1. Chapter 10 Accounting Exposure

2. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-2 Overview of Translation Accounting exposure, also called translation exposure, arises because financial statements of foreign subsidiaries – which are stated in foreign currency – must be restated in the parent’s reporting currency for the firm to prepare consolidated financial statements. The accounting process of translation, involves converting these foreign subsidiaries financial statements into US dollar-denominated statements.

3. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-3 Overview of Translation Translation exposure is the potential for an increase or decrease in the parent’s net worth and reported net income caused by a change in exchange rates since the last translation. While the main purpose of translation is to prepare consolidated statements, management uses translated statements to assess performance (facilitation of comparisons across many geographically distributed subsidiaries).

4. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-4 Overview of Translation Translation in principle is simple: –Foreign currency financial statements must be restated in the parent company’s reporting currency –If the same exchange rate were used to remeasure each and every line item on the individual statement (I/S and B/S), there would be no imbalances resulting from the remeasurement –What if a different exchange rate were used for different line items on an individual statement (I/S and B/S)? –An imbalance would reslult

5. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-5 Overview of Translation Why would we use a different exchange rate in remeasuring different line items? –Translation principles in many countries are often a complex compromise between historical and current market valuation –Historical exchange rates can be used for certain equity accounts, fixed assets, and inventory items, while current exchange rates can be used for current assets, current liabilities, income, and expense items.

6. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-6 Overview of Translation Most countries today specify the translation method used by a foreign subsidiary based on the subsidiary’s business operations (subsidiary characterization). For example, a foreign subsidiary’s business can be categorized 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, with cash flows and business lines that are highly interrelated. A self-sustaining foreign entity is one that operates in the local economic environment independent of the parent company.

7. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-7 Overview of Translation A foreign subsidiary’s 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. The US, requires that the functional currency of the foreign subsidiary be determined based on the nature and purpose of the subsidiary.

8. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-8 Overview of Translation Two basic methods for the translation of foreign subsidiary financial statements are employed worldwide: –The current rate method –The temporal method Regardless of which method is employed, a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured, but also designate where any imbalance is to be recorded (current income or an equity reserve account).

9. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-9 Overview of Translation The current rate method is the most prevalent in the world today. –Assets and liabilities are translated at the current rate of exchange –Income statement items are translated at the exchange rate on the dates they were recorded or an appropriately weighted average rate for the period –Dividends (distributions) are translated at the rate in effect on the date of payment –Common stock and paid-in capital accounts are translated at historical rates

10. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-10 Overview of Translation Gains or losses caused by translation adjustments are not included in the calculation of consolidated net income. Rather, translation gains or losses are reported separately and accumulated in a separate equity reserve account (on the B/S) with a title such as cumulative translation adjustment (CTA). The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings).

11. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-11 Overview of Translation Under the temporal method, specific assets are translated at exchange rates consistent with the timing of the item’s creation. This method assumes that a number of individual line item assets such as inventory and net plant and equipment are restated regularly to reflect market value. Gains or losses resulting from remeasurement are carried directly to current consolidated income, and not to equity reserves (increased variability of consolidated earnings).

12. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-12 Overview of Translation If these items were not restated but were instead carried at historical cost, the temporal method becomes the monetary/nonmonetary method of translation. –Monetary assets and liabilities are translated at current exchange rates –Nonmonetary assets and liabilities are translated at historical rates –Income statement items are translated at the average exchange rate for the period –Dividends (distributions) are translated at the exchange rate on the date of payment –Equity items are translated at historical rates

13. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-13 Overview of Translation The US differentiates foreign subsidiaries on the basis of functional currency, not subsidiary characterization. –If the financial statements of the foreign subsidiary are maintained in US dollars, translation is not required –If the statements are maintained in the local currency, and the local currency is the functional currency, they are translated by the current rate method –If the statements are maintained in local currency, and the US dollar is the functional currency, they are remeasured by the temporal method –If the statements are in local currency and neither the local currency or 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

