Translation Exposure

1
Chapter 13

• Translation Exposure

2
The Goals of Chapter 13
0

• Introduce the translation exposure
• When financial statements of subsidiaries are
  restated in the parents reporting currency for
  preparing consolidated financial statements, the
  values of foreign incomes, assets, liabilities,
  or equities are affected by changes in exchange
  rates
• Learn how foreign subsidiaries are characterized
  for translation purpose, and the meaning of a
  functional currency
• Introduce two translation accounting methods, the
  current rate method and the temporal method
• Discuss the balance sheet hedge method to manage
  the translation exposure

3
Overview of Translation Exposure
13-3
4
Overview of Translation Exposure

• For MNEs, financial statements of foreign
  subsidiarieswhich are stated in foreign
  currencymust be restated in the parents
  reporting currency for preparing consolidated
  financial statements
• This accounting process is called translation
• Translation exposure is the potential for an
  increase or decrease in the parent firms net
  worth and reported net income caused by a change
  in exchange rates since the last translation
• Although the main purpose of translation is to
  prepare consolidated statements, management also
  uses translated statements to assess performance
  of foreign subsidiaries in a common currency

5
Overview of Translation Exposure

• Translation in principle is simple
• Financial statements in foreign currencies must
  be restated in the parent companys reporting
  currency for consolidation purposes
• The problem arises from the difference between
  the exchange rates for acquiring assets,
  liabilities, and equities or generating income
  and the exchange rates on the translation date
• Generally, historical exchange rates are used for
  equity accounts, fixed assets, and inventory
  items, while current exchange rates can be used
  for current assets, current liabilities, income,
  and expense items
• Since different exchange rates were used for
  different items on the income statement (I/S) and
  the balance sheet (B/S), there would be
  imbalances resulting from the translation

6
Overview of Translation Exposure

• Translation methods differ by country along two
  dimensions
• First is how a foreign subsidiary is
  characterized on its degree of independence of
  the parent firm
• The degree of independence of the parent firm
  decides the characterization of a foreign
  subsidiary
• More specifically, a foreign subsidiary can be
  characterized as either an integrated foreign
  entity or a self-sustaining foreign entity
• An integrated foreign entity is one that operates
  as an extension of the parent firm, with cash
  flows and business lines that are highly
  interrelated with those of the parent firm
• A self-sustaining foreign entity is one that
  operates in the local economic environment
  independent of the parent firm
• Most countries specify different translation
  methods for integrated or self-sustaining foreign
  subsidiaries

7
Overview of Translation Exposure

• Second is the definition of which currency is
  most important for the foreign subsidiarys
  operations
• A foreign subsidiarys functional currency is the
  currency of the primary economic environment in
  which the subsidiary operates and in which it
  generates cash flows
• In other words, it is the dominant currency used
  by that foreign subsidiary in its day-to-day
  operations
• A usual relationship between the functional
  currency and integrated or self-sustaining
  subsidiaries
• An integrated subsidiary is essentially an
  extension of the parent firm, so the functional
  currency of the integrated subsidiary is the same
  as that used by the parent firm
• ?Note that the financial statements of this
  integrated subsidiary are still expressed in the
  foreign currency due to the law in the foreign
  nation, so the translation exposure remains when
  the parent firm prepares the consolidated
  financial statements
• An self-sustaining subsidiary is considered a
  separate entity from the parent company, so it
  will adopt a different functional currency as
  that used by the parent firm

8
Overview of Translation Exposure

• The practice in the United States
• Rather than using the integrated or
  self-sustaining terms (the subsidiary
  characterization) to distinguish foreign
  subsidiaries, management must evaluate the nature
  and purpose of foreign subsidiaries to determine
  appropriate functional currency of a foreign
  subsidiary
• Six economic indicators are used to determine the
  functional currency of foreign subsidiaries,
  including cash flow, sales price, sales market,
  expense, financing, and intercompany transactions
  and arrangements indicators. See Exhibit 13.1 in
  the text book
• According to the six economic indicators, if a
  subsidiary has high (minor) interrelation with
  the parent firm and should use the parent firms
  currency (foreign currency) as the functional
  currency, it is equivalent to a integrated
  foreign entity (self-sustaining entity)
• Please note that the selection of the functional
  currency is determined by the economic realities
  of the subsidiarys operations and is not a
  discretionary management decision

