Module 6 - Foreign Exchange Exposure

Foreign exchange exposure is a measure of sensitivity of a firm's cash flows, market value and
profitability to change as a result of changes in exchange rates. As organizations are becoming
increasingly more globalised, firms are finding it necessary to pay special attention to foreign
exchange exposure and accordingly, design and implement suitable hedging strategies. The
primary goal of all MNCs is to protect the corporate cash flows from a negative impact of
exchange rate fluctuations.
There are mainly three forms, by which MNCs are exposed to exchange rate fluctuations,
(1) Transaction Exposure, (2) Translation Exposure and (3) Economic Exposure
Translation Exposure
Translation exposure, sometimes also called accounting exposure, refers to gains or losses caused
by the translation of foreign currency assets and liabilities into the currency of the parent
company for accounting purposes. Accounting exposure, also known as translation exposure,
arises because MNCs may wish to translate financial statements of foreign affiliates into their
home currency in order to prepare consolidated financial statements or to compare financial
results.
For example, foreign affiliates of US companies must restate the franc, sterling or mark
statements into US dollars so that the foreign values can be added to the parent US dollar
denominated balance sheet and income statement. This accounting process is called translation.
Assets and liabilities that are translated at the current exchange rate are considered to be exposed
as the balance sheet will be affected by fluctuations in currency values over time; those
translated at a historical exchange rate will be regarded as not exposed as they will not be
affected by exchange rate fluctuations. So, the difference between exposed assets and exposed
liabilities is called translation exposure.
Translation Exposure = Exposed assets - Exposed liabilities
Translation Methods: Four methods of foreign currency translation have been developed.

The current rate method

The monetary/non-monetary method

The temporal method.

The current/non-current method

The first two methods are allowed by the US accounting standard.

1. Current Rate Method:

Under this method all balance sheet and income items are translated at the current rate of
exchange, except for stockholders' equity which is translated at historical rate. Income statement
items including depreciation and cost of goods sold, are translated at either the actual exchange
rates on the dates the various revenues and expenses were incurred or at the weighted average
exchange rate for the period. Dividends paid are translated at the exchange rate prevailing on the
date the payment was made.
The common stock account and paid-in-capital accounts are translated at historical rates. Further,
gains or losses caused by translation adjustment are not included in the net income but are
reported separately and accumulated in a separate equity account known as Cumulative
Translation Adjustment (CTA). Thus CTA account helps in balancing the balance sheet balance,
since translation gains or losses are not adjusted through the income statement.

Advantages of Current Rate Method: The two main advantages of the current rate method are;

First, the relative proportions of the individual balance sheet accounts remain the same
and hence do not distort the various balance sheet ratios like the debt-equity ratio, current
ratio, etc.

Second, the variability in reported earnings due to foreign exchange gains or losses is
eliminated as the translation gain/loss is shown in a separate account - the CTA account.

Disadvantages of Current Rate Method:

The main drawback of the current rate method is that various items in the balance sheet
which are recorded at historical costs are translated back into dollars at a different rate.

2. Monetary/Non-Monetary Method:
The monetary/non-monetary method differentiates between monetary and non- monetary
items. Monetary items are those that represent a claim to receive or an obligation to pay a
fixed amount of foreign currency unit, e.g., cash, accounts receivable, current liabilities,
accounts payable and long term debt.
Non-monetary items are those items that do not represent a claim to receive or an obligation
to pay a fixed amount of foreign currency items, e.g., inventory, fixed assets, long-term
investments. According to this method, all monetary items are translated at the current rate
while non-monetary items are translated at historical rates.

