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CHAPTER 16 MULTINATIONAL OPERATIONS Presenter’s name Presenter’s title dd Month yyyy.

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1 CHAPTER 16 MULTINATIONAL OPERATIONS Presenter’s name Presenter’s title dd Month yyyy

2 Click the icon to add an image. The photo will be cropped to fit the placeholder. PRESENTATION CURRENCY AND FUNCTIONAL CURRENCY Presentation currency: The currency in which the company presents (reports) its financial statements. Functional currency: The currency in which the company conducts its primary activity. Local currency: The currency used within the country in which the company operates. Often, presentation currency = functional currency = local currency. Often, functional currency of subsidiary ≠ functional and presentation currency of parent. Copyright © 2015 CFA Institute 2

3 FOREIGN CURRENCY TRANSACTION EXPOSURE Copyright © 2015 CFA Institute 3 Goods Payment Currency?

4 FOREIGN CURRENCY TRANSACTION EXPOSURE Copyright © 2015 CFA Institute 4 Goods ?

5 FOREIGN CURRENCY TRANSACTION EXPOSURE Copyright © 2015 CFA Institute 5 Goods ?

6 FOREIGN CURRENCY TRANSACTION EXPOSURE IMPORTER makes purchase denominated in foreign currency with timing difference between purchase date and payment date. Example: Finnish importer FinnCo makes credit purchase from MexCo. If the purchase is denominated in Mexican pesos, FinnCo has foreign currency transaction exposure. Downside risk to FinnCo: If value of peso increases relative to the euro during the time between the purchase date and payment date, FinnCo must spend more euros to settle its account payable in pesos. EXPORTER makes sale denominated in foreign currency with timing difference between sale date and payment receipt date. Example: Mexican exporter MexCo makes credit sale to FinnCo. If the sale is denominated in euros, MexCo has foreign currency transaction exposure. Downside risk to MexCo: If value of peso increases relative to euro during the time between the sale date and receipt of payment, MexCo can buy fewer pesos with the euros it receives. Copyright © 2015 CFA Institute 6

7 CHANGES IN EXCHANGE RATES IMPACT ON SALES: EXAMPLE 1 FinnCo sells goods to a customer in the United Kingdom for £10,000 with payment to be received in British pounds. Credit terms allow 45 days for receipt of payment. FinnCo’s functional and presentation currency is the euro. Exchange rate on the date of the transaction: £1 = €1.460 Exchange rate on the date of payment: £1 = €1.475 Question: What is FinnCo’s foreign exchange gain or loss? Copyright © 2015 CFA Institute 7

8 CHANGES IN EXCHANGE RATES IMPACT ON SALES: EXAMPLE 1 Copyright © 2015 CFA Institute 8 £FX Rate€ Euro value of FinnCo’s receivable on transaction date10,0001.460 14,600 Euro value of FinnCo’s receivable on receipt date10,0001.475 14,750 FinnCo’s foreign exchange gain 150

9 CHANGES IN EXCHANGE RATES IMPACT ON SALES: EXAMPLE 2 FinnCo sells goods to a customer in the United Kingdom for £10,000 with payment to be received in British pounds. Credit terms allow 45 days for receipt of payment. Exchange rate on the date of the transaction: £1 = €1.460 Exchange rate on the date of payment: £1 = €1.475 Assume that the transaction date was in November Year 1, the payment date was in January Year 2, and the company has a 31 December year-end. Exchange rate on 31 December, Year 1:£1 = €1.480 Question: What is FinnCo’s foreign exchange gain or loss for Year 1? And for Year 2? Copyright © 2015 CFA Institute 9

10 CHANGES IN EXCHANGE RATES IMPACT ON SALES: EXAMPLE 2 Copyright © 2015 CFA Institute 10 Transaction date Exchange rate: £1 = €1.460 Value of receivable: €14,600 Balance sheet date Exchange rate: £1 = €1.480 Value of receivable: €14,800 Payment receipt date Exchange rate: £1 = €1.475 Value of receivable: €14,750 Gain of €200 Loss of €50 Overall actual realized foreign currency gain = €150