9
Translation Methods
13-9
10
Translation Methods

• There are four basic methods for translating
  financial statements of foreign subsidiaries
  current/non-current method (???????) (oldest
  one), monetary/non-monetary method (???????),
  current rate method (?????), and temporal method
  (???)
• Current assets and liabilities are assets and
  liabilities that can be cash in or due in the
  near future, usually within one year
• Monetary assets and liabilities indicate cash,
  A/R, A/P, and assets or obligations that are
  realizable (or settled) at the cash amount stated
  in the accounts
• A translation method must not only designate at
  what exchange rate individual balance sheet and
  income statement items are restated, but also
  designate where any imbalance is to be recorded
  (typically in either current income in I/S or an
  equity reserve account in B/S)

11
Translation Methods

• The current rate method is the most prevalent
  translation method in the world today
• For the balance sheet
• All assets and liabilities are translated at the
  current exchange rate at the date of generating
  consolidated financial statements
• Common stock and paid-in capital accounts are
  translated at historical exchange rates, which is
  the exchange rates at the time point of acquiring
  equity capital
• For the income statement
• All income statement items, e.g., revenues,
  expenses, and depreciation, are translated at the
  actual exchange rate on the dates they were
  incurred or at an appropriately weighted average
  exchange rate for the reporting period
• Dividends distributions are translated at the
  actual exchange rate on the date of payment

12
Translation Methods

• For gains or losses caused by translation
  adjustments
• Rather than recording the gains or losses to be
  the current income in the consolidated I/S,
  translation gains or losses are reported and
  accumulated in a separate equity reserve account
  (on the B/S) with a title such as cumulative
  translation adjustment (CTA)
• Advantages and disadvantages of the current rate
  method
• The biggest advantage is that the gain or loss on
  translation does not pass through the income
  statement but goes directly to a reserve account,
  which can reduce variability of reported earnings
• A second advantage is that the relative
  proportions of individual balance sheet accounts
  remain the same, i.e., the translation does not
  affect such balance sheet ratios as the current
  ratio or the debt-to-equity ratio (see Slide
  13.23 later)
• The disadvantage is that it violates the
  accounting principle of carrying balance sheet
  accounts at historical costs

13
Translation Methods

• The monetary/non-monetary translation method
• For the balance sheet
• Monetary assets (cash, marketable securities,
  accounts receivable, and long-term receivables)
  and monetary liabilities (current liability and
  long-term liability) are translated at the
  current exchange rate
• Other non-monetary assets and liabilities are
  translated at historical exchange rates
• Common stock and paid-in capital accounts are
  translated at historical exchange rates
• For the income statement
• Income statement items are translated at the
  average exchange rate for the reporting period,
  except that the accounts which are directly
  associated with non-monetary asset or liabilities
  (like the depreciation and cost of goods sold)
  are translated at historical exchange rate
• Dividends distributions are translated at the
  actual exchange rate on the date of payment

14
Translation Methods

• For gains or losses caused by translation
  adjustments
• Gains or losses resulting from translation are
  carried directly to current consolidated income,
  which introduce additional variability of
  consolidated earnings
• Finally, the change of the net income in I/S
  caused by the translation will affect retained
  earnings in B/S
• Advantages and disadvantages of the
  monetary/nonmonetary method
• The advantage is that foreign non-monetary assets
  are carried at their original cost in the parent
  firms consolidated statement, which is
  consistent with the original cost treatment of
  domestic assets of the parent firm in most
  countries
• The disadvantage is that unrealized foreign
  exchange translating gains or losses (paper gains
  or losses) are included in quarterly earnings per
  share (EPS), thus increasing variability of
  reported earnings

15
Translation Methods

• The temporal translation method
• Almost the same as the monetary/non-monetary
  method
• The major difference is that the temporal method
  assumes that it is possible for inventory or net
  plant and equipment to be translated at the
  current exchange rate
• For these items, if its market value (historical
  cost) is reported in the balance sheet, i.e.,
  they are restated to reflect market values, the
  current exchange rate (historical exchange rate)
  is employed for translation
• The comparisons among the current rate method,
  the monetary/non-monetary method, and the
  temporal method for translating balance sheets
  are shown on the next slide

16
Translation Methods

• Current or historical exchange rates are employed
  for different items in different translation
  methods

Current rate method Monetary/non-monetary method Temporal method
Asset
Cash Current rate Current rate Current rate
Accounts receivable Current rate Current rate Current rate
Inventory Current rate Historical rate Historical rate / Current rate
Net plant and equipment Current rate Historical rate Historical rate / Current rate
Liability and Equity
Accounts payable Current rate Current rate Current rate
Short-term debt Current rate Current rate Current rate
Long-term debt Current rate Current rate Current rate
Common stock Historical rate Historical rate Historical rate
17
Translation Methods

