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" MANAGING TRANSLATION EXPOSURE : TOWARDS A STRATEGIC APPROACH "

Since the 1950s, the global enviornment in which Multinational Corporations (MNCs) have operated has remarkably grown. The share of world exports in world GDP between the early 1970s and late 1990s increased from one-eigth to one-fifth. The stock of foreign direct investment as a proportion of world output doubled from 5 to 10 % during a period of 1980-1996. Global volume in foreign exchange trading exceeds $ 1500 billion a day in 1997. As per the UNCTAD 2000 reports, there are around 60,000 companies having more than 500,000 affiliates all over the world.

International money and capital markets in stocks, bonds, foreign exchange futures, options and euro-currencies approach 24 hours a day operational status. Because of this growth in international commercial transactions, cross-border investments, fund flows and financial operations in general have to be considered when global companies plan, formulate and implement optimal organizational structures for their international operations. These international operations must be consolidated, translated into the parent company's currency reported back to parent firms, accounted for, so that international top management may properly manage their respective companies.


. WHAT IS TRANSLATION EXPOSURE ? :

Translation Exposure, commonly known as Accounting Exposure, arises because financial statements of foreign affiliates which are stated in a foreign currency, must be restated in the parent company's reporting currency to prepare consolidated financial statements. If exchange rates have changed since the previous reporting period, this translation or restatement, of those assets, liabilities, revenues, expenses, gains and losses that are denominated in foreign currencies will result in foreign exchange gains or losses. The possible extent of these gains or losses is measured by the translation exposure figures.


. DOES TRANSLATION EXPOSURE MATTER ? :

There are several advantages for consolidating the foreign operations into the MNCs books of accounts. Consolidation presents a more complete picture of the global firm and enables company analysts to better evaluate and plan operations. Hidden reserves can be more readily disclosed. It reduces secrecy, especially for tax authorities. It facilitates the implementation of company-wide employee incentive programs.

But the important thing is, whether this translation exposure affect an MNC's cash flows or not ? Some analysts suggest that translation exposure is not relevant, and hence, subsidiary earnings need not be converted into the parent's currency. However, the consolidated earnings of MNCs with foreign subsidiaries are affected as a result of translation exposure. Since earnings can affect stock prices, many MNCs are concerned about translation exposure. There have been number of examples in which news that an MNC's earnings were adversely affected by translation exposure resulted in an immediate decline in their respective stock prices. For example, in 1996, the Chief Executive of IBM announced that Second Quarter's earnings would be reduced by $ 0.25 per share simply because of the impact of exchange rates on the foreign earnings as they are translated in dollars to consolidate all of IBM's earnings. If this decline in earnings is not important to investors because it only aff!
ects reported earnings and does not affect cash flow, then investors should not have reacted to the announcement. Yet, investors did react by selling shares of IBM stock.

Many investors tend to use earnings while valuing firms using estimated cash flows or price earnings ratio. Since an MNC's translation exposure affects its consolidated earning which affects the MNC's value, it has to be accepted that MNCs are concerned about translation exposure. What attributes to this fact, is the important question. Translation Exposure is dependent on the degree of foreign involvement by foreign subsidiaries, the locations of foreign subsidiaries and the accounting methods being used by them.


. MEASURING TRANSLATION EXPOSURE :

If currency values change, as explained earlier, foreign exchange translation gains or losses may result. Assets and liabilities that are translated at the current exchange rate are considered to be exposed, those translated at a historical exchange rate will maintain their historic home currency values, and hence, not exposed. Thus translation exposure is simply the difference between exposed assets and exposed liabilities. There are four different accounting methods to record these exposed results. It is quite pertinent here to take a brief note of those methods.


(a)CURRENT / NON-CURRENT METHOD = The underlying priniple of this method is that assets and liabilities should be translated based on their maturity. Current assets and current liabilities, which usually have a maturity of one year or less, are converted at the current exchange rate. Non-current assets and liabilities are translated at the historical exchange rate in effect at the time they were first recorded on the books. Under this method, a foreign subsidiary with current assets in excess of current liabilities will cause a translation gain (loss) if the local currency appreciates (depreciates). The reverse will happen in case of negative working capital.

As far as income items are concerned, most of the income items are converted at the average exchange rate of the period. The depreciation item, as it relates to non-current items, will be translated at the same historical rate at which the corresponding item in the balance-sheet.


