Accounting Exposure

Eiteman et al., Chapter 10

Winter 2004

Accounting Exposure
Accounting exposure, also called translation exposure, results from the need to restate foreign subsidiaries nancial statements, usually stated in foreign currency, into the parents reporting currency when preparing the consolidated nancial statements. Restating nancial statements may lead to changes in the parents net worth or net income.

Translation Exposure
When converting nancial statement items (transactions) denominated in currencies other than the parent currency, two choices of exchange rate are possible: The historical rate, the exchange rate prevailing at the time of the transaction The current rate, the exchange rate prevailing at the balance sheet date or during the income statement period

Translation Exposure
Conversion of nancial statements into the parents currency creates the following concerns: The exposure to exchange rate changes The treatment of translation gains or losses

Translation Exposure
SFAS 52 provides two translation methods: The temporal method, or remeasurement process The current rate method, or translation process

Translation Exposure
The method used to restate nancial statements is based on the choice of functional currency for each subsidiary. The functional currency is the primary currency used in the subsidiarys operations. This currency may be the foreign subsidiarys local currency, the parents currency, or a third currency.

Translation Exposure
There exists three categories of foreign operations:
Relatively self-contained, independent entities operating primarily in local markets. The functional currency of these entities is generally the local currency. Signicantly integrated operations that serve as sales outlets for the parents products and services. The functional currency should be the parents currency in this case. Subsidiaries operating in highly inationary economies. The use of the parents currency as the functional currency is required in this case.

Translation Exposure
If the foreign entitys functional currency is the local currency, nancial statements are translated using the current rate method. If the foreign entitys functional currency is the parents currency, nancial statements are remeasured using the temporal method.

Translation Exposure
If the functional currency of a foreign subsidiary is not the local currency, then the subsidiarys nancial statements are 1. Remeasured in the subsidiarys functional currency using the temporal method; 2. Translated from functional to parents currency using the current rate method.

The Current Rate Method

All assets and liabilities are translated at the rate in effect on the balance sheet date. All items on the income statement are translated at an appropriate average exchange rate or at the rate prevailing when the various revenues, expenses, gains and losses were incurred (historical rate). Dividends paid are translated at the rate in effect on the payment date. Common stock, paid-in capital and retained earnings are translated at historical rates.

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The Current Rate Method

When the current rate method is used, gains and losses from translation are reported in a separate equity account called cumulative translation adjustment (CTA). Gains and losses do not appear in the income statement when the current rate method is used.

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The Current Rate Method

Advantages of CTA
Eliminates the variability of net earnings due to translation gains or losses. The relative proportions of individual balance sheet accounts remain the same (debt-to-equity ratio, for example).

Main disadvantage of CTA

Violates the accounting principle of carrying balance sheet accounts at historical cost.

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The Current Rate Method

Under the current rate method, translation exposure is Assets(A) Liabilities(L) = stockholders equity(SE ). Common stock and retained earnings, for example, are part of SE . If common stock is issued at some point in time, then the value of the issue in the parents currency is determined by the exchange rate prevailing when the shares were issued.

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The Current Rate Method

Similarly, the value of the earnings retained during a year in the parents currency is based on the exchange rate used to translate the income statement in that year. When the exchange rate changes, the value of A L in the parents currency varies but the value of SE in the parents currency stays the same or, at least, changes according to a different rate. The CTA account is needed for the balance sheet to balance.

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The Current Rate Method: An Example

Foreign Subsidiary, Inc., (FSI) has been acquired on December 31, 2000 when the exchange rate was LC1.25/$ (LC stands for FSIs local currency). On December 31, 2001, the exchange rate was LC1.15/$. The average exchange rate during 2001 was LC1.18/$. On December 31, 2002, the exchange rate was LC1.22/$. The average exchange rate during 2002 was LC1.20/$.