• Many of the worlds largest industrial
  countriesas well as the relatively newly formed
  International Accounting Standards Committee
  (IASC)follow the same basic translation
  procedure
• Different translation method is employed for
  integrated foreign entities or self-sustaining
  foreign entities
• Integrated foreign entities are typically
  remeasured using the temporal method
• Self-sustaining foreign entities are translated
  at the current rate method, also termed the
  closing-rate method
• Translation methods employed in selected
  countries are shown on the following slide

18
Exhibit 13.3 Comparison of Translation Methods in
Selected Countries
19
Translation Methods

• However, the U.S. adopts a different rule to
  decide the translation method for foreign
  subsidiaries, because the U.S. distinguishes
  foreign subsidiaries on the basis of functional
  currency, not on subsidiary characterization
• If the financial statements of the foreign
  subsidiary are maintained in U.S. dollars,
  translation is not required
• For the financial statements maintained in the
  local currency
• If the local currency is the functional currency,
  they are translated by the current rate method
• If the US dollar is the functional currency, they
  are remeasured by the temporal method
• If neither the local currency nor the US dollar
  is the functional currency, the statements must
  first be remeasured into the functional currency
  by the temporal method, and then translated into
  US dollars by the current rate method

20
Exhibit 13.2 Procedure Flow Chart for United
States Translation Practices
(equivalent to self-sustaining subsidiary case)
(equivalent to integrated subsidiary case)
? The term remeasure also means to translate.
Remeasure is often used for the temporal
method, and translate is often used for the
current rate method
21
Translation Methods

• A special provision for foreign subsidiaries of
  U.S. firms in hyperinflation countries
• Hyperinflation means cumulative inflation has
  been approximately 100 or more over a three-year
  period
• Financial statements of these subsidiaries must
  be translated into the home currency by the
  temporal method
• The rationale is as follows
• Inflation ?, foreign currency depreciates ? if
  the current rate method is employed, the
  depreciation cost and the net value of plant and
  equipment would be very small in the consolidated
  I/S and B/S ? depreciation understated and
  profits overstated or the disappearing asset
  problem
• Current U.S. translation practices are delineated
  in Statement of Financial Accounting Standards
  Number 52, usually referred to as FAS 52, which
  was issued by the Financial Accounting Standard
  Board (FASB) in December 1981

22
Translation Example Trident Germany
13-22
23
Translation Example Trident Germany

• The example of Trident Germany is used to
  illustrate the current rate and temporal
  translation method
• The following example deals with balance sheet
  only, the more complex procedures for translating
  income statements can be found in international
  accounting texts
• The information of Trident Germany is as follows
• The functional currency is the euro, and the
  reporting currency of its parent company is the
  U.S. dollar
• Plant, equipment, long-term debt, common stock
  equity are acquired at the EX rate of 1.2760/
• Inventory on hand was purchased or manufactured
  during the last quarter when the average EX rate
  was 1.2180/
• The spot EX rate is 1.2/ today (Dec. 31, 2010)
• When Trident Germany reopened on Jan. 2, 2011,
  the euro had dropped 16.67 versus the dollar to
  be 1.0/
• The inventory and the net plant and equipment are
  reported in their historical costs

24
Exhibit 13.4 Trident Germany Balance Sheet after
the Depreciation
December 31, 2010
January 2, 2011
current EX rate
historical EX rate or the historical composite
rate
The CTAs are determined such that the balance
sheet will balance
6,200,000 1.2
current EX rate
historical EX rate
current EX rate
historical EX rate
R/Es are cumulative result of prior yearly
earnings translated at historical rates in that
year, plus translation gains or losses from each
year
Translation gains (losses)
R/Es are translated at a composite rate (assumed
1.2/ here) that is equivalent to having each
past years addition to retained earnings
translated at the exchange rate in that year
For the temporal method, the translation gain or
loss would pass through the income statement,
affecting reported net income and finally
affecting retained earnings
25
Translation Example Trident Germany

• In addition to creating a before and after
  translated balance sheet to calculate the
  translation exposure, there is a simpler method
  through multiplying the value of net exposed
  assets with the percentage of depreciation
• An exposed asset (liability) is an asset
  (liability) whose value drops (rises) with the
  depreciation of the functional currency and rises
  (drops) with an appreciation of that currency
• Net exposed assets means exposed assets minus
  exposed liabilities
• The translation losses (gains) is a decrease
  (increase) of the value of net exposed assets
• Exposed assets and liabilities for different
  translation methods are shown on the next slide

26
Translation Example Trident Germany

• Is each balance sheet item an exposed asset or
  liability under different translation methods?

