Module - 30 Translation/Accounting Exposure: Measurement and Management

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International Finance
Vinod Gupta School of Management, IIT.Kharagpur.

J oint Initiative IITs and IISc Funded by MHRD - 1 -

Module - 30
Translation/Accounting Exposure:
Measurement and Management

Developed by: Dr. Prabina Rajib
Associate Professor (Finance & Accounts)

Vinod Gupta School of Management

IIT Kharagpur, 721 302

Email: prabina@vgsom.iitkgp.ernet.in

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Accounting is the language of business. Accounting principles help a company in the
process of recording, classifying, reporting and analyzing financial data. As we know,
accounting reports (Profit Loss or Income statement, Balance Sheet and Cash flow
Statements) helps to measure a companys performance.

Translation/Accounting exposure results when an MNC/parent translates its
subsidiarys financial data to its home currency for consolidated financial reporting.
Translation exposure does not directly affect cash flows, but companies are
concerned with this exposure because of its potential impact on reported
consolidated earnings.

A detailed working of translation exposure is beyond scope of this module. Readers must
consult a book on accounting to get a detailed understanding of quantification of
accounting exposure.

This session covers the following:
Measurement of Translation Exposure
o Current/Non-current Method.
o Monetary/Non-Monetary Method
o Current Rate
US GAAP, Indian GAAP and Consolidation of Accounts
Management of Translation Exposure
o Balance Sheet Hedge
o Derivatives Hedge

Lesson - 30
Translation/Accounting Exposure:
Measurement and Management
Highlights & Motivations:
Learning Objectives:
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Session 29 highlights that, if the foreign exchange rate changes, translation of financial
statement gives rise to translation exposure. In other words, a firms value of items
reported in financial statements may change because the exchange rate has changed from
the last reporting date to the current reporting date.

When consolidation of financial statements is done, values of assets and liabilities
translated at the prevailing exchange rate changes. Values of assets and liabilities which
are translated at the historical rate are not affected by the exchange rate movement.
However, certain assets and liabilities which are reported as per the changed exchange
rate, may decline or increase in value.

Values of assets and liabilities whose value changes due to change in exchange rate is
known as exposed items. Translation exposure is measured by the difference
between exposed asset and exposed liabilities.

Three different accounting methods are used by companies to identify and record the
exposed assets and liabilities. These are
Current/Non-Concurrent Method.
Monetary/Non-Monetary Method
Current Rate

Current/ Non-Current method: Under this method, current assets and current
liabilities of the foreign subsidiary to be converted at the current exchange rate (rate
prevailing on the Balance sheet date) while all non-current items i.e, long term assets and
liabilities are converted at historical rate (the exchange rate prevailing on the date of the
acquisition of foreign asset or liabilities). The depreciation item, as it is a non-current
item, is translated at the same historical rate at which the corresponding fixed asset in the
balance sheet.

Monetary/Non- Monetary Method: Under this method, all monetary items in the
balance sheet i.,e short term debts, cash, marketable securities, accounts
payables/receivables etc. are converted at exchange rate prevailing on the balance sheet
date. All other non-monetary items such as inventory, long-term assets and long term
liabilities are converted at historical rate. It is important to note here that inventory is
converted at current exchange rate in Current/Non-Current Method, while it is
30.1 Measurement of Translation Exposure
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converted at a historical rate (average) in Monetary/Non-Monetary approach. The
depreciation item, like the Current/Non-Current Method is translated at the same
historical rate at which the corresponding fixed asset in the balance sheet. This method is
based on the fundamental premise that only monetary assets/liabilities are exposed to
change exchange risk. Non monetary assets/liabilities are not exposed because according
to the purchasing power parity theory, the effect of exchange rate fluctuations would be
balanced by the inflation differential between both countries in the long run. Hence long
term assets/liabilities with higher longevity should not treated as exposed asset/liabilities.

Current Rate Method: All balance-sheet and income statement items are translated at
the current rate. It is one of the simplest methods for converting accounts.

As per the AS 11 requirement, if a foreign operation is treated as integral foreign
entity then the consolidation of report should be done as the Monetary/Non-
Monetary Method.AS 11 require the assets and liabilities, both monetary and non-
monetary, of the non-integral foreign operation should be translated at the current rate
method.