14. 10-14 Exhibit 10.2 Procedure Flow Chart for United States Translation Practices If the financial statements of the foreign subsidiary are expressed in a foreign currency, the following determinations need to be made. Purpose: Foreign currency financial statements must be translated into U.S. dollars Is the local currency the functional currency? No Yes Translated to dollars (current rate method) Is the dollar the functional currency? Remeasure from foreign currency to functional (temporal method) and translate to dollars (current rate method) Remeasure to dollars (temporal method) Yes No * The term “remeasure” means to translate, as to change the unit of measure, from a foreign currency to the functional currency.

15. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-15 Overview of Translation Many of the world’s largest industrial countries – as well as the relatively newly formed International Accounting Standards Committee (IASC) follow the same basic translation procedure: –A foreign subsidiary is an integrated foreign entity or a self-sustaining foreign entity –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.

16. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-16 Managing Translation Exposure The main technique to minimize translation exposure is called a balance sheet hedge. A balance sheet hedge requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet. If this can be achieved for each foreign currency, net translation exposure will be zero. If a firm translates by the temporal method, a zero net exposed position is called monetary balance. Complete monetary balance cannot be achieved under the current rate method.

17. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-17 Managing Translation Exposure The cost of a balance sheet hedge depends on relative borrowing costs. These hedges are a compromise in which the denomination of balance sheet accounts is altered, perhaps at a cost in terms of interest expense or operating efficiency, to achieve some degree of foreign exchange protection.

18. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-18 Managing Translation Exposure If a firm’s 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 firm’s debt/equity ratios will be maintained within specific limits –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

19. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-19 Managing Translation Exposure Management will find it almost impossible to offset both translation and transaction exposure at the same time. As a general matter, firms seeking to reduce both types of exposure usually reduce transaction exposure first. Taxes complicate the decision to seek protection against transaction or translation exposure. Transaction losses are considered “realized” and are deductible from pre-tax income while translation losses are only “paper” losses and are not deductible from pre-tax income.

20. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-20 Evaluation of Performance An MNE must be able to set specific financial goal, monitor progress by all units of the enterprise towards those goals, and evaluate results. An MNE must be able to measure the performance of each of its subsidiaries on a consistent basis, and managers of subsidiaries must be given unambiguous objectives against which they will be judged.

21. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-21 Evaluation of Performance The MNE must determine for itself the proper balance between three operating financial objectives: –Maximization of consolidated after-tax income –Minimization of the firm’s effective global tax burden –Correct positioning of the firm’s income, cash flows, and available funds These goals are frequently inconsistent.

22. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-22 Evaluation of Performance Managers of foreign subsidiaries must be able to run their own operations efficiently according to achievable objectives. All firms expand and modify their domestic profitability measures when applying them to foreign subsidiaries. In addition, some firms establish foreign subsidiaries for objectives not related to normal corporate profit-oriented goals.

23. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-23 Evaluation of Performance There are four purposes of an internal evaluation system: –To ensure adequate profitability –To have an early warning system if something is wrong –To have a basis for allocating resources –To evaluate individual managers

24. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-24 Evaluation of Performance International financial evaluation of foreign subsidiaries is both unique and difficult. Use of one foreign exchange translation method, in an attempt to measure results in the home currency, will present a different measure of success or of compliance with predetermined goals than use of some other translation method.

25. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-25 Evaluation of Performance The results of any control system must be judged against distortions of performance caused by widely differing national business environments. International measurement systems are distorted by decisions to benefit the world system (MNE) at the expense of a specific local subsidiary.

26. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10-26 Evaluation of Performance The impact of exchange rate movements on the measured performance of foreign subsidiaries is one of the single largest dilemmas facing management of the MNE. The evaluation of the performance of an MNE subsidiary involves three different evaluation dimensions: –Management evaluation –Subsidiary evaluation –Strategic evaluation