INTERNATIONAL
FINANCIAL
MANAGEMENT
EUN / RESNICK
Second Edition
14Chapter FourteenManagement of Translation Exposure
Chapter Objective:
This chapter discusses the impact that unanticipated
changes in exchange rates may have on the
consolidated financial statements of the multinational
company.
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reserved,
14-1
Chapter Outline
? Translation Methods
? FASB Statement 8
? FASB Statement 52
? Management of Translation Exposure
? Empirical Analysis of the Change from FASB 8 to
FASB 52
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reserved,
14-2
Translation Methods
? Current/Noncurrent Method
? Monetary/Nonmonetary Method
? Temporal Method
? Current Rate Method
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reserved,
14-3
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.
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reserved,
14-4
Current/Noncurrent Method
? Current assets
translated at
the spot rate.
e.g,DM2=$1
? Noncurrent
assets
translated at
the historical
rate in effect
when the item
was first
recorded on
the books,
e.g,DM3=$1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
Ca s h 2,1 0 0 D M $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $750
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,8 0 0
Cu r r e n t l i a b i l i t i e s 1,2 0 0 D M $600
L o n g -T e r m d e b t 1,8 0 0 D M $600
Co m m o n s t o c k 2,7 0 0 D M $900
Re t a i n e d e a r n i n g s 9 0 0 D M $700
CT A -------- --------
T o t a l L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,8 0 0
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reserved,
14-5
Monetary/Nonmonetary Method
? The underlying principal 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.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-6
Monetary/Nonmonetary Method
? All monetary
balance sheet
accounts are
translated at the
current exchange
rate,e.g,DM2=$1
? All other balance
sheet accounts are
translated at the
historical exchange
rate in effect when
the account was first
recorded,
e.g.DM3=$1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
M o n e t a r y /
N o n m o n e t a r y
Ca s h 2,1 0 0 D M $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $500
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,5 5 0
Cu r r e n t l i a b i l i t i e s 1,2 0 0 D M $600
L o n g -T e r m d e b t 1,8 0 0 D M $900
Co m m o n s t o c k 2,7 0 0 D M $900
Re t a i n e d e a r n i n g s 9 0 0 D M $0
CT A -------- --------
T o t a l L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,4 0 0
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reserved,
14-7
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.
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reserved,
14-8
Temporal Method
? Items carried on the
books at their
current value are
translated at the
spot exchange rate.
e.g,DM2=$1
? Items that are
carried on the
books at historical
costs are translated
at the historical
exchange rates,
e.g,DM3=$1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
T e m p o r a l
Ca s h 2,1 0 0 D M $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $900
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,9 5 0
Cu r r e n t l i a b i l i t i e s 1,2 0 0 D M $600
L o n g -T e r m d e b t 1,8 0 0 D M $900
Co m m o n s t o c k 2,7 0 0 D M $900
Re t a i n e d e a r n i n g s 9 0 0 D M $0
CT A -------- --------
T o t a l L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,4 0 0
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reserved,
14-9
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 make the
balance sheet balance,
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reserved,
14-10
Current Rate Method
? All balance sheet
items (except for
stockholder’s
equity) are
translated at the
current exchange
rate.
? A,plug” equity
account named
cumulative
translation
adjustment is used
to make the balance
sheet balance
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
Cu r r e n t
Ra t e
Ca s h D M 2,1 0 0 $ 1,0 5 0
I n v e n t o r y D M 1,5 0 0 $750
N e t fi x e d a s s e t s D M 3,0 0 0 $ 1,5 0 0
T o t a l As s e t s D M 6,6 0 0 $ 3,3 0 0
Cu r r e n t l i a b i l i t i e s D M 1,2 0 0 $600
L o n g -T e r m d e b t D M 1,8 0 0 $900
Co m m o n s t o c k D M 2,7 0 0 $900
Re t a i n e d e a r n i n g s D M 9 0 0 $360
CT A -------- $540
T o t a l L i a b i l i t i e s
a n d Eq u i t y
D M 6,6 0 0 $ 3,3 0 0
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reserved,
14-11
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
Ca s h 2,1 0 0 D M $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $750 $500 $900 $750
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0 $ 1,0 0 0 $ 1,0 0 0 $ 1,5 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Cu r r e n t
l i a b i l i t i e s
1,2 0 0 D M $600 $600 $600 $600
L o n g -T e r m
d e b t
1,8 0 0 D M $600 $900 $900 $900
Co m m o n s t o c k 2,7 0 0 D M $900 $900 $900 $900
Re t a i n e d
e a r n i n g s
9 0 0 D M $700 $150 $550 $360
CT A -------- -------- -------- -------- $540
T o t a l
L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Spot exchange rate
earnings
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reserved,
14-12
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
Ca s h 2,1 0 0 D M $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $750 $500 $900 $750
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0 $ 1,0 0 0 $ 1,0 0 0 $ 1,5 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Cu r r e n t
l i a b i l i t i e s
1,2 0 0 D M $600 $600 $600 $600
L o n g -T e r m
d e b t
1,8 0 0 D M $600 $900 $900 $900
Co m m o n s t o c k 2,7 0 0 D M $900 $900 $900 $900
Re t a i n e d
e a r n i n g s
9 0 0 D M $700 $150 $550 $360
CT A -------- -------- -------- -------- $540
T o t a l
L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Book value of inventory
at spot exchange rate
Book
value of
inventory
historic
rate
Current value of inventory
at spot exchange rate.
