Accounting Exposure

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.
2Translation Exposure
When converting financial statement items (transactions)
denominated in currencies other than the parent currency, two
choices of exchange rate are possible:
² The historical rate, the exchange rate prevailing at the time
of the transaction
² The current rate, the exchange rate prevailing at the balance
sheet date or during the income statement period
Translation Exposure
Conversion of financial statements into the parent’s currency
creates the following concerns:
² The exposure to exchange rate changes
² The treatment of translation gains or losses
SFAS 52 provides two translation methods:
² The temporal method, or remeasurement process

² The current rate method, or translation process
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.
There exists three categories of foreign operations:
² Relatively self-contained, independent entities operating primarily in
local markets. The functional currency of these entities is generally the
local currency.
² 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.
² Subsidiaries operating in highly inflationary economies. The use of the
parent’s currency as the functional currency is required in this case.
² If the foreign entity’s functional currency is the local
currency, financial statements are translated using the
current rate method.
² If the foreign entity’s functional currency is the parent’s
currency, financial statements are remeasured using the
temporal method.
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.
The Current Rate Method
² All assets and liabilities are translated at the rate in effect on the balance
sheet date.
² 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).
² Dividends paid are translated at the rate in effect on the payment date.
² Common stock, paid-in capital and retained earnings are translated at
historical rates.
10The 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
Advantages of CTA
² Eliminates the variability of net earnings due to translation gains or

losses.
² The relative proportions of individual balance sheet accounts remain the
same (debt-to-equity ratio, for example).
Main disadvantage of CTA
² Violates the accounting principle of carrying balance sheet accounts at
historical cost.
12The 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
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.
14The Current Rate Method: An Example
Foreign Subsidiary, Inc., (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
Foreign Subsidiary, Inc.
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
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
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
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
Assets as of December 31 (in $)
2000 2001 2002
(Rate) (LC1.25/$) (LC1.15/$) (LC1.22/$)

Cash 33 177 328
Fixed assets 826 1,315 1,662
Net fixed assets 682 939 1,062
Total assets 1,170 1,774 2,162
Liabilities and Equity as of December 31 (in $)
2000 2001 2002
Total liabilities 485 897 1,190
Common stock ? ? ?
Retained earnings ? ? ?
Total equity ? ? ?
Cumulative translation adjustment ? ? ?
21
Income Statement (in $)
2001 2002
(Rate) (LC1.18/$) (LC1.20/$)

COGS 549 611
Net income 128 148
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
CS2000 =
276
1:25
= $221:
Since common stock does not change in 2001 and 2002, the
translated value is $221 in these years, too.
23
What happens to retained earnings (RE)?
Retained earnings in 2000 are translated at the rate prevailing
when the company was acquired, i.e. LC1.25/$, which gives
RE2000 = 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
RE2001 = RE2000 + 1511:18 = 465 + 128 = $593:

In 2002, retained earnings increased by LC178 and the 2002
average exchange rate is LC1.20/$. Translated retained earnings
in 2002 are then
RE2002 = RE2001 + 1781:20 = 593 + 148 = $741:
25
2000 2001 2002
Total equity 685 814 962
Cumulative translation adjustment – 63 10
26The Temporal Method
² 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).
² Non-monetary assets (inventory, fixed assets, etc.) and
non-monetary liabilitites are translated at their historical
rate.
27
The Temporal Method
Note:
² 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.
² 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.
² Dividends paid are translated at the rate in effect on the payment
date.
² 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:
Logic behind differentiating monetary and non-monetary assets:
² Translation gains and losses on monetary accounts are

presumed meaningful components of expenses or revenue
because monetary accounts closely approximate market
values.
² 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.
32The Temporal Method: An Example
2000 2001 2002
Cash 33 177 328
Inventory 168 ? ?
Current assets 489 ? ?
Fixed assets 826 ? ?
Accumulated depreciation 144 ? ?
Net fixed assets 682 ? ?
Total assets 1,170 ? ?
33

2000 2001 2002
Retained earnings 465 ? ?
Total equity 685 ? ?
Total liabilities and equity 1,170 ? ?
2001 2002
COGS ? ?
Gross margin ? ?
Depreciation ? ?
Foreign exchange gain (loss) ? ?
Net income ? ?
35
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,
COGS2001 =
210
1:25
648¡210
1:18
= $539:
The same procedure can be applied to obtain 2002 COGS.
Inventory
Since COGS in both 2001 and 2002 is greater than the previous
year-end inventory, inventory in 2001 and 2002 was
2001 :
264
1:18
= $224
2002 :
372
1:20
= $310
37
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
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
Blended rate for 2001 =
FA2001 in LC
FA2001 in $
1;512
1;232
= 1:227
and thus
Dollar depreciation in 2001 =
252
1:227
= $205:
39
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.
2000 2001 2002
Cash 33 177 328
Fixed assets 826 1,232 1,662
Net fixed assets 682 883 1,067
Total assets 1,170 1,712 2,172
41
2000 2001 2002

Total equity 685 815 982
2001 2002
COGS 539 615
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

Accounting Exposure

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Accounting Exposure

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Accounting Exposure

Eiteman et al., Chapter 10

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.

When converting ﬁnancial statement items (transactions)

denominated in currencies other than the parent currency, two

choices of exchange rate are possible:

² The historical rate, the exchange rate prevailing at the time

² The current rate, the exchange rate prevailing at the balance

sheet date or during the income statement period

Conversion of ﬁnancial statements into the parent’s currency

creates the following concerns:

² The exposure to exchange rate changes

² The treatment of translation gains or losses

SFAS 52 provides two translation methods:

² The temporal method, or remeasurement process

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

This currency may be the foreign subsidiary’s local currency, the

parent’s currency, or a third currency.

There exists three categories of foreign operations:

² Relatively self-contained, independent entities operating primarily in

local markets. The functional currency of these entities is generally the

² 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.

² Subsidiaries operating in highly inﬂationary economies. The use of the

parent’s currency as the functional currency is required in this case.

² If the foreign entity’s functional currency is the local

currency, ﬁnancial statements are translated using the

current rate method.

² If the foreign entity’s functional currency is the parent’s

currency, ﬁnancial statements are remeasured using the

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

2. Translated from functional to parent’s currency using the

current rate method.

The Current Rate Method

² 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).

² Common stock, paid-in capital and retained earnings are translated at

10The Current Rate Method

translation are reported in a separate equity account called

cumulative translation adjustment (CTA).

current rate method is used.

The Current Rate Method

² Eliminates the variability of net earnings due to translation gains or

² The relative proportions of individual balance sheet accounts remain the

same (debt-to-equity ratio, for example).

Main disadvantage of CTA

² Violates the accounting principle of carrying balance sheet accounts at

12The 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