(b) MONETARY / NON-MONETARY METHOD = All monetary items appearing in balance-sheet such as cash, marketable securities, accounts receivables, notes payable, accounts payable etc. of a foreign subsidiary are translated at the current exchange rate. All other non-monetary items such as inventory, fixed assets and long-term investments are translated at historical rates.

Under this method, most income statement items are translated at the average exchange rate for the period. However, depreciation is converted at the historical rate of the items recorded I the balance-sheet.


(c) TEMPORL METHOD = This method is a modified version of monetary / non-monetary method. Monetary items such as cash, receivables and payables, both current and non-current are converted at the current exchange rate. Other items are translated at the current rate, if they are taken on books at the current value.

Income items are normally translated at an average rte for the reporting period. However, depreciation and amortization charges are translated at historical rates.

(d) CURRENT RATE METHOD = All balance-sheet and income statement items are translated at the current rate. Under this method, if a firm's foreign currency denominated assets exceed its foreign currency denominated liabilities, a devaluation must result in a loss and a revaluation, in a gain.



. WHICH TRANSLATION METHOD IS SUITABLE ? :


This is, in fact, a key issue from financial theory point of view. If compared, the current / non-current method seems to be less realistic as it values long-term debt at historical cost. However, other methods justify the translation as monetary assets and liabilities are valued at the current exchange rate.

If global scenario is reviewed, US MNCs accepted current / non-current method of foreign currency translation from 1930 to 1975. After 1976, US MNCs adopted FASB - 8 which was based on temporal method. But, this method faced criticisms from various spheres. The paramount issue was whether the real assets of a foreign subsidiary should be translated at historical exchange rate, as provisioned in FASB - 8 or at the current exchange rate ? A number of empirical studies were conducted to compare FASB - 8 and FASB - 52, the current rate method. FASB - 52 assumes that real assets are exposed one for one to exchange rate changes. Some of the renowned researchers like Collins and Salatka, and Bartov found that earnings reponse co-efficients of US MNC with foreign operations improved when FASB - 52 was adopted.

It will be of great concern to quote the findings of surveys conducted by Arthur Anderson & Co.; Coopers and Lybrand; Deloitte and Touch, Earnst & Young; KPMG Peat Marwick, and Price Waterhouse (1991) and to learn which method is preferred and adopted by various developed nations. The MNCs have been categorized as 'Integrated Foreign Entity' and 'Self-sustaining Foreign Entity'. At international level, temporal method is used in the case of former while current rate method is used in case of latter. In the countries like USA, Canada, Australia, Netherlands, France & U.K., the temporal and current rate methods are used in case of 'integrated' and 'self-sustaining' foreign entities respectively. But Japan and Germany use the same method i.e. temporal method in both the cases.


. EVIDENCES FROM ASIAN COUNTRIES :


As a number of research works are there from U.S. MNCs point of view critically proving that FASB - 52 justifies in most of the cases. But there is hardly any research recording the translation gains or losses from Asian perspective.

Needless to say, Asian region has fairly done well in terms of foreign commercial transactions particularly following the phase of globalization. The number of Asian companies are enhancing their exports to European and American regions. Large scale companies are establishing affiliates overseas as well. This is certainly a hot issue to address this accounting exposure specially when the most of the Asian countries are having the weaker currency values against their trading partners. The 1997 Asian Financial Crisis has jerked the large scale export-oriented business firms almost in the whole Asian region. Some of the companies were found to record heavy losses due to translation exposure while others reported gains in terms of translation exposure despite of having actual business losses. Ultimately, it affects the shareholders' wealth. At this stage, it seems very much exigent to highlight the accounting treatment being followed by the Asian countries to help cope up with t!
ranslation exposure.


(a)CHINA = In 1992, the Accounting Standards for Business Enterprises (ASFBE) was promulgated leading to substantial changes in Chinese accounting system. Making this standard effective from July 1993, it aimed to harmonise accounting regulations across all industries and types of business ownership in the country.

According to the ASFBE, business enterprises must use Chinese Currency (RMB Y) as the recording currency. However, foreign currency may be chosen as the recording currency if it is the functional currency in operation. But, if transactions are denominated in foreign currencies, then they should be translated into Chinese currency based on the official exchange rates on transaction dates. So all foreign currency items must be translated as per the exchange rates operative on the balance-sheet date. The exchange gains and losses should form part of current income accounts.