earnings
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reserved,
14-13
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
Ca s h 2,1 0 0 D M $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $750 $500 $900 $750
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0 $ 1,0 0 0 $ 1,0 0 0 $ 1,5 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Cu r r e n t
l i a b i l i t i e s
1,2 0 0 D M $600 $600 $600 $600
L o n g -T e r m
d e b t
1,8 0 0 D M $600 $900 $900 $900
Co m m o n s t o c k 2,7 0 0 D M $900 $900 $900 $900
Re t a i n e d
e a r n i n g s
9 0 0 D M $700 $150 $550 $360
CT A -------- -------- -------- -------- $540
T o t a l
L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
historic
rate
spot exchange rate.
earnings
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reserved,
14-14
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
Ca s h 2,1 0 0 D M $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $750 $500 $900 $750
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0 $ 1,0 0 0 $ 1,0 0 0 $ 1,5 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Cu r r e n t
l i a b i l i t i e s
1,2 0 0 D M $600 $600 $600 $600
L o n g -T e r m
d e b t
1,8 0 0 D M $600 $900 $900 $900
Co m m o n s t o c k 2,7 0 0 D M $900 $900 $900 $900
Re t a i n e d
e a r n i n g s
9 0 0 D M $700 $150 $550 $360
CT A -------- -------- -------- -------- $540
T o t a l
L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
spot rate
earnings
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reserved,
14-15
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
Ca s h 2,1 0 0 D M $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $750 $500 $900 $750
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0 $ 1,0 0 0 $ 1,0 0 0 $ 1,5 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Cu r r e n t
l i a b i l i t i e s
1,2 0 0 D M $600 $600 $600 $600
L o n g -T e r m
d e b t
1,8 0 0 D M $600 $900 $900 $900
Co m m o n s t o c k 2,7 0 0 D M $900 $900 $900 $900
Re t a i n e d
e a r n i n g s
9 0 0 D M $700 $150 $550 $360
CT A -------- -------- -------- -------- $540
T o t a l
L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
spot ratehistorical rate
earnings
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reserved,
14-16
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
Ca s h 2,1 0 0 D M $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $750 $500 $900 $750
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0 $ 1,0 0 0 $ 1,0 0 0 $ 1,5 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Cu r r e n t
l i a b i l i t i e s
1,2 0 0 D M $600 $600 $600 $600
L o n g -T e r m
d e b t
1,8 0 0 D M $600 $900 $900 $900
Co m m o n s t o c k 2,7 0 0 D M $900 $900 $900 $900
Re t a i n e d
e a r n i n g s
9 0 0 D M $700 $150 $550 $360
CT A -------- -------- -------- -------- $540
T o t a l
L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
historical rate
earnings
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-17
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
Ca s h 2,1 0 0 D M $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $750 $500 $900 $750
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0 $ 1,0 0 0 $ 1,0 0 0 $ 1,5 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Cu r r e n t
l i a b i l i t i e s
1,2 0 0 D M $600 $600 $600 $600
L o n g -T e r m
d e b t
1,8 0 0 D M $600 $900 $900 $900
Co m m o n s t o c k 2,7 0 0 D M $900 $900 $900 $900
Re t a i n e d
e a r n i n g s
9 0 0 D M $700 $150 $550 $360
CT A -------- -------- -------- -------- $540
T o t a l
L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
From income statement
earnings
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reserved,
14-18
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
Ca s h 2,1 0 0 D M $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $750 $500 $900 $750
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0 $ 1,0 0 0 $ 1,0 0 0 $ 1,5 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Cu r r e n t
l i a b i l i t i e s
1,2 0 0 D M $600 $600 $600 $600
L o n g -T e r m
d e b t
1,8 0 0 D M $600 $900 $900 $900
Co m m o n s t o c k 2,7 0 0 D M $900 $900 $900 $900
Re t a i n e d
e a r n i n g s
9 0 0 D M $700 $150 $550 $360
CT A -------- -------- -------- -------- $540
T o t a l
L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Under the current rate method,a,plug” equity account named
cumulative translation adjustment makes the balance sheet balance.
