Topic 8
Translation Exposure
Text Book: Refer to Chapter 10
Subtitles
8.1 Translation & measurement
8.2 Translation exposure relevance
8.3 Translation exposure management
8.1 Translation Methods
• Current/Noncurrent Method
• Monetary/Nonmonetary Method
• Temporal Method
• Current Rate Method
10-3
Current/Noncurrent Method
• The underlying principal is that assets and liabilities should be
translated based on their maturity.
• Current assets translated at the spot rate.
• Noncurrent assets translated at the historical rate in effect when the item was
first recorded on the books.
• This method of foreign currency translation was generally accepted in
the United States from the 1930s until 1975, at which time FASB 8
became effective.
10-4
Current/Noncurrent Method
• Current assets Balance Sheet Local Current/
translated at the spot Currency Noncurrent
rate. Cash € 2,100 $1,050
e.g. €2 = $1 Inventory € 1,500 $750
• Noncurrent assets Net fixed assets € 3,000 $1,000
translated at the Total Assets € 6,600 $2,800
historical rate in effect Current liabilities € 1,200 $600
when the item was first Long-Term debt € 1,800 $600
recorded on the books. Common stock € 2,700 $900
e.g. €3 = $1 Retained earnings € 900 $700
CTA -------- --------
Total Liabilities and € 6,600 $2,800
Equity
10-5
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, etc.) are
translated at the historical exchange rate in effect when the account was first
recorded.
10-6
Monetary/Nonmonetary Method
• All monetary balance Balance Sheet Local Monetary/
sheet accounts are Currency Nonmonetary
translated at the current
exchange rate. e.g. €2 = Cash € 2,100 $1,050
$1 Inventory € 1,500 $500
Net fixed assets € 3,000 $1,000
• All other balance sheet
accounts are translated Total Assets € 6,600 $2,550
at the historical exchange Current liabilities € 1,200 $600
rate in effect when the Long-Term debt € 1,800 $900
account was first Common stock € 2,700 $900
recorded. e.g. €3 = $1 Retained earnings € 900 $0
CTA -------- --------
Total Liabilities and € 6,600 $2,400
Equity
10-7
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.
10-8
Temporal Method
• Items carried on the books Balance Sheet Local Temporal
at their current value are Currency
translated at the spot Cash € 2,100 $1,050
exchange rate.
Inventory € 1,500 $900
e.g. €2 = $1 Net fixed assets € 3,000 $1,000
• Items that are carried on Total Assets € 6,600 $2,950
the books at historical Current liabilities € 1,200 $600
costs are translated at the Long-Term debt € 1,800 $900
historical exchange rates. Common stock € 2,700 $900
e.g. €3 = $1 Retained earnings € 900 $0
CTA -------- --------
Total Liabilities and € 6,600 $2,400
Equity
10-9
Current Rate Method
• All balance sheet items (except for stockholder’s equity) are
translated at the current exchange rate.
• Very simple method in application.
• A “plug” equity account named cumulative translation adjustment is
used to balance the balance sheet.
10-10
Current Rate Method
• All balance sheet items (except
for stockholder’s equity) are Balance Sheet Local Current
translated at the current Currency Rate
exchange rate. Cash €2,100.00 $1,050
• A “plug” equity account named Inventory €1,500.00 $750
cumulative translation Net fixed assets €3,000.00 $1,500
adjustment is used to balance Total Assets €6,600.00 $3,300
the balance sheet. Current liabilities €1,200.00 $600
Long-Term debt €1,800.00 $900
Common stock €2,700.00 $900
Retained earnings €900.00 $360
CTA -------- $540
Total Liabilities €6,600.00 $3,300
and Equity
10-11
How Various Translation Methods Deal with a
Change in Exchange Rate from €3 = $1 to €2 = $1:
Cash
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
Spot exchange rate
10-12
How Various Translation Methods Deal with a
Change in Exchange Rate from €3 = $1 to €2 = $1:
Inventory
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 Book $600 $600 $600
Long-Term debt €1,800 $600 value of $900 $900 $900
Common stock €2,700 $900 inventory$900 $900 $900
Retained earnings €900 $700 historic $150 $550 $360
CTA -------- -------- rate -------- -------- $540
Total Liabilities €6,600 $2,800 $2,550 $2,950 $3,300
and Equity
Book value of inventory Current value of inventory
at spot exchange rate at spot exchange rate
10-13
How Various Translation Methods Deal with a
Change in Exchange Rate from €3 = $1 to €2 = $1:
Fixed Assets
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
Historic rate Spot exchange rate
10-14
How Various Translation Methods Deal with a
Change in Exchange Rate from €3 = $1 to €2 = $1:
Total Assets
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
Cash + Inventory + Net Fixed Assets
10-15
How Various Translation Methods Deal with a Change in
Exchange Rate from €3 = $1 to €2 = $1: Current Liabilities
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
Spot rate
10-16
How Various Translation Methods Deal with a Change in
Exchange Rate from €3 = $1 to €2 = $1: Long-Term Debt
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 Spot rate
10-17
How Various Translation Methods Deal with a Change in
Exchange Rate from €3 = $1 to €2 = $1: Retained Earnings
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
Requires income statement data (see slides 23, 24, 25)
10-18
How Various Translation Methods Deal with a
Change in Exchange Rate from €3 = $1 to €2 = $1:
CTA
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
Under the current rate method, a “plug” equity account named
cumulative translation adjustment balances the balance sheet.
