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Translation Exposure (or chapter 10)

Translation Exposure (or chapter 10). Agenda. How translation exposure arises? Functional currency? Current Rate Method vs. Temporal Method. Balance Sheet Hedge? Earnings Management. Translation Exposure.

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Translation Exposure (or chapter 10)

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  1. Translation Exposure (or chapter 10)

  2. Agenda • How translation exposure arises? • Functional currency? • Current Rate Method vs. Temporal Method. • Balance Sheet Hedge? • Earnings Management.

  3. Translation Exposure • Potential for increase/ decrease in parent’s net worth & reported income due to forex change. • Translation method differ: • based on operation • Integrated Foreign Entity: cash flow integrated w/ parent • Self-sustaining Foreign Entity –independent of parent • based on functional currency (currency of economic activity) • Which currency is functional? Not a discretionary management decision! • Cash flow • Sales prices • Sales market • Expenses • Financing • Intercompany tranactions

  4. Translation Methods

  5. Purpose:Need to translate foreign subs statement into US$ If subs financial statements kept in $, no need for translation. Is local currency functional currency? Yes No Is US$ functional currency? Use current rate method 1. Remeasure from foreign currency to functional by temporal method 2. Translate to US$ by current rate method No Remeasure to US$ by temporal method Yes US Translation Procedures

  6. Hyperinflation Countries • FAS #52: US subs in countries where cumulative inflation 100%+ over 3 years use temporal method • Why? B/c if current rate method, depreciation understated & profits overstated => book value of PP&E would disappear. • International Practices: • Integrated subsidiaries: re-measure using temporal method. • Self-sustaining subsidiaries: translate by current rate method.

  7. Translation Example • Suppose EUR depreciated 16.67% from $1.2/EUR to $1.0/EUR • Functional currency EUR, Parent: US$ • PP&E, common stock acquired @ $1.276/EUR • Inventory purchased/manufactured @ $1.218/EUR • Exposed assets:asset whose value drops w/ depreciation of functional currency & rises w/ appreciation of functional currency. • Net exposed assets: exposed assets – exposed liability • Implications: • Appreciation-> increase net exposed assets. • Depreciation -> decrease net exposed assets.

  8. BALANCE SHEET TRANSLATION

  9. How to manage accounting exposure? • Balance Sheet Hedge –requires equal amount of exposed forex assets & liabilities on consolidated balance sheet • Termed monetary balance under temporal method • Cost: • Costly if borrowing cost of parent higher. • How to manage it if depreciation expected? • Reduce EUR exposed assets, no change on EUR exposed liab. • Increase EUR exposed liabilities, no change on EUR exposed assets. • When balance sheet hedge justified? • Subs to be liquidated • Firm has debt covenants to maintain debt/equity ratios • Management evaluated on basis of certain income statement and balance sheet measures • Subs operating in hyperinflationary country

  10. For example…

  11. Earnings Management EARNINGS INCRASING EARNINGS SMOOTHING LOSS AVOIDANCE LOSS AVOIDANCE

  12. Things to remember… • How translation exposure arises? • Functional currency? • Current Rate Method vs. Temporal Method. • Balance sheet hedge • Earnings Management.

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