Income statement items are translated at the average exchange rare for the period, except for
items such as depreciation and cost of goods sold that are directly associated with nonmonetary assets or liabilities. These accounts are translated at their historical rates.
3. Temporal Method:
This method is a modified version of the monetary/non-monetary method. The only
difference is that under the temporal method inventory is usually translated at the historical
rate but it can be translated at the current rate if the inventory is shown in the balance sheet at
market values. In the monetary/nonmonetary method inventory is always translated at the
historical rate. Under the temporal method, income statement items are normally translated at
an average exchange rate for the -Period. However, cost of goods sold and depreciation are
translated at historical rates.
4. Current/Non-Current Method:
The current/non-current method is perhaps the oldest approach. No longer allowable under
generally accepted accounting practices in the United States. Under the current/non-current
method, all current assets and current liabilities of foreign affiliates are translated into the
home currency at the current exchange rate while non-current assets and non- current
liabilities are translated at historical rates.
In the balance sheet, exposure to gains or losses from fluctuating currency values is
determined by the net of current assets less current liabilities. Gains or losses on long-term
assets and liabilities are not shown currently. Items in the income statement are generally
translated it the average exchange rate for the period covered. However, those items that
relate to revenue or expense items associated with non- current assets (such as depreciation
changes) or long-term liabilities (amortization of debt discount) are translated at the same rate
as the corresponding balance sheet items.
Comparison of Four Translation Methods
Monetary/Non-monetary Method

All monetary balance sheet accounts (cash, marketable securities, accounts receivable,

etc.) of a foreign subsidiary are translated at the current exchange rate.

All other (non-monetary) balance sheet accounts (owners' equity, land) are translated at

the historical exchange rate in effect when the account was first recorded.
Current-Non Current Method

All current assets and current liabilities of foreign affiliates are translated into the parent

currency at current exchange rates.

All non current assets, non current liabilities, and owner's equity are translated at

historical exchange rates.

Most income statement items are related to current assets or liabilities and are translated

at the average exchange rate over the reporting period.

Depreciation is related to non current assets and translated at the historical exchange rate

Temporal Method

Monetary assets and monetary liabilities are translated at current exchange rates.

Monetary assets include cash, accounts receivables, and notes receivable. In general, all

liabilities are monetary.

Non monetary assets, non monetary liabilities, and owner's equity are translated at

historical rates.
o

Non monetary assets include inventory and fixed assets.

Most Income statements items related to current items are translated at average ER

Depreciation and cost of goods sold are related to real assets ( Non monetary) and are

translated at historical ER
Current Rate Method

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 a 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).

FASB 8 and FASB 52

Due to exchange rate fluctuations of the early 1970's the Financial Accounting Standards
Board (FASB) was forced to study the issue. The study eventually became FASB 8. This was a
significant departure from prior methods. Basically FASB Statement No. 8 provided that
cash, receivables and payables were translated at current exchange rates while fixed assets and
liabilities were translated at historical rates. FASB 8 resulted in much criticism. Due to this
criticism the FASB sponsored another study that resulted in FASB 52.
The basic outcome of FASB 52 was that if a foreign entity's books are not kept in the
functional currency, then the books must be re-measured into the functional currency prior to
translation. For example, an U.S. parent may have a self-contained foreign subsidiary located
in Germany. The German subsidiary may have a branch located in France. The functional
currency is most likely German marks. The branch operations books kept in French francs
must be re-measured in German marks (the functional currency) before translation into the
reporting currency of the parent.

Unrealized foreign currency gains or losses, except from re-measurement, are separately stated
as a component of owner's equity. The accumulated translation adjustments are taken into
account in measuring the gain or loss on sale of the investment of the foreign operations.
Functional vs. Reporting Currency
According to FASB 52, firms must use the current rate method to translate foreign currency
denominated assets and liabilities into dollars. All foreign currency revenue and expense items
on the income statement must be translated at either the exchange rate in effect on the date
these items were recognized or at an appropriate weighted average exchange rate for the
period. The other important part about FASB 52 is that it requires translation gains and losses
to be accumulated and shown in a separate equity account on the parents balance sheet. This
account is known as the cumulative translation adjustment account.
FASB 52 differentiates between a foreign affiliates functional and reporting currency.
Functional currency is defined as the currency of the primary economic environment in which
the affiliate operates and in which it generates cash flows. Generally, this is the local currency
of the country in which the entity conducts most of its business. Under certain circumstances
the -functional currency may be the parent firms home country currency or some third country
currency.