Different countries have different accounting requirement (known as Generally accepted
Accounting Principles or GAAPs) for treating a foreign operation in different manner
and also the method applicable for consolidating foreign operation. For a given company,
translation exposure varies from country to country depending on which countrys GAAP
has been used to prepare the consolidated statement. Indian companies like Infosys,
ICICI Bank and Wipro with their ADRs ( American Depository Receipts
1
) listed in stock
exchanges of USA is required to prepare their consolidated report as per US GAAP as
well as Indian GAAP.

The following Box 30.1 shows how different GAAPs have different impact on
companys financial figure

1
ADRs and GDRs are discussed in detail in later sessions.
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Box 30.1: US GAAP, Indian GAAP and Consolidation of Accounts
Source: http://money.outlookindia.com/article.aspx?86427

Balance sheets of Indian companies have been much maligned for hiding more than they
reveal. But the magic phrase "according to US GAAP" is changing all that. Several
companies have begun publishing the impact of following the US Generally Accepted
Accounting Principles (GAAP) on their accounts. In fact, a few have even gone beyond a
mere US GAAP reconciliation, and publish their entire accounts according to US GAAP, like
Infosys Technologies.
What is US GAAP? Chartered accountants' bodies lay out accounting principles to be
followed in a country, while preparing any statement of accounts. In India, accounting
standards are prepared by the Institute of Chartered Accountants of India. The ones set
down by the US Federal Accounting Standards Bureau are used by US firms, and are
recognised as one of the most stringent. Accounting standards take into account a
country's tax laws and company laws. Since these laws differ widely from country to
country, accounting standards also vary in their treatment of expenses and income.
Accounts prepared according to standards followed in various countries can result in widely
different accounting statements.
How it's different. There are about 250 major and minor differences between the two
accounting standards. Important among these are the treatment of deferred taxes, depreciation
and in accounting for investments. Fundamentally though, the standards differ on two counts.

One, under US GAAP, the notion of fair value predominates, whether in the valuation of
investments or assets. Two, US GAAP insist on consolidation, which means adding up assets
from all subsidiaries, associates and joint ventures of the company in question.
ACCOUNTING : A MATTER OF PRINCIPLE
INFOSYS RELIANCE ICICI

Indian
accounts
US GAAP
Indian
accounts
US GAAP
Indian
accounts
US GAAP
EPS (Rs) 40.9 23.9 18.0 NA* 18.2 13.6
Net worth (Rs
cr)
541.4 586.4 12,369.0 NA* 6,517.8 3,650.8
Net profit (Rs
crore)
135.3 73.3 1,704.0 1,378.0 1,000.8 744.7
*Figures unavailable as Reliance only publishes a reconciliation between US GAAP income
statements and Indian accounts.
Earnings figures. The impact of the difference between Indian standards and US GAAP
comes through in the all-important earnings and return figures -- numbers that any investor
looks at (See table: A Matter of Accounting Principles).
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With the introduction of International Accounting standard (IAS), the difference in
consolidation due to GAAP differences will vanish. The IAS 21 prescribes
How to include foreign currency transactions and foreign operations in the
financial statements of an entity?
How to translate financial statements into a parents reporting currency?

More details about IAS 21 is available at http://www.iasplus.com/standard/ias21.htm

Details given in the Box 30.2 show some information about accounting /translation risk
faced by companies.

Box 30.1 (Continued): US GAAP, Indian GAAP and consolidation of Accounts
Source: http://money.outlookindia.com/article.aspx?86427
US GAAP is more stringent and results in greater transparency, as it calls for greater
disclosures. As a result, earnings of all Indian companies will be lower under US
GAAP.For example, in the case of Infosys, while Indian accounts show a net profit of
Rs 135 crore for 1998-99, US GAAP shows a much lower Rs 73 crore.
Consolidated statements. This is a major change over Indian accounting statements. US
GAAP requires that a company add the accounts of its subsidiaries to its balance
sheet. It defines a subsidiary as one in which a company has majority ownership
and also has management and operational control. This is not compulsory under
Indian accounting, though many Indian companies do so voluntarily. Consolidated
statements clearly spell out the total earnings of the company and that of its
subsidiaries.

