Translation Exposure (or chapter 10).

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Presentation transcript:

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 (as of balance sheet date). Assets & Liabilities: -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 If subs financial statements kept in $, no need for translation. Is local currency functional currency? Purpose: Need to translate foreign subs statement into US$ No Is US$ functional currency? Yes Use current rate method Remeasure to US$ by temporal method Yes 1. Remeasure from foreign currency to functional by temporal method 2. Translate to US$ by current rate method No

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 LOSS AVOIDANCE

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