10-19
How Various Translation Methods Deal with a
Change in Exchange Rate from €3 = $1 to €2 = $1:
Sales
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales € 10,000 $4,000 $4,000 $4,000 $4,000
COGS € 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation € 1,000 $333 $333 $333 $400
Net operating income € 1,500 $667 $1,167 $667 $600
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Addition to Retained
Earnings € 900 $700 $150 $550 $360
Sales translate at the average exchange rate over the period, €2.50 = $1
10-20
How Various Translation Methods Deal with a
Change in Exchange Rate from €3 = $1 to €2 = $1:
COGS
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales € 10,000 $4,000 $4,000 $4,000 $4,000
COGS € 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation € 1,000 $333 $333 $333 $400
Net operating income € 1,500 $667 $1,167 $667 $600
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Addition to Retained
Earnings € 900 $700 $150 $550 $360
Translate at €2.50 = $1 Translate at old exchange rate, €3.00 = $1
10-21
How Various Translation Methods Deal with a Change in
Exchange Rate from €3 = $1 to €2 = $1: Depreciation
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales € 10,000 $4,000 $4,000 $4,000 $4,000
COGS € 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation € 1,000 $333 $333 $333 $400
Net operating income € 1,500 $667 $1,167 $667 $600
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Addition to Retained
Earnings € 900 $700 $150 $550 $360
Translate at €3 = $1 Translate at average exchange rate, €2.5 = $1
10-22
How Various Translation Methods Deal with a
Change from
€3 = $1 to €2 = $1: Recognition of Forex
Gain/Loss Current/Noncurrent Method
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales € 10,000 $4,000 $4,000 $4,000 $4,000
COGS € 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation € 1,000 $333 $333 $333 $400
Net operating income € 1,500 $667 $1,167 $667 $600
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Addition to Retained
Earnings € 900 $700 $150 $550 $360
First solve for retained earnings so total assets = total liabilities:
total assets – current liabilities – long-term debt – common stock
$2,800 – $600 – $600 – $900 = $700 = addition to retrained earnings
Add back on dividends to get net income. Then solve for forex gain (loss) by differencing profit after tax and net income:
$700 – $400 = $300. 10-23
How Various Translation Methods Deal with a Change
from €3 = $1 to €2 = $1: Monetary/Nonmonetary Method
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales € 10,000 $4,000 $4,000 $4,000 $4,000
COGS € 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation € 1,000 $333 $333 $333 $400
Net operating income € 1,500 $667 $1,167 $667 $600
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Addition to Retained
Earnings € 900 $700 $150 $550 $360
First solve for retained earnings so total assets = total liabilities:
total assets – current liabilities – long-term debt – common stock
$2,550 – $600 –$900 –$900 = $150 = addition to retrained earnings
Add back on dividends to get net income. Then solve for forex gain (loss) by differencing profit after tax and net income:
$150 – $700 = –$550. 10-24
How Various Translation Methods Deal with a
Change from €3 = $1 to €2 = $1: Temporal Method
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales € 10,000 $4,000 $4,000 $4,000 $4,000
COGS € 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation € 1,000 $333 $333 $333 $400
Net operating income € 1,500 $667 $1,167 $667 $600
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Addition to Retained
Earnings € 900 $700 $150 $550 $360
First solve for retained earnings so total assets = total liabilities:
total assets – current liabilities – long-term debt – common stock
$2,950 – $600 –$900 – $900 = $550 = addition to retrained earnings
Add back on dividends to get net income. Then solve for forex gain (loss) by differencing profit after tax and
net income: $550 – $400 = $150.
10-25
FASB Statement 8
• Essentially the temporal method, with some subtleties.
• Such as translating inventory at historical rates, which is a hassle.
• Requires taking foreign exchange gains and losses through the income
statement.
• This leads to variability in reported earnings, which leads to irritated
corporate executives.
10-26
FASB Statement 52
• The mechanics of the FASB 52 translation process
• Function currency
• Reporting currency
• Highly inflationary economies
10-27
The Mechanics of FASB Statement 52:
Function Currency vs. Reporting Currency
• Function currency
• The currency that the business is conducted in.
• Reporting currency
• The currency in which the MNC prepares its consolidated
financial statements.
10-28
The Mechanics of FASB Statement
52
• Two-stage process
• First, determine in which currency the foreign entity keeps its books.
• If the local currency in which the foreign entity keeps its books is not the
functional currency, remeasurement into the functional currency is required.
• Second, when the foreign entity’s functional currency is not the same as the
parent’s currency, the foreign entity’s books are translated using the current
rate method.
