INTERNATIONAL

FINANCIAL
MANAGEMENT

Fourth Edition

EUN / RESNICK

10-1 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Management of
Translation Exposure 10
Chapter Ten
INTERNATIONAL
Chapter Objective: FINANCIAL
MANAGEMENT
This chapter discusses the impact that
unanticipated changes in exchange rates may
have on the consolidated financial statements of
Fourth Edition
the multinational company. EUN / RESNICK

10-2 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Outline
 Translation Methods
 FASB Statement 8
 FASB Statement 52
 Management of Translation Exposure
 Empirical Analysis of the Change from FASB 8 to
FASB 52

10-3 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Translation Methods
 Current/Noncurrent Method
 Monetary/Nonmonetary Method
 Temporal Method
 Current Rate Method

10-4 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Current/Noncurrent Method
 The underlying principal is that assets and
liabilities should be translated based on their
maturity.
 Current assets translated at the spot rate.
 Noncurrent assets translated at the historical rate in
effect when the item was first recorded on the books.
 This method of foreign currency translation was
generally accepted in the United States from the
1930s until 1975, at which time FASB 8 became
effective.
10-5 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Current/Noncurrent Method
 Current assets Balance Sheet Local Current/
translated at the Currency Noncurrent
spot rate. Cash € 2,100 $1,050
e.g. €2=$1 Inventory € 1,500 $750
 Noncurrent assets Net fixed assets € 3,000 $1,000
translated at the Total Assets € 6,600 $2,800
historical rate in Current liabilities € 1,200 $600
effect when the Long-Term debt € 1,800 $600
item was first Common stock € 2,700 $900
recorded on the Retained earnings € 900 $700
books. CTA -------- --------
e.g. €3=$1 Total Liabilities and € 6,600 $2,800
Equity
10-6 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Monetary/Nonmonetary Method
 The underlying principle is that monetary accounts have a
similarity because their value represents a sum of money
whose value changes as the exchange rate changes.
 All monetary balance sheet accounts (cash, marketable
securities, accounts receivable, etc.) of a foreign
subsidiary are translated at the current exchange rate.
 All other (nonmonetary) balance sheet accounts (owners’
equity, land) are translated at the historical exchange rate
in effect when the account was first recorded.

10-7 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Monetary/Nonmonetary Method
 All monetary Balance Sheet Local Monetary/
balance sheet Currency Nonmonetary
accounts are Cash € 2,100 $1,050
translated at the Inventory € 1,500 $500
current exchange Net fixed assets € 3,000 $1,000
rate. e.g. €2=$1 Total Assets € 6,600 $2,550
Current liabilities € 1,200 $600
 All other balance
sheet accounts are Long-Term debt € 1,800 $900
Common stock € 2,700 $900
translated at the
historical exchange Retained earnings € 900 $0
rate in effect when CTA -------- --------
the account was first Total Liabilities and € 6,600 $2,400
Equity
recorded. e.g.€3=$1
10-8 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Temporal Method
 The underlying principal is that assets and
liabilities should be translated based on how they
are carried on the firm’s books.
 Balance sheet account are translated at the current
spot exchange rate if they are carried on the books
at their current value.
 Items that are carried on the books at historical
costs are translated at the historical exchange rates
in effect at the time the firm placed the item on the
books.
10-9 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Temporal Method
 Items carried on the Balance Sheet Local Temporal
books at their Currency
current value are Cash € 2,100 $1,050
translated at the Inventory € 1,500 $900
spot exchange rate. Net fixed assets € 3,000 $1,000
e.g. €2=$1 Total Assets € 6,600 $2,950
 Items that are Current liabilities € 1,200 $600
carried on the Long-Term debt € 1,800 $900
books at historical Common stock € 2,700 $900
costs are translated Retained earnings € 900 $0
at the historical CTA -------- --------
exchange rates. Total Liabilities and € 6,600 $2,400
e.g. €3=$1 Equity

10-10 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Current Rate Method
 All balance sheet items (except for stockholder’s
equity) are translated at the current exchange rate.
 Very simple method in application.
 A “plug” equity account named cumulative
translation adjustment is used to make the
balance sheet balance.