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Companies employ two methods to manage to manage translation exposure. These two
methods are

Balance Sheet Hedge
Derivatives Hedge

Box 30.2: Translation risk Balance sheet

Source: http://www.trelleborg.com/annual-
report2009/eng/Governanceandresponsibility/Financialriskmanagement.html

In connection with the translation of Group investments in foreign subsidiaries to
SEK, there is a risk that changes in exchange rates will affect the consolidated
balance sheet.

Policy: Investments in foreign subsidiaries and associated companies may be
hedged in a range of between 0 and 100 percent of the investments value
(which, because of the tax effect, implies a maximum hedge ratio of 70 percent). A
decision to hedge follows an overall evaluation of foreign-exchange levels and the
effects on the financial net, liquidity and taxes, as well as on the Groups debt/equity
ratio.

At year-end 2009, the Groups net investments in foreign subsidiaries and associated
companies amounted to approximately SEK 19,541 M (19,492). The net
investments have increased due to changes in the capital structure and accrued
profits of foreign operations which have overcompensated negative translation
differences. Translation differences in 2009 amounted to SEK -454 M (1,184),
calculated after hedging through loans and derivative instruments with deductions
for estimated taxes. At year-end 2009, 44 percent (48) of net investments had been
hedged. If SEK appreciates by 1 percent in relation to all currencies in which the
Trelleborg Group has foreign net investments, there would be a negative change in
shareholders equity of SEK 108 M (neg: 102) before consideration of possible tax
effects.
14.1 Management of Translation exposure:
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Balance Sheet Hedge: In this, the parent identifies items in Balance sheet of the
subsidiary which assets and liabilities are exposed to changes in foreign exchange when the
parent prepares the consolidated accounts i.e, parent identifies exposed asset and exposed
liabilities. As part of the balance sheet hedge, the parent creates an equal amount of liability
in a foreign currency as that of exposed asset. The amount of liability matches the exposed
asset and the currency denomination of liability matches the currency of exposed asset. When
exchange rate moves, the positive (negative) benefit of favourable (unfavourable) movement
of exchange rate gets nullified by matching assets and liabilities denominated in common
currency. Similarly the parent creates equal amount of assets as that of its exposed liability in
the same currency denomination to that of the exposed liability. If exchange rate movement,
negatively affects its liability it would positively affect the assets.

For balance sheet hedge, a parent company
Decreases soft-currency assets and increase soft-currency liabilities.
Increase hard-currency assets and decrease hard-currency liabilities.

Hard currency is a currency which is expected to appreciate in near future while soft
currency is a currency which is expected to depreciate in future.

However, it is worth stressing here that creating foreign currency asset and liabilities for
managing translation exposure gives rise to transaction exposure. As foreign exchange rate
can move in a diametrically different direction in the next reporting time, a company may
once again have to readjust its foreign current asset liability as part of the balance sheet
hedge. Hence companies normally companies prefer to give precedence to the management
of transaction exposure rather than managing translation exposure.

Derivatives Hedge: In a derivatives hedge, parent anticipates what would be the extent of
net exposed asset in the consolidated report well before the actual preparation of the financial
report. Depending on the anticipated amount of net exposed asset and the parent expectation
regarding the future exchange rate, the parent enters into forward contract. In a sense, the
forward contract is a speculative one as the parent does not know the exact amount of
exposed asset until the consolidated report is prepared.

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1. A U.S. company has an affiliate in Spain. This affiliate has exposed assets of 200
million Lira and exposed liabilities of 300 million Lira. If the exchange rate
appreciates from $0.0004 per peso to $0.0005 per Lira, what is the company's
translation gain or loss?
a. -$10,000
b. -$15,000
c. +$10,000
d. +$15,000

2. Which is the easiest method for preparation of consolidation of financial accounts.
a. Current/Non-Concurrent Method.
b. Monetary/Non-Monetary Method
c. Current Rate Method
d. All of the above
3. Which of the following is not a translation method?
e. current/noncurrent
f. monetary/nonmonetary
g. permanent
h. Current
4. Which activity(ies) is not part of the balance sheet hedge undertaken to manage
accounting exposure?
a. Increase hard currency liability
b. Increase soft currency assets
c. Create an exposure in a new currency
d. All of above.
e. None of these.