10-29
FASB Statement 52 Flow Chart
Parent’s currency
Foreign
Nonparent Functional
entity’s books
kept in? Currency? Third currency
Currency
Local currency Temporal
Remeasurement
Currency
Parent’s
Current Rate
Translation
Parent’s Currency
10-30
Highly Inflationary Economies
• Foreign entities are required to remeasure financial statements using
the temporal method “as if the functional currency were the
reporting currency.”
10-31
International Accounting Standards
• Since January 2005, all companies doing business in the European Union
must use the accounting standards distributed by the International
Accounting Standards Board (IASB).
• Similar to the American FASB, the IASB publishes it standards in a series of
pronouncements called International Financial Reporting Standards.
• It also adopted and maintains the pronouncements of the predecessor
body, the IASC, called International Accounting Standards (IAS).
10-32
International Accounting Standards
(continued)
• IAS 21, The Effects of Changes in Foreign Exchange Rates is the
European standard for handling foreign currency translation.
• IAS 21 most closely resembles the monetary/nonmonetary translation
method discussed earlier in the chapter.
10-33
International Accounting Standards
(concluded)
• In 2009 IASB and FASB issued a memorandum of understanding to
achieve substantial convergence of accounting standards by 2011.
• Consequently, most countries may soon follow a common standard
for foreign currency translation.
10-34
8.3 Management of Translation
Exposure
• Translation exposure vs. transaction exposure
• Hedging translation exposure
• Balance sheet hedge
• Derivatives hedge
• Translation exposure vs. operating exposure
10-35
Translation Exposure versus
Transaction Exposure
• Translation exposure
• The effect that unanticipated changes in exchange rates
has on the firm’s consolidated financial statements.
• An accounting issue.
• Transaction exposure
• The effect that unanticipated changes in exchange rates
has on the firm’s cash flows.
• A finance issue and the subject of Chapter 8.
• It is generally not possible to eliminate both translation
exposure and transaction exposure.
10-36
Hedging Translation Exposure
• If the managers of the firm wish to manage their accounting numbers
as well as their business, they have two methods for dealing with
translation exposure:
• Balance sheet hedge
• Derivatives hedge
10-37
Balance Sheet Hedge
• Eliminates the mismatch between net assets and net liabilities
denominated in the same currency.
• May create transaction exposure, however.
10-38
Derivatives Hedge
• An example would be the use of a forward contract with a maturity of
the reporting period to attempt to manage the accounting numbers.
• Using a derivatives hedge to control translation exposure really
involves speculation about foreign exchange rate changes, however.
10-39
Translation Exposure versus
Operating Exposure
• The effect that unanticipated changes in exchange
rates has on the firm’s ongoing operations.
• Operating exposure is a substantive issue with which
the management of the firm should concern itself
with.
10-40
Empirical Analysis of the Change
from FASB 8 to FASB 52
• There did not appear to be a revaluation of firms’ values
following the change.
• This suggests that market participants do not react to cosmetic
earnings changes.
• Other researchers have found similar results when
investigating other accounting changes.
• This highlights the futility of attempting to manage translation
gains and losses.
10-41
Summary
• Translation exposure relates to the effect that an unanticipated
change in exchange rates will have on the consolidated
financial reports of a MNC.
• The four recognized methods for consolidating the financial
reports of a MNC include the current/noncurrent method, the
monetary/nonmonetary method, the temporal method, and
the current rate method.
• An example comparing and contrasting the four translation
methods was presented. It was noted that under the current
rate method the gain or loss due to translation adjustment
does not affect reported cash flows, as it does with the other
three translation methods.
10-42
Summary (continued)
• The old translation method, FASB 8, was discussed and compared
with the present prescribed process, FASB 52.
• In implementing FASB 52, the functional currency of the foreign
entity must be translated into the reporting currency in which the
consolidated statements are reported. The local currency of a
foreign entity may not always be its functional currency. If it is not,
the temporal method of translation is used to remeasure the
foreign entity’s books into the functional currency. The current rate
method is used to translate from the functional currency to the
reporting currency. In some cases, a foreign entity’s functional
currency may be the same as the reporting currency, in which case
translation is not necessary.
10-43
Summary (continuing)
• The European Union follows IAS 21, a monetary/nonmonetary
translation method promulgated by the International Accounting
Standards Board.
• A case application illustrating the translation process of the balance
sheet of a parent firm with two foreign wholly owned affiliates
according to FASB 52 was presented. This was done assuming the
foreign exchange rates had not changed since the inception of the
businesses, and again after an assumed change, to more thoroughly
show the effects of balance sheet consolidation under FASB 52.
When a net translation exposure exists, a cumulative translation
adjustment account is necessary to bring balance to the consolidated
balance sheet after an exchange rate change.
10-44
Summary (concluded)
• Two ways to control translation risk were presented: a balance
sheet hedge and a derivatives “hedge.” Since translation exposure
does not have an immediate direct effect on operating cash flows,
its control is relatively unimportant in comparison to transaction
exposure, which involves potential real cash flow losses. Since it is,
generally, not possible to eliminate both translation and
transaction exposure, it is more logical to effectively manage
transaction exposure, even at the expense of translation exposure.
10-45