1. Translation Exposure
(or chapter 10)

2. Agenda How translation exposure arises? Functional currency?
Current Rate Method vs. Temporal Method.
Balance Sheet Hedge?
Earnings Management.

3. Translation Exposure
Potential for increase/ decrease in parent’s net worth & reported income due to forex change.
Translation method differ:
based on operation
Integrated Foreign Entity: cash flow integrated w/ parent
Self-sustaining Foreign Entity –independent of parent
based on functional currency (currency of economic activity)
Which currency is functional? Not a discretionary management decision!
Cash flow
Sales prices
Sales market
Expenses
Financing
Intercompany tranactions

4. Translation Methods Current (Closing) Rate Method Temporal Method
Assets & Liabilities: current rate (as of balance sheet date).
Assets & Liabilities:
-Monetary: current rates.
-Non-monetary (inventory & fixed historical rates
Income statement Items: actual rate when items incurred.
Income Statement Items: average rates except for depreciation & cost of goods sold historical rates)
Distributions: dividends the rate on date of payment.
Equity Items: Common stock & Paid-in capital historical rates. Retained earnings +/- income/loss for the year.
Equity Items: Common stock & Paid-in capital historical rates. Retained earnings +/- income/loss +/- imbalance from translation.
Translation Adjustments: not included into consolidated income but in equity reserve account.
Translation Adjustments: unrealized forex gains/ losses included in primary earnings.

5. US Translation Procedures
If subs financial statements kept in $,
no need for translation.
Is local currency
functional currency?
Purpose: Need to translate foreign subs statement into US$ No
Is US$
functional currency?
Yes
Use current rate method
Remeasure to US$
by temporal method
Yes
1. Remeasure from foreign
currency to functional
by temporal method
2. Translate to US$
by current rate method No

6. Hyperinflation Countries
FAS #52: US subs in countries where cumulative inflation 100%+ over 3 years use temporal method
Why? B/c if current rate method, depreciation understated & profits overstated => book value of PP&E would disappear.
International Practices:
Integrated subsidiaries: re-measure using temporal method.
Self-sustaining subsidiaries: translate by current rate method.

7. Translation Example
Suppose EUR depreciated 16.67% from $1.2/EUR to $1.0/EUR
Functional currency EUR, Parent: US$
PP&E, common stock $1.276/EUR
Inventory $1.218/EUR
Exposed assets:asset whose value drops w/ depreciation of functional currency & rises w/ appreciation of functional currency.
Net exposed assets: exposed assets – exposed liability
Implications:
Appreciation -> increase net exposed assets.
Depreciation -> decrease net exposed assets.

8. BALANCE SHEET TRANSLATION

9. How to manage accounting exposure?
Balance Sheet Hedge –requires equal amount of exposed forex assets & liabilities on consolidated balance sheet
Termed monetary balance under temporal method
Cost:
Costly if borrowing cost of parent higher.
How to manage it if depreciation expected?
Reduce EUR exposed assets, no change on EUR exposed liab.
Increase EUR exposed liabilities, no change on EUR exposed assets.
When balance sheet hedge justified?
Subs to be liquidated
Firm has debt covenants to maintain debt/equity ratios
Management evaluated on basis of certain income statement and balance sheet measures
Subs operating in hyperinflationary country

10. For example…

11. Earnings Management EARNINGS INCRASING EARNINGS SMOOTHING
LOSS AVOIDANCE
LOSS AVOIDANCE

12. Things to remember… How translation exposure arises?
Functional currency?
Current Rate Method vs. Temporal Method.
Balance sheet hedge
Earnings Management.