1. Chapter 14 Management of Translation Exposure Management 3460 Institutions and Practices in International Finance Fall 2003 Greg Flanagan

2. Nov 27, 2003 2 Chapter Objectives define 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.

3. Nov 27, 2003 3 Chapter Objectives discuss and differentiate various translation methods: current/noncurrent monetary/nonmonetary temporal current rate

4. Nov 27, 2003 4 Chapter Objectives (continued) summarize the FASB statement 52 discuss 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

5. Nov 27, 2003 5 Definition Translation Exposure – the potential that the firm’s consolidated financial statements can be affected by changes in exchange rates.

6. 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.

7. 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.

8. 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

9. 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

10. 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

11. 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.

12. 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

13. Nov 27, 2003 13 Current Rate Method All 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.

14. 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

15. Nov 27, 2003 15 How Various Translation Methods Deal with a Change from €3 to €2 = $1 Spot exchange rate

16. Nov 27, 2003 16 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.

17. Nov 27, 2003 17 How Various Translation Methods Deal with a Change from €3 to €2 = $1 historic ratespot exchange rate

18. Nov 27, 2003 18 How Various Translation Methods Deal with a Change from €3 to €2 = $1 spot rate

19. Nov 27, 2003 19 How Various Translation Methods Deal with a Change from €3 to €2 = $1 spot rate historical rate

20. Nov 27, 2003 20 How Various Translation Methods Deal with a Change from €3 to €2 = $1 historical rate

21. Nov 27, 2003 21 How Various Translation Methods Deal with a Change from €3 to €2 = $1 From income statement

22. Nov 27, 2003 22 How Various Translation Methods Deal with a Change from €3 to €2 = $1 Under the current rate method, a “plug” equity account named cumulative translation adjustment makes the balance sheet balance.

23. Nov 27, 2003 23 How Various Translation Methods Deal with a Change from €3 to €2 = $1 Sales translate at average exchange rate over the period, €2.50 = $1

24. Nov 27, 2003 24 How Various Translation Methods Deal with a Change from €3 to €2 = $1 Translate at €2.50 = $1 Translate at new exchange rate, €2.00 = $1

25. Nov 27, 2003 25 How Various Translation Methods Deal with a Change from €3 to €2 = $1 Translate at €3 = $1Translate at average exchange rate, €2.5 = $1

26. Nov 27, 2003 26 How Various Translation Methods Deal with a Change from €3 to €2 = $1 14.1 Note the effect on after-tax profit.

27. Nov 27, 2003 27 How Various Translation Methods Deal with a Change from €3 to €2 = $1 14.1 Note the effect that foreign exchange gains (losses) has on net income.

28. 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).

29. Nov 27, 2003 29 The Mechanics of FAS52 Function Currency The currency that the business is conducted in. Reporting Currency The currency in which the MNC prepares its consolidated financial statements.

30. 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.

31. 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? Parent’s Currency Functional Currency? Local currency Temporal Remeasurement Parent’s currency Nonparent Currency Third currency The Mechanics of FAS52

32. 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”.

33. Nov 27, 2003 33 Management of Translation Exposure Translation Exposure vs. Transaction Exposure Hedging Translation Exposure Balance Sheet Hedge Derivatives Hedge Translation Exposure vs. Operating Exposure

34. Nov 27, 2003 34 Translation Exposure versus Transaction Exposure Translation Exposure The effect that unanticipated changes in exchange rates has on the firm’s consolidated financial statements  accounting issue. Transaction Exposure A 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.

35. 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 Hedge Derivatives Hedge

36. 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.

37. 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.

38. 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.

39. 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.

40. 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.

41. 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.

42. 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

43. 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.