Measuring Accounting Exposure International Finance Dr. A. DeMaskey

Learning Objectives What are the three different types of foreign exchange exposures? What is accounting exposure and how is it measured? What are the two primary methods of converting foreign currency denominated financial statements into the reporting currency of the U.S. parent company? What is transaction exposure and how is it measured? What is the difference between accounting measures of exposure and the economic effects of currency changes on the value of the firm?

Foreign Exchange Risk Management Exposure refers to the degree to which a company is affected by exchange rate changes. Exchange rate risk is defined as the variability of a firm’s value due to uncertain changes in the rate of exchange.

Types of Exposures Accounting or Translation Exposure Economic Exposure Transaction Exposure Operating Exposure

Translation Exposure It arises from the need, for purposes of reporting and consolidation, to convert the results of foreign operations from the local currency to the home currency. Paper exchange gains or losses Retrospective in nature Short-term in nature

Transaction Exposure It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency. Real exchange gains or losses Mixes retrospective and prospective Short-term in nature

Operating Exposure It arises because currency fluctuations combined with price level changes can alter the amounts and riskiness of a firm’s future revenues and costs. Real exchange gains or losses Prospective in nature Long-term in nature

Economic Exposure It is defined as the extent to which the value of the firm, as measured by the present value of all expected future cash flows, will change when exchange rates change.

Measuring Translation Exposure The difference between exposed assets and exposed liabilities. Exposed assets and liabilities are translated at the current exchange rate. Non-exposed assets and liabilities are translated at the historical exchange rate.

Translation Methods Current/Noncurrent Method Monetary/Nonmonetary Method Temporal Method Current Rate Method

FASB-8 (January 1, 1976) Utilizes the temporal method for translating balance sheet and income statement into the U.S. dollar. Unrealized translation gains or losses were recorded within the income statement thereby affecting net income.

FASB-52 (December 15, 1981) Utilizes the current rate method for translating balance sheet and income statement into the U.S. dollar. Unrealized translation gains or losses are recorded in a separate equity account on the parent’s consolidated balance sheet called the “Cumulative Translation Adjustment (CTA)” account.

Reporting vs. Functional Currency The reporting currency is the currency in which the parent company prepares its own financial statements. The functional currency is the currency of the primary economic environment in which the affiliate generates and expenses cash. Integrated foreign entity Self-sustained entity

US Translation Procedures The US differentiates foreign subsidiaries on the basis of the functional currency, not subsidiary characterization. This, in turn, determines which translation method is used: Local currency Current rate method U.S. dollar Temporal method

Hyperinflation Countries A hyperinflationary country is one which has cumulative inflation of approximately 100% or more over a three year period. Functional currency U.S. dollar Translation method Temporal method

Measuring Translation Exposure: Illustration Zapata Auto Parts, the Mexican affiliate of American Diversified, Inc., had the following balance sheet on January 1: Assets (Ps million) Liabilities (Ps million) Cash, marketable securities 1,000 Current liabilities 47,000 Accounts receivables 50,000 Long-term debt 12,000 Inventory 32,000 Equity 135,000 Fixed assets 111,000 194,000 194,000 ______________________________________________________________ The exchange rate on January 1st was Ps 8,000/$ and on December 31st is Ps 12,000/$

Zapata Auto Parts Translation Exposure to Exchange Rate Risk Under Alternative Translation Methods (in Ps million) Current/ Noncurrent Monetary/ Nonmonetary ________________________________________________________________________________ Translation Method Temporal Current Cash and Marketable Sec. Accounts Receivables Inventory Net Fixed Assets Current Liabilities Long-Term Debt Equity 1,000 50,000 32,000 111,000 47,000 12,000 135,000 __________ ___________ __________ ________ Net Exposure ========= ========== ========= ======= _________________________________________________________________________________ Note: The exchange rate on January 1st is Ps 8,000/$

Transaction Exposure It arises from the various types of transactions that require settlement in a foreign currency. Purchasing or selling on credit goods or services denominated in foreign currency. Borrowing and lending funds with repayment made in foreign currency. Acquiring assets denominated in foreign currency.

Net Transaction Exposure Is measured currency by currency. Is the difference between contractually fixed future cash inflows and cash outflows in each currency. It represents real gains and losses.

Accounting Practice and Economic Reality Accounting focuses on: Earnings and book values. They reflect past decisions. Has virtually no impact on firm value. Finance focuses on: Cash flows and market values. They reflect future decisions. Directly affect firm value.