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Translation Exposure

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Potential for increase/ decrease in parent's net worth & reported income ... Retained earnings /- income/loss /- imbalance ... Retained earnings /- income ... – PowerPoint PPT presentation

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Title: Translation Exposure


1
Translation Exposure (or chapter 10)
2
Agenda
  • How translation exposure arises?
  • Functional currency?
  • Current Rate Method vs. Temporal Method.
  • Balance Sheet Hedge?
  • Earnings Management.

3
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

4
Translation Methods
Current (Closing) Rate Method Temporal Method
Assets Liabilities translate _at_ current rate (as of balance sheet date). Assets Liabilities -Monetary translate _at_ current rates. -Non-monetary (inventory fixed assets) _at_ historical rates
Income statement Items translate _at_ actual rate when items incurred. Income Statement Items translated _at_ average rates except for depreciation cost of goods sold (_at_ historical rates)
Distributions dividends translated _at_ the rate on date of payment. Distributions dividends translated _at_ the rate on date of payment.
Equity Items Common stock Paid-in capital translated _at_ historical rates. Retained earnings /- income/loss for the year. Equity Items Common stock Paid-in capital translated _at_ 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.
5
US Translation Procedures
6
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 gt book value of
    PPE would disappear.
  • International Practices
  • Integrated subsidiaries re-measure using
    temporal method.
  • Self-sustaining subsidiaries translate by
    current rate method.

7
Translation Example
  • Suppose EUR depreciated 16.67 from 1.2/EUR to
    1.0/EUR
  • Functional currency EUR, Parent US
  • PPE, common stock acquired _at_ 1.276/EUR
  • Inventory purchased/manufactured _at_ 1.218/EUR
  • Exposed assetsasset whose value drops w/
    depreciation of functional currency rises w/
    appreciation of functional currency.
  • Net exposed assets exposed assets exposed
    liability
  • Implications
  • Appreciation -gt increase net exposed assets.
  • Depreciation -gt decrease net exposed assets.

8
BALANCE SHEET TRANSLATION
9
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

10
For example
11
Earnings Management
EARNINGS INCRASING
EARNINGS SMOOTHING
LOSS AVOIDANCE
LOSS AVOIDANCE
12
Things to remember
  • How translation exposure arises?
  • Functional currency?
  • Current Rate Method vs. Temporal Method.
  • Balance sheet hedge
  • Earnings Management.
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