Measuring Accounting Exposure

1
Measuring Accounting Exposure

• International Finance

Dr. A. DeMaskey
2
Learning Objectives

• What are the three different types of foreign
  exchange exposures?
• What is accounting exposure and how is it
  measured?
• What are the two primary methods of converting
  foreign currency denominated financial statements
  into the reporting currency of the U.S. parent
  company?
• What is transaction exposure and how is it
  measured?
• What is the difference between accounting
  measures of exposure and the economic effects of
  currency changes on the value of the firm?

3
Foreign Exchange Risk Management

• Exposure refers to the degree to which a company
  is affected by exchange rate changes.
• Exchange rate risk is defined as the variability
  of a firms value due to uncertain changes in the
  rate of exchange.

4
Types of Exposures

• Accounting or Translation Exposure
• Economic Exposure
• Transaction Exposure
• Operating Exposure

5
Translation Exposure

• It arises from the need, for purposes of
  reporting and consolidation, to convert the
  results of foreign operations from the local
  currency to the home currency.
• Paper exchange gains or losses
• Retrospective in nature
• Short-term in nature

6
Transaction Exposure

• It stems from the possibility of incurring
  exchange gains or losses on transactions already
  entered into and denominated in a foreign
  currency.
• Real exchange gains or losses
• Mixes retrospective and prospective
• Short-term in nature

7
Operating Exposure

• It arises because currency fluctuations combined
  with price level changes can alter the amounts
  and riskiness of a firms future revenues and
  costs.
• Real exchange gains or losses
• Prospective in nature
• Long-term in nature

8
Economic Exposure

• It is defined as the extent to which the value of
  the firm, as measured by the present value of all
  expected future cash flows, will change when
  exchange rates change.

9
Measuring Translation Exposure

• The difference between exposed assets and exposed
  liabilities.
• Exposed assets and liabilities are translated at
  the current exchange rate.
• Non-exposed assets and liabilities are translated
  at the historical exchange rate.

10
Translation Methods

• Current/Noncurrent Method
• Monetary/Nonmonetary Method
• Temporal Method
• Current Rate Method

11
FASB-8 (January 1, 1976)

• Utilizes the temporal method for translating
  balance sheet and income statement into the U.S.
  dollar.
• Unrealized translation gains or losses were
  recorded within the income statement thereby
  affecting net income.

12
FASB-52 (December 15, 1981)

• Utilizes the current rate method for translating
  balance sheet and income statement into the U.S.
  dollar.
• Unrealized translation gains or losses are
  recorded in a separate equity account on the
  parents consolidated balance sheet called the
  Cumulative Translation Adjustment (CTA) account.

13
Reporting vs. Functional Currency

• The reporting currency is the currency in which
  the parent company prepares its own financial
  statements.
• The functional currency is the currency of the
  primary economic environment in which the
  affiliate generates and expenses cash.
• Integrated foreign entity
• Self-sustained entity

14
US Translation Procedures

• The US differentiates foreign subsidiaries on the
  basis of the functional currency, not subsidiary
  characterization.
• This, in turn, determines which translation
  method is used
• Local currency
• Current rate method
• U.S. dollar
• Temporal method

15
Hyperinflation Countries

• A hyperinflationary country is one which has
  cumulative inflation of approximately 100 or
  more over a three year period.
• Functional currency
• U.S. dollar
• Translation method
• Temporal method

16
Measuring Translation Exposure Illustration

• Zapata Auto Parts, the Mexican affiliate of
  American Diversified, Inc., had the following
  balance sheet on January 1
• Assets (Ps million) Liabilities (Ps million)
• Cash, marketable securities 1,000 Current
  liabilities 47,000
• Accounts receivables 50,000 Long-term
  debt 12,000
• Inventory 32,000 Equity
  135,000
• Fixed assets 111,000
• 194,000 194,000
• _________________________________________________
  _____________
• The exchange rate on January 1st was Ps 8,000/
  and on December 31st is Ps 12,000/

17
Zapata Auto PartsTranslation Exposure to
Exchange Rate Risk Under Alternative Translation
Methods (in Ps million)
Current/ Noncurrent
Monetary/ Nonmonetary
Translation Method
Temporal
Current
__________________________________________________
______________________________
Cash and Marketable Sec. Accounts
Receivables Inventory Net Fixed Assets Current
Liabilities Long-Term Debt Equity
1,000 50,000 32,000 111,000 47,000 12,000 135,000

__________ ___________ __________
________
Net Exposure

__________________________________________________
_______________________________
Note The exchange rate on January 1st is Ps
8,000/
18
Transaction Exposure

• It arises from the various types of transactions
  that require settlement in a foreign currency.
• Purchasing or selling on credit goods or services
  denominated in foreign currency.
• Borrowing and lending funds with repayment made
  in foreign currency.
• Acquiring assets denominated in foreign currency.

19
Net Transaction Exposure

• Is measured currency by currency.
• Is the difference between contractually fixed
  future cash inflows and cash outflows in each
  currency.
• It represents real gains and losses.

20
Accounting Practice and Economic Reality

• Accounting focuses on
• Earnings and book values.
• They reflect past decisions.
• Has virtually no impact on firm value.
• Finance focuses on
• Cash flows and market values.
• They reflect future decisions.
• Directly affect firm value.