10-11 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Current Rate Method
 All balance sheet Balance Sheet Local Current
items (except for Currency Rate
stockholder’s Cash €2,100.00 $1,050
equity) are Inventory €1,500.00 $750
translated at the Net fixed assets €3,000.00 $1,500
current exchange
Total Assets €6,600.00 $3,300
rate.
Current liabilities €1,200.00 $600
 A “plug” equity Long-Term debt €1,800.00 $900
account named
Common stock €2,700.00 $900
cumulative
Retained earnings €900.00 $360
translation
adjustment is used CTA -------- $540
to make the balance Total Liabilities €6,600.00 $3,300
sheet balance and Equity
10-12 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
How Various Translation Methods Deal with
a Change from €3 to €2 = $1

Balance Sheet Local Current/ Monetary/ Temporal Current

Currency Noncurrent Nonmonetary Rate
Cash €2,100 $1,050 $1,050 $1,050 $1,050
Inventory €1,500 $750 $500 $900 $750
Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500
Total Assets €6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities €1,200 $600 $600 $600 $600
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
Retained earnings €900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540
Total Liabilities €6,600 $2,800 $2,550 $2,950 $3,300
and Equity
Spot exchange rate
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How Various Translation Methods Deal with
a Change from €3 to €2 = $1

Balance Sheet Local Current/ Monetary/ Temporal Current

Currency Noncurrent Nonmonetary Rate
Cash €2,100 $1,050 $1,050 $1,050 $1,050
Inventory €1,500 $750 $500 $900 $750
Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500
Total Assets €6,600 $2,800 $2,550 $2,950 $3,300
Book
Current liabilities €1,200 $600 $600 $600 $600
value of
Long-Term debt €1,800 $600
inventory $900 $900 $900
Common stock €2,700 $900 historic $900 $900 $900
Retained earnings €900 $700 rate $150 $550 $360
CTA -------- -------- -------- -------- $540
Total Liabilities €6,600 $2,800 $2,550 $2,950 $3,300
and Equity
Book value of inventory Current value of inventory
at spot exchange rate at spot exchange rate.
10-14 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
How Various Translation Methods Deal with
a Change from €3 to €2 = $1

Balance Sheet Local Current/ Monetary/ Temporal Current

Currency Noncurrent Nonmonetary Rate
Cash €2,100 $1,050 $1,050 $1,050 $1,050
Inventory €1,500 $750 $500 $900 $750
Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500
Total Assets €6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities €1,200 $600 $600 $600 $600
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
Retained earnings €900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540
Total Liabilities €6,600 $2,800 $2,550 $2,950 $3,300
and Equity
historic rate spot exchange rate
10-15 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
How Various Translation Methods Deal with
a Change from €3 to €2 = $1

Balance Sheet Local Current/ Monetary/ Temporal Current

Currency Noncurrent Nonmonetary Rate
Cash €2,100 $1,050 $1,050 $1,050 $1,050
Inventory €1,500 $750 $500 $900 $750
Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500
Total Assets €6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities €1,200 $600 $600 $600 $600
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
Retained earnings €900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540
Total Liabilities €6,600 $2,800 $2,550 $2,950 $3,300
and Equity
spot rate
10-16 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
How Various Translation Methods Deal with
a Change from €3 to €2 = $1

Balance Sheet Local Current/ Monetary/ Temporal Current

Currency Noncurrent Nonmonetary Rate
Cash €2,100 $1,050 $1,050 $1,050 $1,050
Inventory €1,500 $750 $500 $900 $750
Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500
Total Assets €6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities €1,200 $600 $600 $600 $600
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
Retained earnings €900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540
Total Liabilities €6,600 $2,800 $2,550 $2,950 $3,300
and Equity
historical rate spot rate
10-17 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
How Various Translation Methods Deal with
a Change from €3 to €2 = $1

