Chapter 11 Translation Exposure Learning Objectives Examine how

Chapter 11 Translation Exposure

Learning Objectives • Examine how the process of consolidation of a multinational firm’s financial results creates translation exposure • Illustrate both theoretical and practical differences between the two primary methods of translating or remeasuring foreign currencydenominated financial statements • Understand how translation can potentially alter the value of a multinational firm • Explore the costs, benefits, and effectiveness of managing translation exposure 11 -2 © 2016 Pearson Education, Inc. All rights reserved.

Overview of Translation • Translation exposure, also called accounting exposure, arises because financial statements of foreign subsidiaries—which are stated in foreign currency—must be restated in the parent’s reporting currency for the firm to prepare consolidated financial statements. • The accounting process of translation, involves converting these foreign subsidiaries financial statements into US dollar-denominated statements. 11 -3 © 2016 Pearson Education, Inc. All rights reserved.

Exhibit 11. 1 Ganado’s Cross-Border Investments and Consolidation 11 -4 © 2016 Pearson Education,

Overview of Translation • Translation exposure is the potential for an increase or decrease in the parent’s net worth and reported net income caused by a change in exchange rates since the last translation. • While the main purpose of translation is to prepare consolidated statements, management uses translated statements to assess performance (facilitation of comparisons across many geographically distributed subsidiaries). 11 -5 © 2016 Pearson Education, Inc. All rights reserved.

Overview of Translation • Translation in principle is simple: – Foreign currency financial statements must be restated in the parent company’s reporting currency – If the same exchange rate were used to remeasure each and every line item on the individual statement (I/S and B/S), there would be no imbalances resulting from the remeasurement – What if a different exchange rate were used for different line items on an individual statement (I/S and B/S)? – An imbalance would result 11 -6 © 2016 Pearson Education, Inc. All rights reserved.

Overview of Translation • Why would we use a different exchange rate in remeasuring different line items? – Translation principles in many countries are often a complex compromise between historical and current market valuation. – Historical exchange rates can be used for certain equity accounts, fixed assets, and inventory items, while current exchange rates can be used for current assets, current liabilities, income, and expense items. 11 -7 © 2016 Pearson Education, Inc. All rights reserved.

Overview of Translation • Most countries today specify the translation method used by a foreign subsidiary based on the subsidiary’s business operations (subsidiary characterization). • For example, a foreign subsidiary’s business can be categorized as either an integrated foreign entity or a self-sustaining foreign entity. • An integrated foreign entity is one that operates as an extension of the parent, with cash flows and business lines that are highly interrelated. • A self-sustaining foreign entity is one that operates in the local economic environment independent of the parent company. 11 -8 © 2016 Pearson Education, Inc. All rights reserved.

Overview of Translation • A foreign subsidiary’s functional currency is the currency of the primary economic environment in which the subsidiary operates and in which it generates cash flows. • In other words, it is the dominant currency used by that foreign subsidiary in its day-to-day operations. • The U. S. , requires that the functional currency of the foreign subsidiary be determined based on the nature and purpose of the subsidiary. The U. S. does not distinguish between subsidiaries that are integrated or self-sustaining. 11 -9 © 2016 Pearson Education, Inc. All rights reserved.

Translation Methods • Two basic methods for the translation of foreign subsidiary financial statements are employed worldwide: – The current rate method – The temporal method • Regardless of which method is employed, a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured, but also designate where any imbalance is to be recorded (current income or an equity reserve account). 11 -10 © 2016 Pearson Education, Inc. All rights reserved.

Translation Methods • The current rate method is the most prevalent in the world today. – Assets and liabilities are translated at the current rate of exchange – Income statement items are translated at the exchange rate on the dates they were recorded or an appropriately weighted average rate for the period – Dividends (distributions) are translated at the rate in effect on the date of payment – Common stock and paid-in capital accounts are translated at historical rates 11 -11 © 2016 Pearson Education, Inc. All rights reserved.

Translation Methods • Gains or losses caused by translation adjustments are not included in the calculation of consolidated net income. • Rather, translation gains or losses are reported separately and accumulated in a separate equity reserve account (on the B/S) with a title such as cumulative translation adjustment (CTA). • The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings). 11 -12 © 2016 Pearson Education, Inc. All rights reserved.

Translation Methods • Under the temporal method, specific assets are translated at exchange rates consistent with the timing of the item’s creation. • This method assumes that a number of individual line item assets such as inventory and net plant and equipment are restated regularly to reflect market value. • Gains or losses resulting from remeasurement are carried directly to current consolidated income, and not to equity reserves (increased variability of consolidated earnings). 11 -13 © 2016 Pearson Education, Inc. All rights reserved.

Translation Methods • If these items were not restated but were instead carried at historical cost, the temporal method becomes the monetary/nonmonetary method of translation. – Monetary assets and liabilities are translated at current exchange rates – Nonmonetary assets and liabilities are translated at historical rates – Income statement items are translated at the average exchange rate for the period – Dividends (distributions) are translated at the exchange rate on the date of payment – Equity items are translated at historical rates 11 -14 © 2016 Pearson Education, Inc. All rights reserved.

