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Chapter 14
Management of
Translation Exposure
Chapter Objectives
¢define translation exposure.
¢explain why we care about translation
¢explain the impact that unanticipated
changes in exchange rates may have
on the consolidated financial
statements of the multinational
company.
¢
€3=$1
Monetary/Nonmonetary
Method
¢ The underlying principle is that monetary accounts
have a similarity because their value represents a
sum of money whose value changes as the
exchange rate changes.
¢ All monetary balance sheet accounts (cash,
marketable securities, accounts receivable, etc.)
of a foreign subsidiary are translated at the current
exchange rate.
¢ All other (nonmonetary) balance sheet accounts
(owners’ equity, land) are translated at the
historical exchange rate in effect when the
account was first recorded. i.e. PPP
9 Nov 27, 2003
Monetary/Nonmonetary
Method
¢ All monetary
balance sheet Balance Sheet Local Monetary/
Currency Nonmonetary
accounts are
Cash € 2,100 $1,050
translated at the Inventory € 1,500 $500
current exchange Net fixed assets € 3,000 $1,000
rate. i.e. €2=$1 Total Assets € 6,600 $2,550
¢ All other balance Current liabilities € 1,200 $600
sheet accounts Long-Term debt € 1,800 $900
are translated at Common stock € 2,700 $900
Retained earnings € 900 $0
the historical
exchange rate in CTA -------- --------
Total Liabilities and € 6,600 $2,400
effect when the Equity
account was first
recorded. i.e.
€3=$1
¢ 10 Nov 27, 2003
Temporal Method
¢The underlying principal is that assets and
liabilities should be translated based on
how they are carried on the firm’s books.
¢Balance sheet account are translated at the
current spot exchange rate if they are
carried on the books at their current value.
¢Items that are carried on the books at
historical costs are translated at the
historical exchange rates in effect at the
time the firm placed the item on the books.
spot rate
18 Nov 27, 2003
How Various Translation
Methods Deal with a Change
from €3 to €2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash €2,100 $1,050 $1,050 $1,050 $1,050
Inventory €1,500 $750 $500 $900 $750
Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500
Total Assets €6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities €1,200 $600 $600 $600 $600
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
Retained earnings €900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540
Total Liabilities €6,600 $2,800 $2,550 $2,950 $3,300
and Equity
historical rate
20 Nov 27, 2003
How Various Translation
Methods Deal with a Change
from €3 to €2 = $1
Balance Sheet Local Current/ Monetary/ Temporal Current
Currency Noncurrent Nonmonetary Rate
Cash €2,100 $1,050 $1,050 $1,050 $1,050
Inventory €1,500 $750 $500 $900 $750
Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500
Total Assets €6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities €1,200 $600 $600 $600 $600
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
Retained earnings €900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540
Total Liabilities €6,600 $2,800 $2,550 $2,950 $3,300
and Equity
Note the effect that foreign exchange gains (losses) has on net income.
14.1
27 Nov 27, 2003
FAS8 – superseded
¢Essentially the temporal method, with some
subtleties,
lsuch as translating inventory at
historical rates (a hassle).
¢Required taking foreign exchange gains and
losses through the income statement.
¢This lead to variability in reported earnings
(irritated corporate executives).
Current Rate
Parent’s
Translation
Parent’s Currency
14-31 Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
Highly Inflationary
Economies
¢Highly inflationary economies—over
100% over three years
¢Foreign entities are required to
remeasure financial statements
using the temporal method “as if the
functional currency were the
reporting currency”.
*P. Sercu and R. Uppal, International Financial Markets and the Firm, 1994
42 Nov 27, 2003
ECONOMIC EXPOSURE: ACCOUNTING EXPOSURE:
5. Also exists for firms without foreign 5. Accounting exposure only exists in the case of
subsidiaries, such as exporting firms, import- foreign direct investment, since pure exporting or
competing firms, and notably potential import-substituting firms have no foreign
import-competing firms. subsidiaries.