Chapter 14 Management of Translation Exposure Management 3460 Institutions and Practices in...

Chapter 14 Management of

Translation Exposure

Management 3460 Institutions and Practices in

International Finance

Fall 2003Greg Flanagan

Nov 27, 2003 2

Chapter Objectivesdefine translation exposure.

explain why we care about translation

explain the impact that unanticipated changes in exchange rates may have on the consolidated financial statements of the multinational company.

Nov 27, 2003 3

Chapter Objectivesdiscuss and differentiate various

translation methods:current/noncurrentmonetary/nonmonetarytemporalcurrent rate

Nov 27, 2003 4

Chapter Objectives (continued)summarize the FASB statement 52discuss the management of

translation exposure.evaluate the empirical analysis of the

change from FAS8 to FAS52.discuss the importance of translation

exposure in comparison with economic and transaction exposure

Nov 27, 2003 5

Definition

Translation Exposure – the potential that the firm’s consolidated financial statements can be affected by changes in exchange rates.

Nov 27, 2003 6

Why do we Care about Translation?

managers, analysts and investors need some idea about the importance of the foreign business translated accounting data give an approximate idea of this.

performance measurement for bonus plans, hiring, firing, and promotion decisions.

accounting value serves as a benchmark to evaluate valuation.

for income tax purposes. legal requirement to consolidate financial

statements.

Nov 27, 2003 7

Current/Noncurrent Method The underlying principal is that assets and

liabilities should be translated based on their maturity.current assets translated at the spot rate.noncurrent assets translated at the historical

rate in effect when the item was first recorded on the books.

generally accepted in the US from the 1930s -1975, at which time FAS8 became effective.

Short-term gains/losses will be recognized long term will not be.

Nov 27, 2003 8

Current/Noncurrent Method

Current assets /liabilities translated at the spot rate.i.e. €2=$1

Noncurrent assets /liabilities translated at the historical rate in effect when the item was first recorded on the books. i.e. €3=$1

Balance Sheet Local Currency

Current/ Noncurrent

Cash € 2,100 $1,050 Inventory € 1,500 $750 Net fixed assets € 3,000 $1,000

Total Assets € 6,600 $2,800 Current liabilities € 1,200 $600 Long-Term debt € 1,800 $600 Common stock € 2,700 $900 Retained earnings € 900 $700CTA -------- --------Total Liabilities and

Equity€ 6,600 $2,800

Nov 27, 2003 9

Monetary/Nonmonetary Method

The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes.

All monetary balance sheet accounts (cash, marketable securities, accounts receivable, etc.) of a foreign subsidiary are translated at the current exchange rate.

All other (nonmonetary) balance sheet accounts (owners’ equity, land) are translated at the historical exchange rate in effect when the account was first recorded. i.e. PPP

Nov 27, 2003 10

Monetary/Nonmonetary Method

All monetary balance sheet accounts are translated at the current exchange rate. i.e. €2=$1

All other balance sheet accounts are translated at the historical exchange rate in effect when the account was first recorded. i.e.€3=$1


Monetary/ Nonmonetary

Cash € 2,100 $1,050 Inventory € 1,500 $500 Net fixed assets € 3,000 $1,000


Equity€ 6,600 $2,400

Nov 27, 2003 11

Temporal Method The underlying principal is that assets and

liabilities should be translated based on how they are carried on the firm’s books.

Balance sheet account are translated at the current spot exchange rate if they are carried on the books at their current value.

Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books.

Nov 27, 2003 12

Temporal Method Items carried on the

books at their current value are translated at the spot exchange rate. i.e. €2=$1

Items that are carried on the books at historical costs are translated at the historical exchange rates. i.e. €3=$1


Temporal

Cash € 2,100 $1,050 Inventory € 1,500 $900Net fixed assets € 3,000 $1,000


Equity€ 6,600 $2,400

Nov 27, 2003 13

Current Rate MethodAll balance sheet items (except for

stockholder’s equity) are translated at the current exchange rate.

Very simple method in application.A “plug” equity account named cumulative

translation adjustment is used to make the balance sheet balance.

