Professional Documents
Culture Documents
Agenda
How translation exposure arises?
Functional currency?
Current Rate Method vs. Temporal Method. Balance Sheet Hedge? Earnings Management.
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Translation Exposure
Potential for increase/ decrease in parents 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
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Translation Methods
Current (Closing) Rate Method Temporal Method
Assets & Liabilities: translate @ current rate Assets & Liabilities: (as of balance sheet date). -Monetary: translate @ current rates. -Non-monetary (inventory & fixed assets): @ historical rates Income statement Items: translate @ actual rate when items incurred. Income Statement Items: translated @ average rates except for depreciation & cost of goods sold (@ historical rates) Distributions: dividends translated @ the rate on date of payment.
Equity Items: Common stock & Paid-in capital translated @ historical rates. Retained earnings +/- income/loss for the year. Translation Adjustments: not included into consolidated income but in equity reserve account.
Equity Items: Common stock & Paid-in capital translated @ historical rates. Retained earnings +/- income/loss +/imbalance from translation. Translation Adjustments: unrealized forex gains/ losses included in primary earnings.
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US Translation Procedures
Purpose: Need to translate foreign subs statement into US$
If subs financial statements kept in $, no need for translation. Is local currency functional currency?
No
Is US$ functional currency? 1. Remeasure from foreign currency to functional by temporal method 2. Translate to US$ by current rate method
Yes
No
Yes
Hyperinflation Countries
International Practices:
Integrated subsidiaries: re-measure using temporal
method. Self-sustaining subsidiaries: translate by current rate method.
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 @ $1.218/EUR Exposed assets:asset whose value drops w/ depreciation of functional currency & rises w/ appreciation of functional currency. Net exposed assets: exposed assets exposed liability Implications:
Appreciation -> increase net exposed assets. Depreciation -> decrease net exposed assets.
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$ $ $ $ $
$ $ $ $ $
Liabilities & Net Worth Accounts payable 800,000 Short-term bank loan 1,600,000 Lont-term debt 1,600,000 Common stock 1,800,000 Retained earnings 6,200,000 CTA account Total 12,000,000 TEMPORAL METHOD Assets Cash Accounts receivable Inventory Net plant & equipment Total
$ $ $ $ $ $
$ $ $ $ $ $ $
Dec-02 EUR ($/EUR) 1,600,000 1.20 3,200,000 1.20 2,400,000 1.22 4,800,000 1.28 12,000,000
$ $ $ $ $
Jan-03 $ ($/EUR) 1,920,000 1.00 3,840,000 1.00 2,923,200 1.22 6,124,800 1.28 14,808,000
$ $ $ $ $
Liabilities & Net Worth Accounts payable 800,000 Short-term bank loan 1,600,000 Lont-term debt 1,600,000 Common stock 1,800,000 Retained earnings 6,200,000 CTA account (loss) Total 12,000,000
$ $ $ $ $ $
$ $ $ $ $ $ $
Balance Sheet Hedge requires equal amount of exposed forex assets & liabilities on consolidated balance sheet
Reduce EUR exposed assets, no change on EUR exposed liab. Increase EUR exposed liabilities, no change on EUR exposed
assets.
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
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For example
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Earnings Management
EARNINGS INCRASING EARNINGS SMOOTHING
LOSS AVOIDANCE
LOSS AVOIDANCE
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Things to remember
How translation exposure arises?
Functional currency?
Current Rate Method vs. Temporal Method. Balance sheet hedge
Earnings Management.
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