Translation Exposure BY RAHUL ROY

Agenda
How translation exposure arises?

Functional currency?
Current Rate Method vs. Temporal Method. Balance Sheet Hedge? Earnings Management.
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Translation Exposure
Potential for increase/ decrease in parents net worth & reported income due to forex change. Translation method differ:

based on operation
Integrated Foreign Entity: cash flow integrated w/ parent Self-sustaining Foreign Entity independent of parent

based on functional currency (currency of economic activity) Which currency is functional? Not a discretionary management
decision!
Cash flow Sales prices Sales market Expenses Financing Intercompany tranactions
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Translation Methods
Current (Closing) Rate Method Temporal Method
Assets & Liabilities: translate @ current rate Assets & Liabilities: (as of balance sheet date). -Monetary: translate @ current rates. -Non-monetary (inventory & fixed assets): @ historical rates Income statement Items: translate @ actual rate when items incurred. Income Statement Items: translated @ average rates except for depreciation & cost of goods sold (@ historical rates) Distributions: dividends translated @ the rate on date of payment.

Distributions: dividends translated @ the rate on date of payment.

Equity Items: Common stock & Paid-in capital translated @ historical rates. Retained earnings +/- income/loss for the year. Translation Adjustments: not included into consolidated income but in equity reserve account.

Equity Items: Common stock & Paid-in capital translated @ historical rates. Retained earnings +/- income/loss +/imbalance from translation. Translation Adjustments: unrealized forex gains/ losses included in primary earnings.
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US Translation Procedures
Purpose: Need to translate foreign subs statement into US$
If subs financial statements kept in $, no need for translation. Is local currency functional currency?

No
Is US$ functional currency? 1. Remeasure from foreign currency to functional by temporal method 2. Translate to US$ by current rate method

Yes

Use current rate method

No

Yes

Remeasure to US$ by temporal method

 FAS #52: US subs in countries where cumulative

inflation 100%+ over 3 years use temporal method

Hyperinflation Countries

Why? B/c if current rate method, depreciation

understated & profits overstated => book value of PP&E would disappear.

International Practices:
Integrated subsidiaries: re-measure using temporal
method. Self-sustaining subsidiaries: translate by current rate method.

Translation Example

Suppose EUR depreciated 16.67% from $1.2/EUR to $1.0/EUR Functional currency EUR, Parent: US$ PP&E, common stock acquired @ $1.276/EUR Inventory purchased/manufactured @ $1.218/EUR Exposed assets:asset whose value drops w/ depreciation of functional currency & rises w/ appreciation of functional currency. Net exposed assets: exposed assets exposed liability Implications:

Appreciation -> increase net exposed assets. Depreciation -> decrease net exposed assets.
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BALANCE SHEET TRANSLATION

CURRENT RATE METHOD Assets Cash Accounts receivable Inventory Net plant & equipment Total Dec-02 EUR ($/EUR) 1,600,000 1.20 3,200,000 1.20 2,400,000 1.20 4,800,000 1.20 12,000,000 Jan-03 $ ($/EUR) 1,920,000 1.00 3,840,000 1.00 2,880,000 1.00 5,760,000 1.00 14,400,000 $ 1,600,000 3,200,000 2,400,000 4,800,000 12,000,000

$ $ $ $ $

$ $ $ $ $

Liabilities & Net Worth Accounts payable 800,000 Short-term bank loan 1,600,000 Lont-term debt 1,600,000 Common stock 1,800,000 Retained earnings 6,200,000 CTA account Total 12,000,000 TEMPORAL METHOD Assets Cash Accounts receivable Inventory Net plant & equipment Total

1.20 1.20 1.20 1.28 1.20

$ $ $ $ $ $

960,000 1,920,000 1,920,000 2,296,800 7,440,000 (136,800) 14,400,000

1.00 1.00 1.00 1.28 1.20

$ $ $ $ $ $ $

800,000 1,600,000 1,600,000 2,296,800 7,440,000 (1,736,800) 12,000,000

Dec-02 EUR ($/EUR) 1,600,000 1.20 3,200,000 1.20 2,400,000 1.22 4,800,000 1.28 12,000,000

$ $ $ $ $

Jan-03 $ ($/EUR) 1,920,000 1.00 3,840,000 1.00 2,923,200 1.22 6,124,800 1.28 14,808,000

$ $ $ $ $

$ 1,600,000 3,200,000 2,923,200 6,124,800 13,848,000

Liabilities & Net Worth Accounts payable 800,000 Short-term bank loan 1,600,000 Lont-term debt 1,600,000 Common stock 1,800,000 Retained earnings 6,200,000 CTA account (loss) Total 12,000,000

1.20 1.20 1.20 1.28

$ $ $ $ $ $

960,000 1,920,000 1,920,000 2,296,800 7,711,200 14,808,000

1.00 1.00 1.00 1.28 1.20

$ $ $ $ $ $ $

800,000 1,600,000 1,600,000 2,296,800 7,711,200 (160,000) 8 13,848,000

How to manage accounting exposure?

Balance Sheet Hedge requires equal amount of exposed forex assets & liabilities on consolidated balance sheet

Termed monetary balance under temporal method Cost:

Costly if borrowing cost of parent higher.

How to manage it if depreciation expected?

Reduce EUR exposed assets, no change on EUR exposed liab. Increase EUR exposed liabilities, no change on EUR exposed
assets.

When balance sheet hedge justified?

Subs to be liquidated Firm has debt covenants to maintain debt/equity ratios Management evaluated on basis of certain income statement and
balance sheet measures Subs operating in hyperinflationary country
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For example

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Earnings Management
EARNINGS INCRASING EARNINGS SMOOTHING

LOSS AVOIDANCE

LOSS AVOIDANCE

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Things to remember
How translation exposure arises?

Functional currency?
Current Rate Method vs. Temporal Method. Balance sheet hedge

Earnings Management.
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