earnings
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reserved,
14-19
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
For notes,see Exhibit 14.1
I n c o m e S t a t e m e n t
L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
S a l e s 1 0,0 0 0 D M $ 4,0 0 0 $ 4,0 0 0 $ 4,0 0 0 $ 4,0 0 0
CO G S 7,5 0 0 D M $ 3,0 0 0 $ 2,5 0 0 $ 3,0 0 0 $ 3,0 0 0
D e p r e c i a t i o n 1,0 0 0 D M $333 $333 $333 $400
N e t o p e r a t i n g i n c o m e 1,5 0 0 D M $667 $ 1,1 6 7 $667 $600
I n c o m e t a x (4 0 % ) 6 0 0 D M $267 $467 $267 $240
P r o fi t a ft e r t a x 9 0 0 D M $400 $700 $400 $360
$300 -$ 5 5 0 $150
N e t i n c o m e 9 0 0 D M $700 $150 $550 $360
D i v i d e n d s 0 D M $0 $0 $0 $0
Ad d i t i o n t o Re t a i n e d
Ea r n i n g s 9 0 0 D M $700 $150 $550 $360
F o r e i g n e x c h a n g e g a i n (l o s s )
Sales translate at average exchange rate over the period,DM2.50 = $1
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reserved,
14-20
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
For notes,see Exhibit 14.1
I n c o m e S t a t e m e n t
L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
S a l e s 1 0,0 0 0 D M $ 4,0 0 0 $ 4,0 0 0 $ 4,0 0 0 $ 4,0 0 0
CO G S 7,5 0 0 D M $ 3,0 0 0 $ 2,5 0 0 $ 3,0 0 0 $ 3,0 0 0
D e p r e c i a t i o n 1,0 0 0 D M $333 $333 $333 $400
N e t o p e r a t i n g i n c o m e 1,5 0 0 D M $667 $ 1,1 6 7 $667 $600
I n c o m e t a x (4 0 % ) 6 0 0 D M $267 $467 $267 $240
P r o fi t a ft e r t a x 9 0 0 D M $400 $700 $400 $360
$300 -$ 5 5 0 $150
N e t i n c o m e 9 0 0 D M $700 $150 $550 $360
D i v i d e n d s 0 D M $0 $0 $0 $0
Ad d i t i o n t o Re t a i n e d
Ea r n i n g s 9 0 0 D M $700 $150 $550 $360
F o r e i g n e x c h a n g e g a i n (l o s s )
Translate at DM2.50 = $1 Translate at new exchange rate,DM2.00 = $1
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-21
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
For notes,see Exhibit 14.1
I n c o m e S t a t e m e n t
L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
S a l e s 1 0,0 0 0 D M $ 4,0 0 0 $ 4,0 0 0 $ 4,0 0 0 $ 4,0 0 0
CO G S 7,5 0 0 D M $ 3,0 0 0 $ 2,5 0 0 $ 3,0 0 0 $ 3,0 0 0
D e p r e c i a t i o n 1,0 0 0 D M $333 $333 $333 $400
N e t o p e r a t i n g i n c o m e 1,5 0 0 D M $667 $ 1,1 6 7 $667 $600
I n c o m e t a x (4 0 % ) 6 0 0 D M $267 $467 $267 $240
P r o fi t a ft e r t a x 9 0 0 D M $400 $700 $400 $360
$300 -$ 5 5 0 $150
N e t i n c o m e 9 0 0 D M $700 $150 $550 $360
D i v i d e n d s 0 D M $0 $0 $0 $0
Ad d i t i o n t o Re t a i n e d
Ea r n i n g s 9 0 0 D M $700 $150 $550 $360
F o r e i g n e x c h a n g e g a i n (l o s s )
Translate at DM3 = $1 Translate at average exchange rate,DM2.5 = $1
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-22
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
For notes,see Exhibit 14.1
I n c o m e S t a t e m e n t
L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
S a l e s 1 0,0 0 0 D M $ 4,0 0 0 $ 4,0 0 0 $ 4,0 0 0 $ 4,0 0 0
CO G S 7,5 0 0 D M $ 3,0 0 0 $ 2,5 0 0 $ 3,0 0 0 $ 3,0 0 0
D e p r e c i a t i o n 1,0 0 0 D M $333 $333 $333 $400
N e t o p e r a t i n g i n c o m e 1,5 0 0 D M $667 $ 1,1 6 7 $667 $600
I n c o m e t a x (4 0 % ) 6 0 0 D M $267 $467 $267 $240