Balance Sheet Local Current/ Monetary/ Temporal Current

Currency Noncurrent Nonmonetary Rate
Cash €2,100 $1,050 $1,050 $1,050 $1,050
Inventory €1,500 $750 $500 $900 $750
Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500
Total Assets €6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities €1,200 $600 $600 $600 $600
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
Retained earnings €900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540
Total Liabilities €6,600 $2,800 $2,550 $2,950 $3,300
and Equity
historical rate
10-18 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
How Various Translation Methods Deal with
a Change from €3 to €2 = $1

Balance Sheet Local Current/ Monetary/ Temporal Current

Currency Noncurrent Nonmonetary Rate
Cash €2,100 $1,050 $1,050 $1,050 $1,050
Inventory €1,500 $750 $500 $900 $750
Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500
Total Assets €6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities €1,200 $600 $600 $600 $600
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
Retained earnings €900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540
Total Liabilities €6,600 $2,800 $2,550 $2,950 $3,300
and Equity
From income statement
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How Various Translation Methods Deal with
a Change from €3 to €2 = $1

Balance Sheet Local Current/ Monetary/ Temporal Current

Currency Noncurrent Nonmonetary Rate
Cash €2,100 $1,050 $1,050 $1,050 $1,050
Inventory €1,500 $750 $500 $900 $750
Net fixed assets €3,000 $1,000 $1,000 $1,000 $1,500
Total Assets €6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities €1,200 $600 $600 $600 $600
Long-Term debt €1,800 $600 $900 $900 $900
Common stock €2,700 $900 $900 $900 $900
Retained earnings €900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540
Total Liabilities €6,600 $2,800 $2,550 $2,950 $3,300
and Equity
Under the current rate method, a “plug” equity account named
cumulative translation adjustment makes the balance sheet balance.
10-20 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 How Various Translation Methods Deal with
a Change from €3 to €2 = $1
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales € 10,000 $4,000 $4,000 $4,000 $4,000
COGS € 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation € 1,000 $333 $333 $333 $400
Net operating income € 1,500 $667 $1,167 $667 $600
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Addition to Retained
Earnings € 900 $700 $150 $550 $360
Sales translate at average exchange rate over the period, €2.50 = $1
For notes, see Exhibit 14.1
10-21 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 How Various Translation Methods Deal with
a Change from €3 to €2 = $1
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales € 10,000 $4,000 $4,000 $4,000 $4,000
COGS € 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation € 1,000 $333 $333 $333 $400
Net operating income € 1,500 $667 $1,167 $667 $600
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Addition to Retained
Earnings € 900 $700 $150 $550 $360
Translate at €2.50 = $1 Translate at new exchange rate, €2.00 = $1
For notes, see Exhibit 14.1
10-22 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 How Various Translation Methods Deal with
a Change from €3 to €2 = $1
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales € 10,000 $4,000 $4,000 $4,000 $4,000
COGS € 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation € 1,000 $333 $333 $333 $400
Net operating income € 1,500 $667 $1,167 $667 $600
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Addition to Retained
Earnings € 900 $700 $150 $550 $360

Translate at €3 = $1 Translate at average exchange rate, €2.5 = $1

For notes, see Exhibit 14.1
10-23 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 How Various Translation Methods Deal with
a Change from €3 to €2 = $1
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales € 10,000 $4,000 $4,000 $4,000 $4,000
COGS € 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation € 1,000 $333 $333 $333 $400
Net operating income € 1,500 $667 $1,167 $667 $600
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Addition to Retained
Earnings € 900 $700 $150 $550 $360

Note the effect on after-tax profit.

