14 Chapter Fourteen Management of Translation Exposure Chapter Objective: • This chapter discusses the impact that unanticipated changes in exchange rates may have on the consolidated financial statements of the multinational company. Chapter Outline • Translation Methods • Management of Translation Exposure
Translation Exposure • Translation exposure, (also called accounting exposure), results from the need to restate foreign subsidiaries’ financial statements, usually stated in foreign currency, into the parent’s reporting currency when preparing the consolidated financial statements. • Restating financial statements may lead to changes in the parent’s net worth or net income. • Two methods • Current rate method • Temporal Approach
The Current Rate Method • All assets and liabilities are translated at the rate in effect on the balance sheet date. • All items on the income statement are translated at an appropriate average exchange rate or at the rate prevailing when the various revenues, expenses, gains and losses were incurred (historical rate). • Dividends paid are translated at the rate in effect on the payment date. • Common stock and paid-in capital accounts are recorded at historical rates. Year-end retained earnings consist of Beginning RE plus or minus any income or loss for the year. • Gains and losses resulting from translation are reported in a special reserve account on the consolidated balance sheet with such title as cumulative translation adjustment (CTA).
The Current Rate Method • Advantages of CTA • Eliminates the variability of net earnings due to translation gains or losses. • The relative proportions of individual balance sheet accounts remain the same (debt-to-equity ratio, for example). • Main disadvantage of CTA • violates the accounting principle of carrying balance sheet accounts at historical cost.
The Current Rate Method: An Example • Foreign Subsidiary, Inc., (FSI) has been acquired on December 31, 2000 when the exchange rate was LC1.25/$ (LC stands for FSI’s local currency). • On December 31, 2001, the exchange rate was LC1.15/$. The average exchange rate during 2001 was LC1.18/$. • On December 31, 2002, the exchange rate was LC1.22/$. The average exchange rate during 2002 was LC1.20/$.
Temporal Method • Monetary assets (cash, marketable securities, AR) and monetary liabilities (current liabilities and LTD) are translated at the current ER (exchange rate at the balance sheet date). • Non-monetary assets (inventory, fixed assets, etc.) and non-monetary liabilities are translated at their historical rate. • Income statement items are translated at the average ER over the period, except for items that are associated with non-monetary assets or liabilities, such as COGS (inventory) and depreciation (fixed assets), which are translated at their historical rate. • Dividends paid are translated at the rate in effect on the payment date. • Equity items are translated at their historical rate, and include any imbalance.
Temporal Method • Logic behind differentiating monetary and non-monetary assets: • Translation gains and losses on monetary accounts are presumed meaningful components of expenses or revenue because monetary accounts closely approximate market values. • Translation gains and losses on non-monetary accounts are less meaningful since non-monetary accounts reflect historical costs.
Temporal Method • Gains and losses resulting from translation are carried directly to current consolidated income • Unlike the current rate method these gains and losses do not go to an equity reserve account. • FX gains and losses introduce volatility of consolidated earnings. • This volatility is damped to the extent that many items in the temporal approach are translated at their historical costs. • The main advantage of this method is that it complies with the accounting principle of carrying balance sheet accounts at historical cost.
Hedging Translation Exposure The managers have two methods for dealing with translation exposure. 1. Balance Sheet Hedge • Eliminates the mismatch between net assets and net liabilities denominated in the same currency. • May create transaction exposure, however. 2. Derivatives Hedge: • An example would be the use of forward contracts with a maturity of the reporting period to attempt to manage the accounting numbers. • Using a derivatives hedge to control translation exposure really involves speculation about foreign exchange rate changes, however.
Translation Exposure versus Transaction Exposure • Translation Exposure • The effect that unanticipated changes in exchange rates has on the firm’s consolidated financial statements. • An accounting issue. • Transaction Exposure • The effect that unanticipated changes in exchange rates has on the firm’s cash flows. • A finance issue • It is generally not possible to eliminate both translation exposure and transaction exposure.