Accounting Exposure

Eiteman et al., Chapter 10

Winter 2004
Accounting Exposure
Accounting exposure, also called translation exposure, results
from the need to restate foreign subsidiaries’ nancial statements,
usually stated in foreign currency, into the parent’s reporting
currency when preparing the consolidated nancial statements.
Restating nancial statements may lead to changes in the
parent’s net worth or net income.
2Translation Exposure
When converting nancial statement items (transactions)
denominated in currencies other than the parent currency, two
choices of exchange rate are possible:
² The historical rate, the exchange rate prevailing at the time
of the transaction
² The current rate, the exchange rate prevailing at the balance
sheet date or during the income statement period
3
Translation Exposure
Conversion of nancial statements into the parent’s currency
creates the following concerns:
² The exposure to exchange rate changes
² The treatment of translation gains or losses
4Translation Exposure
SFAS 52 provides two translation methods:
² The temporal method, or remeasurement process
² The current rate method, or translation process
5
Translation Exposure
The method used to restate nancial statements is based on the
choice of functional currency for each subsidiary.
The functional currency is the primary currency used in the
subsidiary’s operations.
This currency may be the foreign subsidiary’s local currency, the
parent’s currency, or a third currency.
6Translation Exposure
There exists three categories of foreign operations:
² Relatively self-contained, independent entities operating primarily in
local markets. The functional currency of these entities is generally the
local currency.
² Signi cantly integrated operations that serve as sales outlets for the
parent’s products and services. The functional currency should be the
parent’s currency in this case.
² Subsidiaries operating in highly in ationary economies. The use of the
parent’s currency as the functional currency is required in this case.
7
Translation Exposure
² If the foreign entity’s functional currency is the local
currency, nancial statements are translated using the
current rate method.
² If the foreign entity’s functional currency is the parent’s
currency, nancial statements are remeasured using the
temporal method.
8Translation Exposure
If the functional currency of a foreign subsidiary is not the local
currency, then the subsidiary’s nancial statements are
1. Remeasured in the subsidiary’s functional currency using the
temporal method;
2. Translated from functional to parent’s currency using the
current rate method.
9
The Current Rate Method
² All assets and liabilities are translated at the rate in effect on the balance
sheet date.
² All items on the income statement are translated at an appropriate average
exchange rate or at the rate prevailing when the various revenues,
expenses, gains and losses were incurred (historical rate).
² Dividends paid are translated at the rate in effect on the payment date.
² Common stock, paid-in capital and retained earnings are translated at
historical rates.
10The Current Rate Method
When the current rate method is used, gains and losses from
translation are reported in a separate equity account called
cumulative translation adjustment (CTA).
Gains and losses do not appear in the income statement when the
current rate method is used.
11
The Current Rate Method
Advantages of CTA
² Eliminates the variability of net earnings due to translation gains or
losses.
² The relative proportions of individual balance sheet accounts remain the
same (debt-to-equity ratio, for example).
Main disadvantage of CTA
² Violates the accounting principle of carrying balance sheet accounts at
historical cost.
12The Current Rate Method
Under the current rate method, translation exposure is
Assets(A) ¡ Liabilities(L) = stockholders’ equity(SE):
Common stock and retained earnings, for example, are part of
SE. If common stock is issued at some point in time, then the
value of the issue in the parent’s currency is determined by the
exchange rate prevailing when the shares were issued.
13
The Current Rate Method
Similarly, the value of the earnings retained during a year in the
parent’s currency is based on the exchange rate used to translate
the income statement in that year.
When the exchange rate changes, the value of A¡L in the
parent’s currency varies but the value of SE in the parent’s
currency stays the same or, at least, changes according to a
different rate. The CTA account is needed for the balance sheet
to balance.
14The Current Rate Method: An Example
Foreign Subsidiary, Inc., (FSI) has been acquired on December
31, 2000 when the exchange rate was LC1.25/$ (LC stands for
FSI’s local currency).
On December 31, 2001, the exchange rate was LC1.15/$. The
average exchange rate during 2001 was LC1.18/$.
On December 31, 2002, the exchange rate was LC1.22/$. The
average exchange rate during 2002 was LC1.20/$.
15
The Current Rate Method: An Example
Foreign Subsidiary, Inc.
Assets as of December 31 (in LC)
2000 2001 2002
Cash 41 204 400
Accounts receivable 360 492 570
Inventory 210 264 372
Current assets 611 960 1,342
Fixed assets 1,032 1,512 2,208
Accumulated depreciation 180 432 732
Net xed assets 852 1,080 1,296
Total assets 1,463 2,040 2,638
16The Current Rate Method: An Example
Foreign Subsidiary, Inc.
