CHAPTER 8CHAPTER 8

MEASURING MEASURING ACCOUNTING ACCOUNTING

EXPOSUREEXPOSURE

CHAPTER OVERVIEWCHAPTER OVERVIEW

I.I. ALTERNATIVE MEASURES OF ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSUREFOREIGN EXCHANGE EXPOSURE

II.II.ALTERNATIVE CURRENCY ALTERNATIVE CURRENCY TRANSLATION METHODSTRANSLATION METHODS

III.III. STATEMENT OF FINANCIAL STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 8ACCOUNTING STANDARDS NO. 8

CHAPTER OVERVIEW (con’t)CHAPTER OVERVIEW (con’t)

IV.IV. STATEMENT OF FINANCIALSTATEMENT OF FINANCIALACCOUNTING STANDARDS ACCOUNTING STANDARDS

NO.52NO.52V.V. TRANSACTION EXPOSURETRANSACTION EXPOSUREVI.VI. ACCOUNTING PRACTICE AND ACCOUNTING PRACTICE AND

ECONOMIC REALITYECONOMIC REALITY

PART I. ALTERNATIVE MEASURES PART I. ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSUREOF FOREIGN EXCHANGE EXPOSURE

I.I. ALTERNATIVE MEASURES OF FOREIGN ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSUREEXCHANGE EXPOSUREA.A. Three Types of ExposureThree Types of Exposure1.1. Accounting Exposure:Accounting Exposure:when reporting and when reporting and consolidating consolidating financial financial statements requires statements requires conversion from foreign to conversion from foreign to local currency.local currency.

ALTERNATIVE MEASURES OF ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSUREFOREIGN EXCHANGE EXPOSURE

2.2. Transaction Exposure: Transaction Exposure: occurs from changes in the occurs from changes in the

value value of foreign currency of foreign currency contracts as contracts as a result of a result of exchange rate exchange rate changes. changes.

ALTERNATIVE MEASURES OF ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSUREFOREIGN EXCHANGE EXPOSURE

3.3. Operating ExposureOperating Exposurearises because exchange ratearises because exchange ratechanges alter the value of changes alter the value of

futurefuturerevenues and costs.revenues and costs.

ALTERNATIVE MEASURES OF ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSUREFOREIGN EXCHANGE EXPOSURE

Economic ExposureEconomic Exposure= Transaction + Operating= Transaction + Operating ExposuresExposures

PART II. ALTERNATIVE CURRENCY PART II. ALTERNATIVE CURRENCY TRANSLATION METHODS TRANSLATION METHODS

I.I. FOUR METHODS OF TRANSLATIONFOUR METHODS OF TRANSLATIONA.A. Current/Noncurrent MethodCurrent/Noncurrent Method1. 1. Current accounts use Current accounts use current current exchange rate for exchange rate for conversion.conversion.2. 2. Income statement accounts Income statement accounts use use average exchange rate average exchange rate for the for the period.period.

ALTERNATIVE CURRENCY ALTERNATIVE CURRENCY TRANSLATION METHODSTRANSLATION METHODS

B.B. Monetary/Nonmonetary MethodMonetary/Nonmonetary Method1.1. Monetary accounts use Monetary accounts use

current ratecurrent rate2.2. Pertains toPertains to

- cash- cash- accounts receivable- accounts receivable- accounts payable- accounts payable- long term debt- long term debt

ALTERNATIVE CURRENCY ALTERNATIVE CURRENCY TRANSLATION METHODSTRANSLATION METHODS

3.3. Nonmonetary accountsNonmonetary accounts- use historical rates- use historical rates- Pertains to - Pertains to inventoryinventoryfixed assetsfixed assetslong term investmentslong term investments4.4. Income statement accounts Income statement accounts - use average exchange rate - use average exchange rate for the for the period.period.

ALTERNATIVE CURRENCY ALTERNATIVE CURRENCY TRANSLATION METHODSTRANSLATION METHODS

C.C. Temporal MethodTemporal Method1.1. Similar to Similar to

monetary/nonmonetarymonetary/nonmonetarymethod.method.

2.2. Use current method for Use current method for inventory.inventory.

ALTERNATIVE CURRENCY ALTERNATIVE CURRENCY TRANSLATION METHODSTRANSLATION METHODS

D.D. Current Rate MethodCurrent Rate Methodall statements use current all statements use current

exchange rate for exchange rate for conversions.conversions.

PART III. STATEMENT OF FINANCIAL PART III. STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 8ACCOUNTING STANDARDS NO. 8

I.I. FASB NO. 8FASB NO. 8A.A. Uniform conversion rules Uniform conversion rules establishedestablishedB.B. Temporal method utilizedTemporal method utilizedC.C. Translation gains or lossesTranslation gains or losses1. Reported on income statement1. Reported on income statement2. Result: net income greatly 2. Result: net income greatly affected by exchange rate affected by exchange rate volatility.volatility.

