Accounting Exposure
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Chapter 10 Accounting Exposure
Overview of Translation • Accounting exposure, also called translation 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 Indian rupee-denominated statements. 10-2
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). 10-3
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 each and every line item on the individual statement (I/S and B/S), there would be no imbalances resulting from the remeasurement – What if a different exchange rate were used for different line items on an individual statement (I/S and B/S)? – An imbalance would reslult 10-4
Overview of Translation • Why would we use a different exchange rate in remeasuring 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. 10-5
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. • 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. 10-6
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-today operations. • The US, requires that the functional currency of the foreign subsidiary be determined based on the nature and purpose of the subsidiary. 10-7
Overview of Translation • 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 remeasured, but also designate where any imbalance is to be recorded (current income or an equity reserve account).
10-8
Overview of Translation • 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 10-9
Overview of Translation • 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). 10-10
Overview of Translation • 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 remeasurement are carried directly to current consolidated income, and not to equity reserves (increased variability of consolidated earnings). 10-11
Overview of Translation • 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
10-12
Overview of Translation • The US differentiates foreign subsidiaries on the basis of functional currency, not subsidiary characterization. – If the financial statements of the foreign subsidiary are maintained in US dollars, translation is not required – If the statements are maintained in the local currency, and the local currency is the functional currency, they are translated by the current rate method – If the statements are maintained in local currency, and the US dollar is the functional currency, they are remeasured by the temporal method – If the statements are in local currency and neither the local currency or the US dollar is the functional currency, the statements must first be remeasured into the functional currency by the temporal method, and then translated into US dollars by the current rate method 10-13
Exhibit 10.2 Procedure Flow Chart for United States Translation Practices Purpose: Foreign currency financial statements must be translated into U.S. dollars If the financial statements of the foreign subsidiary are expressed in a foreign currency, the following determinations need to be made. Is the local currency the functional currency?
Yes
No Is the dollar the functional currency? Remeasure from foreign currency to functional (temporal method) and translate to dollars (current rate method)
Translated to dollars (current rate method)
No
Yes
Remeasure to dollars (temporal method)
* The term “remeasure” means to translate, as to change the unit of measure, from a foreign currency to the functional currency. 10-14
Overview of Translation • Many of the world’s largest industrial countries – as well as the relatively newly formed 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 – Self-sustaining foreign entities are translated at the current rate method, also termed the closing-rate method. 10-15
Translation Procedure in India • In India Accounting Standard 11 is applied in translating the financial statements of foreign operations. • This Statement does not specify the currency in which an enterprise presents its financial statements. • However, an enterprise normally uses the currency of the country in which it is domiciled. • If it uses a different currency, this Statement requires disclosure of the reason for using that currency. 10-16
Translation Procedure in India • This Statement also requires disclosure of the reason for any change in the reporting currency. • This Statement does not deal with the restatement of an enterprise’s financial statements from its reporting currency into another currency for the convenience of users accustomed to that currency or for similar purposes. 10-17
Translation Procedure in India • This Statement does not deal with the presentation in a cash flow statement of cash flows arising from transactions in a foreign currency and the translation of cash flows of a foreign operation which is dealt in Accounting Standard for Cash Flow Statements. • This Statement also does not deal with exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs 10-18
Translation Procedure in India • At each balance sheet date: 1. Foreign currency monetary items should be reported using the closing rate. However, in certain circumstances, the closing rate may not reflect with reasonable accuracy the amount in reporting currency that is likely to be realised from, or required to disburse, a foreign currency monetary item at the balance sheet date, e.g., where there are restrictions on remittances or where the closing rate is unrealistic and it is not possible to effect an exchange of currencies at that rate at the balance sheet date. 2. Non-monetary items which are carried in terms of historical cost denominated in a foreign currency should be reported using the exchange rate at the date of the transaction; and non-monetary items which are carried at fair value or other similar valuation denominated in a foreign currency should be reported using the exchange rates that existed when the values were determined.
10-19
Translation Procedure in India • For the purposes of disclosure the statement prescribes that an enterprise should disclose: 1. the amount of exchange differences included in the net profit or loss for the period; and net exchange differences accumulated in foreign currency translation reserve as a separate component of shareholders’ funds, and a reconciliation of the amount of such exchange differences at the beginning and end of the period. 10-20
Translation Procedure in India 2. When there is a change in the classification of a significant foreign operation, an enterprise should disclose: • the nature of the change in classification; • the reason for the change; • the impact of the change in classification on shareholders’ funds; and • the impact on net profit or loss for each prior period presented had the change in classification occurred at the beginning of the earliest period presented.
