Chapter 10

Translation
Exposure
 Learning Objectives

• Explain the meaning behind the designation of a

foreign subsidiary’s “functional currency”
• Illustrate both the theoretical and practical
differences between the two primary methods of
translating or re-measuring foreign currency
denominated financial statements
• Understand how an accounting-based concept like
translation can have valuation impacts on
multinational firms
• Analyze the costs and benefits of managing
translation exposure

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 Overview of Translation

• Translation exposure, also called accounting

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
(foreign subsidiaries of U.S. companies)

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 Overview of Translation

• Translation exposure - potential 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,-when
change to single currency(facilitates comparisons
across subsidiaries)

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 Overview of Translation

• Translation in principle is simple:

– Foreign currency financial statements must be
restated in the parent company’s reporting currency
– If the same exchange rate were used to remeasure
every line item on I/S and B/S, there would be no
imbalances
– If a different exchange rate were used for different
line items on I/S and B/S, imbalances would result
• There are two financial statements for each subsidiary
that must be translated for consolidation: income
statement and balance sheet

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 Overview of Translation

• Why different exchange rates in remeasuring

different line items?
– Translation principles are often a complex compromise
between historical and current market valuation
– Historical exchange rates for certain equity accounts, fixed
assets, and inventory items
– Current exchange rates can be used for current assets,
current liabilities, income, and expense items

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 Translation Methods

• 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, either
method must designate
– The exchange rate individual I/S and B/S items are
remeasured
– Where any imbalance is to be recorded (current income or
an equity reserve account).

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 Current Rate Method

• Most prevalent method today

• All financial statement line items are translated at the
“current” exchange rate

• Assets and liabilities – translated at the current rate

• Income statement items – all items including depreciation
and cost of goods sold, are translated at either the actual
rate on the dates were incurred or at an appropriately
weighted average exchange rate for the period
• Dividends (distributions) - at the rate on payment date
• Common stock and paid-in capital - at historical rates. Year
end retained earning consist of the original year-beginning
retained earnings plus minus any income or loss for the
year
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 Current Rate Method

• Gains or losses caused by translation not included

in the consolidated net income.
• Reported separately and accumulated in a
separate equity reserve account (on the B/S) with
a title such as cumulative translation adjustment
(CTA)
• Advantage: the gain or loss on translation does
not pass through the income statement reducing
variability of reported earnings

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 Temporal Method

• Specific assets and liabilities are translated at

exchange rates consistent with the timing of the
item’s creation
• Assets such as inventory and net plant and
equipment are restated regularly to reflect market
value
• Gains or losses are carried directly to current
consolidated income increasing variability of
consolidated earnings

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 Temporal Method

• If items were not restated (carried at historical

cost), the temporal method becomes the
monetary/nonmonetary method of translation.
– Monetary A/L - at current rates
– Nonmonetary A/L - at historical rates (inventory
and fixed assets)
– I/S items - at the average exchange rate for the
period
– Dividends (distributions) - at the rate on
payment date
– Equity items – common stock and paid-in capital
account at historical rates

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 Overview of Translation

• World’s largest industrial countries and as well as

the 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
• Operates as an extension of the parent company, with cash flows and
general business lines that interrelated with those of the parent
– Self-sustaining foreign entities translated at the current
rate method or “closing-rate method”
• operates in the local economic environment independent of the parent
company.

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 Trident Corporation’s Translation
Exposure

• Trident Corporation, U.S.-based corporation with

U.S.
• Each subsidiary of Trident-the United States, Europe
and China have their own set financial statement
• Each constructed in the local currency (renminbi,
dollar, euro)
• income statements and balance sheet of subsidiary
will be translated into U.S. dollars for consolidation
and reporting

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 Trident Corporation’s Translation
Exposure
• Exhibit 10.2 shows Trident’s operating structure
• Exhibit 10.3 describes Trident’s sales and earnings by
operating unit for 2009 and 2010

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 Exhibit 10.2 Trident Corporation: US
Multinational

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 Exhibit 10.3 Trident Corporation,
Selected Financial Results, 2009-2010

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 Trident Corporation’s Translation
Exposure
• Even though earnings are up in local currency from 2009
to 2010,consolidated earnings are down slightly because
the euro lost value against the dollar dropping from
$1.40/€ to $1.32/€

• Same to the Chines subsidiary’s sales and earnings in

2009 and 2010.

• The Chinese renminbi, was revalued against the U.S.

dollar from Rmb6.83/$ to Rmb6.70/$. YUN600

• The result was an increase in the dollar value of both

Chines sales and profits

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 Trident Corporation’s Translation
Exposure

• The translation loss or gain is larger under the

current rate method because inventory and net
plant and equipment, as well as all monetary
assets, are deemed exposed (current rate)
• Asset decrease and liabilities and net worth
increase
• Managerial implications: depending on the
accounting method of the moment, management
might select different assets and liabilities for
reduction or increase

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 Exhibit 10.4 Trident Europe’s
Translation Loss After Depreciation of
the Euro: Current Rate Method

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 Exhibit 10.5 Trident Europe’s
Translation Loss After Depreciation of
the Euro: Temporal Method

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 Managing Translation Exposure

• The main technique to minimize translation

exposure is called a balance sheet hedge.
• Requires an equal amount of exposed foreign
currency assets and liabilities on a firm’s
consolidated balance sheet
• Zero net translation exposure
– In the temporal method, a zero net exposed position is called
monetary balance
– Cannot be achieved under the current rate method

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 Managing Translation Exposure

• When is a balance sheet hedge justified?

– The foreign subsidiary is about to be liquidated so that its
CTA would be realized
– Debt/equity ratios need to be maintained within specific
limits
– Management is evaluated on the basis of certain I/S and
B/S measures that are affected by translation losses or
gains
– Foreign subsidiary in a hyperinflationary environment

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 Summary of Learning Objectives

• Translation exposure is the potential for loss or

gain from translating foreign– currency-
denominated statements of foreign subsidiaries
into the parent’s reporting currency
• A foreign subsidiary’s functional currency is the
dominant currency used by that foreign subsidiary
in its day-today operations

10-27 © 2016, Pearson Education, Ltd. All rights reserved.

 Summary of Learning Objectives

• The two basic procedures for translation used in

most countries today are the current rate method
and the temporal method
• Technical aspects of translation include questions
about when to recognize gains or losses in the
income statement, the distinction between
functional and reporting currency, and the
treatment of subsidiaries in hyperinflation
countries

10-28 © 2016, Pearson Education, Ltd. All rights reserved.

 Summary of Learning Objectives

• Translation gains and losses can be quite different

from operating gains and losses, not only in
magnitude but also in sign. Management may need
to determine which is of greater significance prior
to deciding which exposure is to be managed first
• The main technique for managing translation
exposure is a balance sheet hedge. This calls for
having an equal amount of exposed foreign
currency assets and liabilities

10-29 © 2016, Pearson Education, Ltd. All rights reserved.