PART IV. STATEMENT OF INANCIAL PART IV. STATEMENT OF INANCIAL ACCOUNTING STANDARDS NO. 52ACCOUNTING STANDARDS NO. 52

I.I. FASB NO. 52FASB NO. 52A.A. Dissatisfaction with FASB No. 8Dissatisfaction with FASB No. 8

true profitability often disguised bytrue profitability often disguised byexchange rate volatility.exchange rate volatility.

B.B. Balance sheet translation uses Balance sheet translation uses current rate method.current rate method.

STATEMENT OF INANCIAL STATEMENT OF INANCIAL ACCOUNTING STANDARDS NO. 52ACCOUNTING STANDARDS NO. 52

C.C. Income statement usesIncome statement uses1. 1. Weighted average rate Weighted average rate

during period during period oror

2. 2. The rate in effect when The rate in effect when revenue and revenue and

expensesexpensesincurred.incurred.

STATEMENT OF FINANCIAL STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 52ACCOUNTING STANDARDS NO. 52

D.D. Translation Gains or LossesTranslation Gains or Losses

1. 1. Recorded in separate equity Recorded in separate equity account on balance sheet.account on balance sheet.

2. 2. Known as cumulative Known as cumulative translation translation adjustment adjustment account.account.

STATEMENT OF INANCIAL STATEMENT OF INANCIAL ACCOUNTING STANDARDS NO. 52ACCOUNTING STANDARDS NO. 52

E.E. New Distinction under FASB No. 52:New Distinction under FASB No. 52:functional v. reporting currencyfunctional v. reporting currency1. 1. Functional currencyFunctional currency for foreign subsidiary = the for foreign subsidiary = the

currency used in the primary currency used in the primary economic environment economic environment

in which it in which it operates. operates.

STATEMENT OF INANCIAL STATEMENT OF INANCIAL ACCOUNTING STANDARDS NO. 52ACCOUNTING STANDARDS NO. 52

2. 2. Reporting currency Reporting currency the currency the parent firm the currency the parent firm

uses to prepare its uses to prepare its financial financial statements.statements.

STATEMENT OF FINANCIAL STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 52ACCOUNTING STANDARDS NO. 52

3. If foreign subsidiary’s operations are 3. If foreign subsidiary’s operations are direct extension of parent firmdirect extension of parent firm

e.g. Hong Kong assembly plant e.g. Hong Kong assembly plant whichwhich

sells all its products in the U.S. sells all its products in the U.S. market. market.

PART V.PART V.TRANSACTION EXPOSURETRANSACTION EXPOSUREI.I. WHEN DOES IT OCCUR?WHEN DOES IT OCCUR?

A. From the time of agreement to time ofA. From the time of agreement to time ofpayment.payment.

B.B. Arises from possibility of exchange Arises from possibility of exchange rate rate

gains and losses from the gains and losses from the transaction.transaction.

TRANSACTION EXPOSURETRANSACTION EXPOSURE

II. MEASUREMENTII. MEASUREMENTA. Currency by currencyA. Currency by currencyB.B. Equals the difference between Equals the difference between1. The contractually-fixed invoice1. The contractually-fixed invoice amount in a specific currencyamount in a specific currency2. The final payment amount 2. The final payment amount denominated in current exchange denominated in current exchange rate for the specific currency.rate for the specific currency.

PART VI. ACCOUNTING PRACTICE PART VI. ACCOUNTING PRACTICE AND ECONOMIC REALITYAND ECONOMIC REALITY

I.I. Accounting v. Economic ExposureAccounting v. Economic Exposuremeasurement of exchange rate risk measurement of exchange rate risk indicates major difference exists.indicates major difference exists. A. Accounting exposureA. Accounting exposure

reflects past decisions of the firm.reflects past decisions of the firm.

ACCOUNTING PRACTICE AND ACCOUNTING PRACTICE AND ECONOMIC REALITYECONOMIC REALITY

B. Economic exposureB. Economic exposure

1. Focuses on future impact of 1. Focuses on future impact of exchange rate changes. exchange rate changes.

2. Not all future cash flows appear on2. Not all future cash flows appear on

the firm’s balance sheet.the firm’s balance sheet.

ACCOUNTING PRACTICE AND ACCOUNTING PRACTICE AND ECONOMIC REALITYECONOMIC REALITY

II. Recommendations for International II. Recommendations for International Business ExecutivesBusiness ExecutivesA. There is no relationship betweenA. There is no relationship between

1. 1. Information from historical Information from historical accounting techniques, andaccounting techniques, and2. 2. The firm’s actual operating The firm’s actual operating

results.results.

ACCOUNTING PRACTICE AND ACCOUNTING PRACTICE AND ECONOMIC REALITYECONOMIC REALITY

B. Chief executives should:B. Chief executives should:

base management decisions on thebase management decisions on the

economic effects of exchange rate economic effects of exchange rate change.change.