Translation Methods • The U. S. differentiates foreign subsidiaries on the basis of functional currency, not subsidiary characterization. – If the financial statements of the foreign subsidiary are maintained in U. S. dollars, translation is not required – If the statements are maintained in the local currency, and the local currency is the functional currency, they are translated by the current rate method – If the statements are maintained in local currency, and the U. S. dollar is the functional currency, they are remeasured by the temporal method – If the statements are in local currency and neither the local currency nor the U. S. dollar is the functional currency, the statements must first be remeasured into the functional currency by the temporal method, and then translated into U. S. dollars by the current rate method – See Exhibit 11. 2 11 -15 © 2016 Pearson Education, Inc. All rights reserved.

Exhibit 11. 2 Flow Chart for U. S. Translation Practices 11 -16 © 2016

Translation Methods • Many of the world’s largest industrial countries—as well as the relatively newly formed International Accounting Standards Committee (IASC) follow the same basic translation procedure: – A foreign subsidiary is an integrated foreign entity or a self-sustaining foreign entity – Integrated foreign entities are typically remeasured using the temporal method – Self-sustaining foreign entities are translated at the current rate method, also termed the closing -rate method. 11 -17 © 2016 Pearson Education, Inc. All rights reserved.

Ganado Corporation’s Translation Exposure • Ganado Corporation is a U. S. -based corporation with foreign subsidiaries in Europe and China • The company is publicly traded on the NYSE • Each set of financials will be constructed in the local currency (renminbi, dollar, euro), but the subsidiary income statements and balance sheets will also be translated into U. S. dollars • See Exhibit 11. 3 11 -18 © 2016 Pearson Education, Inc. All rights reserved.

Exhibit 11. 3 Ganado Corporation: A U. S. Multinational 11 -19 © 2016 Pearson

Ganado Corporation’s Translation Exposure: Income • Exhibit 11. 4 describes Ganado’s sales and earnings by operating unit for 2009 and 2010 – 2010 Sales U. S. = $300 M – 2010 Sales Europe = $158. 4 M = $1. 32/€ * € 120 M – 2010 Sales China = $89. 6 M = Rmb 600/Rmb 6. 7/$ • Even though earnings are up in local currency from 2009 to 2010, consolidated earnings are down slightly because the euro lost value against the dollar dropping from $1. 40/€ to $1. 32/€ while the China operation gained 11 -20 © 2016 Pearson Education, Inc. All rights reserved.

Exhibit 11. 4 Ganado Corporation, Selected Financial Results, 2009– 2010 11 -21 © 2016

Ganado Corporation’s Translation Exposure: Balance Sheet • The functional currency of Ganado’s European subsidiary is the euro, and the reporting currency of its parent, Ganado Corporation, is the U. S. dollar – Plant and equipment and long-term debt and common stock issued some time in the past when the exchange rate was $1. 2760/€ – Inventory currently on hand was purchased or manufactured during the immediately prior quarter when the average exchange rate was $1. 2180/€ 11 -22 © 2016 Pearson Education, Inc. All rights reserved.

Ganado Corporation’s Translation Exposure: Balance Sheet • As seen in Exhibits 11. 5 and 11. 6, the translation loss or gain is larger under the current rate method because inventory and net plant and equipment, as well as all monetary assets, are deemed exposed • The managerial implications of this fact are very important • Depending on the accounting method of the moment, management might select different assets and liabilities for reduction or increase—as a result impacting “real” decisions 11 -23 © 2016 Pearson Education, Inc. All rights reserved.

Exhibit 11. 5 Ganado Europe’s Translation Loss After Depreciation of the Euro: Current Rate

Exhibit 11. 6 Ganado Europe’s Translation Loss After Depreciation of the Euro: Temporal Method

Managing Translation Exposure • The main technique to minimize translation exposure is called a balance sheet hedge. • A balance sheet hedge requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet. • If this can be achieved for each foreign currency, net translation exposure will be zero. • If a firm translates by the temporal method, a zero net exposed position is called monetary balance. • Complete monetary balance cannot be achieved under the current rate method. 11 -26 © 2016 Pearson Education, Inc. All rights reserved.

Managing Translation Exposure • If a firm’s subsidiary is using the local currency as the functional currency, the following circumstances could justify when to use a balance sheet hedge: – The foreign subsidiary is about to be liquidated, so that the value of its CTA would be realized – The firm has debt covenants or bank agreements that state the firm’s debt/equity ratios will be maintained within specific limits – Management is evaluated on the basis of certain income statement and balance sheet measures that are affected by translation losses or gains – The foreign subsidiary is operating in a hyperinflationary environment 11 -27 © 2016 Pearson Education, Inc. All rights reserved.