management of translation exposure

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Management of

Translation Exposure

Chapter Objective:

This chapter discusses the impact that unanticipatedchanges in exchange rates may have on theconsolidated financial statements of the multinationalcompany.

Chapter Outline Translation Methods

Management of Translation Exposure

14Chapter Fourteen


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Translation Exposure

Translation exposure, (also called accounting exposure), resultsfrom the need to restate foreign subsidiaries financial

statements, usually stated in foreign currency, into the parentsreporting currency when preparing the consolidated financialstatements.

Restating financial statements may lead to changes in theparents net worth or net income.

Two methods Current rate method

Temporal Approach


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The Current Rate Method

Advantages of CTA

Eliminates the variability of net earnings due to translation

gains or losses.

The relative proportions of individual balance sheet

accounts remain the same (debt-to-equity ratio, for

example).

Main disadvantage of CTA

violates the accounting principle of carrying balance sheet

accounts at historical cost.


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The Current Rate Method: An Example

Foreign Subsidiary, Inc., (FSI) has been acquired onDecember 31, 2000 when the exchange rate was LC1.25/$

(LC stands for FSIs local currency). On December 31, 2001, the exchange rate was LC1.15/$.

The average exchange rate during 2001 was LC1.18/$.

On December 31, 2002, the exchange rate was LC1.22/$.The average exchange rate during 2002 was LC1.20/$.


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Temporal Method

Monetary assets (cash, marketable securities, AR) and monetary

liabilities (current liabilities and LTD) are translated at the current ER

(exchange rate at the balance sheet date). Non-monetary assets (inventory, fixed assets, etc.) and non-monetary

liabilities are translated at their historical rate.

Income statement items are translated at the average ER over the

period, except for items that are associated with non-monetary assets or

liabilities, such as COGS (inventory) and depreciation (fixed assets),which are translated at their historical rate.

Dividends paid are translated at the rate in effect on the payment date.

Equity items are translated at their historical rate, and include any

imbalance.


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Temporal Method

Logic behind differentiating monetary and non-monetaryassets:

Translation gains and losses on monetary accounts arepresumed meaningful components of expenses or revenue

because monetary accounts closely approximate marketvalues.

Translation gains and losses on non-monetary accounts are

less meaningful since non-monetary accounts reflecthistorical costs.


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Temporal Method

Gains and losses resulting from translation are carrieddirectly to current consolidated income

Unlike the current rate method these gains and losses do notgo to an equity reserve account.

FX gains and losses introduce volatility of consolidatedearnings.

This volatility is damped to the extent that many items in thetemporal approach are translated at their historical costs.

The main advantage of this method is that it complies withthe accounting principle of carrying balance sheet accountsat historical cost.


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The Temporal Method: An Example


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Translation Exposure versus

Transaction Exposure Translation Exposure

The effect that unanticipated changes in exchange rates

has on the firms consolidated financial statements. An accounting issue.

Transaction Exposure The effect that unanticipated changes in exchange rates

has on the firms cash flows. A finance issue

It is generally not possible to eliminate bothtranslation exposure and transaction exposure.

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management of translation exposure