11 CHANGES IN EXCHANGE RATES IMPACT ON SALES AND PURCHASES Foreign Currency TransactionType of ExposureStrengthensWeakens Export saleAsset (account receivable)GainLoss Import purchaseLiability (account payable)LossGain Copyright © 2015 CFA Institute 11

12 CHANGES IN EXCHANGE RATES IMPACT ON SALES: EXAMPLE 2 Alternative 1 Report transaction gain as part of “other operating expenses, net.” Gross profit margin: no impact Operating profit margin: higher Net profit margin: no impact Alternative 2 Report transaction gain as part of “nonoperating expenses, net.” Gross profit margin: no impact Operating profit margin: lower Net profit margin: no impact Copyright © 2015 CFA Institute 12 Where will FinnCo report the foreign currency transaction gain in Year 1?

13 IMPACT OF CHANGES IN EXCHANGE RATES: EXAMPLE DISCLOSURE “Our exposure to foreign currency transaction gains and losses is the result of assets and liabilities, (including inter-company transactions) that are denominated in currencies other than the relevant entity’s functional currency.... Transaction gains and losses on these foreign exchange contracts are recognized each period in other income, net included on the consolidated statements of income. During the years ended December 31, 2011, 2010, and 2009, we recorded net realized and unrealized foreign currency transaction gains of $9 million and $13 million, and a transaction loss of $1 million, respectively.” Yahoo! Inc., Annual Report (2011) Copyright © 2015 CFA Institute 13

14 TRANSLATING SUBSIDIARIES’ SALES INTO THE PARENT COMPANY’S PRESENTATION CURRENCY In most cases, a foreign subsidiary will operate primarily in the currency of the country where it is located, which will differ from the currency in which the parent company presents its financial statements. To prepare worldwide consolidated financial statements, the parent company must translate the foreign currency financial statements of their foreign subsidiaries into the parent company’s presentation currency. Copyright © 2015 CFA Institute 14

15 TRANSLATING SUBSIDIARIES’ SALES INTO THE PARENT COMPANY’S PRESENTATION CURRENCY For example, assume the US subsidiary of a German company keeps its books in US dollars, and the South African subsidiary of the German company keeps its books in South African rands. The German parent company must prepare consolidated financial statements in euros. Revenues are translated at the exchange rate that existed when the transactions took place. For practical reasons, a rate that approximates the exchange rates at the dates of the transactions, such as an average exchange rate, may be used. If the US dollar and South African rand appreciate against the euro over the course of a given year, the amount of sales translated into euro will be greater than if the subsidiaries’ currencies weaken against the euro. Copyright © 2015 CFA Institute 15

16 TRANSLATING FOREIGN CURRENCY FINANCIAL STATEMENTS INTO THE PARENT COMPANY’S PRESENTATION CURRENCY In consolidated financial statements, the assets, liabilities, revenues, and expenses of both domestic and foreign subsidiaries are added to those of the parent company. Overall, two questions must be addressed: 1.What exchange rate should be used for each line item? 2.Where should the translation adjustment be reported? Copyright © 2015 CFA Institute 16

17 WHAT EXCHANGE RATE SHOULD BE USED FOR EACH LINE ITEM? Current rate method: Use spot exchange rate on balance sheet date for all assets and liabilities. Temporal method: –Use spot exchange rate on balance sheet date for all monetary assets and liabilities (and for all non-monetary assets and liabilities that are measured at their current value). –Use historical exchange rate for non-monetary assets and liabilities that are measured at historical cost. Copyright © 2015 CFA Institute 17

18 WHAT EXCHANGE RATE SHOULD BE USED FOR EACH LINE ITEM? When the subsidiary’s functional currency is different from the parent’s functional currency: All assets and liabilities: Translate at current exchange rate (current rate method) Equity accounts: Translate at historical exchange rates Revenues and expenses: Translate at average exchange rate, which approximates exchange rate on transaction date When the subsidiary’s functional currency is the same as the parent’s functional currency: Monetary assets and liabilities: Translate at current exchange rate Non-monetary assets and liabilities: -Historical cost at historical exchange rates -Current value at valuation date exchange rate Equity accounts: Translate at historical exchange rates Revenues and expenses: -Not related to non-monetary assets, translate at average exchange rate -Related to non-monetary assets, use historical exchange rate. Copyright © 2015 CFA Institute 18

