Translation Exposure INTERNATIONAL FINANCIAL

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Chapter FourteenManagement ofTranslation Exposure INTERNATIONAL14FINANCIALMANAGEMENTChapter Objective:This chapter discusses the impact that unanticipatedchanges in exchange rates may have on theconsolidated financial statements of the multinationalcompany.EUN / RESNICKSecond Edition

Chapter Outline Translation MethodsFASB Statement 8FASB Statement 52Management of Translation ExposureEmpirical Analysis of the Change from FASB 8 toFASB 52McGraw-Hill/Irwinreserved.14-1Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Translation Methods Current/Noncurrent MethodMonetary/Nonmonetary MethodTemporal MethodCurrent Rate MethodMcGraw-Hill/Irwinreserved.14-2Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Current/Noncurrent Method The underlying principal is that assets andliabilities should be translated based on theirmaturity. Current assets translated at the spot rate.Noncurrent assets translated at the historical rate ineffect when the item was first recorded on the books.This method of foreign currency translation wasgenerally accepted in the United States from the1930s until 1975, at which time FASB 8 right 2001 by The McGraw-Hill Companies, Inc. All rights

Current/Noncurrent MethodCurrent assetstranslated atthe spot rate.e.g. DM2 1 Noncurrentassetstranslated atthe historicalrate in effectwhen the itemwas firstrecorded onthe books.e.g. DM3 1 McGraw-Hill/Irwinreserved.14-4Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Monetary/Nonmonetary Method The underlying principal is that monetary accounts have asimilarity because their value represents a sum of moneywhose value changes as the exchange rate changes.All monetary balance sheet accounts (cash, marketablesecurities, accounts receivable, etc.) of a foreign subsidiaryare translated at the current exchange rate.All other (nonmonetary) balance sheet accounts (owners’equity, land) are translated at the historical exchange ratein effect when the account was first recorded.McGraw-Hill/Irwinreserved.14-5Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Monetary/Nonmonetary Method All monetarybalance sheetaccounts aretranslated at thecurrent exchangerate. e.g. DM2 1All other balancesheet accounts aretranslated at thehistorical exchangerate in effect whenthe account was firstrecorded.e.g.DM3 1McGraw-Hill/Irwinreserved.14-6Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Temporal Method The underlying principal is that assets andliabilities should be translated based on how theyare carried on the firm’s books.Balance sheet account are translated at the currentspot exchange rate if they are carried on the booksat their current value.Items that are carried on the books at historicalcosts are translated at the historical exchange ratesin effect at the time the firm placed the item on thebooks.McGraw-Hill/Irwinreserved.14-7Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Temporal Method Items carried on thebooks at theircurrent value aretranslated at thespot exchange rate.e.g. DM2 1Items that arecarried on thebooks at historicalcosts are translatedat the historicalexchange rates.e.g. DM3 1McGraw-Hill/Irwinreserved.14-8Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Current Rate Method All balance sheet items (except for stockholder’sequity) are translated at the current exchange rate.Very simple method in application.A “plug” equity account named cumulativetranslation adjustment is used to make thebalance sheet balance.McGraw-Hill/Irwinreserved.14-9Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Current Rate Method All balance sheetitems (except forstockholder’sequity) aretranslated at thecurrent exchangerate.A “plug” equityaccount namedcumulativetranslationadjustment is usedto make the balancesheet balanceMcGraw-Hill/Irwinreserved.14-10Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

How Various Translation Methods Deal witha Change from DM3 to DM2 1earningsSpot exchange rateMcGraw-Hill/Irwinreserved.14-11Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

How Various Translation Methods Deal witha Change from DM3 to DM2 1Bookvalue ofinventoryhistoricrateearningsBook value of inventoryat spot exchange rateMcGraw-Hill/Irwinreserved.14-12Current value of inventoryat spot exchange rate.Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

How Various Translation Methods Deal witha Change from DM3 to DM2 13spot exchange rate.Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

How Various Translation Methods Deal witha Change from DM3 to DM2 1earningsspot rateMcGraw-Hill/Irwinreserved.14-14Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

How Various Translation Methods Deal witha Change from DM3 to DM2 1earningshistorical rateMcGraw-Hill/Irwinreserved.14-15spot rateCopyright 2001 by The McGraw-Hill Companies, Inc. All rights

How Various Translation Methods Deal witha Change from DM3 to DM2 1earningshistorical rateMcGraw-Hill/Irwinreserved.14-16Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

How Various Translation Methods Deal witha Change from DM3 to DM2 1earningsFrom income statementMcGraw-Hill/Irwinreserved.14-17Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