Liabilities and Equity as of December 31 (in LC)
2000 2001 2002
Accounts payable 306 348 288
Notes payable 132 156 216
Long-term debt 168 528 948
Total liabilities 606 1,032 1,452
Common stock 276 276 276
Retained earnings 581 732 910
Total equity 857 1,008 1,186
Total liabilities and equity 1,463 2,040 2,638
17
The Current Rate Method: An Example
Foreign Subsidiary, Inc.
Income Statement (in LC)
2001 2002
Revenues 1,548 1,716
COGS 648 733
Gross margin 900 983
Depreciation 252 300
Other expenses 497 505
Net income 151 178
18The Current Rate Method: An Example
Under the current rate method, all assets and all liabilities are
translated using the exchange rate in effect on the balance sheet
date (December 31 of each year).
Equity items are translated using the appropriate historical
exchange rate and all income statement items are translated at the
exchange rate at the time of the transaction (the average annual
exchange rate).
19
The Current Rate Method: An Example
Foreign Subsidiary, Inc.
Assets as of December 31 (in $)
2000 2001 2002
(Rate) (LC1.25/$) (LC1.15/$) (LC1.22/$)
Cash 33 177 328
Accounts receivable 288 428 467
Inventory 168 230 305
Current assets 489 835 1,100
Fixed assets 826 1,315 1,662
Accumulated depreciation 144 376 600
Net xed assets 682 939 1,062
Total assets 1,170 1,774 2,162
20The Current Rate Method: An Example
Foreign Subsidiary, Inc.
Liabilities and Equity as of December 31 (in $)
2000 2001 2002
Accounts payable 245 303 236
Notes payable 106 136 177
Long-term debt 134 459 777
Total liabilities 485 897 1,190
Common stock ? ? ?
Retained earnings ? ? ?
Total equity ? ? ?
Cumulative translation adjustment ? ? ?
Total liabilities and equity 1,170 1,774 2,162
21
The Current Rate Method: An Example
Foreign Subsidiary, Inc.
Income Statement (in $)
2001 2002
(Rate) (LC1.18/$) (LC1.20/$)
Revenues 1,312 1,430
COGS 549 611
Gross margin 763 819
Depreciation 214 250
Other expenses 421 421
Net income 128 148
22The Current Rate Method: An Example
What happens to common stock (CS)?
The subsidiary was acquired on December 31, 2000, and thus the
initial value for common stock, 276, is translated using the
exchange rate on December 31, 2000, which gives
CS2000 =
276
1:25
= $221:
Since common stock does not change in 2001 and 2002, the
translated value is $221 in these years, too.
23
The Current Rate Method: An Example
What happens to retained earnings (RE)?
Retained earnings in 2000 are translated at the rate prevailing
when the company was acquired, i.e. LC1.25/$, which gives
RE2000 = 5811:25 = $465:
In 2001, retained earnings increased by LC151. The appropriate
rate for this change being the average exchange rate LC1.18/$,
translated retained earnings in 2001 are
RE2001 = RE2000 + 1511:18 = 465 + 128 = $593:
24The Current Rate Method: An Example
In 2002, retained earnings increased by LC178 and the 2002
average exchange rate is LC1.20/$. Translated retained earnings
in 2002 are then
RE2002 = RE2001 + 1781:20 = 593 + 148 = $741:
25
The Current Rate Method: An Example
Foreign Subsidiary, Inc.
Liabilities and Equity as of December 31 (in $)
2000 2001 2002
Accounts payable 245 303 236
Notes payable 106 136 177
Long-term debt 134 459 777
Total liabilities 485 897 1,190
Common stock 221 221 221
Retained earnings 465 593 741
Total equity 685 814 962
Cumulative translation adjustment – 63 10
Total liabilities and equity 1,170 1,774 2,162
26The Temporal Method
² Monetary assets (cash, marketable securities, accounts
receivable, inventory) and monetary liabilities (current
liabilities and long-term debt) are translated at the current
exchange rate (exchange rate at the balance sheet date).
² Non-monetary assets (inventory, xed assets, etc.) and
non-monetary liabilitites are translated at their historical
rate.
27
The Temporal Method
Note:
² Inventory is considered a monetary asset if it is recorded at
market value on the balance sheet. If it is recorded at
historical cost, then it is considered a non-monetary asset.
28The Temporal Method
² Income statement items are translated at the average exchange rate
over the period, except for items that are associated with
non-monetary assets or liabilities, such as cost of goods sold
(inventory) and depreciation ( xed assets), which are translated at
their historical rate.
² Dividends paid are translated at the rate in effect on the payment
date.
² Equity items are translated at their historical rate, and include any
imbalance.
29
The Temporal Method
Under this method, gains and losses appear on the income
statement.
Gains and losses on the balance sheet will be hidden in
stockholders’ equity.
