Translation

Translation .
..Exposure
Definition
Translation Exposure – the potential

that the firm’s consolidated financial
statements can be affected by
changes in exchange rates.
Translation Exposure(contd)..
If a firm has subsidiaries in many countries
the fluctuations in exchange rate will make
the assets valuation different in different
periods. The changes in asset valuation
due to fluctuations in exchange rate will
affect the group’s asset , capital structure
ratios, profitability ratios , solvency ratios
etc.
Translation Exposure= Exposed Asset-
Exposed Liabilities
Why do we Care about
Translation?
 managers, analysts and investors need some
idea about the importance of the foreign
business  translated accounting data give an
approximate idea of this.
 performance measurement for bonus plans,
hiring, firing, and promotion decisions.
 accounting value serves as a benchmark to
evaluate valuation.
 for income tax purposes.
 legal requirement to consolidate financial
statements.
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.
generally accepted in the US from the 1930s
-1975, at which time FAS8 became effective.
Short-term gains/losses will be recognized
long term will not be.
Current/Noncurrent Method
Balance Sheet Local Current/
 Current assets Currency Noncurrent
/liabilities Cash € 2,100 $1,050
translated at the Inventory € 1,500 $750
spot rate. Net fixed assets € 3,000 $1,000
Total Assets € 6,600 $2,800
i.e. €2=$1 Current liabilities € 1,200 $600
 Noncurrent Long-Term debt € 1,800 $600
assets /liabilities Common stock € 2,700 $900
translated at the Retained earnings € 900 $700
historical rate in CTA -------- --------
effect when the Total Liabilities and € 6,600 $2,800
item was first Equity
recorded on the
books. i.e. €3=$1
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) are translated at the historical
exchange rate in effect when the account was first
recorded. i.e. PPP
Monetary/Nonmonetary
Method
 All monetary
Balance Sheet Local Monetary/
balance sheet Currency Nonmonetary
accounts are Cash € 2,100 $1,050
current exchange Net fixed assets € 3,000 $1,000
rate. i.e. €2=$1 Total Assets € 6,600 $2,550
Current liabilities € 1,200 $600
 All other balance Long-Term debt € 1,800 $900
sheet accounts are Common stock € 2,700 $900
translated at the Retained earnings € 900 $0
historical exchange CTA -------- --------
rate in effect when Total Liabilities and € 6,600 $2,400
Equity
the account was first
recorded. i.e.€3=$1
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.
 Note : Its modified form of Monetary/ Non Monetary

method where difference is that inventory could be also
recorded at current spot price of market value
Temporal Method
 Items carried on the
Balance Sheet Local Temporal
books at their Currency
current value are Cash € 2,100 $1,050
spot exchange rate. Net fixed assets Market Value€ 3,000 $1,000
i.e. €2=$1 Total Assets € 6,600 $2,950
 Items that are Current liabilities € 1,200 $600
Long-Term debt € 1,800 $900
carried on the Common stock € 2,700 $900
books at historical Retained earnings € 900 $0
costs are translated CTA -------- --------
at the historical Total Liabilities and € 6,600 $2,400
exchange rates. Equity
i.e. €3=$1
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.
Current Rate Method
Balance Sheet Local Current
 All balance sheet Currency Rate
items (except for
Cash €2,100.00 $1,050
stockholder’s equity)
are translated at the Inventory €1,500.00 $750
current exchange Net fixed assets €3,000.00 $1,500
rate. i.e. €2=$1 Total Assets €6,600.00 $3,300
 A “plug” equity Current liabilities €1,200.00 $600
account named Long-Term debt €1,800.00 $900
cumulative Common stock €2,700.00 $900
translation Retained earnings €900.00 $360
adjustment is used CTA -------- $540
to make the balance Total Liabilities €6,600.00 $3,300
sheet balance
and Equity
How Various Translation Methods
Deal with a Change
from €3 to €2 = $1
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

How Various Translation
Methods Deal with a Change
from €3 to €2 = $1
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
Long-Term debt €1,800 $600 Book
$900 $900 $900
Common stock €2,700 $900 value
$900 of $900 $900
Retained earnings €900 $700 $150
inventory $550 $360
CTA -------- -------- --------
historic -------- $540
and Equity
rate
Book value of inventory Current value of inventory

at spot exchange rate at spot exchange rate.
from €3 to €2 = $1
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
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
CTA -------- -------- -------- -------- $540
and Equity
historic rate
from €3 to €2 = $1
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
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
CTA -------- -------- -------- -------- $540
and Equity
spot rate
from €3 to €2 = $1
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
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
CTA -------- -------- -------- -------- $540
and Equity
historical rate spot rate

from €3 to €2 = $1
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
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
CTA -------- -------- -------- -------- $540
and Equity
historical rate
from €3 to €2 = $1
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
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
CTA -------- -------- -------- -------- $540
and Equity
From income statement

from €3 to €2 = $1
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
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
CTA -------- -------- -------- -------- $540
and Equity
Under the current rate method, a “plug” equity account named

cumulative translation adjustment makes the balance sheet balance.
from Local
€3 toCurrent/
€2 =Monetary/
$1 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 average exchange rate over the period, €2.50 = $1

from €3 to €2 = $1
Local Current/ Monetary/ Temporal Current
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
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Earnings € 900 $700 $150 $550 $360
Translate at €2.50 = $1 Translate at new exchange rate, €2.00 = $1

from €3 to €2 = $1
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
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Earnings € 900 $700 $150 $550 $360
Translate at €3 = $1 Translate at average exchange rate, €2.5 = $1

from €3 to €2 = $1
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
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Earnings € 900 $700 $150 $550 $360
Note the effect on after-tax profit.