10-21
Translation Procedure in India • The revised AS 11 (2003) uses the terms, integral foreign operation and non-integral foreign operation respectively for the expressions “foreign operations that are integral to the operations of the reporting enterprise” and “foreign entity” used in IAS 21. • The intention is to communicate the meaning of these terms concisely. • This change has no effect on the requirements in revised AS 11 (2003). • Revised AS 11 (2003) provides additional implementation guidance by including two more indicators for the classification of a foreign operation as a non-integral foreign operation 10-22
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. 10-23
Managing Translation Exposure • The cost of a balance sheet hedge depends on relative borrowing costs. • These hedges are a compromise in which the denomination of balance sheet accounts is altered, perhaps at a cost in terms of interest expense or operating efficiency, to achieve some degree of foreign exchange protection. 10-24
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 10-25
Managing Translation Exposure • Management will find it almost impossible to offset both translation and transaction exposure at the same time. • As a general matter, firms seeking to reduce both types of exposure usually reduce transaction exposure first. • Taxes complicate the decision to seek protection against transaction or translation exposure. • Transaction losses are considered “realized” and are deductible from pre-tax income while translation losses are only “paper” losses and are not deductible from pre-tax income.
10-26
Evaluation of Performance • An MNE must be able to set specific financial goal, monitor progress by all units of the enterprise towards those goals, and evaluate results. • An MNE must be able to measure the performance of each of its subsidiaries on a consistent basis, and managers of subsidiaries must be given unambiguous objectives against which they will be judged. 10-27
Evaluation of Performance • The MNE must determine for itself the proper balance between three operating financial objectives: – Maximization of consolidated after-tax income – Minimization of the firm’s effective global tax burden – Correct positioning of the firm’s income, cash flows, and available funds
• These goals are frequently inconsistent. 10-28
Evaluation of Performance • Managers of foreign subsidiaries must be able to run their own operations efficiently according to achievable objectives. • All firms expand and modify their domestic profitability measures when applying them to foreign subsidiaries. • In addition, some firms establish foreign subsidiaries for objectives not related to normal corporate profit-oriented goals. 10-29
Evaluation of Performance • There are four purposes of an internal evaluation system: – To ensure adequate profitability – To have an early warning system if something is wrong – To have a basis for allocating resources – To evaluate individual managers
10-30
Evaluation of Performance • International financial evaluation of foreign subsidiaries is both unique and difficult. • Use of one foreign exchange translation method, in an attempt to measure results in the home currency, will present a different measure of success or of compliance with predetermined goals than use of some other translation method.
10-31
Evaluation of Performance • The results of any control system must be judged against distortions of performance caused by widely differing national business environments. • International measurement systems are distorted by decisions to benefit the world system (MNE) at the expense of a specific local subsidiary. 10-32
Evaluation of Performance • The impact of exchange rate movements on the measured performance of foreign subsidiaries is one of the single largest dilemmas facing management of the MNE. • The evaluation of the performance of an MNE subsidiary involves three different evaluation dimensions: – Management evaluation – Subsidiary evaluation – Strategic evaluation 10-33
Overview of Translation • Accounting exposure, also called translation 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 Indian rupee-denominated statements. 10-2
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). 10-3
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 each and every line item on the individual statement (I/S and B/S), there would be no imbalances resulting from the remeasurement – What if a different exchange rate were used for different line items on an individual statement (I/S and B/S)? – An imbalance would reslult 10-4
Overview of Translation • Why would we use a different exchange rate in remeasuring 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. 10-5
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. • 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. 10-6
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-today operations. • The US, requires that the functional currency of the foreign subsidiary be determined based on the nature and purpose of the subsidiary. 10-7
Overview of Translation • 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 remeasured, but also designate where any imbalance is to be recorded (current income or an equity reserve account).
10-8
Overview of Translation • 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 10-9
Overview of Translation • 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). 10-10
Overview of Translation • 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 remeasurement are carried directly to current consolidated income, and not to equity reserves (increased variability of consolidated earnings). 10-11
Overview of Translation • 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
10-12
Overview of Translation • The US differentiates foreign subsidiaries on the basis of functional currency, not subsidiary characterization. – If the financial statements of the foreign subsidiary are maintained in US dollars, translation is not required – If the statements are maintained in the local currency, and the local currency is the functional currency, they are translated by the current rate method – If the statements are maintained in local currency, and the US dollar is the functional currency, they are remeasured by the temporal method – If the statements are in local currency and neither the local currency or the US dollar is the functional currency, the statements must first be remeasured into the functional currency by the temporal method, and then translated into US dollars by the current rate method 10-13
Exhibit 10.2 Procedure Flow Chart for United States Translation Practices Purpose: Foreign currency financial statements must be translated into U.S. dollars If the financial statements of the foreign subsidiary are expressed in a foreign currency, the following determinations need to be made. Is the local currency the functional currency?