The exposure to exchange rate changes under this method is
Monetary Assets ¡ Monetary Liabilities:
30The Temporal Method
Logic behind differentiating monetary and non-monetary assets:
² Translation gains and losses on monetary accounts are
presumed meaningful components of expenses or revenue
because monetary accounts closely approximate market
values.
² Translation gains and losses on non-monetary accounts are
less meaningful since non-monetary accounts re ect
historical costs.
31
The Temporal Method: An Example
Let us remeasure FSI’s nancial statements using the temporal
method.
The methodology is the same as with the current rate method for
cash, accounts receivable, accounts payable, notes payable,
long-term debt, common stock, revenues and other expenses.
32The Temporal Method: An Example
Foreign Subsidiary, Inc.
Assets as of December 31 (in $)
2000 2001 2002
Cash 33 177 328
Accounts receivable 288 428 467
Inventory 168 ? ?
Current assets 489 ? ?
Fixed assets 826 ? ?
Accumulated depreciation 144 ? ?
Net xed assets 682 ? ?
Total assets 1,170 ? ?
33
The Temporal Method: An Example
Foreign Subsidiary, Inc.
Liabilities and Equity as of December 31 (in $)
2000 2001 2002
Accounts payable 245 303 236
Notes payable 106 136 177
Long-term debt 134 459 777
Total liabilities 485 897 1,190
Common stock 221 221 221
Retained earnings 465 ? ?
Total equity 685 ? ?
Total liabilities and equity 1,170 ? ?
34The Temporal Method: An Example
Foreign Subsidiary, Inc.
Income Statement (in $)
2001 2002
Revenues 1,312 1,430
COGS ? ?
Gross margin ? ?
Depreciation ? ?
Other expenses 421 421
Foreign exchange gain (loss) ? ?
Net income ? ?
35
The Temporal Method: An Example
COGS
COGS was LC648 in 2001. Assuming FIFO as the inventory
accounting method, this means that the 2000 inventory of 210
has been sold and the rest has been purchased throughout 2001 at
the 2001 average exchange rate. That is,
COGS2001 =
210
1:25
+
648¡210
1:18
= $539:
The same procedure can be applied to obtain 2002 COGS.
36The Temporal Method: An Example
Inventory
Since COGS in both 2001 and 2002 is greater than the previous
year-end inventory, inventory in 2001 and 2002 was
2001 :
264
1:18
= $224
2002 :
372
1:20
= $310
37
The Temporal Method: An Example
Fixed Assets
Fixed assets in 2000 are obtained using the exchange rate at the
acquisition date. Whenever xed assets are purchased within a
year, it is done at the average annual exchange rate for that year.
This gives us
2000 : 1;032=1:25 = $826
2001 : 826 + (1;512¡1;032)=1:18 = $1;232
2002 : 1;232 + (2;028¡1;512)=1:20 = $1;662
38The Temporal Method: An Example
Depreciation
The rate used to remeasure depreciation has to be consistent with the
rates used to remeasure xed assets. To do so, we can de ne blended
rates that will be used with depreciation. In 2001, for example, the
blended rate would be
Blended rate for 2001 =
FA2001 in LC
FA2001 in $
=
1;512
1;232
= 1:227
and thus
Dollar depreciation in 2001 =
252
1:227
= $205:
39
The Temporal Method: An Example
Depreciation
The same procedure applies for depreciation in 2002 and
accumulated depreciation increases with the depreciation
expense on the income statement.
Retained earnings are such that the balance sheet balances, and
thus a line for foreign exchange gain (or loss) has to be added to
the income statement.
40The Temporal Method: An Example
Foreign Subsidiary, Inc.
Assets as of December 31 (in $)
2000 2001 2002
Cash 33 177 328
Accounts receivable 288 428 467
Inventory 168 224 310
Current assets 489 829 1,105
Fixed assets 826 1,232 1,662
Accumulated depreciation 144 349 595
Net xed assets 682 883 1,067
Total assets 1,170 1,712 2,172
41
The Temporal Method: An Example
Foreign Subsidiary, Inc.
Liabilities and Equity as of December 31 (in $)
2000 2001 2002
Accounts payable 245 303 236
Notes payable 106 136 177
Long-term debt 134 459 777
Total liabilities 485 897 1,190
Common stock 221 221 221
Retained earnings 465 594 761
Total equity 685 815 982
Total liabilities and equity 1,170 1,712 2,172
42The Temporal Method: An Example
Foreign Subsidiary, Inc.
Income Statement (in $)
2001 2002
Revenues 1,312 1,430
COGS 539 615
Gross margin 773 815
Depreciation 205 246
Other expenses 421 421
Foreign exchange gain (loss) (17) 19
Net income 129 167
43
Current Rate vs Temporal
What effect does each method have on the rm’s ratios?
44