P r o fi t a ft e r t a x 9 0 0 D M $400 $700 $400 $360
$300 -$ 5 5 0 $150
N e t i n c o m e 9 0 0 D M $700 $150 $550 $360
D i v i d e n d s 0 D M $0 $0 $0 $0
Ad d i t i o n t o Re t a i n e d
Ea r n i n g s 9 0 0 D M $700 $150 $550 $360
F o r e i g n e x c h a n g e g a i n (l o s s )
Note the effect on after-tax profit.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-23
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
For notes,see Exhibit 14.1
I n c o m e S t a t e m e n t
L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
S a l e s 1 0,0 0 0 D M $ 4,0 0 0 $ 4,0 0 0 $ 4,0 0 0 $ 4,0 0 0
CO G S 7,5 0 0 D M $ 3,0 0 0 $ 2,5 0 0 $ 3,0 0 0 $ 3,0 0 0
D e p r e c i a t i o n 1,0 0 0 D M $333 $333 $333 $400
N e t o p e r a t i n g i n c o m e 1,5 0 0 D M $667 $ 1,1 6 7 $667 $600
I n c o m e t a x (4 0 % ) 6 0 0 D M $267 $467 $267 $240
P r o fi t a ft e r t a x 9 0 0 D M $400 $700 $400 $360
$300 -$ 5 5 0 $150
N e t i n c o m e 9 0 0 D M $700 $150 $550 $360
D i v i d e n d s 0 D M $0 $0 $0 $0
Ad d i t i o n t o Re t a i n e d
Ea r n i n g s 9 0 0 D M $700 $150 $550 $360
F o r e i g n e x c h a n g e g a i n (l o s s )
Note the effect that foreign exchange gains (losses) has on net income.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-24
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.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-25
FASB Statement 52
? The Mechanics of the FASB 52 Translation
Process
? Function Currency
? Reporting Currency
? Highly Inflationary Economies
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reserved,
14-26
The Mechanics of FASB Statement 52
? Function Currency
? The currency that the business is conducted in.
? Reporting Currency
? The currency in which the MNC prepares its
consolidated financial statements.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-27
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.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-28
Current Rate
Translation
Parent’s Currency
Foreign
entity’s books
kept in?
Pa
ren
t’s
Cu
rre
nc
y
Functional
Currency?
Local currency Temporal Remeasurement
Parent’s currency
Nonparent
Currency Third currency
The Mechanics of FASB Statement 52
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-29
Highly Inflationary Economies
? Foreign entities are required to remeasure
financial statements using the temporal method
“as if the functional currency were the reporting
currency”.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-30
Management of Translation Exposure
? Translation Exposure vs,Transaction Exposure
? Hedging Translation Exposure
? Balance Sheet Hedge
? Derivatives Hedge
? Translation Exposure vs,Operating Exposure
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-31
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 13.
? It is generally not possible to eliminate both
translation exposure and transaction exposure.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-32
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
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reserved,
14-33
Balance Sheet Hedge
? Eliminates the mismatch between net assets and
net liabilities denominated in the same currency.
