Translation Exposure or chapter 10 Agenda How translation

Translation Exposure (or chapter 10)

Agenda § How translation exposure arises? § Functional currency? § Current Rate Method vs. Temporal Method. § Balance Sheet Hedge? § Earnings Management.

§ § Translation Exposure Potential for increase/ decrease in parent’s net worth & reported income due to forex change. Translation method differ: • based on operation – Integrated Foreign Entity: cash flow integrated w/ parent – Self-sustaining Foreign Entity –independent of parent • based on functional currency (currency of economic activity) • Which currency is functional? Not a discretionary management decision! – – – Cash flow Sales prices Sales market Expenses Financing Intercompany tranactions

Translation Methods Current (Closing) Rate Method Temporal Method Assets & Liabilities: translate @ current rate Assets & Liabilities: (as of balance sheet date). -Monetary: translate @ current rates. -Non-monetary (inventory & fixed assets): @ historical rates Income statement Items: translate @ actual rate when items incurred. Income Statement Items: translated @ average rates except for depreciation & cost of goods sold (@ historical rates) Distributions: dividends translated @ the rate on date of payment. Equity Items: Common stock & Paid-in capital translated @ historical rates. Retained earnings +/- income/loss for the year. Equity Items: Common stock & Paid-in capital translated @ historical rates. Retained earnings +/- income/loss +/imbalance from translation. Translation Adjustments: not included into consolidated income but in equity reserve account. Translation Adjustments: unrealized forex gains/ losses included in primary earnings.

US Translation Procedures Purpose: Need to translate foreign subs statement into US$ If subs financial statements kept in $, no need for translation. Is local currency functional currency? Yes No Is US$ functional currency? 1. Remeasure from foreign currency to functional by temporal method 2. Translate to US$ by current rate method Use current rate method No Yes Remeasure to US$ by temporal method

Hyperinflation Countries § FAS #52: US subs in countries where cumulative inflation 100%+ over 3 years use temporal method • Why? B/c if current rate method, depreciation understated & profits overstated => book value of PP&E would disappear. § International Practices: • Integrated subsidiaries: re-measure using temporal • method. Self-sustaining subsidiaries: translate by current rate method.

Translation Example § § § § Suppose EUR depreciated 16. 67% from $1. 2/EUR to $1. 0/EUR Functional currency EUR, Parent: US$ PP&E, common stock acquired @ $1. 276/EUR Inventory purchased/manufactured @ $1. 218/EUR Exposed assets: asset whose value drops w/ depreciation of functional currency & rises w/ appreciation of functional currency. Net exposed assets: exposed assets – exposed liability Implications: • Appreciation -> increase net exposed assets. • Depreciation -> decrease net exposed assets.

BALANCE SHEET TRANSLATION

How to manage accounting exposure? § Balance Sheet Hedge –requires equal amount of exposed forex assets & liabilities on consolidated balance sheet • Termed monetary balance under temporal method • Cost: § § – Costly if borrowing cost of parent higher. How to manage it if depreciation expected? • Reduce EUR exposed assets, no change on EUR exposed liab. • Increase EUR exposed liabilities, no change on EUR exposed assets. When balance sheet hedge justified? • Subs to be liquidated • Firm has debt covenants to maintain debt/equity ratios • Management evaluated on basis of certain income statement and • balance sheet measures Subs operating in hyperinflationary country

For example…

Earnings Management EARNINGS INCRASING EARNINGS SMOOTHING LOSS AVOIDANCE

Things to remember… § How translation exposure arises? § Functional currency? § Current Rate Method vs. Temporal Method. § Balance sheet hedge § Earnings Management.