Chapter 11

Translation Exposure
 Overview of Translation

• Translation exposure, also called accounting

exposure, arises from the accounting process of
translation: 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.
Exhibit 11.1 Ganado’s Cross-
Border Investments and
Consolidation
 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
• 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 re-measure each and every
line item on the individual statement (income statement and balance
sheet), there would be no imbalances resulting from the re-
measurement Due to currency principle, we cannot use the same exchange rates for all currency.
– What if a different exchange rate were used for different line items on
an individual statement (I/S and B/S)?
– An imbalance would result
 Overview of Translation

• Why would we use a different exchange rate in re-

measuring 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).
• For example, a foreign subsidiary’s business can be categorized
as either an integrated foreign entity or a self-sustaining
foreign entity. the integrated foreign entity is closely related to its parent company.
• 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.
• The U.S. requires that the functional currency of the foreign
subsidiary be determined based on the nature and purpose of
the subsidiary. The U.S. does not distinguish between
subsidiaries that are integrated or self-sustaining.
 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, a translation
method must not only designate at what exchange rate
individual balance sheet and income statement items are re-
measured, but also designate where any imbalance is to be
recorded (current income or an equity reserve account).
 Translation Methods
• 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
 Translation Methods
• 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).
 Translation Methods
• 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 re-measurement are carried
directly to current consolidated income, and not to equity
reserves (increased variability of consolidated earnings).
 Translation Methods
• 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
 Exhibit 11.2 Flow Chart for
U.S. Translation Practices

2 steps involved
 Translation Methods
• Many of the world’s largest industrial countries—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 re-
measured using the temporal method
– Self-sustaining foreign entities are translated at
the current rate method, also termed the closing-
rate method.
 Ganado Corporation’s
Translation Exposure
• Ganado Corporation is a U.S.-based corporation with
foreign subsidiaries in Europe and China
• The company is publicly traded on the NYSE
• Each set of financials will be constructed in the local
currency (renminbi, dollar, euro), but the subsidiary
income statements and balance sheets will also be
translated into U.S. dollars
• See Exhibit 11.3
Exhibit 11.3 Ganado
Corporation: A U.S.
Multinational
 Ganado Corporation’s
Translation Exposure: Income
• Exhibit 11.4 describes Ganado’s sales and earnings by
operating unit for 2009 and 2010.
– 2010 Sales U.S. = $300M
– 2010 Sales Europe = $158.4M = $1.32/€ * €120M
– 2010 Sales China = $89.6M = Rmb600/Rmb6.7/$
• In the case of Europe, even though earnings are up in euro
from 2009 to 2010, consolidated earnings are down slightly
because the euro lost value against the dollar dropping from
$1.40/€ to $1.32/€.
• China’s earnings remains constant in RMB, but gains 1.9%
after translation.
 Exhibit 11.4 Ganado Corporation,
Selected Financial Results, 2009–
2010

the euro depreciates

if you invest in stock and the currency depreciates =>

we will lose our money

no country has a loss in

earnings after summarize, the consolidated FS
records a change in exchange rates
=> earnings when converting to US $
change. That's why it records loss
 Ganado Corporation’s
Translation Exposure:
Balance Sheet
• The functional currency of Ganado’s European
subsidiary is the euro, and the reporting currency of
its parent, Ganado Corporation, is the U.S. dollar
– Plant and equipment & long-term debt were
acquired, and common stock were issued some
time in the past when the exchange rate was
$1.2760/€
– Inventory currently on hand was purchased or
manufactured during the immediately prior
quarter when the average exchange rate was
$1.2180/€
 Ganado Corporation’s
Translation Exposure:
Balance Sheet
• As seen in Exhibits 11.5 and 11.6, 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
• Depending on the accounting method of the
moment, management might select different assets
and liabilities for reduction or increase—as a result
impacting “real” decisions
 Exhibit 11.5 Ganado Europe’s
Translation Loss After Depreciation of
the Euro: Current Rate Method
 Exhibit 11.6 Ganado Europe’s
Translation Loss After Depreciation of
the Euro: Temporal Method

non-monetary
items

the last value we need to add (minus) the translation gain (loss)
 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
• 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