? May create transaction exposure,however.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-34
Derivatives Hedge
? An example would be the use of forward contracts
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.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-35
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.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-36
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.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-37
End Chapter Fourteen
FINANCIAL
MANAGEMENT
EUN / RESNICK
Second Edition
14Chapter FourteenManagement of Translation Exposure
Chapter Objective:
This chapter discusses the impact that unanticipated
changes in exchange rates may have on the
consolidated financial statements of the multinational
company.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-1
Chapter Outline
? Translation Methods
? FASB Statement 8
? FASB Statement 52
? Management of Translation Exposure
? Empirical Analysis of the Change from FASB 8 to
FASB 52
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-2
Translation Methods
? Current/Noncurrent Method
? Monetary/Nonmonetary Method
? Temporal Method
? Current Rate Method
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-3
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.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-4
Current/Noncurrent Method
? Current assets
translated at
the spot rate.
e.g,DM2=$1
? Noncurrent
assets
translated at
the historical
rate in effect
when the item
was first
recorded on
the books,
e.g,DM3=$1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
Ca s h 2,1 0 0 D M $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $750
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,8 0 0
Cu r r e n t l i a b i l i t i e s 1,2 0 0 D M $600
L o n g -T e r m d e b t 1,8 0 0 D M $600
Co m m o n s t o c k 2,7 0 0 D M $900
Re t a i n e d e a r n i n g s 9 0 0 D M $700
CT A -------- --------
T o t a l L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,8 0 0
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-5
Monetary/Nonmonetary Method
? The underlying principal 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.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-6
Monetary/Nonmonetary Method
? All monetary
balance sheet
accounts are
translated at the
current exchange
rate,e.g,DM2=$1
? All other balance
sheet accounts are
translated at the
historical exchange
rate in effect when
the account was first
recorded,
e.g.DM3=$1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
M o n e t a r y /
N o n m o n e t a r y
Ca s h 2,1 0 0 D M $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $500
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,5 5 0
Cu r r e n t l i a b i l i t i e s 1,2 0 0 D M $600
L o n g -T e r m d e b t 1,8 0 0 D M $900
Co m m o n s t o c k 2,7 0 0 D M $900
Re t a i n e d e a r n i n g s 9 0 0 D M $0
CT A -------- --------
T o t a l L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,4 0 0
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-7
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.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-8
Temporal Method
? Items carried on the
books at their
current value are
translated at the
spot exchange rate.
e.g,DM2=$1
? Items that are
carried on the
books at historical
costs are translated
at the historical
exchange rates,
e.g,DM3=$1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
T e m p o r a l
Ca s h 2,1 0 0 D M $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $900
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,9 5 0
Cu r r e n t l i a b i l i t i e s 1,2 0 0 D M $600
L o n g -T e r m d e b t 1,8 0 0 D M $900
Co m m o n s t o c k 2,7 0 0 D M $900
Re t a i n e d e a r n i n g s 9 0 0 D M $0
CT A -------- --------
T o t a l L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,4 0 0
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-9
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 make the
balance sheet balance,
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-10
Current Rate Method
? All balance sheet
items (except for
stockholder’s
equity) are
translated at the
current exchange
rate.
? A,plug” equity
account named
cumulative
translation
adjustment is used
to make the balance
sheet balance
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
Cu r r e n t
Ra t e
Ca s h D M 2,1 0 0 $ 1,0 5 0
I n v e n t o r y D M 1,5 0 0 $750
N e t fi x e d a s s e t s D M 3,0 0 0 $ 1,5 0 0
T o t a l As s e t s D M 6,6 0 0 $ 3,3 0 0
Cu r r e n t l i a b i l i t i e s D M 1,2 0 0 $600
L o n g -T e r m d e b t D M 1,8 0 0 $900
Co m m o n s t o c k D M 2,7 0 0 $900
Re t a i n e d e a r n i n g s D M 9 0 0 $360
CT A -------- $540
T o t a l L i a b i l i t i e s
a n d Eq u i t y
D M 6,6 0 0 $ 3,3 0 0
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-11
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
Ca s h 2,1 0 0 D M $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $750 $500 $900 $750
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0 $ 1,0 0 0 $ 1,0 0 0 $ 1,5 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Cu r r e n t
l i a b i l i t i e s
1,2 0 0 D M $600 $600 $600 $600
L o n g -T e r m
d e b t
1,8 0 0 D M $600 $900 $900 $900
Co m m o n s t o c k 2,7 0 0 D M $900 $900 $900 $900
Re t a i n e d
e a r n i n g s
9 0 0 D M $700 $150 $550 $360
CT A -------- -------- -------- -------- $540
T o t a l
L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Spot exchange rate
earnings
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-12
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
Ca s h 2,1 0 0 D M $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $750 $500 $900 $750
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0 $ 1,0 0 0 $ 1,0 0 0 $ 1,5 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Cu r r e n t
l i a b i l i t i e s
1,2 0 0 D M $600 $600 $600 $600
L o n g -T e r m
d e b t
1,8 0 0 D M $600 $900 $900 $900
Co m m o n s t o c k 2,7 0 0 D M $900 $900 $900 $900
Re t a i n e d
e a r n i n g s
9 0 0 D M $700 $150 $550 $360
CT A -------- -------- -------- -------- $540
T o t a l
L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Book value of inventory
at spot exchange rate
Book
value of
inventory
historic
rate
Current value of inventory
at spot exchange rate.
