1. Measuring Accounting Exposure
International Finance
Dr. A. DeMaskey

2. 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?

3. 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.

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

5. 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

6. 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

7. 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

8. 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.

9. 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.

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

11. 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.

12. 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.

13. 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

14. 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

15. 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

16. 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 ,000
Accounts receivables ,000 Long-term debt ,000
Inventory ,000 Equity ,000
Fixed assets ,000
194, ,000
______________________________________________________________
The exchange rate on January 1st was Ps 8,000/$ and on December 31st is Ps 12,000/$

17. 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/$

18. 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.

19. 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.

20. 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.