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The Current Rate Method: An Example

Foreign Subsidiary, Inc. Assets as of December 31 (in LC) 2000 Cash Accounts receivable Inventory Current assets Fixed assets Accumulated depreciation Net xed assets Total assets 41 360 210 611 1,032 180 852 1,463 2001 204 492 264 960 1,512 432 1,080 2,040 2002 400 570 372 1,342 2,208 732 1,296 2,638

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The Current Rate Method: An Example

Foreign Subsidiary, Inc. Liabilities and Equity as of December 31 (in LC) 2000 Accounts payable Notes payable Long-term debt Total liabilities Common stock Retained earnings Total equity Total liabilities and equity 306 132 168 606 276 581 857 1,463 2001 348 156 528 1,032 276 732 1,008 2,040 2002 288 216 948 1,452 276 910 1,186 2,638

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The Current Rate Method: An Example

Foreign Subsidiary, Inc. Income Statement (in LC) 2001 Revenues COGS Gross margin Depreciation Other expenses Net income 1,548 648 900 252 497 151 2002 1,716 733 983 300 505 178

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The Current Rate Method: An Example

Under the current rate method, all assets and all liabilities are translated using the exchange rate in effect on the balance sheet date (December 31 of each year). Equity items are translated using the appropriate historical exchange rate and all income statement items are translated at the exchange rate at the time of the transaction (the average annual exchange rate).

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The Current Rate Method: An Example

Foreign Subsidiary, Inc. Assets as of December 31 (in $) (Rate) Cash Accounts receivable Inventory Current assets Fixed assets Accumulated depreciation Net xed assets Total assets 2000 (LC1.25/$) 33 288 168 489 826 144 682 1,170 2001 (LC1.15/$) 177 428 230 835 1,315 376 939 1,774 2002 (LC1.22/$) 328 467 305 1,100 1,662 600 1,062 2,162

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The Current Rate Method: An Example

Foreign Subsidiary, Inc. Liabilities and Equity as of December 31 (in $) 2000 Accounts payable Notes payable Long-term debt Total liabilities Common stock Retained earnings Total equity Cumulative translation adjustment Total liabilities and equity 245 106 134 485 ? ? ? ? 1,170 2001 303 136 459 897 ? ? ? ? 1,774 2002 236 177 777 1,190 ? ? ? ? 2,162

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The Current Rate Method: An Example

Foreign Subsidiary, Inc. Income Statement (in $) (Rate) Revenues COGS Gross margin Depreciation Other expenses Net income 2001 (LC1.18/$) 1,312 549 763 214 421 128 2002 (LC1.20/$) 1,430 611 819 250 421 148

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The Current Rate Method: An Example

What happens to common stock (CS)? The subsidiary was acquired on December 31, 2000, and thus the initial value for common stock, 276, is translated using the exchange rate on December 31, 2000, which gives CS2000 = 276 = $221. 1.25

Since common stock does not change in 2001 and 2002, the translated value is $221 in these years, too.

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The Current Rate Method: An Example

What happens to retained earnings (RE )? Retained earnings in 2000 are translated at the rate prevailing when the company was acquired, i.e. LC1.25/$, which gives RE2000 = 5811.25 = $465. In 2001, retained earnings increased by LC151. The appropriate rate for this change being the average exchange rate LC1.18/$, translated retained earnings in 2001 are RE2001 = RE2000 + 1511.18 = 465 + 128 = $593.
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The Current Rate Method: An Example

In 2002, retained earnings increased by LC178 and the 2002 average exchange rate is LC1.20/$. Translated retained earnings in 2002 are then RE2002 = RE2001 + 1781.20 = 593 + 148 = $741.

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The Current Rate Method: An Example

Foreign Subsidiary, Inc. Liabilities and Equity as of December 31 (in $) 2000 Accounts payable Notes payable Long-term debt Total liabilities Common stock Retained earnings Total equity Cumulative translation adjustment Total liabilities and equity 245 106 134 485 221 465 685 1,170 2001 303 136 459 897 221 593 814 63 1,774 2002 236 177 777 1,190 221 741 962 10 2,162

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The Temporal Method

Monetary assets (cash, marketable securities, accounts receivable, inventory) and monetary liabilities (current liabilities and long-term debt) are translated at the current exchange rate (exchange rate at the balance sheet date). Non-monetary assets (inventory, xed assets, etc.) and non-monetary liabilitites are translated at their historical rate.

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The Temporal Method

Note: Inventory is considered a monetary asset if it is recorded at market value on the balance sheet. If it is recorded at historical cost, then it is considered a non-monetary asset.

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The Temporal Method

Income statement items are translated at the average exchange rate over the period, except for items that are associated with non-monetary assets or liabilities, such as cost of goods sold (inventory) and depreciation (xed assets), which are translated at their historical rate. Dividends paid are translated at the rate in effect on the payment date. Equity items are translated at their historical rate, and include any imbalance.

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The Temporal Method

Under this method, gains and losses appear on the income statement. Gains and losses on the balance sheet will be hidden in stockholders equity. The exposure to exchange rate changes under this method is Monetary Assets Monetary Liabilities.