earnings
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-13
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
Ca s h 2,1 0 0 D M $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $750 $500 $900 $750
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0 $ 1,0 0 0 $ 1,0 0 0 $ 1,5 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Cu r r e n t
l i a b i l i t i e s
1,2 0 0 D M $600 $600 $600 $600
L o n g -T e r m
d e b t
1,8 0 0 D M $600 $900 $900 $900
Co m m o n s t o c k 2,7 0 0 D M $900 $900 $900 $900
Re t a i n e d
e a r n i n g s
9 0 0 D M $700 $150 $550 $360
CT A -------- -------- -------- -------- $540
T o t a l
L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
historic
rate
spot exchange rate.
earnings
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-14
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
Ca s h 2,1 0 0 D M $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $750 $500 $900 $750
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0 $ 1,0 0 0 $ 1,0 0 0 $ 1,5 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Cu r r e n t
l i a b i l i t i e s
1,2 0 0 D M $600 $600 $600 $600
L o n g -T e r m
d e b t
1,8 0 0 D M $600 $900 $900 $900
Co m m o n s t o c k 2,7 0 0 D M $900 $900 $900 $900
Re t a i n e d
e a r n i n g s
9 0 0 D M $700 $150 $550 $360
CT A -------- -------- -------- -------- $540
T o t a l
L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
spot rate
earnings
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-15
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
Ca s h 2,1 0 0 D M $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $750 $500 $900 $750
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0 $ 1,0 0 0 $ 1,0 0 0 $ 1,5 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Cu r r e n t
l i a b i l i t i e s
1,2 0 0 D M $600 $600 $600 $600
L o n g -T e r m
d e b t
1,8 0 0 D M $600 $900 $900 $900
Co m m o n s t o c k 2,7 0 0 D M $900 $900 $900 $900
Re t a i n e d
e a r n i n g s
9 0 0 D M $700 $150 $550 $360
CT A -------- -------- -------- -------- $540
T o t a l
L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
spot ratehistorical rate
earnings
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-16
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
Ca s h 2,1 0 0 D M $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $750 $500 $900 $750
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0 $ 1,0 0 0 $ 1,0 0 0 $ 1,5 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Cu r r e n t
l i a b i l i t i e s
1,2 0 0 D M $600 $600 $600 $600
L o n g -T e r m
d e b t
1,8 0 0 D M $600 $900 $900 $900
Co m m o n s t o c k 2,7 0 0 D M $900 $900 $900 $900
Re t a i n e d
e a r n i n g s
9 0 0 D M $700 $150 $550 $360
CT A -------- -------- -------- -------- $540
T o t a l
L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
historical rate
earnings
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
14-17
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
Ca s h 2,1 0 0 D M $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $750 $500 $900 $750
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0 $ 1,0 0 0 $ 1,0 0 0 $ 1,5 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Cu r r e n t
l i a b i l i t i e s
1,2 0 0 D M $600 $600 $600 $600
L o n g -T e r m
d e b t
1,8 0 0 D M $600 $900 $900 $900
Co m m o n s t o c k 2,7 0 0 D M $900 $900 $900 $900
Re t a i n e d
e a r n i n g s
9 0 0 D M $700 $150 $550 $360
CT A -------- -------- -------- -------- $540
T o t a l
L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
From income statement
earnings
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14-18
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
Ba l a n c e S h e e t L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
Ca s h 2,1 0 0 D M $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0 $ 1,0 5 0
I n v e n t o r y 1,5 0 0 D M $750 $500 $900 $750
N e t fi x e d a s s e t s 3,0 0 0 D M $ 1,0 0 0 $ 1,0 0 0 $ 1,0 0 0 $ 1,5 0 0
T o t a l As s e t s 6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Cu r r e n t
l i a b i l i t i e s
1,2 0 0 D M $600 $600 $600 $600
L o n g -T e r m
d e b t
1,8 0 0 D M $600 $900 $900 $900
Co m m o n s t o c k 2,7 0 0 D M $900 $900 $900 $900
Re t a i n e d
e a r n i n g s
9 0 0 D M $700 $150 $550 $360
CT A -------- -------- -------- -------- $540
T o t a l
L i a b i l i t i e s a n d
Eq u i t y
6,6 0 0 D M $ 2,8 0 0 $ 2,5 5 0 $ 2,9 5 0 $ 3,3 0 0
Under the current rate method,a,plug” equity account named
cumulative translation adjustment makes the balance sheet balance.
