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Fundamentals of Multinational Finance Sixth Edition

Chapter 11 Translation Exposure

Learning Objectives 11.1 Describe how the consolidation of a multinational firm’s foreign entities creates translation exposure

11.2 Examine the two major methods of translation, including their theoretical and practical differences

11.3 Understand how translation can potentially alter the value of a firm

11.4 Illustrate the cost and effectiveness of managing translation exposure

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Overview of Translation (1 of 7) • Translation Exposure

– aka Accounting Exposure § Arises because financial statements of foreign

subsidiaries, which are stated in foreign currency, must be restated in the parent’s reporting currency

– The main purpose of translation is to prepare consolidated financial statements for use by investors, creditors, and governments

– Management also uses the translated statements to assess the performance of foreign subsidiaries

Overview of Translation (2 of 7) • Consolidation Accounting

– The process of combining the financial results of all subsidiary companies into the combined financial results of the parent company

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Overview of Translation (3 of 7) • Concepts and Definitions

– Example: § Ganado Corporation

– U.S.-based multinational parent company – Required to report consolidated financial results

according to U.S. GAAP in U.S. dollars § Ganado China

– A wholly owned foreign subsidiary of Ganado Corporation

– Maintains its financial statements in Chinese yuan

Overview of Translation (4 of 7) • Concepts and Definitions

– Example (cont.): § Ganado U.S.

– Wholly owned domestic subsidiary of Ganado Corporation

– Maintains its financial statements in U.S. dollars § Ganado Europe

– Wholly owned foreign subsidiary of Ganado Corporation based in Germany

– Maintains its financial statements in euros

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Exhibit 11.1: Consolidation and Translation of Financial Results for Ganado

Overview of Translation (5 of 7) • Concepts and Definitions

– Reporting Currency § The currency that the reporting entity uses to prepare its financial statements

and for consolidated reporting – Foreign Entity

§ Any distinct or separable business that prepares its financial statements in any currency other than the reporting currency of the parent company

– Distinct and Separable Operation § If the foreign subsidiary operates completely separately from the parent

company – Ganado Europe

– Integrated Foreign Entity § The foreign subsidiary operates as an extension of the parent company’s

operations – Ganado China

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Overview of Translation (6 of 7) • Concepts and Definitions

– Functional Currency § The currency of the primary economic environment in

which a distinct entity operates – Foreign Currency Financial Statements

§ Only the income statement and balance sheet need be translated for consolidation purposes

Overview of Translation (7 of 7) • Remeasurement and Translation

– Foreign Currency Measurement (Remeasurement) § The process by which a foreign entity expresses

transactions whose terms are denominated in a foreign currency in its functional currency

– Foreign Currency Translation § If a foreign entity’s financial statements are maintained

in a functional currency, and that functional currency is different from the reporting currency of the parent company, the process for preparation of the financial statements is termed translation

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Translation Methods (1 of 7) • Current Rate Method

– All financial statement line items are translated at the “current” exchange rate with few exceptions

– The most prevalent in the world today

• 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).

Translation Methods (2 of 7) • Current Rate Method

– Assets and Liabilities

§ Translated at the current rate of exchange

– Income Statement Items

§ Translated at the exchange rate on the dates they were recorded or an appropriately weighted average rate for the period

– Distributions (Dividends)

§ Translated at the rate in effect on the date of payment

– Equity Items

§ Common stock and paid-in capital accounts are translated at historical rates

§ Year-end retained earnings consist of the original year-beginning retained earnings +/− any income or loss for the year

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Translation Methods (3 of 7) • Current Rate Method

– Gains or losses caused by translation adjustments are not included in the calculation of consolidated net income

– Translation gains or losses are reported separately and accumulated in a separate equity reserve account on the balance sheet

Translation Methods (4 of 7) • Temporal Method

– Specific assets and liabilities are translated at exchange rates consistent with the timing of those items’ creation

– Assumes that a number of individual line item assets 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

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Translation Methods (5 of 7) • Temporal Method

– Monetary Assets and Monetary Liabilities § Translated at current exchange rates

– Nonmonetary Assets and Nonmonetary Liabilities § Translated at historical rates

– Income Statement Items § Translated at the average exchange rate for the period

– Distributions (Dividends) § Translated at the exchange rate on the date of payment

– Equity Items § Common stock and paid-in capital accounts are translated at historical rates § Year-end retained earnings consist of the original year-beginning retained

earnings +/− any income or loss for the year, +/− any imbalance from translation

Translation Methods (6 of 7) • U.S. Translation Procedures

– The U.S. differentiates foreign subsidiaries on the basis of functional currency, not subsidiary characterization. § If the financial statements of the foreign subsidiary of a U.S. company are

maintained in U.S. dollars, then translation is not required § If the financial statements of the foreign subsidiary are maintained in the local

currency and the local currency is the functional currency, then they are translated using the current rate method

§ If the financial statements of the foreign subsidiary are maintained in the local currency and the U.S. dollar is the functional currency, then they are remeasured using the temporal method

§ If the financial statements of foreign subsidiaries are maintained the local currency and neither the local currency nor the U.S. dollar is the functional currency, then the statements must first be remeasured into the functional currency by the temporal method, and then translated into dollars using the current rate method

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Exhibit 11.2: Flow Chart for U.S. Translation Practices

Translation Methods (7 of 7) • International Translation Process

– The accounting guidance for foreign currency reporting and translation issues in the United States is found in Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 830, Foreign Currency Matters

– More than 100 countries use International Financial Reporting Standards (IFRS)

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Exhibit 11.3: Differences Between U.S. GAAP and IFRS Regarding Translation

Issue International Financial Reported Standards (IFRS)

U.S. Generally Accepted Accounting Principles (GAAP)

Article for guidance IAS 21 and IAS 29 ASC 830

Determination of Functional Currency

International standards establish a

hierarchy of indicators (primary and

secondary) for determination of functional

currency.

