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 financial statements, usually stated in foreign currency, into the parent s reporting currency when preparing the consolidated financial statements. Restating financial statements may lead to changes in the parent s net worth or net income. 2
Translation Exposure When converting financial statement items (transactions) denominated in currencies other than the parent currency, two choices of exchange rate are possible: The historical rate, the exchange rate prevailing at the time of the transaction The current rate, the exchange rate prevailing at the balance sheet date or during the income statement period 3 Translation Exposure Conversion of financial statements into the parent s currency creates the following concerns: The exposure to exchange rate changes The treatment of translation gains or losses 4
Translation Exposure SFAS 52 provides two translation methods: The temporal method, or remeasurement process The current rate method, or translation process 5 Translation Exposure The method used to restate financial 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. 6
Translation Exposure There exists three categories of foreign operations: Relatively self-contained, independent entities operating primarily in local markets. The functional currency of these entities is generally the local currency. Significantly 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. Subsidiaries operating in highly inflationary economies. The use of the parent s currency as the functional currency is required in this case. 7 Translation Exposure If the foreign entity s functional currency is the local currency, financial statements are translated using the current rate method. If the foreign entity s functional currency is the parent s currency, financial statements are remeasured using the temporal method. 8
Translation Exposure If the functional currency of a foreign subsidiary is not the local currency, then the subsidiary s financial 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 All assets and liabilities are translated at the rate in effect on the balance sheet date. 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). Dividends paid are translated at the rate in effect on the payment date. Common stock, paid-in capital and retained earnings are translated at historical rates. 10
The 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 Eliminates the variability of net earnings due to translation gains or losses. The relative proportions of individual balance sheet accounts remain the same (debt-to-equity ratio, for example). Main disadvantage of CTA Violates the accounting principle of carrying balance sheet accounts at historical cost. 12
The 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. 14
The Current Rate Method: An Example, (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 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 fixed assets 852 1,080 1,296 Total assets 1,463 2,040 2,638 16
The Current Rate Method: An Example 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 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 18
The 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 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 fixed assets 682 939 1,062 Total assets 1,170 1,774 2,162 20
The Current Rate Method: An Example 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 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 22
The 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 CS 2000 = 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 RE 2000 = 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 RE 2001 = RE 2000 + 1511.18 = 465 + 128 = $593. 24
The Current Rate Method: An Example In 2002, retained earnings increased by LC178 and the 2002 average exchange rate is LC1.20/$. Translated retained earnings in 2002 are then RE 2002 = RE 2001 + 1781.20 = 593 + 148 = $741. 25 The Current Rate Method: An Example 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 26
The Temporal Method 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). Non-monetary assets (inventory, fixed assets, etc.) and non-monetary liabilitites are translated at their historical rate. 27 The Temporal Method Note: 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. 28
The Temporal Method 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 (fixed assets), which are translated at their historical rate. Dividends paid are translated at the rate in effect on the payment date. 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. 30
The Temporal Method Logic behind differentiating monetary and non-monetary assets: Translation gains and losses on monetary accounts are presumed meaningful components of expenses or revenue because monetary accounts closely approximate market values. Translation gains and losses on non-monetary accounts are less meaningful since non-monetary accounts reflect historical costs. 31 The Temporal Method: An Example Let us remeasure FSI s financial 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. 32
The Temporal Method: An Example 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 fixed assets 682?? Total assets 1,170?? 33 The Temporal Method: An Example 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?? 34
The Temporal Method: An Example 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, COGS 2001 = 210 1.25 + 648 210 1.18 = $539. The same procedure can be applied to obtain 2002 COGS. 36
The 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 : 2002 : 264 1.18 = $224 372 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 fixed 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 38
The Temporal Method: An Example Depreciation The rate used to remeasure depreciation has to be consistent with the rates used to remeasure fixed assets. To do so, we can define blended rates that will be used with depreciation. In 2001, for example, the blended rate would be and thus Blended rate for 2001 = FA 2001 in LC FA 2001 in $ = 1,512 1,232 = 1.227 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. 40
The Temporal Method: An Example 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 fixed assets 682 883 1,067 Total assets 1,170 1,712 2,172 41 The Temporal Method: An Example 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 42
The Temporal Method: An Example 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 firm s ratios? 44