earnings
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14-19
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
For notes,see Exhibit 14.1
I n c o m e S t a t e m e n t
L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
S a l e s 1 0,0 0 0 D M $ 4,0 0 0 $ 4,0 0 0 $ 4,0 0 0 $ 4,0 0 0
CO G S 7,5 0 0 D M $ 3,0 0 0 $ 2,5 0 0 $ 3,0 0 0 $ 3,0 0 0
D e p r e c i a t i o n 1,0 0 0 D M $333 $333 $333 $400
N e t o p e r a t i n g i n c o m e 1,5 0 0 D M $667 $ 1,1 6 7 $667 $600
I n c o m e t a x (4 0 % ) 6 0 0 D M $267 $467 $267 $240
P r o fi t a ft e r t a x 9 0 0 D M $400 $700 $400 $360
$300 -$ 5 5 0 $150
N e t i n c o m e 9 0 0 D M $700 $150 $550 $360
D i v i d e n d s 0 D M $0 $0 $0 $0
Ad d i t i o n t o Re t a i n e d
Ea r n i n g s 9 0 0 D M $700 $150 $550 $360
F o r e i g n e x c h a n g e g a i n (l o s s )
Sales translate at average exchange rate over the period,DM2.50 = $1
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14-20
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
For notes,see Exhibit 14.1
I n c o m e S t a t e m e n t
L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
S a l e s 1 0,0 0 0 D M $ 4,0 0 0 $ 4,0 0 0 $ 4,0 0 0 $ 4,0 0 0
CO G S 7,5 0 0 D M $ 3,0 0 0 $ 2,5 0 0 $ 3,0 0 0 $ 3,0 0 0
D e p r e c i a t i o n 1,0 0 0 D M $333 $333 $333 $400
N e t o p e r a t i n g i n c o m e 1,5 0 0 D M $667 $ 1,1 6 7 $667 $600
I n c o m e t a x (4 0 % ) 6 0 0 D M $267 $467 $267 $240
P r o fi t a ft e r t a x 9 0 0 D M $400 $700 $400 $360
$300 -$ 5 5 0 $150
N e t i n c o m e 9 0 0 D M $700 $150 $550 $360
D i v i d e n d s 0 D M $0 $0 $0 $0
Ad d i t i o n t o Re t a i n e d
Ea r n i n g s 9 0 0 D M $700 $150 $550 $360
F o r e i g n e x c h a n g e g a i n (l o s s )
Translate at DM2.50 = $1 Translate at new exchange rate,DM2.00 = $1
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14-21
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
For notes,see Exhibit 14.1
I n c o m e S t a t e m e n t
L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
S a l e s 1 0,0 0 0 D M $ 4,0 0 0 $ 4,0 0 0 $ 4,0 0 0 $ 4,0 0 0
CO G S 7,5 0 0 D M $ 3,0 0 0 $ 2,5 0 0 $ 3,0 0 0 $ 3,0 0 0
D e p r e c i a t i o n 1,0 0 0 D M $333 $333 $333 $400
N e t o p e r a t i n g i n c o m e 1,5 0 0 D M $667 $ 1,1 6 7 $667 $600
I n c o m e t a x (4 0 % ) 6 0 0 D M $267 $467 $267 $240
P r o fi t a ft e r t a x 9 0 0 D M $400 $700 $400 $360
$300 -$ 5 5 0 $150
N e t i n c o m e 9 0 0 D M $700 $150 $550 $360
D i v i d e n d s 0 D M $0 $0 $0 $0
Ad d i t i o n t o Re t a i n e d
Ea r n i n g s 9 0 0 D M $700 $150 $550 $360
F o r e i g n e x c h a n g e g a i n (l o s s )
Translate at DM3 = $1 Translate at average exchange rate,DM2.5 = $1
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14-22
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
For notes,see Exhibit 14.1
I n c o m e S t a t e m e n t
L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
S a l e s 1 0,0 0 0 D M $ 4,0 0 0 $ 4,0 0 0 $ 4,0 0 0 $ 4,0 0 0
CO G S 7,5 0 0 D M $ 3,0 0 0 $ 2,5 0 0 $ 3,0 0 0 $ 3,0 0 0
D e p r e c i a t i o n 1,0 0 0 D M $333 $333 $333 $400
N e t o p e r a t i n g i n c o m e 1,5 0 0 D M $667 $ 1,1 6 7 $667 $600
I n c o m e t a x (4 0 % ) 6 0 0 D M $267 $467 $267 $240
P r o fi t a ft e r t a x 9 0 0 D M $400 $700 $400 $360
$300 -$ 5 5 0 $150
N e t i n c o m e 9 0 0 D M $700 $150 $550 $360
D i v i d e n d s 0 D M $0 $0 $0 $0
Ad d i t i o n t o Re t a i n e d
Ea r n i n g s 9 0 0 D M $700 $150 $550 $360
F o r e i g n e x c h a n g e g a i n (l o s s )
Note the effect on after-tax profit.
