1. Copyright © 2010 Pearson Prentice Hall. All rights reserved. Chapter 13 Translation Exposure

2. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-2 Overview of Translation Translation exposure, also called accounting exposure, arises because financial statements of foreign subsidiaries must be restated for consolidated financial statements. The accounting process of translation, involves converting foreign subsidiaries financial statements into US dollar- denominated statements.

3. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-3 Overview of Translation Translation exposure is the potential for an increase or decrease in the parent’s net worth and reported net income management uses translated statements to assess performance

4. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-4 Overview of Translation –If the same exchange rate were used, there would be no imbalances –if a different exchange rate were used an imbalance would result

5. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-5 Why use a different exchange rate? –between historical and current market valuation. –Historical exchange rates can be used for certain equity accounts, fixed assets, and inventory items

6. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-6 Subsidiary characterization 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.

7. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-7 functional currency(P.345) 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.

8. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-8 13. 2Translation Method Two basic methods –The current rate method –The temporal method designate at what exchange rate individual balance sheet and income statement items are remeasured, but also designate where any imbalance is to be recorded

9. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-9 Current rate method(P.347) 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

10. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-10 Current Rate Method Rather 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

11. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-11 Temporal Method(P.348) specific assets are translated at exchange rates consistent with the timing of the item’s creation. Assumes 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

12. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-12 Temporal Method(P.348) 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

13. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-13 U.S Translation Procedures(P.348) US differentiates on the basis of functional currency, not subsidiary characterization. –If the local currency is the functional currency, they are translated by the current rate method –If the US dollar is the functional currency, they are remeasured by the temporal method –If the statements are in local currency and neither the local currency or the US dollar is the functional currency, the statements must first be remeasured into the functional currency by the temporal method, and then translated into US dollars by the current rate method

14. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-14 Exhibit 13.2 Procedure Flow Chart for United States Translation Practices

15. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-15 International Translation Practices(P.350) –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.

16. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-16 Translation Example: Trident Europe(P.350) The functional currency of Trident Europe is the euro, and the reporting currency of its parent, Trident 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/€

17. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-17 Exhibit 13.4 Trident Europe: Translation Loss Just after Depreciation of the Euro

18. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-18 Exhibit 13.5 Trident Europe: Translation Loss or Gain: Comparison of Current Rate and Temporal Methods

19. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-19 Translation Example: Trident Europe As seen in exhibit 13.4 and 13.5, 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 accounting method of the moment, management might select different assets and liabilities for reduction or increase – as a result impacting “real” decisions

20. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-20 13.3 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.

21. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-21 Balance Sheet Hedge Defined(P.356) The cost of a balance sheet hedge depends on relative borrowing costs. These hedges are a compromise in which the denomination of balance sheet accounts is altered, perhaps at a cost in terms of interest expense or operating efficiency, to achieve some degree of foreign exchange protection.

22. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-22 When is Balance Sheet Hedge justified 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

23. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-23 Mini-Case Questions: La Jolla Engineering Services Do you believe Meaghan O’Connor should spend time and resources attempting to manage translation losses, which many consider to be purely an accounting phenomenon? How would you characterize or structure your analysis of each of the individual country threats to La Jolla? What specific features of their individual problems seem to be intertwined with currency issues? What would you recommend Meaghan do?

24. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-24 Exhibit 13.1 Economic Indicators for Determining the Functional Currency

25. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-25 Exhibit 13.3 Comparison of Translation Methods Employed in Selected Countries

26. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-26 Exhibit 13.6 Comparison of Translation Exposure with Operating Exposure, Depreciation of Euro from $1.200/€ to $1.0000/€ for Trident Europe

27. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 13-27 Exhibit 13.7 Trident Europe, Balance Sheet Exposure