Multinational Business Finance
Fifteenth Edition
Chapter 11
Translation Exposure
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Learning Objectives
11.1 Describe how the process of consolidation of a
multinational firm’s foreign entities creates translation
exposure
11.2 Examine the two major methods of translation,
including their theoretical and practical differences
11.3 Understand how translation can potentially alter the
value of a multinational firm
11.4 Explore how to manage translation exposure,
including how one company uses swaps to do so
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Translation Exposure (1 of 2)
• Translation exposure, also called accounting exposure,
arises because financial statements of foreign
subsidiaries—which are stated in foreign currency—must
be restated in the parent’s reporting currency for the firm
to prepare consolidated financial statements.
• The accounting process of translation, involves
converting these foreign subsidiaries financial statements
into U.S. dollar-denominated statements.
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Translation Exposure (2 of 2)
• Translation exposure is the potential for an increase or
decrease in the parent’s net worth and reported net
income caused by a change in exchange rates since the
last translation.
• While the main purpose of translation is to prepare
consolidated statements, management uses translated
statements to assess performance (facilitation of
comparisons across many geographically distributed
subsidiaries).
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Overview of Translation (1 of 4)
• Consolidation accounting is the process of combining the
financial results of all subsidiary companies into the
combined financial results of the parent company.
• Our purpose here, however, is not to discuss or detail
consolidation accounting, but rather the currency risk to
the multinational firm that arises from the currency
translation of foreign currency-denominated financial
statements of its foreign subsidiaries.
• We will use our example multinational firm Ganado
Corporation to demonstrate (see Exhibit 11.1).
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Exhibit 11.1 Consolidation and Translation
of Financial Results for Aidan
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Overview of Translation (2 of 4)
• Reporting currency is the currency that the reporting entity
uses to prepare its financial statements. Any other currency
used by an entity of this same multinational firm in its financial
statements is a foreign currency.
• Any distinct or separable business that prepares its financial
statements in any currency other than the reporting currency
of the parent company is considered a foreign entity.
• If the foreign subsidiary operates as an extension of the parent
company’s operations, it is classified as an integrated foreign
entity. If the foreign subsidiary operates completely separately
from the parent company, it is classified as a distinct or
separable operation.
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Overview of Translation (3 of 4)
• Functional currency is the currency of the primary
economic environment in which the subsidiary operates.
• All incorporated businesses will possess all three
traditional financial statements—the income statement,
balance sheet, and statement of cash flows. However,
only two of these statements need to be translated for
consolidation purposes: the income statement and the
balance sheet.
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Overview of Translation (4 of 4)
• If a foreign entity’s functional currency is the reporting
currency (the currency of the parent company used for
consolidated reporting purposes), the process for
preparing the financial statements is termed
remeasurement.
• If a foreign entity’s financial statements are maintained in
a functional currency, and that functional currency is
different from the reporting currency of the parent
company, the process for preparation of the financial
statements is termed translation. Any changes arising
from translation are termed cumulative translation
adjustment (CTA).
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Translation Methods (1 of 7)
• Two basic methods for the translation of foreign
subsidiary financial statements are employed worldwide:
– Current rate method
– Temporal method
• Regardless of which method is employed, a translation
method must not only designate at what exchange rate
individual balance sheet and income statement items are
remeasured, but also designate where any imbalance is
to be recorded (current income or an equity reserve
account).
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Translation Methods (2 of 7)
• The current rate method 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
– Equity items, such as common stock and paid-in
capital accounts, are translated at historical rates
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Translation Methods (3 of 7)
• Gains or losses caused by translation adjustments are
not included in the calculation of consolidated net
income.
• Rather, translation gains or losses are 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
(reducing variability of reported earnings).
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Translation Methods (4 of 7)
• Under the temporal method, specific assets are
translated at exchange rates consistent with the timing of
the item’s creation.
• This method assumes that a number of individual line
item assets such as 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 (increased variability of consolidated
earnings).
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Translation Methods (5 of 7)
• If these items were not restated but were instead carried at
historical cost, the temporal method becomes the
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
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Translation Methods (6 of 7)
• The U.S. differentiates foreign subsidiaries on the basis of functional
currency, not subsidiary characterization.
– If the financial statements of the foreign subsidiary are maintained in
U.S. dollars, translation is not required
– If the statements are maintained in the local currency, and the local
currency is the functional currency, they are translated by the current
rate method
– If the statements are maintained in local currency, and the U.S. dollar is
the functional currency, they are remeasured by the temporal method
– If the statements are in local currency and neither the local currency nor
the U.S. dollar is the functional currency, the statements must first be
remeasured into the functional currency by the temporal method, and
then translated into U.S. dollars by the current rate method
– See Exhibit 11.2
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Exhibit 11.2 Flow Chart for U.S.
Translation Practices
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Translation Methods (7 of 7)
• The accounting guidance for foreign currency reporting and
translation issues in the United States is found in Financial
Accounting Standards Board (FASB) Accounting Standards
Codification (ASC) Topic 830, Foreign Currency Matters.
• A large part of the rest of the world, however, more than
100 countries, use International Financial Reporting
Standards (IFRS).
• Exhibit 11.3 provides a summary of two of the major
differences including:
– Determination of functional currency
– Treatment in economies and currencies suffering
hyperinflation.
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Exhibit 11.3 Differences Between U.S.
