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Measuring Accounting Exposure. International Finance. Dr. A. DeMaskey. Learning Objectives. What are the three different types of foreign exchange exposures? What is accounting exposure and how is it measured?

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measuring accounting exposure

Measuring Accounting Exposure

International Finance

Dr. A. DeMaskey

learning objectives
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?
foreign exchange risk management
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 firm’s value due to uncertain changes in the rate of exchange.
types of exposures
Types of Exposures
  • Accounting or Translation Exposure
  • Economic Exposure
    • Transaction Exposure
    • Operating Exposure
translation exposure
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-termin nature
transaction exposure
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-termin nature
operating exposure
Operating Exposure
  • It arises because currency fluctuations combined with price level changes can alter the amounts and riskiness of a firm’s future revenues and costs.
    • Real exchange gains or losses
    • Prospective in nature
    • Long-termin nature
economic exposure
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.
measuring translation exposure
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.
translation methods
Translation Methods
  • Current/Noncurrent Method
  • Monetary/Nonmonetary Method
  • Temporal Method
  • Current Rate Method
fasb 8 january 1 1976
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.
fasb 52 december 15 1981
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 parent’s consolidated balance sheet called the “Cumulative Translation Adjustment (CTA)” account.
reporting vs functional currency
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
us translation procedures
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
hyperinflation countries
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
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/$

Measuring Translation Exposure: Illustration
slide17
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/$

transaction exposure18
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.
net transaction exposure
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.
accounting practice and economic reality
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.