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14-23
How Various Translation Methods Deal with
a Change from DM3 to DM2 = $1
For notes,see Exhibit 14.1
I n c o m e S t a t e m e n t
L o c a l
Cu r r e n c y
Cu r r e n t /
N o n c u r r e n t
M o n e t a r y /
N o n m o n e t a r y
T e m p o r a l Cu r r e n t
Ra t e
S a l e s 1 0,0 0 0 D M $ 4,0 0 0 $ 4,0 0 0 $ 4,0 0 0 $ 4,0 0 0
CO G S 7,5 0 0 D M $ 3,0 0 0 $ 2,5 0 0 $ 3,0 0 0 $ 3,0 0 0
D e p r e c i a t i o n 1,0 0 0 D M $333 $333 $333 $400
N e t o p e r a t i n g i n c o m e 1,5 0 0 D M $667 $ 1,1 6 7 $667 $600
I n c o m e t a x (4 0 % ) 6 0 0 D M $267 $467 $267 $240
P r o fi t a ft e r t a x 9 0 0 D M $400 $700 $400 $360
$300 -$ 5 5 0 $150
N e t i n c o m e 9 0 0 D M $700 $150 $550 $360
D i v i d e n d s 0 D M $0 $0 $0 $0
Ad d i t i o n t o Re t a i n e d
Ea r n i n g s 9 0 0 D M $700 $150 $550 $360
F o r e i g n e x c h a n g e g a i n (l o s s )
Note the effect that foreign exchange gains (losses) has on net income.
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14-24
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.
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14-25
FASB Statement 52
? The Mechanics of the FASB 52 Translation
Process
? Function Currency
? Reporting Currency
? Highly Inflationary Economies
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14-26
The Mechanics of FASB Statement 52
? Function Currency
? The currency that the business is conducted in.
? Reporting Currency
? The currency in which the MNC prepares its
consolidated financial statements.
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14-27
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.
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14-28
Current Rate
Translation
Parent’s Currency
Foreign
entity’s books
kept in?
Pa
ren
t’s
Cu
rre
nc
y
Functional
Currency?
Local currency Temporal Remeasurement
Parent’s currency
Nonparent
Currency Third currency
The Mechanics of FASB Statement 52
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14-29
Highly Inflationary Economies
? Foreign entities are required to remeasure
financial statements using the temporal method
“as if the functional currency were the reporting
currency”.
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reserved,
14-30
Management of Translation Exposure
? Translation Exposure vs,Transaction Exposure
? Hedging Translation Exposure
? Balance Sheet Hedge
? Derivatives Hedge
? Translation Exposure vs,Operating Exposure
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14-31
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 13.
? It is generally not possible to eliminate both
translation exposure and transaction exposure.
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14-32
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
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14-33
Balance Sheet Hedge
? Eliminates the mismatch between net assets and
net liabilities denominated in the same currency.
? May create transaction exposure,however.
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14-34
Derivatives Hedge
? An example would be the use of forward contracts
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.
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14-35
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.
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14-36
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.
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14-37
End Chapter Fourteen
