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CHAPTER 10 MANAGEMENT OF TRANSLATION EXPOSURE SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Explain the difference in the translation process between the monetary/nonmonetary method and the temporal method.
Answer: Under the monetary/nonmonetary method, all monetary balance sheet accounts of a foreign subsidiary are translated at the current exchange rate. Other balance sheet accounts are translated at the historical rate exchange rate in effect when the account was first recorded. Under the temporal method, monetary accounts are translated at the current exchange rate. Other balance sheet accounts are also translated at the current rate, if they are carried on the books at current value. If they are carried at historical value, they are translated at the rate in effect on the date the item was put on the books. Since fixed assets and inventory are usually carried at historical costs, the temporal method and the monetary/nonmonetary method will typically provide the same translation.
2. How are translation gains and losses handled differently according to the current rate method in comparison to the other three methods, that is, the current/noncurrent method, the monetary/nonmonetary method, and the temporal method?
Answer: Under the current rate method, translation gains and losses are handled only as an adjustment to net worth through an equity account named the “cumulative translation adjustment” account. Nothing passes through the income statement. The other three translation methods pass foreign exchange gains or losses through the income statement before they enter on to the balance sheet through the accumulated retained earnings account.
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3. Identify some instances under FASB 52 when a foreign entity’s functional currency would be the same as the parent firm’s currency.
Answer: Three examples under FASB 52, where the foreign entity’s functional currency will be the same as the parent firm’s currency, are: i) the foreign entity’s cash flows directly affect the parent’s cash flows and are readily available for remittance to the parent firm; ii) the sales prices for the foreign entity’s products are responsive on a short-term basis to exchange rate changes, where sales prices are determined through worldwide competition; and, iii) the sales market is primarily located in the parent’s country or sales contracts are denominated in the parent’s currency.
4. Describe the remeasurement and translation process under FASB 52 of a wholly owned affiliate that keeps its books in the local currency of the country in which it operates, which is different than its functional currency.
Answer: For a foreign entity that keeps its books in its local currency, which is different from its functional currency, the translation process according to FASB 52 is to: first, remeasure the financial reports from the local currency into the functional currency using the temporal method of translation, and second, translate from the functional currency into the reporting currency using the current rate method of translation.
5. It is, generally, not possible to completely eliminate both translation exposure and transaction exposure. In some cases, the elimination of one exposure will also eliminate the other. But in other cases, the elimination of one exposure actually creates the other. Discuss which exposure might be viewed as the most important to effectively manage, if a conflict between controlling both arises. Also, discuss and critique the common methods for controlling translation exposure.
Answer: Since it is, generally, not possible to completely eliminate both transaction and translation exposure, we recommend that transaction exposure be given first priority since it involves real cash flows. The translation process, on-the-other hand, has no direct effect on reporting currency cash flows, and will only have a realizable effect on net investment upon the sale or liquidation of the assets.
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There are two common methods for controlling translation exposure: a balance sheet hedge and a derivatives hedge. The balance sheet hedge involves equating the amount of exposed assets in an exposure currency with the exposed liabilities in that currency, so the net exposure is zero. Thus when an exposure currency exchange rate changes versus the reporting currency, the change in assets will offset the change in liabilities. To create a balance sheet hedge, once transaction exposure has been controlled, often means creating new transaction exposure. This is not wise since real cash flow losses can result. A derivatives hedge is not really a hedge, but rather a speculative position, since the size of the “hedge” is based on the future expected spot rate of exchange for the exposure currency with the reporting currency. If the actual spot rate differs from the expected rate, the “hedge” may result in the loss of real cash flows.
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PROBLEMS
1. Assume that FASB 8 is still in effect instead of FASB 52. Construct a translation exposure report for Centralia Corporation and its affiliates that is the counterpart to Exhibit 10.7 in the text. Centralia and its affiliates carry inventory and fixed assets on the books at historical values.
Solution: The following table provides a translation exposure report for Centralia Corporation and its affiliates under FASB 8, which is essentially the temporal method of translation. The difference between the new report and Exhibit 10.7 is that nonmonetary accounts such as inventory and fixed assets are translated at the historical exchange rate if they are carried at historical costs. Thus, these accounts will not change values when exchange rates change and they do not create translation exposure.
Examination of the table indicates that under FASB 8 there is negative net exposure for the Mexican peso and the euro, whereas under FASB 52 the net exposure for these currencies is positive. There is no change in net exposure for the Canadian dollar and the Swiss franc. Consequently, if the euro depreciates against the dollar from �1.1000/$1.00 to �1.1786/$1.00, as the text example assumed, exposed assets will now fall in value by a smaller amount than exposed liabilities, instead of vice versa. The associated reporting currency imbalance will be $239,415, calculated as follows:
Reporting Currency Imbalance=
- �3,949,000 0 - �3,949,000 0
- = $239,415.
�1.1786 / $1.00 �1.1000 / $1.00
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Translation Exposure Report under FASB 8 for Centralia Corporation and its Mexican and Spanish Affiliates, December 31, 2005 (in 000 Currency Units) Assets Cash
Accounts receivable Inventory Net fixed assets Exposed assets
Liabilities Accounts payable Notes payable Long-term debt Exposed liabilities Net exposure
2. Assume that FASB 8 is still in effect instead of FASB 52. Construct a consolidated balance sheet for Centralia Corporation and its affiliates after a depreciation of the euro from �1.1000/$1.00 to �1.1786/$1.00 that is the counterpart to Exhibit 10.8 in the text. Centralia and its affiliates carry inventory and fixed assets on the books at historical values.
Solution: This problem is the sequel to Problem 1. The solution to Problem 1 showed that if the euro depreciated there would be a reporting currency imbalance of $239,415. Under FASB 8 this is carried through the income statement as a foreign exchange gain to the retained earnings on the balance sheet. The following table shows that consolidated retained earnings increased to $4,190,000 from $3,950,000 in Exhibit 10.8. This is an increase of $240,000, which is the same as the reporting currency imbalance after accounting for rounding error.
Canadian Dollar CD200 0 0 0 CD200 CD 0 0 0 CD 0 CD200
Mexican Peso Ps 6,000 9,000 0 0 Ps15,000 Ps 7,000 17,000 27,000 Ps51,000 (Ps36,000)
Euro � 825 1,045 0 0 � 1,870 � 1,364 935 3,520 � 5,819 (�3,949)
Swiss Franc SF 0 0 0 0 SF 0 SF 0 1,400 0 SF1,400 (SF1,400)
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