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30 Cards in this Set

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Translation Exposure

Exposure of an MNC's consolidated financial statements to exchange rate fluctuations; potential for accounting derived changes in owners equity or NI to occur because of need to translate foreign currency financial statements of foreign affiliates to consolidated financial statements; does not directly impact CFs

Translation Exposure Occurs when:

translates each subsidiary's financial data to its home currency for consolidated financial reporting; impacts reports and therefore could impact stock price

Does Translation Exposure Matter?

Cash Flow Perspective

Stock Price Perspective

Cash Flow Perspective

A weak spot rate today could lead to a weak exchange rate forecast and a weak expected CF or the future when the subsidiary's earnings are reported

Stock Price Perspective

Since a MNC translation exposure effects its consolidated earnings and many investors tend to use earnings when valuing firms, the MNC valuation may be effected

An MNC's degree of translation exposure is dependent on:

1) the proportion of its business conducted by foreign subsidiaries,

2) the locations of its foreign subsidiaries, and

3) the accounting methods that it uses for translation

Translation Exposure =

Exposed Assets - Exposed Liabilities

How do we define exposed?

Historical rate

Current rate

Historical Rate

When assets or liabilities were purchased or acquired or when revenues were recognized then we are not exposed because the rates will not change on the financial statements; same rate always used

Current Rate

We are exposed; not all line items on financial statements are not translated the same way, if we use different exchange rates on different items on financial statements then there will be an imbalance and there will be exposure

Why use a different exchange rate for different line items?

Translation principles differ among countries;

Historical Exchange rates: often used for certain equity accounts, fixed assets, or inventory items

Current Exchange rates: often used for current assets/liabilities, and income and expense items

Subsidiary Characterization

An integrated foreign entity OR

A self-sustaining foreign entity

An integrated foreign entity

Operates as an extension of the parent with CFs and business lines that are highly related

A self-sustaining foreign entity

Operates in the local economic environment independent of the parent company

Functional Currency

The currency of the primary economic environment in which the subsidiary operates and in which it generates CFs; dominate currency used by that foreign subsidiary; can be different from the parent company or the local environment currency or the same (day to day operations currency)

Methods for Translation

The Current Rate Method

The Temporal Method

Translation method must:

Designate the exchange rate individual balance sheet and income statement items are re-measured;

Designate where any imbalance is to be recorded

The Current Rate Method

- Most prevalent used method

- 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

The Current Rate Method: Gains or Losses

Caused by translation adjustments are not included in the calculation of consolidated net income; reported separately and accumulated in equity reserve account on the balance sheet with the title "Cumulative Translation Adjustment (CTA)"

Advantages of Current Rate Method

- the gain or loss on translation does not pass through the income statement but goes on specific account (reduces variability on reported earnings)

- Relative proportion of many balance sheet accounts remains the same

Disadvantage of Current Rate Method

Violates the accounting principle of carrying assets at historical costs

The Temporal Method

Some assets/liabilities are translated at current rates (based on whether they are monetary or non-monetary

- Monetary assets: cash, marketable securities, A/R ==> current rate

- Monetary liabilities: C/L, LT Debt ==> current rate

- Non-monetary assets/ liabilities: inventory and net plant and equipment ==> historical rates

The Temporal Method: Gains or Losses

Resulting from re-measurement are carried directly to current consolidated income;

Translation adjustments pass through the income statement and onto the balance sheet in the retained earnings account

What do U.S based MNCs do?

Base method of translation on the functional currency

U.S Based MNCs (rules):

4 Rules

4) If the statement are in local currency (euros) and neither the local currency (euro) nor the U.S dollar is the functional currency, functional currency is (yen):

1st re-measured into the functional currency (yen) by the temporal method

2nd translated into USD by the current rate method

Go from euros to Yen to USD

3) If the statements are maintained in local currency (euros) and the USD is the functional currency

Temporal method

2) If the statements are maintained in the local currency (euros),and the local currency (euros) is the functional currency (euros)

Current rate method

1) If the financial statements of the foreign subsidiary are maintained in U.S dollars:

Translation is not required

Limitations of Hedging Translation Exposure

1) Inaccurate earnings forecast will limit the ability of this translation exposure

2) Inadequate forward contracts for some currencies

3) Accounting distortions (translations gains/losses are based on the average exchange rate which is unlikely to be the same as the forward rate and translation losses are not tax deductible)

4) Increased transaction exposure by hedging translation exposure