1. Why consolidation of accounting reports leads to Translation exposure?
2. What are the different method of preparing the consolidated report ?
3. How a company can calculate net exposed asset?
4. In your view, management of which exposure ( transaction vs. translation) should
be the priority of a parent company and why ?
Answer to Multiple Choice Questions:

1. c
2. d
3. c
4. a
5. b
6. c
Multiple Choice Questions:
Short Questions:
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1. Accounting exposure, Multinational Business Finance, Eiteman, Moffett,
Stonehill and Pandey, 10
th
Edition, Pearson Education, ISBN, 81-7758-449-9.

2. Different Accounting Standards for different activities of an organization
http://www.mca.gov.in/Ministry/notification/notification_comp_Acct.html
3. Translation Exposure : http://www.blackwellpublishing.com/kim/Study-
Guide/CH10sguide.doc
4. AS 21 Consolidates Financial Statements, Source:
http://www.mca.gov.in/Ministry/notification/pdf/AS_21.pdf
5. Tata Motors has several joint venture, subsidiary and associate companies:
(Source: http://www.tatamotors.com/our_world/associates.php)

6. Some information regarding Nestles global consolidation of accounts
Source:http://www.nestle.com/Resource.axd?Id=E378CCA5-9052-43F4-B8FB-
BC6AD1319100

7. US GAAP, Indian GAAP and consolidation of Accounts. Source:
http://money.outlookindia.com/article.aspx?86427
8. Translation risk Balance Sheet : Source: http://www.trelleborg.com/annual-
report2009/eng/Governanceandresponsibility/Financialriskmanagement.html

References:
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Annexure14.1
Comparison of Tata Motors B/S ( Standalone vs. Consolidated)
Tata Motors Ltd (Standalone) Tata Motors Ltd (Consolidated)
(Rs in Crs) (Rs in Crs)
Year Mar 09 Year Mar 09
SOURCES OF FUNDS : SOURCES OF FUNDS :
Share Capital 514.05 Share Capital 514.05
Reserves Total 11,716.10 Reserves Total 5,426.59
Equity Share Warrants 0 Equity Share Warrants 0
Equity Application Money 0 Equity Application Money 0
Total Shareholders Funds 12,230.15 Total Shareholders Funds 5,940.64
Secured Loans 5,251.65 Minority Interest 403.03
Unsecured Loans 7,913.91 Secured Loans 13,705.50
Total Debt 13,165.56 Unsecured Loans 21,268.35
Total Liabilities 25,395.71 Total Debt 34,973.85
Total Liabilities 41,317.52
APPLICATION OF FUNDS : APPLICATION OF FUNDS :
Gross Block 13,905.17 Gross Block 62,188.03
Less : Accumulated Depreciation 6,259.90 Less: Accumulated Depreciation 33,269.05
Less:Impairment of Assets 0 Net Block 28,918.98
Net Block 7,645.27 Lease Adjustment 0
Lease Adjustment 0 Capital Work in Progress 10,533.00
Capital Work in Progress 6,954.04 Investments 1,257.40
Investments 12,968.13 Current Assets, Loans & Advances
Current Assets, Loans & Advances Inventories 10,154.68
Inventories 2,229.81 Sundry Debtors 4,800.13
Sundry Debtors 1,555.20 Cash and Bank 4,121.34
Cash and Bank 1,141.82 Loans and Advances 13,287.89
Loans and Advances 4,764.86 Total Current Assets 32,364.04
Total Current Assets 9,691.69
Less : Current Liabilities and
Provisions
Less : Current Liabilities and
Provisions Current Liabilities 24,102.57
Current Liabilities 9,122.37 Provisions 7,059.20
Provisions 1,877.26 Total Current Liabilities 31,161.77
Total Current Liabilities 10,999.63 Net Current Assets 1,202.27
Net Current Assets -1,307.94 Miscellaneous Expenses not written off 86.08
Miscellaneous Expenses not written
off 2.02 Deferred Tax Assets 1,605.10
Deferred Tax Assets 1,144.89 Deferred Tax Liability 2,285.31
Deferred Tax Liability 2,010.70 Net Deferred Tax -680.21
Net Deferred Tax -865.81 Total Assets 41,317.52
Total Assets 25,395.71 Contingent Liabilities 6,220.54
Contingent Liabilities 15,524.91 http://www.capitaline.com
http://www.capitaline.com

