Accounting vs Real Exposure

1
Accounting vs Real Exposure

• International Corporate Finance
• P.V. Viswanath

2
Learning Objectives

• What is accounting exposure?
• How does it differ from economic/operating
  exposure?
• Real changes in exchange rates
• How accounting rules contrast with the
  measurement of real changes in exchange rates

3
Accounting Exposure

• Accountants have rules for converting values of
  foreign assets, liabilities, payments and
  receipts into domestic currency in order to
  consolidate financial statements.
• Accounting exposure concerns the effect that
  exchange rates have on values appearing in
  financial statements.
• Translation risk and exposure have to do with how
  asset and liability values appear when converted
  into a firms domestic reporting currency for
  inclusion in financial accounts.
• Transaction risk and exposure have to do with the
  effect of exchange rates on asset or liability
  values when they are liquidated.

4
FAS 8

• Until 1982, the US used FAS 8 to convert foreign
  currency values to dollar values.
• Under FAS 8, all foreign exchange translation
  gains or losses had to be shown in the
  current-period income statement.
• Different treatment was given to current
  operating receipts and expenditures and financial
  assets/liabs on the one hand and fixed assets on
  the other.
• One problem with FAS 8 was that there was a lot
  of volatility in reported income because all
  translation gains had to be included in the
  income statement.

5
Temporal Method

• If local currency values were measured at current
  cost, they were translated at current exchange
  rates
• If they were measured at historical cost, they
  were translated at historical exchange rates.
• Revenues and expenses from foreign entities, as
  well as financial assets and liabilities were
  translated at the average exchange rate
  prevailing during the period.
• Other assets, primarily fixed assets, were
  translated at historical exchange rates.
  Historical costs were used in terms of local
  (i.e. foreign currency).

6
FAS 52

• Since 1982, FAS 52 is used.
• The functional currency is selected for each
  subsidiary. This is the primary currency of the
  subsidiary.
• Any foreign currency income of the subsidiary is
  translated into the function currency according
  to FAS 8 rules.
• For example, euros earned by a British subsidiary
  of a US company will be translated into pounds
  using FAS 8.
• Thus, revenues and expenses in euros will be
  translated into pounds at the average exchange
  rate prevailing during the current period.
• After this, all amounts are translated from the
  functional currency into dollars at the current
  exchange rate.

7
FAS 52

• Translation gains and losses are disclosed and
  accumulated in a separate account showing
  shareholders equity. Only when foreign assets
  or liabilities are liquidated do they become
  transaction gains and appear in the income
  statement.
• If there has been cumulatively over the last
  three years, more than 100 inflation in the
  local currency, the temporal distinction from FAS
  8 is still used.

8
Real Changes in Exchange Rates

• Real changes in exchange rates refer to the true
  economic effects of exchange rates.
• It is the change that produces a difference
  between the rate of return on domestic versus
  foreign assets/liabilities, or in the
  profitability of firms.
• There are no real changes in exchange rates on
  financial assets and liabilities if unhedged
  interest-parity always holds ex-post.
• There are no real changes in exchange rates for
  fixed (real assets if PPP always holds ex post.

9
Financial assets/liabilities

• Suppose Aviva, a US Corporation, has invested in
  British bonds.
• Keep in mind that we are looking at accounting
  treatment, i.e. ex post recognition of events
  that have occurred during the year.
• A depreciation of the British pound will decrease
  the dollar value of these bonds when converted
  into dollars at the new exchange rate.
• However, if the interest rates on the British
  bonds were sufficiently higher than US interest
  rates, the firm would be no worse off having
  invested in British bonds than investing in US
  bonds.

10
Financial assets/liabilities

• The real change for financial assets held for a
  year
• Real change in e (1 r)(e1-e0)/e0 (r - r)
• This is also the ex post deviation from unhedged
  interest-rate parity.
• Hence, a real change in the exchange rate for
  financial securities occurs when there is an ex
  post departure from uncovered interest parity.

11
Financial assets/liabilities An example

• Suppose 100 were invested in US and UK assets.
• e0 1.5, e11.8, rUS 5, rUK 4.
• The real change in the exchange rate
• (1.8-1.5)/1.5(1.04) (0.05-0.04) 0/198 or
  19.8
• The UK investment turns out to be more profitable
  than the US one because of the appreciation of
  the pound.
• This might be because real growth (or expected
  future real growth) in the UK turned out to be
  greater than in the US.

12
Financial assets/liabilities Accounting

• The 100 invested in the US would generate 5
  income.
• The 100 would be converted to 66.67, and would
  generate (66.67)(.04) or 2.67 income.
• Translated to dollars, this works out to
  (2.67)(1.8) 4.8.
• The principal of 66.67 would be translated
  according to FAS 52 rules at current rates, to
  (66.67(1.8) 120, for a translation gain of
  20, which would show up in the balance sheet.
• The total return would be 20 (from the balance
  sheet) 4.8 (income statement) or 24.8, which
  is 19.8 greater than the 5 generated from the
  US investment.

13
Real Assets/Liabilities

• The return on real assets, whose value is
  denominated in dollars is ?US?US
• The return on assets invested in British fixed
  assets, when translated at the new exchange rate
  is
• (e1/e0)(1 ?UK ?UK)-1
• The real change in exchange rates is
• (e1-e0)/e0(1 ?UK) - (?US - ?UK) ?US -
  ?UK(e1)/e0
• The first two terms add up to zero if ex-post PPP
  holds
• The last term is the application of an ex-post
  PPP condition to return flows from the asset.

14
Real assets/liabilities real change

• With FAS 52, the values of fixed assets are
  translated at current exchange rates, but the
  local currency asset values are based on
  historical cost.
• This affects the translation issue, as well.
• Suppose 100 were invested in US and UK assets.
• The real realized return over 1 year on US assets
  is 5 and on UK assets, 4 ?US 10, ?UK 8,
  e0 1.5, e11.8
• The real change in the exchange rate is
• (e1-e0)/e0(1 ?UK) - (?US - ?UK) ?US -
  ?UK(e1)/e0
• (0.3/1.5)(1.08) (.10 0.08) (.05 -
  .04(1.8/1.5)) 0.194
• This means that there is a real relative gain on
  the British asset of 19.4

15
Real assets/liabilities accounting

• The income on the US asset is 5 (100x.05)
• The capital gain is 10 (100x0.1)
• On the UK asset, income of 2.67 (0.04x100/1.5)
  is recorded, which is translated to 2.67(1.8)
  4.8
• At the end of the period, the asset value is
  translated into dollars at (100/1.5)(1.8) 120
• In actuality, the new asset is worth
  (100/1.5)(1.08) 72, which translated into
  would be 129.6
• The actual relative gain in holding the UK asset
  is 129.64.8-15 119.4
• In fact, the translated relative gain from the UK
  asset is 1204.8-15 109.8, or 9.6 less than it
  should be.
• This can be computed as (100/1.5)(1.8)(0.08)
  9.6

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FAS 52 Summary of effects

• FAS 52 procedure values assets using historical
  costs and current exchange rates, but puts
  translation gains or losses in a separate
  shareholder equity account.
• FAS 52 produces correct measures of real changes
  in exchange rates for financial assets if
  shareholder equity effects are included as part
  of income.
• FAS 52 produces incorrect measures of real
  changes in exchange rates for fixed assets.
  Correct values on fixed assets require using
  current exchange rates and current market values.