For notes, see Exhibit 14.1
10-24 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 How Various Translation Methods Deal with
a Change from €3 to €2 = $1
Local Current/ Monetary/ Temporal Current
Income Statement Currency Noncurrent Nonmonetary Rate
Sales € 10,000 $4,000 $4,000 $4,000 $4,000
COGS € 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation € 1,000 $333 $333 $333 $400
Net operating income € 1,500 $667 $1,167 $667 $600
Income tax (40%) € 600 $267 $467 $267 $240
Profit after tax € 900 $400 $700 $400 $360
Foreign exchange gain (loss) $300 -$550 $150
Net income € 900 $700 $150 $550 $360
Dividends €0 $0 $0 $0 $0
Addition to Retained
Earnings € 900 $700 $150 $550 $360

Note the effect that foreign exchange gains (losses) has on net income.
For notes, see Exhibit 14.1
10-25 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 FASB Statement 8
 Essentially the temporal method, with some
subtleties.
 Such as translating inventory at historical rates, which
is a hassle.
 Requires taking foreign exchange gains and losses
through the income statement.
 This leads to variability in reported earnings.
 Which leads to irritated corporate executives.

10-26 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 FASB Statement 52
 The Mechanics of the FASB 52 Translation
Process
 Function Currency
 Reporting Currency
 Highly Inflationary Economies

10-27 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
The Mechanics of FASB Statement 52
 Function Currency
 The currency that the business is conducted in.
 Reporting Currency
 The currency in which the MNC prepares its
consolidated financial statements.

10-28 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
The Mechanics of FASB Statement 52
 Two-Stage Process
 First, determine in which currency the foreign entity
keeps its books.
 If the local currency in which the foreign entity keeps
its books is not the functional currency, remeasurement
into the functional currency is required.
 Second, when the foreign entity’s functional currency is
not the same as the parent’s currency, the foreign
entity’s books are translated using the current rate
method.
10-29 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
The Mechanics of FASB Statement 52
Parent’s currency
Foreign Nonparent
entity’s books Functional
kept in? Currency? Third currency
Currency
Local currency Temporal
Remeasurement
Currency

Current Rate
Parent’s

Translation

Parent’s Currency
10-30 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Highly Inflationary Economies
 Foreign entities are required to remeasure
financial statements using the temporal method
“as if the functional currency were the reporting
currency”.

10-31 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Management of Translation Exposure
 Translation Exposure vs. Transaction Exposure
 Hedging Translation Exposure
 Balance Sheet Hedge
 Derivatives Hedge
 Translation Exposure vs. Operating Exposure

10-32 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Translation Exposure versus
Transaction Exposure
 Translation Exposure
 The effect that unanticipated changes in exchange rates
has on the firm’s consolidated financial statements.
 An accounting issue.
 Transaction Exposure
 The effect that unanticipated changes in exchange rates
has on the firm’s cash flows.
 A finance issue and the subject of Chapter 13.
 It is generally not possible to eliminate both
translation exposure and transaction exposure.
10-33 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Hedging Translation Exposure
 If the managers of the firm wish to manage their
accounting numbers as well as their business, they
have two methods for dealing with translation
exposure.
 Balance Sheet Hedge
 Derivatives Hedge

10-34 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Balance Sheet Hedge
 Eliminates the mismatch between net assets and
net liabilities denominated in the same currency.
 May create transaction exposure, however.

10-35 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Derivatives Hedge
 An example would be the use of forward contracts
with a maturity of the reporting period to attempt
to manage the accounting numbers.
 Using a derivatives hedge to control translation
exposure really involves speculation about foreign
exchange rate changes, however.

10-36 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Translation Exposure versus
Operating Exposure
 The effect that unanticipated changes in exchange
rates has on the firm’s ongoing operations.
 Operating exposure is a substantive issue with
which the management of the firm should concern
itself with.

10-37 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Empirical Analysis of the Change
from FASB 8 to FASB 52
 There did not appear to be a revaluation of firms’
values following the change.
 This suggests that market participants do not react
to cosmetic earnings changes.
 Other researchers have found similar results when
investigating other accounting changes.
 This highlights the futility of attempting to
manage translation gains and losses.

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 End Chapter Ten

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