1. Lecture 81 Accounting Exposure Accounting (Translation) Exposure: Potential gain/loss in a firm’s net worth from changes in exchange rate in translating foreign financial statements into the firm’s reporting currency. (Reporting currency: currency in which the parent prepares its financial statement) I. Measuring Accounting Exposure Translation Methods Methods differ in - what exchange rate to use in translating balance sheet and income statement items - How translation gain/loss is recorded

2. Lecture 82 I. Measuring Accounting Exposure 1.Current Rate Method A. All Assets and Liabilities - translated at current exchange rate Income statement items - translated at average rate for the period B. Gain/Loss - recorded in equity reserve account (B/S) ** All Assets and Liabilities are exposed Advantages: less volatile income stable financial ratios Disadvantage: Deviation from historical cost 2.Temporal Method A.Monetary assets and liabilities - translated at current exchange rate Non-monetary assets and liabilities (Inventory & fixed assets - at historical rate Depreciation and C.G.S - translated at historical exchange rate All other income statement items - translated at average rate in the period B.Gain/Loss- charged to current consolidated income ** Only Monetary assets and liabilities are exposed to risk

3. Lecture 83 I. Measuring Accounting Exposure cont’d Translation Practices International (other than U.S.): Differs by foreign-affiliate types 1. Integrated foreign affiliate - Temporal Method ( operates as extension of the parent) 2.Self- sustaining foreign affiliate -Current Rate Method ( operates in local economic environment independent of the parent) U.S. Translation Procedure: Foreign affiliates differentiated based on the affiliates Functional Currency, not by affiliate characterization Functional Currency - currency of primary economic environment in which the affiliate operates. The currency used in its day-to-day operation Functional currency = U.S. $ ===> Integrated foreign affiliate Functional currency = other than $ ==> Self sustaining affiliate

4. Lecture 84 I. Measuring Accounting Exposure cont’d Procedure: If F/S is in U.S. $ ==> No translation If F/S is in local currency, and Functional currency = Local currency ==> Current Rate Method If F/S is in local currency, and Functional currency = U.S Dollar ==> Temporal Method If F/S is in local currency, and Functional currency = currency other than U.S dollar or local currency then, (1) ‘remeasure’ into Functional currency by Temporal Method, and (2) translate from Functional currency into U.S. $ using Current Rate Method (see Exhibit 8-2)

5. Lecture 85 I. Measuring Accounting Exposure cont’d Example: Instrumental du Rhone, S.A - Functional currency = Euro -Parent’s reporting currency = $ - Current spot exchange rate = $1.2000/Euro --- December 31, 2001 - Fixed Assets, and common stock => applicable historical rate = $1.2760/Euro Inventory - historical rate = $1.2180/Euro - Jan 2, 2002 - Euro devalued to $1.0000/Euro Translation, 1.Prepare two balance sheets: before and after exchange rate changes Compute “incremental” gain/loss in translation (Exhibit 8-4) 2.Determine the “ net exposed assets” multiply by amount of ‘depreciation’ or ‘appreciation’ of functional currency (Exhibit 8-5, 8-6)

6. Lecture 86 II. Managing Accounting Exposure Balance Sheet Hedge –Balancing Exposed foreign currency assets and foreign currency liabilities costs of balance sheet hedge include –borrowing costs –compromise in operating efficiency and optimal capital structure