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Annexure 14.2:
US GAAP Impact on Some Indian Companies Consolidated Report.
http://www.indianexpress.com/ie/daily/20000716/ibu16034.html

J ULY 15: The application of US generally accepted accounting principles (GAAP) has
had a mixed impact on the bottomlines of Indian companies. While HCL Infosystems and
Hughes Software's balance sheets look much healthier, Infosys Technologies and ICICI's
profits have taken a beating.

Infosys Technologies' net profit under US GAAP comes to $61.34 million (Rs 273 crore),
which is nearly 10 per cent (Rs 29 crore) lower than its $67.77 million (Rs 301 crore) net
profit under the Indian GAAP for the year ended March 2000.

In ICICI's case, its $167.40 million (Rs 745 crore) net profit as per US GAAP is 25 per
cent (Rs 256 crore) lower than its net profit of $225 million (Rs 1001 crore) during the
year ended March 1999.

However, the picture is completely different in the case of HCL Infosystems and Hughes
Software who are already following the stringent accounting policies which has boosted
their bottomlines when profit is calculated as per US GAAP norms.

HCL's net profit of Rs 34.92 crore as per Indian GAAP vaults to Rs 57.14 crore when
calculated under the US GAAP for the year ended J une 1999 as a result of adjustments on
account of accrued income on lease, depreciation and extended warranty income.
Similarly, Hughes Software's profit of Rs 17.81 crore as per Indian GAAP is much lower
when compared to its profit of Rs 23.53 crore under US GAAP for the year ended March
1999.

Infosys' profits were down under US GAAP on account of deferred tax liability of $0.08
million, provision for retirement benefits to employees ($0.74 million) and employee
stock-based compensation ($0.51 million). Similarly, ICICI's profits slipped under US
GAPP norms because of provision on account of allowance for credit losses, amortisation
of fees, deferred tax adjustments, preference dividend payment and inter-company
elimination.

These are the findings of a study done by the Centre for Accounting Research and
Education, a research body promoted by the All India Chartered Accountants Society.

Accounting treatment under US accounting practices is stringent as compared to Indian
accounting standards. Material differences exist between the financial statements
prepared according to Indian and the US GAAP. Material differences arise due to
provision for deferred taxes, accounting for stock-based compensation (ESOP) and
valuation of short-term investments, which are market to market and adjusted against
retained earnings.

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"Major differences occur on account of consolidation of accounts of subsidiaries, which
is currently not followed under the Indian GAAP. As a result, the impact of subsidiaries
which are making losses is not reflected in the accounts under the Indian GAAP," Centre
for Accounting Research and Education's vice-chairman Vinod Rustagi told the Financial
Express.

"There is a need to provide for deferred taxes, amortisation of deferred stock
compensation, consolidation of accounts and provision for diminution in the value of
current investments so as to present a true and fair picture of the company," he said.

Experts feel that with more and more corporates looking for a listing on US bourses,
sooner or later, they will have to follow the US accounting policies to reflect the actual
financial picture. This would result in a scaling down of the profits as shown under the
Indian GAAP.

A company has to accept all the principles under the US GAAP before being eligible for
listing at any of the US stock exchanges. Non-US companies with registered securities in
the US may issue financial statements under US GAAP or another comprehensive basis
of accounting principles provided reconciliation to the US GAAP is provided in the note
to accounts.

Copyright 2000 Indian Express Newspapers (Bombay) Ltd.

http://www.pwc.com/en_GX/gx/ifrs-
reporting/pdf/Illustrative_IFRS_corporate_consolidated_financial_statements_2009.pdf

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