Transcript Translation Exposure - Villanova University

Measuring Accounting
Exposure
0011 0010 1010 1101 0001 0100 1011
2
4
International Finance
Dr. A. DeMaskey
1
Learning Objectives
0011 0010 1010 1101 0001 0100 1011
• What are the three different types of foreign exchange
exposures?
• What is accounting exposure and how is it measured?
• What are the two primary methods of converting foreign
currency denominated financial statements into the
reporting currency of the U.S. parent company?
• What is transaction exposure and how is it measured?
• What is the difference between accounting measures of
exposure and the economic effects of currency changes on
the value of the firm?
1
2
4
Foreign Exchange Risk
Management
0011 0010 1010 1101 0001 0100 1011
• Exposure refers to the degree to which a
company is affected by exchange rate
changes.
• Exchange rate risk is defined as the
variability of a firm’s value due to uncertain
changes in the rate of exchange.
1
2
4
Types of Exposures
0011 0010 1010 1101 0001 0100 1011
• Accounting or Translation Exposure
• Economic Exposure
– Transaction Exposure
– Operating Exposure
1
2
4
Translation Exposure
0011 0010 1010 1101 0001 0100 1011
• It arises from the need, for purposes of
reporting and consolidation, to convert the
results of foreign operations from the local
currency to the home currency.
– Paper exchange gains or losses
– Retrospective in nature
– Short-term in nature
1
2
4
Transaction Exposure
0011 0010 1010 1101 0001 0100 1011
• It stems from the possibility of incurring
exchange gains or losses on transactions
already entered into and denominated in a
foreign currency.
1
2
4
– Real exchange gains or losses
– Mixes retrospective and prospective
– Short-term in nature
Operating Exposure
0011 0010 1010 1101 0001 0100 1011
• It arises because currency fluctuations
combined with price level changes can alter
the amounts and riskiness of a firm’s future
revenues and costs.
– Real exchange gains or losses
– Prospective in nature
– Long-term in nature
1
2
4
Economic Exposure
0011 0010 1010 1101 0001 0100 1011
• It is defined as the extent to which the value
of the firm, as measured by the present
value of all expected future cash flows, will
change when exchange rates change.
1
2
4
Measuring Translation Exposure
0011 0010 1010 1101 0001 0100 1011
• The difference between exposed assets and
exposed liabilities.
1
2
– Exposed assets and liabilities are translated at
the current exchange rate.
– Non-exposed assets and liabilities are translated
at the historical exchange rate.
4
Translation Methods
0011 0010 1010 1101 0001 0100 1011
• Current/Noncurrent Method
• Monetary/Nonmonetary Method
• Temporal Method
• Current Rate Method
1
2
4
FASB-8 (January 1, 1976)
0011 0010 1010 1101 0001 0100 1011
• Utilizes the temporal method for translating
balance sheet and income statement into the
U.S. dollar.
• Unrealized translation gains or losses were
recorded within the income statement
thereby affecting net income.
1
2
4
FASB-52 (December 15, 1981)
0011 0010 1010 1101 0001 0100 1011
• Utilizes the current rate method for
translating balance sheet and income
statement into the U.S. dollar.
• Unrealized translation gains or losses are
recorded in a separate equity account on the
parent’s consolidated balance sheet called
the “Cumulative Translation Adjustment
(CTA)” account.
1
2
4
Reporting vs. Functional
Currency
0011 0010 1010 1101 0001 0100 1011
• The reporting currency is the currency in
which the parent company prepares its own
financial statements.
• The functional currency is the currency of
the primary economic environment in which
the affiliate generates and expenses cash.
1
– Integrated foreign entity
– Self-sustained entity
2
4
US Translation Procedures
0011 0010 1010 1101 0001 0100 1011
• The US differentiates foreign subsidiaries on the
basis of the functional currency, not subsidiary
characterization.
• This, in turn, determines which translation method
is used:
– Local currency
Current rate method
– U.S. dollar
Temporal method
1
2
4
Hyperinflation Countries
0011 0010 1010 1101 0001 0100 1011
• A hyperinflationary country is one which
has cumulative inflation of approximately
100% or more over a three year period.
– Functional currency
U.S. dollar
– Translation method
Temporal method
1
2
4
Measuring Translation Exposure:
Illustration
0011 0010 1010 1101 0001 0100 1011
Zapata Auto Parts, the Mexican affiliate of American
Diversified, Inc., had the following balance sheet on January 1:
Assets (Ps million)
1
Liabilities (Ps million)
2
Cash, marketable securities 1,000
Current liabilities
47,000
Accounts receivables
50,000
Long-term debt
12,000
Inventory
32,000
Equity
135,000
Fixed assets
111,000
194,000
194,000
______________________________________________________________
The exchange rate on January 1st was Ps 8,000/$ and on December 31st is
Ps 12,000/$
4
Zapata Auto Parts
Translation Exposure to Exchange Rate Risk Under
Alternative Translation Methods (in Ps million)
0011 0010 1010 1101 0001 0100 1011
Current/
Monetary/
Noncurrent Nonmonetary Temporal
Translation Method
________________________________________________________________________________
Current
Cash and Marketable Sec.
Accounts Receivables
Inventory
Net Fixed Assets
1,000
50,000
32,000
111,000
Current Liabilities
Long-Term Debt
Equity
47,000
12,000
135,000
1
2
4
__________ ___________
__________ ________
========= ==========
=========
Net Exposure
=======
_________________________________________________________________________________
Note: The exchange rate on January 1st is Ps 8,000/$
Transaction Exposure
0011 0010 1010 1101 0001 0100 1011
• It arises from the various types of
transactions that require settlement in a
foreign currency.
1
2
– Purchasing or selling on credit goods or
services denominated in foreign currency.
– Borrowing and lending funds with repayment
made in foreign currency.
– Acquiring assets denominated in foreign
currency.
4
Net Transaction Exposure
0011 0010 1010 1101 0001 0100 1011
• Is measured currency by currency.
• Is the difference between contractually
fixed future cash inflows and cash outflows
in each currency.
• It represents real gains and losses.
1
2
4
Accounting Practice and
Economic Reality
0011 0010 1010 1101 0001 0100 1011
• Accounting focuses on:
– Earnings and book values.
– They reflect past decisions.
– Has virtually no impact on firm value.
• Finance focuses on:
– Cash flows and market values.
– They reflect future decisions.
– Directly affect firm value.
1
2
4