19 WHERE SHOULD THE TRANSLATION ADJUSTMENT BE REPORTED? When the subsidiary’s functional currency is different from the parent’s functional currency: Unrealized translation gain/loss is accumulated as a separate component of the parent’s equity. When the subsidiary’s functional currency is the same as the parent’s functional currency: Translation adjustment is reported as a gain or loss in the parent’s net income. Copyright © 2015 CFA Institute 19

20 FACTORS CONSIDERED IN DETERMINING THE FUNCTIONAL CURRENCY The functional currency is the currency that influences sales prices for goods and services. the currency of the country whose competitive forces and regulations mainly determine the sales price of the entity’s goods and services. the currency that mainly influences labor, material, and other costs of providing goods and services. the currency in which funds from financing activities are generated. the currency in which receipts from operating activities are usually retained. Copyright © 2015 CFA Institute 20

21 TRANSLATING FOREIGN CURRENCY FINANCIAL STATEMENTS: EXAMPLE Balance Sheet Item USDExchange Rate (€)EUR Cash $3,0001.00€3,000 Inventory 12,0001.0012,000 Total $15,000 €15,000 Notes payable $5,0001.00€5,000 Common stock 10,0001.0010,000 Total $15,000 €15,000 Copyright © 2015 CFA Institute 21 Translation worksheet for Amerco (US subsidiary), 31 December 20X1 Exchange rate is €1.00 = US$1.00

22 TRANSLATING FOREIGN CURRENCY FINANCIAL STATEMENTS: EXAMPLE Balance Sheet Item USDExchange Rate (€)EUR Cash $ 3,000?€? Inventory 12,000?? Total $15,000 €? Notes payable $5,000?? Common stock 10,0001.0010,000 Total $15,000 €? Copyright © 2015 CFA Institute 22 Translation worksheet for Amerco (US subsidiary), 31 March 20X2 No transactions. Current exchange rate is €0.80 = US$1.00.

23 TRANSLATING FOREIGN CURRENCY FINANCIAL STATEMENTS: EXAMPLE Copyright © 2015 CFA Institute 23 Translation worksheet for Amerco (US subsidiary), 31 March 20X2 No transactions. Current exchange rate is €0.80 = US$1.00. US Dollar Exchange Rate (€)Euro Change in Euro Value since 31 Dec 20X1 Cash$3,0000.80 C€2,400 –€ 600 Inventory12,0000.80 C9,600 –2,400 Total$15,000 €12,000 –€3,000 Notes payable$5,0000.80 C€4,000 –€1,000 Common stock10,0001.00 H10,000 0 Subtotal$15,000 €14,000 –€1,000 Translation adjustment –2,000 Total €12,000 –€3,000

24 TRANSLATING FOREIGN CURRENCY FINANCIAL STATEMENTS: EXAMPLE Copyright © 2015 CFA Institute 24 Translation worksheet for Amerco (US subsidiary), 31 March 20X2 No transactions. Current exchange rate is €0.80 = US$1.00. US Dollar Exchange Rate (€)Euro Change in Euro Value since 31 Dec 20X1 Cash $ 3,0000.80 C€ 2,400–€600 Inventory 12,0001.00 H12,0000 Total $15,000 €14,400–€600 Notes payable $5,0000.80 C€4,000–€1,000 Common stock 10,0001.00 H10,0000 Subtotal $15,000 €14,000–€1,000 Translation adjustment 400 Total €14,400–€600

25 CHANGES IN EXCHANGE RATES IMPACT ON TRANSLATION ADJUSTMENT Foreign Currency (FC) Balance Sheet ExposureStrengthensWeakens Net asset Positive translation adjustment Negative translation adjustment Net liability Negative translation adjustment Positive translation adjustment Copyright © 2015 CFA Institute 25

