Accounting vs Real Exposure International Corporate Finance P.V. Viswanath

2 Learning Objectives  What is accounting exposure?  How does it differ from economic/operating exposure?  Real changes in exchange rates  How accounting rules contrast with the measurement of real changes in exchange rates

P.V. Viswanath3 Accounting Exposure  Accountants have rules for converting values of foreign assets, liabilities, payments and receipts into domestic currency in order to consolidate financial statements.  Accounting exposure concerns the effect that exchange rates have on values appearing in financial statements.  Translation risk and exposure have to do with how asset and liability values appear when converted into a firms’ domestic reporting currency for inclusion in financial accounts.  Transaction risk and exposure have to do with the effect of exchange rates on asset or liability values when they are liquidated.

P.V. Viswanath4 FAS 8  Until 1982, the US used FAS 8 to convert foreign currency values to dollar values.  Under FAS 8, all foreign exchange translation gains or losses had to be shown in the current-period income statement.  Different treatment was given to current operating receipts and expenditures and financial assets/liabs on the one hand and fixed assets on the other.  One problem with FAS 8 was that there was a lot of volatility in reported income because all translation gains had to be included in the income statement.

P.V. Viswanath5 Temporal Method  If local currency values were measured at current cost, they were translated at current exchange rates  If they were measured at historical cost, they were translated at historical exchange rates. Revenues and expenses from foreign entities, as well as financial assets and liabilities were translated at the average exchange rate prevailing during the period. Other assets, primarily fixed assets, were translated at historical exchange rates. Historical costs were used in terms of local (i.e. foreign currency).

P.V. Viswanath6 FAS 52  Since 1982, FAS 52 is used.  The functional currency is selected for each subsidiary. This is the primary currency of the subsidiary.  Any foreign currency income of the subsidiary is translated into the function currency according to FAS 8 rules. For example, euros earned by a British subsidiary of a US company will be translated into pounds using FAS 8. Thus, revenues and expenses in euros will be translated into pounds at the average exchange rate prevailing during the current period.  After this, all amounts are translated from the functional currency into dollars at the current exchange rate.

P.V. Viswanath7 FAS 52  Translation gains and losses are disclosed and accumulated in a separate account showing shareholders’ equity. Only when foreign assets or liabilities are liquidated do they become transaction gains and appear in the income statement.  If there has been cumulatively over the last three years, more than 100% inflation in the local currency, the temporal distinction from FAS 8 is still used.

P.V. Viswanath8 Real Changes in Exchange Rates  Real changes in exchange rates refer to the true economic effects of exchange rates.  It is the change that produces a difference between the rate of return on domestic versus foreign assets/liabilities, or in the profitability of firms.  There are no real changes in exchange rates on financial assets and liabilities if unhedged interest-parity always holds ex-post.  There are no real changes in exchange rates for fixed (real assets if PPP always holds ex post.

P.V. Viswanath9 Financial assets/liabilities  Suppose Aviva, a US Corporation, has invested in British bonds.  Keep in mind that we are looking at accounting treatment, i.e. ex post recognition of events that have occurred during the year.  A depreciation of the British pound will decrease the dollar value of these bonds when converted into dollars at the new exchange rate.  However, if the interest rates on the British bonds were sufficiently higher than US interest rates, the firm would be no worse off having invested in British bonds than investing in US bonds.

P.V. Viswanath10 Financial assets/liabilities  The real change for financial assets held for a year: Real change in e = (1+ r £ )(e 1 -e 0 )/e 0 – (r $ - r £ )  This is also the ex post deviation from unhedged interest-rate parity.  Hence, a real change in the exchange rate for financial securities occurs when there is an ex post departure from uncovered interest parity.

P.V. Viswanath11 Financial assets/liabilities: An example  Suppose $100 were invested in US and UK assets.  e 0 = 1.5, e 1 =1.8, r US = 5%, r UK = 4%.  The real change in the exchange rate = [( )/1.5](1.04) – ( ) = 0/198 or 19.8%  The UK investment turns out to be more profitable than the US one because of the appreciation of the pound.  This might be because real growth (or expected future real growth) in the UK turned out to be greater than in the US.

P.V. Viswanath12 Financial assets/liabilities: Accounting  The $100 invested in the US would generate $5 income.  The $100 would be converted to £66.67, and would generate (66.67)(.04) or £2.67 income.  Translated to dollars, this works out to (2.67)(1.8) = $4.8.  The principal of £66.67 would be translated according to FAS 52 rules at current rates, to (66.67(1.8) = $120, for a translation gain of $20, which would show up in the balance sheet.  The total return would be $20 (from the balance sheet) (income statement) or $24.8, which is $19.8 greater than the $5 generated from the US investment.

P.V. Viswanath13 Real Assets/Liabilities  The return on real assets, whose value is denominated in dollars is  US +  US  The return on assets invested in British fixed assets, when translated at the new exchange rate is: (e 1/ e 0 )(1+  UK +  UK )-1  The real change in exchange rates is: [(e 1 -e 0 )/e 0 ](1+  UK ) - (  US -  UK ) – [  US -  UK (e 1 )/e 0 ]  The first two terms add up to zero if ex-post PPP holds  The last term is the application of an ex-post PPP condition to return flows from the asset.

P.V. Viswanath14 Real assets/liabilities – real change  With FAS 52, the values of fixed assets are translated at current exchange rates, but the local currency asset values are based on historical cost.  This affects the translation issue, as well.  Suppose $100 were invested in US and UK assets.  The real realized return over 1 year on US assets is 5% and on UK assets, 4%;  US = 10%,  UK = 8%, e 0 = 1.5, e 1 =1.8  The real change in the exchange rate is: [(e 1 -e 0 )/e 0 ](1+  UK ) - (  US -  UK ) – [  US -  UK (e 1 )/e 0 ] (0.3/1.5)(1.08) – (.10 – 0.08) – ( (1.8/1.5)) =  This means that there is a real relative gain on the British asset of 19.4%

P.V. Viswanath15 Real assets/liabilities – accounting  The income on the US asset is $5 (100x.05)  The capital gain is $10 (100x0.1)  On the UK asset, income of £2.67 (0.04x100/1.5) is recorded, which is translated to 2.67(1.8) = $4.8  At the end of the period, the asset value is translated into dollars at (100/1.5)(1.8) = $120  In actuality, the new asset is worth (100/1.5)(1.08) = £72, which translated into $ would be $129.6  The actual relative gain in holding the UK asset is =  In fact, the translated relative gain from the UK asset is = 109.8, or 9.6% less than it should be.  This can be computed as (100/1.5)(1.8)(0.08) = $9.6

P.V. Viswanath16 FAS 52: Summary of effects  FAS 52 procedure values assets using historical costs and current exchange rates, but puts translation gains or losses in a separate shareholder equity account.  FAS 52 produces correct measures of real changes in exchange rates for financial assets if shareholder equity effects are included as part of income.  FAS 52 produces incorrect measures of real changes in exchange rates for fixed assets. Correct values on fixed assets require using current exchange rates and current market values.