Yes
No Is the dollar the functional currency? Remeasure from foreign currency to functional (temporal method) and translate to dollars (current rate method)
Translated to dollars (current rate method)
No
Yes
Remeasure to dollars (temporal method)
* The term “remeasure” means to translate, as to change the unit of measure, from a foreign currency to the functional currency. 10-14
Overview of Translation • Many of the world’s largest industrial countries – as well as the relatively newly formed 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 – Self-sustaining foreign entities are translated at the current rate method, also termed the closing-rate method. 10-15
Translation Procedure in India • In India Accounting Standard 11 is applied in translating the financial statements of foreign operations. • This Statement does not specify the currency in which an enterprise presents its financial statements. • However, an enterprise normally uses the currency of the country in which it is domiciled. • If it uses a different currency, this Statement requires disclosure of the reason for using that currency. 10-16
Translation Procedure in India • This Statement also requires disclosure of the reason for any change in the reporting currency. • This Statement does not deal with the restatement of an enterprise’s financial statements from its reporting currency into another currency for the convenience of users accustomed to that currency or for similar purposes. 10-17
Translation Procedure in India • This Statement does not deal with the presentation in a cash flow statement of cash flows arising from transactions in a foreign currency and the translation of cash flows of a foreign operation which is dealt in Accounting Standard for Cash Flow Statements. • This Statement also does not deal with exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs 10-18
Translation Procedure in India • At each balance sheet date: 1. Foreign currency monetary items should be reported using the closing rate. However, in certain circumstances, the closing rate may not reflect with reasonable accuracy the amount in reporting currency that is likely to be realised from, or required to disburse, a foreign currency monetary item at the balance sheet date, e.g., where there are restrictions on remittances or where the closing rate is unrealistic and it is not possible to effect an exchange of currencies at that rate at the balance sheet date. 2. Non-monetary items which are carried in terms of historical cost denominated in a foreign currency should be reported using the exchange rate at the date of the transaction; and non-monetary items which are carried at fair value or other similar valuation denominated in a foreign currency should be reported using the exchange rates that existed when the values were determined.
10-19
Translation Procedure in India • For the purposes of disclosure the statement prescribes that an enterprise should disclose: 1. the amount of exchange differences included in the net profit or loss for the period; and net exchange differences accumulated in foreign currency translation reserve as a separate component of shareholders’ funds, and a reconciliation of the amount of such exchange differences at the beginning and end of the period. 10-20
Translation Procedure in India 2. When there is a change in the classification of a significant foreign operation, an enterprise should disclose: • the nature of the change in classification; • the reason for the change; • the impact of the change in classification on shareholders’ funds; and • the impact on net profit or loss for each prior period presented had the change in classification occurred at the beginning of the earliest period presented.
10-21
Translation Procedure in India • The revised AS 11 (2003) uses the terms, integral foreign operation and non-integral foreign operation respectively for the expressions “foreign operations that are integral to the operations of the reporting enterprise” and “foreign entity” used in IAS 21. • The intention is to communicate the meaning of these terms concisely. • This change has no effect on the requirements in revised AS 11 (2003). • Revised AS 11 (2003) provides additional implementation guidance by including two more indicators for the classification of a foreign operation as a non-integral foreign operation 10-22
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. 10-23
Managing Translation Exposure • The cost of a balance sheet hedge depends on relative borrowing costs. • These hedges are a compromise in which the denomination of balance sheet accounts is altered, perhaps at a cost in terms of interest expense or operating efficiency, to achieve some degree of foreign exchange protection. 10-24
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 10-25
Managing Translation Exposure • Management will find it almost impossible to offset both translation and transaction exposure at the same time. • As a general matter, firms seeking to reduce both types of exposure usually reduce transaction exposure first. • Taxes complicate the decision to seek protection against transaction or translation exposure. • Transaction losses are considered “realized” and are deductible from pre-tax income while translation losses are only “paper” losses and are not deductible from pre-tax income.
10-26
Evaluation of Performance • An MNE must be able to set specific financial goal, monitor progress by all units of the enterprise towards those goals, and evaluate results. • An MNE must be able to measure the performance of each of its subsidiaries on a consistent basis, and managers of subsidiaries must be given unambiguous objectives against which they will be judged. 10-27
Evaluation of Performance • The MNE must determine for itself the proper balance between three operating financial objectives: – Maximization of consolidated after-tax income – Minimization of the firm’s effective global tax burden – Correct positioning of the firm’s income, cash flows, and available funds
• These goals are frequently inconsistent. 10-28
Evaluation of Performance • Managers of foreign subsidiaries must be able to run their own operations efficiently according to achievable objectives. • All firms expand and modify their domestic profitability measures when applying them to foreign subsidiaries. • In addition, some firms establish foreign subsidiaries for objectives not related to normal corporate profit-oriented goals. 10-29
Evaluation of Performance • There are four purposes of an internal evaluation system: – To ensure adequate profitability – To have an early warning system if something is wrong – To have a basis for allocating resources – To evaluate individual managers
10-30
Evaluation of Performance • International financial evaluation of foreign subsidiaries is both unique and difficult. • Use of one foreign exchange translation method, in an attempt to measure results in the home currency, will present a different measure of success or of compliance with predetermined goals than use of some other translation method.
10-31
Evaluation of Performance • The results of any control system must be judged against distortions of performance caused by widely differing national business environments. • International measurement systems are distorted by decisions to benefit the world system (MNE) at the expense of a specific local subsidiary. 10-32
Evaluation of Performance • The impact of exchange rate movements on the measured performance of foreign subsidiaries is one of the single largest dilemmas facing management of the MNE. • The evaluation of the performance of an MNE subsidiary involves three different evaluation dimensions: – Management evaluation – Subsidiary evaluation – Strategic evaluation 10-33
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