Chapter 16 Translation Exposure to Currency Risk

1. Chapter 16Translation Exposure to Currency Risk 16.1 Measuring Translation Exposure The Current/Noncurrent Method in Use Prior to 1976 The Temporal or Monetary/Nonmonetary Method of FAS #8 The Current Rate Method of FAS #52 16.2 Which Translation Method is the Most Realistic 16.3 Corporate Hedging of Translation Exposure 16.4 Accounting for Financial Market Transactions 16.5 Summary and Conclusions

2. Translation exposure to currency risk • Translation (accounting) exposure to currency risk refers to the impact of exchange rate changes on the parent firm’s consolidated financial statements • Financial accounting strives for • Reliability • Validity • These objectives can be in conflict when the market values of assets or liabilities are unobservable

3. Translation accounting methods • The current/noncurrent method • in use in the United States prior to 1976 • The temporal or monetary/nonmonetary method • used in the United States with FAS #8 (1975) • The current/noncurrent method • used in the United States with FAS #52 (1981)

4. The current/noncurrent methodin use prior to 1976 • Current assets and liabilities are translated at the current exchange rate. • Noncurrent assets and liabilities are translated at historical exchange rates. • Most income statement items are translated at the average exchange rate over the reporting period. • Depreciation is translated at historical exchange rates.

5. The temporal or monetary/nonmonetary method of FAS #8 (1975) • Monetary assets and liabilities are translated at the current exchange rate. • All other assets and liabilities are translated at historical exchange rates. • Most income statement items are translated at the average exchange rate over the reporting period. • Depreciation and COGS are translated at historical exchange rates.

6. The problem with FAS #8 • Translation gains or losses were reflected in reported earnings on the income statement. • Changes in translated accounts could overwhelm operating performance, resulting in operating losses even during profitable years. • This resulted in large swings in reported earnings - swings over which managers had no control.

7. The current rate method of FAS #52 (1981) • All assets and liabilities except common equity are translated at the current exchange rate. • Common equity is translated at historical exchange rates. • Income statement items are translated at the current exchange rate. • Any imbalance between the book value of assets and liabilities is recorded as a separate equity account called the cumulative translation adjustment (CTA).

8. A comparison of translation methods Translation method:FAS #8FAS #52 Current/ Monetary/ noncurrent nonmonetary Current rate Assets Short-term financial assets current current current Long-term financial assets historical current current Real assets historical historical current Liabilities and owners’ equity Short-term financial liabilities current current current Long-term financial liabilities historical current current Net worth (common equity) historical historical historical Translation gains or losses flowed through flowed through accumulated the income the income in the CTA statement statement account

9. Corporate hedging of translation exposure • Finance theory states that the firm should only consider hedging risk exposures that are related to firm value. • Hedging has value when it can reduce the variability of firm value and thereby reduce expected taxes, costs of financial distress, or agency costs. • There is no value in hedging noncash transactions that do not cost or risk cash. • Translation exposure involves reported income statement and balance sheet accounts and may or may not involve cash flows.

10. Corporate hedging of translation exposure • Information-based reasons for hedging translation exposure • Satisfying loan covenants • Meeting profit forecasts • Retaining a credit rating • Each of these justifications relies on costly or restricted access to information on the part of investors or information providers.

11. Corporate hedging of translation exposure • There appear to be cross-country differences in corporate hedging of translation exposures, with a greater willingness to hedge on the part of non-U.S. companies than U.S. companies • Studies have compared the hedging policies of companies from each of the following countries with similar U.S. firms • Germany • Finland • United Kingdom

12. Corporate hedging of translation exposure • Policy recommendations • Do not hedge translation exposures unless the purpose is to reduce economic exposure to currency risk. • Use local sources of debt or equity capital to the extent permitted by the MNC’s overall financial goals. • Structure performance evaluation and compensation so that managers are insulated from exchange rates. • If hedging of a unit’s translation exposure is necessary to align managerial incentives with shareholder objectives, treasury should quote market prices. • Noncash exposures should be hedged internally. • Net transaction or operating exposures can be hedged in external financial markets.

13. Accounting for financial market transactions • FAS #133 Accounting for Derivative Instruments and Hedging Activities” • Derivatives are assets and liabilities that should be reported in financial statements. • Fair (market) value is the most relevant measure of value. • Only assets and liabilities should be reported as such. Income and expenses should be reported on the income statement. • Special accounting rules should be limited to qualifying hedge transactions.