How Various Translation Methods Deal witha Change from DM3 to DM2 1earningsUnder the current rate method, a “plug” equity account namedcumulative translation adjustment makes the balance sheet balance.McGraw-Hill/Irwinreserved.14-18Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

How Various Translation Methods Deal witha Change from DM3 to DM2 1Sales translate at average exchange rate over the period, DM2.50 1For notes, see Exhibit 14.1McGraw-Hill/Irwinreserved.14-19Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

How Various Translation Methods Deal witha Change from DM3 to DM2 1Translate at DM2.50 1Translate at new exchange rate, DM2.00 1For notes, see Exhibit 14.1McGraw-Hill/Irwinreserved.14-20Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

How Various Translation Methods Deal witha Change from DM3 to DM2 1Translate at DM3 1Translate at average exchange rate, DM2.5 1For notes, see Exhibit 14.1McGraw-Hill/Irwinreserved.14-21Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

How Various Translation Methods Deal witha Change from DM3 to DM2 1Note the effect on after-tax profit.For notes, see Exhibit 14.1McGraw-Hill/Irwinreserved.14-22Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

How Various Translation Methods Deal witha Change from DM3 to DM2 1Note the effect that foreign exchange gains (losses) has on net income.For notes, see Exhibit 14.1McGraw-Hill/Irwinreserved.14-23Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

FASB Statement 8 Essentially the temporal method, with somesubtleties. Such as translating inventory at historical rates, whichis a hassle.Requires taking foreign exchange gains and lossesthrough the income statement.This leads to variability in reported earnings.Which leads to irritated corporate t 2001 by The McGraw-Hill Companies, Inc. All rights

FASB Statement 52 The Mechanics of the FASB 52 TranslationProcess Function CurrencyReporting CurrencyHighly Inflationary EconomiesMcGraw-Hill/Irwinreserved.14-25Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

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 itsconsolidated financial t 2001 by The McGraw-Hill Companies, Inc. All rights

The Mechanics of FASB Statement 52 Two-Stage Process First, determine in which currency the foreign entitykeeps its books.If the local currency in which the foreign entity keepsits books is not the functional currency, remeasurementinto the functional currency is required.Second, when the foreign entity’s functional currency isnot the same as the parent’s currency, the foreignentity’s books are translated using the current t 2001 by The McGraw-Hill Companies, Inc. All rights

The Mechanics of FASB Statement 52Parent’s currencyForeignentity’s bookskept urrencyLocal currencyThirdcurrencyTemporalRemeasurementCurrent RateTranslationParent’s CurrencyMcGraw-Hill/Irwinreserved.14-28Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Highly Inflationary Economies Foreign entities are required to remeasurefinancial statements using the temporal method“as if the functional currency were the 29Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Management of Translation Exposure Translation Exposure vs. Transaction ExposureHedging Translation Exposure Balance Sheet HedgeDerivatives HedgeTranslation Exposure vs. Operating ExposureMcGraw-Hill/Irwinreserved.14-30Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Translation Exposure versusTransaction Exposure Translation Exposure Transaction Exposure The effect that unanticipated changes in exchange rateshas on the firm’s consolidated financial statements.An accounting issue.The effect that unanticipated changes in exchange rateshas on the firm’s cash flows.A finance issue and the subject of Chapter 13.It is generally not possible to eliminate bothtranslation exposure and transaction exposure.McGraw-Hill/Irwinreserved.14-31Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Hedging Translation Exposure If the managers of the firm wish to manage theiraccounting numbers as well as their business, theyhave two methods for dealing with translationexposure. Balance Sheet HedgeDerivatives HedgeMcGraw-Hill/Irwinreserved.14-32Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Balance Sheet Hedge Eliminates the mismatch between net assets andnet liabilities denominated in the same currency.May create transaction exposure, however.McGraw-Hill/Irwinreserved.14-33Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Derivatives Hedge An example would be the use of forward contractswith a maturity of the reporting period to attemptto manage the accounting numbers.Using a derivatives hedge to control translationexposure really involves speculation about foreignexchange rate changes, however.McGraw-Hill/Irwinreserved.14-34Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Translation Exposure versusOperating Exposure The effect that unanticipated changes in exchangerates has on the firm’s ongoing operations.Operating exposure is a substantive issue withwhich the management of the firm should concernitself with.McGraw-Hill/Irwinreserved.14-35Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Empirical Analysis of the Changefrom 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 reactto cosmetic earnings changes.Other researchers have found similar results wheninvestigating other accounting changes.This highlights the futility of attempting tomanage translation gains and losses.McGraw-Hill/Irwinreserved.14-36Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

End Chapter FourteenMcGraw-Hill/Irwinreserved.14-37Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

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 curre

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