U.S. practices require analysis of a

multitude of factors to determine the

functional currency. These indicators are

not ranked in any kind of a hierarchical

structure.

Hyperinflationary Economies

Even if the entity’s host country economy

qualifies as hyperinflationary, the functional

currency is retained.

If the entity’s host country economy

qualifies as hyperinflationary, financial

statements are remeasured as if the

parent company’s reporting currency was

the functional currency.

blank Any financial amounts that are not already

measured at the current rate of exchange

at the end of the period, those amounts

should be indexed using a general price

index, then translated into the reporting

currency at the current rate.

Any exchange rate differences calculated

through remeasurement are therefore

included in consolidated net income.

Ganado Corporation’s Translation Exposure (1 of 4) • Translation Exposure: Income

– Consolidated Sales § 2015

– Ganado USA • Sales of $300 million

– Ganado Europe • Sales of €120 million at $1.32/€ or $158.4 million

– Ganado China • Sales of YUN600 million at YUN6.70/$ or $89.6

million § Total global sales for 2015 were $548.0 million

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Ganado Corporation’s Translation Exposure (2 of 4) • Translation Exposure: Income

– Consolidated Earnings § 2015

– Ganado USA • Earnings of $28.6 million

– Ganado Europe • Earnings of €10.5 million at $1.32/€ or $13.9 million

– Ganado China • Earnings of YUN71.4 million at YUN6.70/$ or $10.7

million § Total global Earnings for 2015 were $53.2 million

Exhibit 11.4: Ganado Corporation, Selected Financial Results, 2014–2015

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Ganado Corporation’s Translation Exposure (3 of 4) • Translation Exposure: Balance Sheet

– Current Rate Method § The functional currency of Ganado’s European subsidiary is

the euro, and the reporting currency of its parent, Ganado Corporation, is the U.S. dollar

§ Plant and equipment and long-term debt and common stock issued some time in the past when the exchange rate was $1.2760/€

§ Inventory currently on hand was purchased or manufactured during the immediately prior quarter when the average exchange rate was $1.2180/€

§ Exhibit 11.5 shows the change in value under the current rate method

Exhibit 11.5: Ganado Europe’s Translation Loss After Depreciation of the Euro: Current Rate Method

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Ganado Corporation’s Translation Exposure (4 of 4) • Translation Exposure: Balance Sheet

– Temporal Method § Translation losses are not accumulated in a separate

equity account § They are passed directly through each quarter’s income

statement

Exhibit 11.6: Ganado Europe’s Translation Loss After Depreciation of the Euro: Temporal Method

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Managing Translation Exposure (1 of 5) • Balance Sheet Hedge

– The main technique to minimize translation exposure – 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

Managing Translation Exposure (2 of 5) • Balance Sheet Hedge

– Example: § To achieve a balance sheet hedge, Ganado Corporation must either (1)

reduce exposed euro assets without simultaneously reducing euro liabilities, or (2) increase euro liabilities without simultaneously increasing euro assets

§ One way to achieve this is to exchange existing euro cash for dollars § If Ganado Europe does not have large euro cash balances, it can borrow

euros and exchange the borrowed euros for dollars § Another subsidiary could also borrow euros and exchange them for

dollars § The essence of the hedge is for the parent or any of its subsidiaries to

create euro debt and exchange the proceeds for dollars. – Current Rate Method

§ Example:

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Managing Translation Exposure (3 of 5) • Balance Sheet Hedge

– Current Rate Method § Example:

– Under the current rate method, Ganado should borrow as much as €8,000,000

– The initial effect of this first step is to increase both an exposed asset (cash) and an exposed liability (notes payable) on the balance sheet of Ganado Europe, with no immediate effect on net exposed assets

– The required follow-up step can take two forms: (1) Ganado Europe could exchange the acquired euros for U.S. dollars and hold those dollars itself, or (2) it could transfer the borrowed euros to Ganado Corporation, perhaps as a euro dividend or as repayment of intracompany debt

– Ganado Corporation could then exchange the euros for dollars

Managing Translation Exposure (4 of 5) • Balance Sheet Hedge

– Temporal Method

§ Example:

– If translation is by the temporal method, the much smaller

amount of only €800,000 need be borrowed

– Ganado Europe could use the proceeds of the loan to

acquire U.S. dollars

– However, Ganado Europe could also use the proceeds to

acquire inventory or fixed assets in Europe

– Under the temporal method, these assets are not

regarded as exposed and do not drop in dollar value

when the euro depreciates

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Managing Translation Exposure (5 of 5) • When Is a Balance Sheet Hedge Justified?

– 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