Nov 27, 2003 14

Current Rate Method All balance sheet

items (except for stockholder’s equity) are translated at the current exchange rate. i.e. €2=$1

A “plug” equity account named cumulative translation adjustment is used to make the balance sheet balance


Current Rate

Cash €2,100.00 $1,050 Inventory €1,500.00 $750 Net fixed assets €3,000.00 $1,500

Total Assets €6,600.00 $3,300 Current liabilities €1,200.00 $600 Long-Term debt €1,800.00 $900 Common stock €2,700.00 $900 Retained earnings €900.00 $360 CTA -------- $540

Total Liabilities and Equity

€6,600.00 $3,300

Nov 27, 2003 15

How Various Translation Methods Deal with a Changefrom €3 to €2 = $1


Current/ Noncurrent


Temporal Current Rate

Cash €2,100 $1,050 $1,050 $1,050 $1,050 Inventory €1,500 $750 $500 $900 $750 Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500

Total Assets €6,600 $2,800 $2,550 $2,950 $3,300 Current liabilities €1,200 $600 $600 $600 $600 Long-Term debt €1,800 $600 $900 $900 $900 Common stock €2,700 $900 $900 $900 $900 Retained earnings €900 $700 $150 $550 $360CTA -------- -------- -------- -------- $540


€6,600 $2,800 $2,550 $2,950 $3,300

Spot exchange rate

Nov 27, 2003 16


Current/ Noncurrent






€6,600 $2,800 $2,550 $2,950 $3,300

How Various Translation Methods Deal with a Change from €3 to €2 = $1

Book value of inventory at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate.

Nov 27, 2003 17


Current/ Noncurrent






€6,600 $2,800 $2,550 $2,950 $3,300


historic rate spot exchange rate

Nov 27, 2003 18


Current/ Noncurrent






€6,600 $2,800 $2,550 $2,950 $3,300


spot rate

Nov 27, 2003 19


Current/ Noncurrent






€6,600 $2,800 $2,550 $2,950 $3,300


spot ratehistorical rate

Nov 27, 2003 20


Current/ Noncurrent






€6,600 $2,800 $2,550 $2,950 $3,300


historical rate

Nov 27, 2003 21


Current/ Noncurrent






€6,600 $2,800 $2,550 $2,950 $3,300


From income statement

Nov 27, 2003 22


Current/ Noncurrent






€6,600 $2,800 $2,550 $2,950 $3,300


Under the current rate method, a “plug” equity account named cumulative translation adjustment makes the balance sheet balance.

Nov 27, 2003 23


Sales translate at average exchange rate over the period, €2.50 = $1

Income StatementLocal

CurrencyCurrent/

Noncurrent Monetary/

NonmonetaryTemporal Current

RateSales € 10,000 $4,000 $4,000 $4,000 $4,000COGS € 7,500 $3,000 $2,500 $3,000 $3,000Depreciation € 1,000 $333 $333 $333 $400Net operating income € 1,500 $667 $1,167 $667 $600Income tax (40%) € 600 $267 $467 $267 $240Profit after tax € 900 $400 $700 $400 $360

$300 -$550 $150Net income € 900 $700 $150 $550 $360Dividends € 0 $0 $0 $0 $0Addition to Retained

Earnings € 900 $700 $150 $550 $360

Foreign exchange gain (loss)

Nov 27, 2003 24


CurrencyCurrent/





Earnings € 900 $700 $150 $550 $360



Translate at €2.50 = $1 Translate at new exchange rate, €2.00 = $1

Nov 27, 2003 25


CurrencyCurrent/





Earnings € 900 $700 $150 $550 $360



Translate at €3 = $1 Translate at average exchange rate, €2.5 = $1

Nov 27, 2003 26


CurrencyCurrent/





Earnings € 900 $700 $150 $550 $360



14.1Note the effect on after-tax profit.

Nov 27, 2003 27


CurrencyCurrent/





Earnings € 900 $700 $150 $550 $360



14.1Note the effect that foreign exchange gains (losses) has on net income.

Nov 27, 2003 28

FAS8 – superseded Essentially the temporal method, with some

subtleties,such as translating inventory at historical

rates (a hassle).Required taking foreign exchange gains and

losses through the income statement. This lead to variability in reported earnings

(irritated corporate executives).

Nov 27, 2003 29

The Mechanics of FAS52

Function CurrencyThe currency that the business is

conducted in.Reporting Currency

The currency in which the MNC prepares its consolidated financial statements.

Nov 27, 2003 30

The Mechanics of FAS52 Two-Stage Process

First, determine in which currency the foreign entity keeps its books.If the local currency in which the foreign entity

keeps its books is not the functional currency, remeasurement into the functional currency is required.

