Accounting Exposure

Overview of Translation
• Accounting exposure, also called translation
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 US dollar-denominated statements.
 Overview of Translation
• 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).
 Overview of Translation
– Foreign currency financial statements must be restated
in the parent company’s reporting currency

– If the same exchange rate were used to remeasure each

and every line item on the individual statement (I/S and
B/S), there would be no imbalances resulting from the
remeasurement

– What if a different exchange rate were used for different

line items on an individual statement (I/S and B/S)? - An
imbalance would reslult
 Overview of Translation
• Why would we use a different exchange rate in
remeasuring different line items?
– Translation principles in many countries are often a
complex compromise between historical and current
market valuation
– Historical exchange rates can be used for certain equity
accounts, fixed assets, and inventory items, while
current exchange rates can be used for current assets,
current liabilities, income, and expense items.
 Overview of Translation
• Most countries today specify the translation method
used by a foreign subsidiary based on the subsidiary’s
business operations (subsidiary characterization) e.g. a
foreign subsidiary’s business can be categorized as
either an integrated foreign entity or a self-sustaining
foreign entity.
• An integrated foreign entity is one that operates as an
extension of the parent, with cash flows and business
lines that are highly interrelated.
• A self-sustaining foreign entity is one that operates in
the local economic environment independent of the
parent company.
 Overview of Translation
• A foreign subsidiary’s functional currency
is the currency of the primary economic
environment in which the subsidiary
operates and in which it generates cash
flows.
• In other words, it is the dominant currency
used by that foreign subsidiary in its day-to-
day operations.
 Overview of Translation
• Two basic methods for the translation of foreign
subsidiary financial statements are employed
worldwide:
– The current rate method
– The 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).
 Overview of Translation
• 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
– Common stock and paid-in capital accounts are
translated at historical rates
 Overview of Translation
• 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).
 Overview of Translation
• 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).
 Overview of Translation
• 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
 Overview of Translation
• Many of the world’s largest industrial countries – as well as
the relatively newly formed International Accounting
Standards Committee (IASC) follow the same basic
translation procedure:
– A foreign subsidiary is an integrated foreign entity or a self-
sustaining foreign entity
– Integrated foreign entities are typically remeasured using the
temporal method
– Self-sustaining foreign entities are translated at the current rate
method, also termed the closing-rate method.
 Managing Translation Exposure
• The main technique to minimize translation exposure is
called a balance sheet hedge.
• A balance sheet hedge 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.
 Managing Translation Exposure
• The cost of a balance sheet hedge depends
on relative borrowing costs.
• These hedges are a compromise in which
the denomination of balance sheet accounts
is altered, perhaps at a cost in terms of
interest expense or operating efficiency, to
achieve some degree of foreign exchange
protection.
 Managing Translation Exposure
• 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
 Managing Translation Exposure
• Management will find it almost impossible to offset
both translation and transaction exposure at the same
time. As a general matter, firms seeking to reduce both
types of exposure usually reduce transaction exposure
first.
• Taxes complicate the decision to seek protection against
transaction or translation exposure.
• Transaction losses are considered “realized” and are
deductible from pre-tax income while translation losses
are only “paper” losses and are not deductible from
pre-tax income.
 Evaluation of Performance
• An MNE must be able to set specific financial
goal, monitor progress by all units of the
enterprise towards those goals, and evaluate
results.
• An MNE must be able to measure the performance
of each of its subsidiaries on a consistent basis,
and managers of subsidiaries must be given
unambiguous objectives against which they will
be judged.
 Evaluation of Performance
• The MNE must determine for itself the proper
balance between three operating financial
objectives:
– Maximization of consolidated after-tax income
– Minimization of the firm’s effective global tax burden
– Correct positioning of the firm’s income, cash flows,
and available funds

• These goals are frequently inconsistent.

 Evaluation of Performance
• Managers of foreign subsidiaries must be able to
run their own operations efficiently according to
achievable objectives.
• All firms expand and modify their domestic
profitability measures when applying them to
foreign subsidiaries.
• In addition, some firms establish foreign
subsidiaries for objectives not related to normal
corporate profit-oriented goals.
 Evaluation of Performance

• There are four purposes of an internal

evaluation system:
– To ensure adequate profitability
– To have an early warning system if something
is wrong
– To have a basis for allocating resources
– To evaluate individual managers
 Evaluation of Performance
• International financial evaluation of foreign
subsidiaries is both unique and difficult.
• Use of one foreign exchange translation
method, in an attempt to measure results in
the home currency, will present a different
measure of success or of compliance with
predetermined goals than use of some other
translation method.
 Evaluation of Performance
• The results of any control system must be
judged against distortions of performance
caused by widely differing national business
environments.
• International measurement systems are
distorted by decisions to benefit the world
system (MNE) at the expense of a specific
local subsidiary.
 Evaluation of Performance
• The impact of exchange rate movements on the
measured performance of foreign subsidiaries is one of
the single largest dilemmas facing management of the
MNE.
• The evaluation of the performance of an MNE
subsidiary involves three different evaluation
dimensions:
– Management evaluation
– Subsidiary evaluation
– Strategic evaluation