from €3 to €2 = $1
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
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Earnings € 900 $700 $150 $550 $360
Note the effect that foreign exchange gains (losses) has on net income.
FAS8 – superseded
Essentially the temporal method, with some
subtleties,
such as translating inventory at historical
rates (a hassle).
Required taking foreign exchange gains and
losses through the income statement.
This lead to variability in reported earnings
(irritated corporate executives).
The Mechanics of FAS52
Function Currency
The currency that the business is
conducted in.
Reporting Currency
The currency in which the MNC
prepares its consolidated financial
statements.
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, re
measurement 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.
Parent’s currency
Foreign
Nonparent Functional Third currency
entity’s books
kept in? Currency?
Currency
Local currency Temporal
Remeasurement
Currency
Current Rate
Parent’s
Translation
Parent’s Currency
14- Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights re
Highly Inflationary
Economies
Highly inflationary economies—over
100% over three years
Foreign entities are required to
remeasure financial statements using
the temporal method “as if the
functional currency were the reporting
currency”.
Management of Translation
Exposure
Translation Exposure vs. Transaction
Exposure
Hedging Translation Exposure
Balance Sheet Hedge
Derivatives Hedge
Translation Exposure vs. Operating
Exposure
Translation Exposure versus
Transaction Exposure
Translation Exposure
The effect that unanticipated changes in exchange
rates has on the firm’s consolidated financial
statements  accounting issue.
Transaction Exposure
A effect that unanticipated changes in exchange
rates has on the firm’s cash flows  finance issue.
It is generally not possible to eliminate both
translation exposure and transaction exposure.
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
Balance Sheet Hedge
Eliminates the mismatch between net
assets and net liabilities denominated
in the same currency.
May create transaction exposure,
however.
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.
However, using a derivatives hedge
to control translation exposure really
involves speculation about foreign
exchange rate changes.
Translation Exposure versus
Operating Exposure
The effect that unanticipated changes
in exchange rates has on the firm’s
ongoing operations.
Operating (economic) exposure is a
substantive issue with which the
management of the firm should
concern itself with.
Empirical Analysis of the
Change from FAS8 to FAS52
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.
Relevance of Translation
(Accounting) Exposure
Should the exchange rate effect be shown as
part of the reporting period, or should it just be
mentioned on the balance sheet, as an
unrealized gain or loss?
Most of the gains are not realized  keep
gains/losses out of income statement.
Translation sounds great, but none of the three
methods produces the true economic value.
Relevance of Translation
(Accounting) Exposure
Should we worry about translation exposure
at all?
If so, should we worry what the best
translation method is?
choice doesn't affect any real cashflow
except for taxes.
only correct method is economic value
anyway
 simplicity/consistency: Current rate method.
The (Ir)relevance of Translation
Exposure*
Economic exposure is far more
relevant!
*P. Sercu and R. Uppal, International Financial Markets and the Firm, 1994
ECONOMIC EXPOSURE: ACCOUNTING EXPOSURE:
1. A forward looking concept: it focuses on 1. A backward-looking concept: it reflects past

future cashflows. decisions as reflected in the subsidiary's assets and
liabilities.
2. Involves real cashflows, not just accounting
figures. 2. A change in an accounting value due to
translation is not a "realized" gain or loss; no
3. Relates to changes in the economic value change in the cash situation is involved —except
(or, in an efficient market, the market value) possibly through taxation effects.
of the firm.
3. Changes the firm's accounting value, but not
4. Contractual exposure depends on the firm’s necessarily its market value.
portfolio of FC engagements undertaken in
the past. Operating exposure depends on the 4. Depends on the accounting rules chosen. This is
environment (especially the market structure because the subsidiary's own internal rules affect
and the input-output mix) and on the firm's its accounting values (e.g., type of depreciation, or
strategic response (e.g., relocation of inventory valuation methods) and also because the
production, changes in the marketing mix or translation process itself can be done in different
financial structure, etc.). ways (see below).
5. Also exists for firms without foreign 5. Accounting exposure only exists in the case of
subsidiaries, such as exporting firms, import- foreign direct investment, since pure exporting or
competing firms, and notably potential import-substituting firms have no foreign
import-competing firms. subsidiaries.

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Translation .

Translation Exposure – the potential

 Note : Its modified form of Monetary/ Non Monetary

Spot exchange rate

Book value of inventory Current value of inventory

historical rate spot rate

From income statement

Under the current rate method, a “plug” equity account named

Sales translate at average exchange rate over the period, €2.50 = $1

Translate at €2.50 = $1 Translate at new exchange rate, €2.00 = $1

Translate at €3 = $1 Translate at average exchange rate, €2.5 = $1

Note the effect on after-tax profit.

1. A forward looking concept: it focuses on 1. A backward-looking concept: it reflects past

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