GAAP and IFRS Regarding Translation
Issue International Financial Reported U.S. Generally Accepted
Standards (IFRS) Accounting Principles (GAAP)
Article for guidance IAS 21 and IAS 29 ASC 830
Determination of International standards establish a U.S. practices require analysis of a
Functional hierarchy of indicators (primary and multitude of factors to determine the
Currency secondary) for determination of functional currency. These indicators
functional currency. are not ranked in any kind of a
hierarchical structure.
Hyperinflationary Even if the entity’s host country If the entity’s host country economy
Economies economy qualifies as qualifies as hyperinflationary, financial
hyperinflationary, the functional statements are remeasured as if the
currency is retained. parent company’s reporting currency
was the functional currency.
Blank Any financial amounts that are not Any exchange rate differences
already measured at the current rate calculated through remeasurement
of exchange at the end of the period, are therefore included in consolidated
those amounts should be indexed net income.
using a general price index, then
translated into the reporting currency
at the current rate.
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Ganado Corporation’s Translation
Exposure (1 of 3)
• Using Aidan Corporation (see Exhibit 11.1), we now
explore the intricacies of translation exposure.
• Aidan Corporation’s sales and earnings, by operating unit
for 2014 and 2015, are described in Exhibit 11.4.
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Exhibit 11.4 Aidan Corporation,
Selected Financial Results, 2014–2015
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Ganado Corporation’s Translation
Exposure (2 of 3)
• The functional currency of Aidan Turkey is the Turkish
lira, and the reporting currency of its parent, Aidan
Corporation, is the euro
– Plant and equipment and long-term debt and common
stock issued some time in the past when the
exchange rate was ₺5.2760/€
– Inventory currently on hand was purchased or
manufactured during the immediately prior quarter
when the average exchange rate was ₺5.2180/€
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Ganado Corporation’s Translation
Exposure (3 of 3)
• As seen in Exhibits 11.5 and 11.6, 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 the accounting method of the moment,
management might select different assets and liabilities
for reduction or increase—as a result impacting “real”
decisions.
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Exhibit 11.5 Aidan Turkey’s Translation Loss
After Depreciation of the Turkish lira: Current
Rate Method
Translation adjustment (CTA) €29,918
(a) Euro retained earnings before depreciation are the cumulative sum of additions to retained
earnings of all prior years, translated at exchange rates in each year.
(b) Translated into euros at the same rate as before depreciation of the Turkish lira.
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Exhibit 11.6 Aidan Turkey’s Translation Loss
After Depreciation of the Turkish lira: Temporal
Method
(a) Euro retained earnings before depreciation are the cumulative sum of additions to retained earnings of all prior
years, translated at exchange rates in each year.
(b) Translated into euros at the same rate as before depreciation of the Turkish lira.
(c) Under the temporal method, the translation of €297,435 would be closed into retained earnings through the income
statement rather than left as a separate item as shown here. Ending retained earnings would actually be €11,826,438 -
€297,435 = €11,529,003.
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Managing Translation Exposure (1 of 4)
• Translation exposure poses risks to both consolidated
income and consolidated equity.
• Although many multinationals regularly manage the risks
arising from balance sheets—net equity investment in
subsidiaries—a number of firms have also hedged the
risks to their consolidated income arising from subsidiary
earnings.
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Managing Translation Exposure (2 of 4)
• Multinational companies that generate large proportions
of their profits offshore are particularly exposed to the
currency risks associated with translation of subsidiary
earnings.
• Many firms frequently hedge dividends declared from the
subsidiary to the parent company, when declared in a
foreign currency, which do not qualify for hedge
accounting.
• This means that the periodic valuation of the financial
derivatives (the hedges) end up impacting reporting
earnings more often than the underlying exposure (the
foreign subsidiary earnings).
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Managing Translation Exposure (3 of 4)
• The main technique to minimize translation exposure is
called a balance sheet hedge, which 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.
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Managing Translation Exposure (4 of 4)
• 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.
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An Illustration of Using Cross-Currency Swaps
to Hedge Translation: McDonald’s (1 of 2)
• McDonald’s investment risks have grown as the company as grown
globally.
• In the United Kingdom, McDonald’s owns the majority of its
restaurants (versus the franchise arrangement). These investments
create three different British pound-denominated currency exposures
for the parent company (see Exhibit 11.7):
– The British subsidiary has equity capital, which is a British
pound-denominated asset of the parent company.
– The parent company provides intracompany debt in the form of a
four-year loan. The loan is denominated in British pounds, and
carries a fixed rate of interest.
– The British subsidiary pays a fixed percentage of gross sales in
royalties to the parent company. This too is pound-denominated.
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Exhibit 11.7 McDonald’s Cross-
Currency Swap Strategy for the U.K
Because the British subsidiary makes all payments to the U.S. parent company in British pounds, McDonald’s U.S. is
long British pounds. By entering into a swap to pay pounds (£) and receive dollars ($), the swap creates an outflow of
£ serviced by the $ inflows. But the cross-currency swap has one additional major feature useful to McDonald’s: the
cross-currency swap has a large principal which is outstanding (bullet repayment) which acts as a counterweight–a
match–to the long-term investment in the U.K. subsidiary.
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An Illustration of Using Cross-Currency Swaps
to Hedge Translation: McDonald’s (2 of 2)
• When the parent company makes an intracompany loan
to the British subsidiary, it must designate whether the
loan is “permanently invested” in that country.
• If the loan is not designated permanent, the foreign
exchange gains and losses related to the loan flow
directly to the parent company’s income statement.
• If the loan is designated as permanent (what McDonald’s
has chosen to date), then the foreign exchange gains and
losses related to the intracompany loan flow only to the
cumulative translation adjustment account (CTA) on the
company’s consolidated balance sheet.
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