Second, when the foreign entity’s functional currency is not the same as the parent’s currency, the foreign entity’s books are translated using the current rate method.

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 14-31

Current Rate

Translation

Parent’s Currency

Foreign entity’s books

kept in?

Par

ent’

s C

urre

ncy

Functional Currency?

Local currency Temporal Remeasurement

Parent’s currency

Nonparent

Currency

Third currency

The Mechanics of FAS52

Nov 27, 2003 32

Highly Inflationary Economies

Highly inflationary economies—over 100% over three years

Foreign entities are required to remeasure financial statements using the temporal method “as if the functional currency were the reporting currency”.

Nov 27, 2003 33

Management of Translation Exposure

Translation Exposure vs. Transaction Exposure

Hedging Translation ExposureBalance Sheet HedgeDerivatives Hedge

Translation Exposure vs. Operating Exposure

Nov 27, 2003 34

Translation Exposure versus Transaction Exposure

Translation ExposureThe effect that unanticipated changes in exchange

rates has on the firm’s consolidated financial statements accounting issue.

Transaction ExposureA effect that unanticipated changes in exchange

rates has on the firm’s cash flows finance issue. It is generally not possible to eliminate both

translation exposure and transaction exposure.

Nov 27, 2003 35

Hedging Translation Exposure

If the managers of the firm wish to manage their accounting numbers as well as their business, they have two methods for dealing with translation exposure.Balance Sheet HedgeDerivatives Hedge

Nov 27, 2003 36

Balance Sheet Hedge

Eliminates the mismatch between net assets and net liabilities denominated in the same currency.

May create transaction exposure, however.

Nov 27, 2003 37

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.

However, using a derivatives hedge to control translation exposure really involves speculation about foreign exchange rate changes.

Nov 27, 2003 38

Translation Exposure versus Operating Exposure

The effect that unanticipated changes in exchange rates has on the firm’s ongoing operations.

Operating (economic) exposure is a substantive issue with which the management of the firm should concern itself with.

Nov 27, 2003 39

Empirical Analysis of the Change from FAS8 to FAS52

There did not appear to be a revaluation of firms’ values following the change.

This suggests that market participants do not react to cosmetic earnings changes.

Other researchers have found similar results when investigating other accounting changes.

This highlights the futility of attempting to manage translation gains and losses.

Nov 27, 2003 40

Relevance of Translation (Accounting) Exposure

Should the exchange rate effect be shown as part of the reporting period, or should it just be mentioned on the balance sheet, as an unrealized gain or loss?

Most of the gains are not realized keep gains/losses out of income statement.

Translation sounds great, but none of the three methods produces the true economic value.

Nov 27, 2003 41

Relevance of Translation (Accounting) Exposure

Should we worry about translation exposure at all?

If so, should we worry what the best translation method is?

choice doesn't affect any real cashflow except for taxes.

only correct method is economic value anyway

simplicity/consistency: Current rate method.

Nov 27, 2003 42

The (Ir)relevance of Translation Exposure*

Economic exposure is far more relevant!

*P. Sercu and R. Uppal, International Financial Markets and the Firm, 1994

Nov 27, 2003 43

ECONOMIC EXPOSURE:

1. A forward looking concept: it focuses on future cashflows.

2. Involves real cashflows, not just accounting figures.

3. Relates to changes in the economic value (or, in an efficient market, the market value) of the firm.

4. Contractual exposure depends on the firm’s portfolio of FC engagements undertaken in the past. Operating exposure depends on the environment (especially the market structure and the input-output mix) and on the firm's strategic response (e.g., relocation of production, changes in the marketing mix or financial structure, etc.).

5. Also exists for firms without foreign subsidiaries, such as exporting firms, import-competing firms, and notably potential import-competing firms.

ACCOUNTING EXPOSURE:

1. A backward-looking concept: it reflects past decisions as reflected in the subsidiary's assets and liabilities.

2. A change in an accounting value due to translation is not a "realized" gain or loss; no change in the cash situation is involved —except possibly through taxation effects.

3. Changes the firm's accounting value, but not necessarily its market value.

4. Depends on the accounting rules chosen. This is because the subsidiary's own internal rules affect its accounting values (e.g., type of depreciation, or inventory valuation methods) and also because the translation process itself can be done in different ways (see below).

5. Accounting exposure only exists in the case of foreign direct investment, since pure exporting or import-substituting firms have no foreign subsidiaries.

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