26 EFFECTS OF TRANSLATION METHOD ON FINANCIAL RATIOS Receivables turnover (sales/receivables) is the same under both current and temporal methods. -Sales are translated at the average exchange rate under both. -Receivables are translated at the current exchange rate under both. Current ratio (current assets/current liabilities) differs. -Inventory is translated at the current exchange rate under the current method, but the historical exchange rate under the temporal method. -If the subsidiary’s currency appreciates relative to the parent, the current ratio will be higher under the current method than the temporal. Copyright © 2015 CFA Institute 26

27 RATIOS UNDER LOCAL CURRENCY VS. RATIOS IN TRANSLATED CURRENCY: CURRENT METHOD Underlying relationships in a subsidiary’s local currency financial statement are preserved when -ratios involve only the balance sheet (e.g., current ratio, debt-to- assets ratio, debt-to-equity ratio). -ratios involve only the income statement (e.g., interest coverage ratio, gross profit margin, operating profit margin, net profit margin). Underlying relationships in a subsidiary’s local currency financial statement are distorted when ratios involve amounts from both the balance sheet and income statement because -assets and liabilities are translated using the current exchange rate. -revenues and expenses are translated using the average exchange rate. -equity accounts are translated at historical exchange rates. Copyright © 2015 CFA Institute 27

28 RATIOS UNDER LOCAL CURRENCY VS. RATIOS IN TRANSLATED CURRENCY: TEMPORAL METHOD Underlying relationships in a subsidiary’s local currency financial statement are preserved when both numerator and denominator use the historical exchange rate (e.g., Inventory turnover = Cost of goods sold/Inventory). Otherwise, underlying relationships in a subsidiary’s local currency financial statement are distorted because of the following: -Monetary assets and liabilities are translated at current exchange rate. -Non-monetary assets and liabilities -Historical cost translated at historical exchange rates. -Current value translated at valuation date exchange rate. -Revenues and expenses -Not related to non-monetary assets, translated at average exchange rate. -Related to non-monetary assets, translated at historical rate. -Equity accounts are translated at historical exchange rates. Copyright © 2015 CFA Institute 28

29 SUBSIDIARIES OPERATING IN HYPERINFLATIONARY ECONOMIES For a subsidiary in a hyperinflationary economy, translating local foreign currency financial statements into the parent’s presentation currency requires the following: Under IFRS First, restate the subsidiary’s local currency financial statements for local inflation. Then, translate the inflation-restated foreign currency financial statements into the parent’s presentation currency using the current exchange rate. Under US GAAP Use the temporal method to translate the subsidiary’s local currency financial statements. Include the resulting translation adjustment as a gain or loss in determining net income. Copyright © 2015 CFA Institute 29

30 SUBSIDIARIES OPERATING IN HYPERINFLATIONARY ECONOMIES: EXAMPLE Assume a US company established a subsidiary in Turkey on 1 January 2000 (at which time Turkey was highly inflationary). The US parent sent the subsidiary US$1,000 on 1 January 2000 to purchase a piece of land at a cost of TL542,700,000 (TL542,700/US$ × US$1,000 = TL542,700,000). Assuming no other assets or liabilities, what are the annual and cumulative translation gains or losses given the following data? Copyright © 2015 CFA Institute 30 DateExchange RatesYear Inflation Rate (%) 01 Jan 2000 TL542,700 = US$1 31 Dec 2000 TL670,800 = US$1200038 31 Dec 2001 TL1,474,525 = US$1200169 31 Dec 2002 TL1,669,000 = US$1200245

31 SUBSIDIARIES OPERATING IN HYPERINFLATIONARY ECONOMIES: EXAMPLE A Turkish subsidiary of a US parent has one asset: A piece of land at an original cost of TL542,700,000. The US parent sent the subsidiary US$1,000. What are the annual and cumulative translation gains or losses under IFRS? Copyright © 2015 CFA Institute 31 Date Inflation Rate (%) Restated Carrying Value in TL Current Exchange Rate TL/$ Translated Amount in US$ Annual Translation Gain (Loss) Cumulative Translation Gain (Loss) 01/01/00 542,700,000542,700$1,000N/A 31/12/00 38748,926,000670,8001,116$116 31/12/01 691,265,684,9401,474,525858(258)(142) 31/12/02 451,835,243,1631,669,0001,100242100