Current rate method Monetary/non-monetary method Temporal method
Asset
Cash Yes Yes Yes
Accounts receivable Yes Yes Yes
Inventory Yes No No (historical rate) / Yes (current rate)
Net plant and equipment Yes No No (historical rate) / Yes (current rate)
Liability and Equity
Accounts payable Yes Yes Yes
Short-term debt Yes Yes Yes
Long-term debt Yes Yes Yes
Common stock No No No
? For every item to be translated at the current
exchange rate, it is an exposed asset or
liability ? On the contrary, for items translated
at the historical exchange rate, they are not
exposed assets or liabilities
27
Exhibit 13.5 Trident Germany Translation Loss or
Gain after the Depreciation or Appreciation
? Translation loss or gain is larger under the
current rate method because inventory and net
plant and equipment are exposed assets
28
Exhibit 13.6 Comparison of Translation Exposure
with Operating Exposure, Depreciation of Euro
from 1.200/ to 1.0000/ for Trident Germany

• ? Translation exposure can be quite different
  from operating (transaction) exposure, especially
  in sign
• ? If the parent firm and all subsidiaries
  denominate all exposed assets and liabilities and
  conduct all transactions in its local currency,
  each subsidiary would have no transaction
  exposure and some operating exposure due to the
  international competition in the domestic market,
  but the consolidated financial statements of the
  parent firm would show translation exposure in
  each local currency
• ? If the parent firm and all subsidiaries
  denominate all exposed assets and liabilities and
  conduct all transactions in the parent firms
  reporting currency, the parent firm would have no
  translation exposure, but each subsidiary would
  have its own operating (transaction) exposure
• ? So, it is almost impossible to offset both
  translation and operating (transaction) exposure
  at the same time
• ? Since the operating (transaction) exposure
  arises from the change of future cash flows, but
  the translation exposure is a paper gain or loss
  due to accounting translation, the importance of
  focusing decisions should be primarily on the
  performance of real cash flows (operating
  (transaction) exposure) and only secondarily on
  the accounting-based measurements of performance
  (translation exposure)

29
Management of Translation Exposure
13-29
30
Managing Translation Exposure

• Since the translation exposure is a paper gains
  or losses, it is highly debatable to hedge
  translation exposure by forward contracts, which
  generated cash profits or losses
• Moreover, cash gains or losses from forward
  contracts have impact on tax liability, but the
  translation gains and losses are independent of
  tax liability
• Managing the translation exposure by adjusting
  the amount of the net exposed assets
• If management expects a foreign currency to
  depreciate (appreciate), it could minimize
  translation exposure by reducing net exposed
  assets (it should increase net exposed assets to
  benefit from a gain)

31
Managing Translation Exposure

• Following the same idea, the main technique to
  minimize translation exposure is called a balance
  sheet hedge, which requires an equal amount of
  exposed foreign currency assets and liabilities
  on a firms consolidated balance sheet
• If this can be achieved for each foreign
  currency, net translation exposure will be zero
• A change in exchange rates will change the value
  of exposed liabilities in an equal amount but in
  a direction opposite to the change in value of
  exposed assets

32
Managing Translation Exposure

• For the Trident Germany with positive net exposed
  assets, the balance sheet hedge should (1) reduce
  euro assets without simultaneously reduce euro
  liabilities or (2) increase euro liabilities
  without increasing euro assets
• One simple way for Trident Germany is to borrow
  euro debt and exchange the proceeds for dollars
  or unexposed assets
• For instance, transfer the borrowed euros to
  Trident company perhaps as a euro dividend or as
  repayment of intracompany debt
• Under the temporal method, Trident Germany could
  also use the euro proceeds to acquire inventory
  or fixed assets because these assets are not
  regarded as exposed assets in the temporal method

33
Managing Translation Exposure

• The cost of a balance sheet hedge depends on
  relative borrowing costs of different currencies
• These hedges are a compromise in which the value
  of net exposed assets is minimized to achieve
  some degree of foreign exchange protection,
  perhaps at a cost in terms of interest expense or
  operating efficiency

34
Managing Translation Exposure

• If a firms subsidiary is using the local
  currency as the functional currency, the
  following circumstances could justify when to use
  a balance sheet hedge
• The foreign subsidiary is about to be liquidated,
  so that the value of its CTA would be realized
• The firm has debt covenants or bank agreements
  that state the firms debt/equity ratios will be
  maintained within specific limits
• Debt/equity ratios are maintained to be constant
  in the current rate method, but are affected in
  the temporal method
• Management is evaluated on the basis of certain
  income statement and balance sheet measures that
  are affected by translation losses or gains
• The foreign subsidiary is operating in a
  hyperinflationary environment