Companies with international operations will have foreign-currency-denominated assets and liabilities, revenues, and expenses. However, because home country investors and the entire financial community are interested in home currency values, the foreign currency balance sheet accounts and income statement must be assigned HC values. In particular, the financial statements of an MNC’s overseas subsidiaries must be translated from local currency to home currency before consolidation with the parent’s financial statements.
If currency values change, foreign exchange translation gains or losses may result. Assets and liabilities that are translated at the current (postchange) exchange rate are considered to be exposed; those translated at a historical (prechange) exchange rate will maintain their historical HC values and, hence, are regarded as not exposed. Translation exposure is simply the difference between exposed assets and exposed liabilities. The controversies among accountants center on which assets and liabilities are exposed and on when accounting-derived foreign exchange gains and losses should be recognized (reported on the income statement). A crucial point to realize in putting these controversies in perspective is that such gains or losses are of an accounting nature—that is, no cash flows are necessarily involved.
Four principal translation methods are available: the current/noncurrent method, the monetary/nonmonetary method, the temporal method, and the current rate method. In practice, there are also variations of each method.
At one time, the current/noncurrent method, whose underlying theoretical basis is maturity, was used by almost all U.S. multinationals. With this method, all the foreign subsidiary’s current assets and liabilities are translated into home currency at the current exchange rate. Each noncurrent asset or liability is translated at its historical exchange rate—that is, at the rate in efffect at the time the asset was acquired or the liability was incurred. Hence, a foreign subsidiary with positive local currency working capital will give rise to a translation loss (gain) from a devaluation (revaluation) with the current/noncurrent method, and vice versa if working capital is negative.
The income statement is translated at the average exchange rate of the period, except for those revenues and expense items associated with noncurrent assets or liabilities. The latter items, such as depreciation expense, are translated at the same rates as the corresponding balance sheet items. Thus, it is possible to see different revenue and expense items with similar maturities being translated at different rates.
The monetary/nonmonetary method differentiates between monetary assets and liabilities—that is, those items that represent a claim to receive, or an obligation to pay, a fixed amount of foreign currency units—and nonmonetary, or physical, assets and liabilities. Monetary items (e.g., cash, accounts payable and receivable, and long-term debt) are translated at the current rate; nonmonetary items (e.g., inventory, fixed assets, and long-term investments) are translated at historical rates.
Income statement items are translated at the average exchange rate during the period, except for revenue and expense items related to nonmonetary assets and liabilities. The latter items, primarily depreciation expense and cost of goods sold, are translated at the same rate as the corresponding balance sheet items. As a result, the cost of goods sold may be translated at a rate different from that used to translate sales.
The temporal method appears to be a modified version of the monetary/nonmonetary method. The only difference is that under the monetary/nonmonetary method, inventory is always translated at the historical rate. Under the temporal method, inventory is normally translated at the historical rate, but it can be translated at the current rate if it is shown on the balance sheet at market values. Despite the similarities, the theoretical bases of the two methods are different. The choice of exchange rate for translation is based on the type of asset or liability in the monetary/nonmonetary method; in the temporal method, it is based on the underlying approach to evaluating cost (historical versus market). Under a historical cost-accounting system, as the United States now has, most accounting theoreticians probably would argue that the temporal method is the appropriate method for translation.
Income statement items normally are translated at an average rate for the reporting period. However, cost of goods sold and depreciation and amortization charges related to balance sheet items carried at past prices are translated at historical rates.
Current Rate Method
The current rate method is the simplest: All balance sheet and income items are translated at the current rate. This method is widely employed by British companies. With some variation, it is the method mandated by the current U.S. translation standard—FASB 52. Under the current rate method, if a firm’s foreign-currency-denominated assets exceed its foreign-currency-denominated liabilities, a devaluation must result in a loss and a revaluation must result in a gain.
Exhibit 10.2 applies the four methods to a hypothetical balance sheet that is affected by both a 25% devaluation and a 37.5% revaluation. Depending on the method chosen, the translation results for the LC devaluation can range from a loss of $205,000 to a gain of $215,000; LC revaluation results can vary from a gain of $615,000 to a loss of $645,000. The assets and liabilities that are considered exposed under each method are the ones that change in dollar value. Note that the translation gains or losses for each method show up as the change in the equity account. For example, the LC devaluation combined with the current rate method results in a $205,000 reduction in the equity account ($1,025,000 − $820,000), which equals the translation loss for this method. Another way to calculate this loss is to take the net LC translation exposure, which equals exposed assets minus exposed liabilities (for the current rate method, this figure is LC 4,100,000, which, not coincidentally, equals its equity value) and multiply it by the $0.05 ($0.25 − $0.20) change in the exchange rate. This calculation yields a translation loss of $205,000 ($0.05 × 4,100,000), the same as calculated in Exhibit 10.2. Another way to calculate this loss is to multiply the net dollar translation exposure by the fractional change in the exchange rate, or $1,025,000 × 0.05/0.25 = $205,000. Either approach gives the correct answer.
10.3 Transaction Exposure
Companies often include transaction exposure as part of their accounting exposure, although as a cash-flow exposure, it is rightly part of a company’s economic exposure. As we have seen, transaction exposure stems from the possibility of incurring future exchange gains or losses on transactions already entered into and denominated in a foreign currency. For example, when IBM sells a mainframe computer to Royal Dutch Shell in England, it typically will not be paid until a later date. If that sale is priced in pounds, IBM has a pound transaction exposure.
A company’s transaction exposure is measured currency by currency and equals the difference between contractually fixed future cash inflows and outflows in each currency. Some of these unsettled transactions, including foreign-currency-denominated debt and accounts receivable, are already listed on the firm’s balance sheet. However, other obligations, such as contracts for future sales or purchases, are not.
Application Computing Transaction Exposure for Boeing
Suppose Boeing Airlines sells five 747s to Garuda, the Indonesian airline, in rupiahs. The rupiah price is Rp 140 billion. To help reduce the impact on Indonesias balance of payments, Boeing agrees to buy parts from various Indonesian companies worth Rp 55 billion.
a. If the spot rate is $0.004/Rp, what is Boeing’s net rupiah transaction exposure?
Solution. Boeing’s net rupiah exposure equals its projected rupiah inflows minus its projected rupiah outflows, or Rp 140 billion − Rp 55 billion = Rp 85 billion. Converted into dollars at the spot rate of $0.004/Rp, Boeing’s transaction exposure equals $340 million.
b. If the rupiah depreciates to $0.0035/Rp, what is Boeing’s transaction loss?
Solution. Boeing will lose an amount equal to its rupiah exposure multiplied by the change in the exchange rate, or 85 billion X (0.004 − 0.0035) = $42.5 million. This loss can also be determined by multiplying Boeing’s exposure in dollar terms by the fractional change in the exchange rate, or 340 million X (0.0005/0.004) = $42.5 million.
Exhibit 10.2 Financial Statement Impact of Translation Alternatives (U.S. $ Thousands)
Although translation and transaction exposures overlap, they are not synonymous. Some items included in translation exposure, such as inventories and fixed assets, are excluded from transaction exposure, whereas other items included in transaction exposure, such as contracts for future sales or purchases, are not included in translation exposure. Thus, it is possible for transaction exposure in a currency to be positive and translation exposure in that same currency to be negative and vice versa.