32 SUBSIDIARIES OPERATING IN HYPERINFLATIONARY ECONOMIES: EXAMPLE A Turkish subsidiary of a US parent has one asset: A piece of land at an original cost of TL542,700,000. The US parent sent the subsidiary US$1,000. What are the annual and cumulative translation gains or losses under US GAAP? Copyright © 2015 CFA Institute 32 Date Carrying Value in TL Historical Exchange Rate Translated Amount in US$ Annual Translation Gain (Loss) Cumulative Translation Gain (Loss) 01/01/00 542,700,000542,700$1,000N/A 31/12/00 542,700,000542,7001,000N/A 31/12/01 542,700,000542,7001,000N/A 31/12/02 542,700,000542,7001,000N/A

33 MULTINATIONAL OPERATIONS AND EFFECTIVE TAX RATE Effective tax rate: Tax expense divided by pretax accounting profits Statutory tax rate: The income tax rate in the company’s home tax jurisdiction. Required disclosures include a reconciliation schedule explaining reasons for the differences between the statutory tax rate and the company’s effective tax rate. When a company earns profits outside its home country and incurs taxes at foreign tax rates that differ from its home country statutory tax rate, the effect will be shown in the reconciliation schedule. Copyright © 2015 CFA Institute 33

34 COMPONENTS OF SALES GROWTH AND SUSTAINABILITY Copyright © 2015 CFA Institute 34 Excerpt from General Mills 2011 Annual Report MD&A

35 COMPONENTS OF SALES GROWTH AND SUSTAINABILITY Copyright © 2015 CFA Institute 35 Excerpt from General Mills 2011 Annual Report Supplementary Schedule

36 COMPONENTS OF SALES GROWTH AND SUSTAINABILITY ABCD Contributions from volume growth8116 Contributions from price increases1813 Foreign currency exchange1181 Net sales growth10 Copyright © 2015 CFA Institute 36 Hypothetical Companies’ Components of International Sales Growth (percentage points)

37 CURRENCY FLUCTUATIONS—POTENTIAL IMPACT ON FINANCIAL RESULTS As discussed, a multinational company’s sales denominated in currencies other than the company’s functional currency give rise to exchange risks. Over the medium to long term, a company can create a “natural hedge” by more closely matching the currency of its expenses with the currency of its sales—for example, –by making more of its purchases in the same currencies as the sales, and/or –by locating its manufacturing facilities in the country of sales. Over shorter time frames, a company can hedge currency risks in the financial markets. Copyright © 2015 CFA Institute 37

38 CURRENCY FLUCTUATIONS—POTENTIAL IMPACT ON FINANCIAL RESULTS For example, BMW AG faces exchange risks arising from sales of vehicles outside the Eurozone. BMW measures currency risk using a “cash-flow-at-risk” model. –Identify forecasted foreign currency transaction exposure. –Exposures are compared with all hedges that are in place to determine unhedged risk positions. –The potential negative impact on earnings is computed based on exchange rate volatility and probability distributions. BMW discloses the potential negative earnings impact of unfavorable changes in exchange rates. Copyright © 2015 CFA Institute 38

39 SUMMARY Fluctuations in foreign exchange rates cause the translated values of foreign currency assets and liabilities to change, giving rise to foreign exchange differences that must be reflected in the financial statements. For export sales (or import purchases), any change in the functional currency value of the foreign currency account receivable (or account payable) that occurs between the transaction date and the settlement date is recognized as a foreign currency transaction gain or loss in net income. For translating foreign subsidiaries’ financial statements into the parent company’s presentation currency, either the current method or the temporal method is used. Companies typically disclose information about the impact of foreign currency on sales growth and sensitivity of profits to currency fluctuations. Copyright © 2015 CFA Institute 39


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