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The Temporal Method

Logic behind differentiating monetary and non-monetary assets: Translation gains and losses on monetary accounts are presumed meaningful components of expenses or revenue because monetary accounts closely approximate market values. Translation gains and losses on non-monetary accounts are less meaningful since non-monetary accounts reect historical costs.

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The Temporal Method: An Example

Let us remeasure FSIs nancial statements using the temporal method. The methodology is the same as with the current rate method for cash, accounts receivable, accounts payable, notes payable, long-term debt, common stock, revenues and other expenses.

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The Temporal Method: An Example

Foreign Subsidiary, Inc. Assets as of December 31 (in $) 2000 Cash Accounts receivable Inventory Current assets Fixed assets Accumulated depreciation Net xed assets Total assets 33 288 168 489 826 144 682 1,170 2001 177 428 ? ? ? ? ? ? 2002 328 467 ? ? ? ? ? ?

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The Temporal Method: An Example

Foreign Subsidiary, Inc. Liabilities and Equity as of December 31 (in $) 2000 Accounts payable Notes payable Long-term debt Total liabilities Common stock Retained earnings Total equity Total liabilities and equity 245 106 134 485 221 465 685 1,170 2001 303 136 459 897 221 ? ? ? 2002 236 177 777 1,190 221 ? ? ?

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The Temporal Method: An Example

Foreign Subsidiary, Inc. Income Statement (in $) 2001 Revenues COGS Gross margin Depreciation Other expenses Foreign exchange gain (loss) Net income 1,312 ? ? ? 421 ? ? 2002 1,430 ? ? ? 421 ? ?

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The Temporal Method: An Example

COGS COGS was LC648 in 2001. Assuming FIFO as the inventory accounting method, this means that the 2000 inventory of 210 has been sold and the rest has been purchased throughout 2001 at the 2001 average exchange rate. That is, COGS2001 = 648 210 210 + = $539. 1.25 1.18

The same procedure can be applied to obtain 2002 COGS.

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The Temporal Method: An Example

Inventory Since COGS in both 2001 and 2002 is greater than the previous year-end inventory, inventory in 2001 and 2002 was 2001 : 2002 : 264 = $224 1.18 372 = $310 1.20

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The Temporal Method: An Example

Fixed Assets Fixed assets in 2000 are obtained using the exchange rate at the acquisition date. Whenever xed assets are purchased within a year, it is done at the average annual exchange rate for that year. This gives us 2000 : 1, 032/1.25 2001 : 826 + (1, 512 1, 032)/1.18 = $826

= $1, 232

2002 : 1, 232 + (2, 028 1, 512)/1.20 = $1, 662

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The Temporal Method: An Example

Depreciation
The rate used to remeasure depreciation has to be consistent with the rates used to remeasure xed assets. To do so, we can dene blended rates that will be used with depreciation. In 2001, for example, the blended rate would be Blended rate for 2001 = and thus Dollar depreciation in 2001 = 252 = $205. 1.227
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1, 512 FA2001 in LC = = 1.227 FA2001 in $ 1, 232

The Temporal Method: An Example

Depreciation The same procedure applies for depreciation in 2002 and accumulated depreciation increases with the depreciation expense on the income statement. Retained earnings are such that the balance sheet balances, and thus a line for foreign exchange gain (or loss) has to be added to the income statement.

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The Temporal Method: An Example

Foreign Subsidiary, Inc. Assets as of December 31 (in $) 2000 Cash Accounts receivable Inventory Current assets Fixed assets Accumulated depreciation Net xed assets Total assets 33 288 168 489 826 144 682 1,170 2001 177 428 224 829 1,232 349 883 1,712 2002 328 467 310 1,105 1,662 595 1,067 2,172

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The Temporal Method: An Example

Foreign Subsidiary, Inc. Liabilities and Equity as of December 31 (in $) 2000 Accounts payable Notes payable Long-term debt Total liabilities Common stock Retained earnings Total equity Total liabilities and equity 245 106 134 485 221 465 685 1,170 2001 303 136 459 897 221 594 815 1,712 2002 236 177 777 1,190 221 761 982 2,172

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The Temporal Method: An Example

Foreign Subsidiary, Inc. Income Statement (in $) 2001 Revenues COGS Gross margin Depreciation Other expenses Foreign exchange gain (loss) Net income 1,312 539 773 205 421 (17) 129 2002 1,430 615 815 246 421 19 167

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Current Rate vs Temporal

What effect does each method have on the rms ratios?

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