
  attention already -- arises,
• not from a company's own foreign currency
  transactions
• but from the consolidation of its foreign
  subsidiaries accounts, on financial statement
  dates
• Consolidation is done mostly for the purpose of
  publishing the annual report, and not for fiscal
  purposes . There are some countries and cases in
  which consolidated income is taxed but that is
  not the general case
• Foreign subsidiaries are incorporated abroad
• they typically keep their accounts in currencies
  other than the parents home currency
• Consolidation of accounts evidently requires
  translation into parent home currency units.
• There are basically two methods to perform this
  translation, neither of which is satisfactory
• The temporal method
• The current rate (or closing rate) method

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The temporal method

• The objective is to reconstruct the foreign
  subsidiary's accounts as they would have been
• if the transactions had been recorded directly in
  parent company currency as they occurred,
  following in so doing the method of Foreign
  Currency Transactions (see above)
• As such, the result is, by construction,
  perfectly consistent with the treatment of assets
  owned and transactions directly handled by the
  parent company.

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Many exchange rates

• Since the purpose is historical reconstruction,
  the various accounts cannot be translated at a
  uniform rate.
• The translation of each unexposed account must be
  done using the particular spot rate that
  prevailed at the time of the transaction (dubbed
  the "historical rate") that gave rise to the
  asset in question.
• Exposed assets and liabilities, however, must be
  translated at the closing rate, in line with the
  updating principle.
• The classification into exposed vs. unexposed is
  identical to the one used for corporations' own
  Foreign Currency Transactions

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The income statement is translated according to
similar principles

• Each sale, purchase or expenditure is translated
• at the spot rate that prevailed when the
  transaction took place.
• When this too cumbersome, the average exchange
  rate for the period is used to translate all
  transactions.
• The translated cost of goods sold is equal to
• translated purchases and production expenditures
• minus the increase in inventories,
• where the beginning-of-period and end-of-period
  translated inventories are identical to those
  shown on the beginning-of-period and
  end-of-period translated balance sheets.
• This ensures perfect consistency between the
  balance sheet and the income statement.

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Translation adjustment

• Since various items (whether of the B/S or of the
  I/S) are translated at different rates, accounts
  which were balanced before translation, no longer
  are afterwards.
• The plug for the imbalance is called the
  translation adjustment
• equal to
• the net amount of exposed assets obtained in
  previous periods times the exchange rate change
  during the period,
• plus the net amount of exposed assets obtained
  this period times the exchange rate change since
  each one of them was acquired.
• It is incorporated into the translated net income
  shown in the income statement.
• The translation of various items of the income
  statement at different exchange rates means that
  the net income expressed in home-currency is not
  the foreign currency net income translated at
  some implied exchange rate.
• Counter-intuitive result The positive foreign
  net income of a subsidiary can very well turn
  into a negative home-currency net income
  contribution for the parent. A gain can translate
  into a loss and vice versa!

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The current-rate method

• The objective of the closing-rate method is
  allegedly to preserve the structure of the
  foreign subsidiary's accounts.
• It requires translation of all accounts at a
  uniform rate.
• In this way all structural ratios (sales to cost
  of goods sold, debt to equity etc...) remain
  unaffected by translation further, a net gain
  remains a net gain and does not turn into a net
  loss.
• More specifically, all balance-sheet items --
  except equity which, of necessity, is carried
  over from the previous period translated b/s --
  are translated at the closing rate.
• This generates a translation adjustment equal to
  the subsidiary's end-of-period net worth (or net
  assets) times the closing rate, minus the
  beginning-of-period net worth times the previous
  period's closing rate, and minus the translated
  retained earnings.
• Alleged to be more meaningful economically.
• For it to have some economic significance, one
  must assume that the entire net asset position in
  the subsidiary (including fixed assets) is
  exposed positively to exchange rate changes the
  same way that local currency debt financing is
  negatively exposed.
• This is the "net investment" doctrine.

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The current-rate method is plagued with logical
problems

• They render the result inconsistent, manipulable
  and difficult to interpret.
• The inconsistency arises mostly between the
  treatment of assets at home and assets abroad.
• The manipulability arises from the fact that the
  same transaction will give rise to different
  gains and losses, depending on whether it is
  handled as a parent company transaction or as a
  foreign subsidiary transaction.
• The lack of interpretability is best illustrated
  by the following example imagine a U.S. parent
  company with a subsidiary in Europe.
• The European subsidiary engages in
  foreign-currency (i.e. non euro) transactions,
  including dollar transactions, which give rise
  locally to transactions gains and losses.
• Upon translation of the euro accounts into dollar
  by the closing rate method, the entire income
  statement, including the transactions gains and
  losses, will be translated using a uniform rate
  and then consolidated with the parent's and other
  subsidiaries accounts.
• Hence dollar transactions of the European
  subsidiary will generally contribute a non zero
  amount to the transactions gain or loss in the
  dollar consolidated statement. This absurd
  result illustrates that the consolidated exchange
  gain or loss is really a meaningless number which
  no one can even attempt to interpret.
• Most damning condemnation
• the home-currency accounts which result from it
  are by design not independent of the choice of
  the currency in which the accounts were
  originally kept.
• Indeed, the only method which would yield pure
  home-currency translated accounts, which would be
  invariant under a change of the original
  currency, is the temporal method.
• The closing rate method really retains the
  foreign currency accounts, except for a scale
  factor, which makes them look as though they are
  in home currency units. 
• The absence of invariance under a change of
  original currency should have prompted logical
  minds to scrap the closing rate method.
• Instead, the U.S. FASB, which was, of course,
  fully aware of the problem, decided to issue
  guidelines as to the proper choice of the
  original currency, as otherwise consolidated
  accounts could have been stated in any number of
  ways, with varying results.
• The original currency of accounting from which
  translation into U.S. dollars should take place,
  it said, is the subsidiary's functional currency.
  And it proceeded to give criteria for a proper
  choice of the functional currency
• basically it is the currency in which the
  subsidiary conducts the major part of its
  business.
• What should be done if, in fact, the subsidiary
  has been keeping its book in some other currency?
  The FASB answer is restate (not translate) the
  books into the functional currency before you
  translate into dollars. And restatement is,
  logically, to be done using the ... temporal
  method!

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Summary and perspective

• Two translation techniques exist
• Temporal method
• Introduces volatility into income resulting in a
  distorted measure of economic performance of
  foreign operations
• Reported XR gain/loss does not recognize impact
  of XR changes on value of fixed assets
• Current-rate method
• Excludes unrealized XR adjustments from income
• But this could be done under any system
• Allegedly more realistic measure of XR impact on
  foreign operation
• Translation adjustment based on FC net assets
• Plagued with logical problems
• A temporal mismatching of FC values and XR

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Conclusion

• Understand accounting for foreign-currency
  transactions of a firm
• Understand why accounting exposure is not valid
  foreign-exchange risk management principle