Management of Translation Exposure

Chapter Ten
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 Chapter Outline
• Translation Methods
• FASB Statement 8
• FASB Statement 52
• International Accounting Standards
• Management of Translation Exposure
• Empirical Analysis of the Change from
FASB 8 to FASB 52
• Summary
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 Translation Exposure
• Translation exposure
– The effect that unanticipated changes in
exchange rates has on the firm’s consolidated
financial statements.
– An accounting issue.
 Translation Methods
• Current/Noncurrent Method
• Monetary/Nonmonetary Method
• Temporal Method
• Current Rate Method

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 Current/Noncurrent Method
• The underlying principal is that assets and
liabilities should be translated based on their
maturity.
– Current assets (and liabilities) translated at the spot
rate.
– Noncurrent assets translated at the historical rate in
effect when the item was first recorded on the books.

• For income statement, most items translated at

average exchange rate

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 Current/Noncurrent Method
• Current assets Balance Sheet Local Current/
translated at the spot Currency Noncurrent
rate. Cash € 2,100 $1,050
e.g. €2 = $1 Inventory € 1,500 $750
Net fixed assets € 3,000 $1,000
• Noncurrent assets
Total Assets € 6,600 $2,800
translated at the
Current liabilities € 1,200 $600
historical rate in
Long-Term debt € 1,800 $600
effect when the item
Common stock € 2,700 $900
was first recorded on
Retained earnings € 900 $700
the books.
CTA -------- --------
e.g. €3 = $1 Total Liabilities and € 6,600 $2,800
Equity
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 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, etc.) are translated at the historical
exchange rate in effect when the account was first
recorded.
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 Monetary/Nonmonetary Method
• All monetary balance Balance Sheet Local Monetary/
sheet accounts are Currency Nonmonetary
translated at the Cash € 2,100 $1,050
current exchange Inventory € 1,500 $500
rate. e.g. €2 = $1 Net fixed assets € 3,000 $1,000
• All other balance Total Assets € 6,600 $2,550
sheet accounts are Current liabilities € 1,200 $600
translated at the Long-Term debt € 1,800 $900
historical exchange Common stock € 2,700 $900
rate in effect when the Retained earnings € 900 $0
account was first
CTA -------- --------
recorded. e.g. €3 = $1
Total Liabilities and € 6,600 $2,400
Equity

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 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.
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 Temporal Method
• Items carried on the Balance Sheet Local Temporal
books at their current Currency
value are translated at Cash € 2,100 $1,050
the spot exchange rate.
Inventory € 1,500 $900
e.g. €2 = $1
Net fixed assets € 3,000 $1,000
• Items that are carried Total Assets € 6,600 $2,950
on the books at
historical costs are Current liabilities € 1,200 $600
translated at the Long-Term debt € 1,800 $900
historical exchange Common stock € 2,700 $900
rates. Retained earnings € 900 $0
e.g. €3 = $1 CTA -------- --------
Total Liabilities and € 6,600 $2,400
Equity

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 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 balance
the balance sheet.

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 Current Rate Method
• All balance sheet items
(except for stockholder’s Balance Sheet Local Current
equity) are translated at the Currency Rate
current exchange rate. Cash €2,100.00 $1,050
• A “plug” equity account Inventory €1,500.00 $750
named cumulative Net fixed assets €3,000.00 $1,500
translation adjustment is Total Assets €6,600.00 $3,300
used to balance the
balance sheet. Current liabilities €1,200.00 $600
Long-Term debt €1,800.00 $900
Common stock €2,700.00 $900
Retained earnings €900.00 $360
CTA -------- $540
Total Liabilities €6,600.00 $3,300
and Equity
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 Measuring Translation Exposure
• Data from Phuket Noodles, a subsidiary of Penang Noodle Corp. of
Malaysia as on January 1, 2014 is given below (in thousand).The
exchange rate on that date was B10.5460/RM.
Cash B120,000
A/c receivables 240,000
Inventory 180,000
Fixed assets 320,000
Current liabilities 100,000
Long-term debt 180,000
Common equities 580,000
a. Using current rate method, what is Phuket Noodles contribution to
its parent translation exposure as on Jan 1, 2014, in both
currencies.
b. If the exchange rate on Jan 1, 2015 is B10.6200/RM, does Penang
Noodle make a gain or a loss? How much?
• Preliminary calculations:

In Baht RM @ B10.546/RM RM@ B10.620/RM

Exposed asset 860,000,000 RM81,547,506 RM80,979,283
Less: Exposed liab. 280,000,000 26,550,351 26,365,348
Net exposure 580,000,000 54,997,155 54,613,935

a. Translation exposure: B580,000,000 or RM54,997,155

b. Translation loss due to drop of baht:

Before: RM54,997,155
After: 54,613,935
Translation ___________
loss : RM382,220
 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

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 Balance Sheet Hedge
• Eliminates the mismatch between net assets
and net liabilities denominated in the same
currency.
• May create transaction exposure, however.
• For e.g., if a firm has net asset exposure of
$1000, and to eliminate this exposure it borrows
(liabilities) extra $1000, then this will create
transaction exposure, since it knows its
(contractual) payable of $1,000 is exposed to
forex risk.
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 Derivatives Hedge
• An example would be the use of a forward
contract with a maturity of the reporting
period to attempt to manage the
accounting numbers.
• Using a derivatives hedge to control
translation exposure really involves
speculation about foreign exchange rate
changes, however, which is not easy.
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