(b) HONGKONG = The Hongkong Society of Accountants (HKSA) came into existence in 1973 to efficiently and effectively manage the accounting policies related issues. According to HKSSAP No 11, the temporal method is recommended for foreign transactions. For foreign investments, the closing rate / net investment method is recommended, though the temporal method is suggested for foreign subsidiaries serving as extensions of the parent company.


(c ) SINGAPORE = Basically, Singapore adopted the International Accounting Standards from the very beginning. In December 2002, Committee on Corporate Disclosure and Governance (CCDG) issued the Financial Reporting Standards (FRS) which are quite similar to the then existing Singapore Accounting Standards (SAS). Except with few minor differences, FRS and IFRS are the same. IFRS - 30 provides that assets, liabilities and equity items are to be translated at the closing rate existing at the date of each balance sheet presented. Items in the P&L account are translated at rates on transaction dates or average rate for the period.


(c) MALAYSIA = In Malaysia, the accounting principles are governed by the Malaysian Accounting Standard Board (MASB). The new provision of MASB - 6 is issued and made operative from July 1, 1999 superseding MASB approved accounting standards IAS - 21. A foreign currency translation should be recorded, on initial recognition in the reporting currency, by applying to the foreign currency amount the exchange rate between the reporting currency and the foreign currency at the date of the transaction. Foreign currency monetary items should be reported using the closing rate while non-monetary items at the date of the transaction. The profit or loss arising from such translation should form part of Income Statement either income or expense.


(d) PHILIPPINES = The Philippines Institute of Certified Public Accountants (PICPA) established and improved generally accepted accounting principles (GAAP) in Philippines. Foreign currency transactions are generally translated at the exchange rate as of the transaction date. Exchange differences are generally treated as a gain or loss in the profit and loss statement. This SFAs No. 8 is quite similar to FASB - 52.


(e) INDIA = The Institute of Chartered Accountants of India is the regulating body of accounting standards and principles. The accounting standard No. 11 is mendated regarding 'Accounting for the Effects of Changes in Foreign Exchange Rates' to come into force from April 1, 1995. According to this AS No. 11, a transaction in a foreign currency should be recorded in the reporting currency and the foreign currency by applying to the foreign currency at the date of the transaction. Monetary items should be reported on closing rate while non-monetary items at the exchange rates at the date of the transaction. The exchange difference should be recognised as income or expense in the period in which they arise.


(f) KOREA = The Korean accounting principles and standards can be found on the same triple form as it is in Japan. The Korean Securities and Exchange Commission (KSEC) takes the main responsibility for standard setting in the field of accounting. As regarding foreign currency translation, the monetary / non-monetary method is adopted by the Korean firms. The current rate method, however, is allowed for the foreign currency translation of foreign subsidiaries and foreign branches. Translation gains and losses arising from long-term foreign currency assets or liabilities are not to be recorded as deferred assets or liabilities but are to be included in determining net income for the period. Foreign currency translation gains and losses resulting from foreign branch and subsidiary operations are not deferred but are accumulated in a separate account called 'Overseas Business Translation Debit / Credit in Shareholders' Equity'.


Reviewing the accounting principles adopted by the Asian countries regarding translation exposure, it is evident that most of the countries are still in the phase of adopting the US based FASB - 52 provision. Sine the currency volatility between Asian countries and rest of the world is bit high, so these Asian countries always have to face this problem. Now, the most important issue comes is how to manage this exposure tactfully so as to minimize the risk of loss.

. MANAGING ACCOUNTING EXPOSURE :


The growing foreign commercial turnover and high degree of foreign exchange volatility have posed a great deal of attention for the managers. Dealing with this critical issue from accounting perception is not the complete solution. Perhaps, it requires a pragmatic and strategic approach to consummate this issue more successfully. The main technique to minimise the accounting exposure is called a balance-sheet hedge. Earlier some firms were observed to hedge accounting exposure in the forward market with the hope to realise profit to offset the non-cash loss from translation. This encouraged the speculation activities in the forward market. Hedging a particular currency exposure means establishing an offsetting currency position such that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge. If this can be achieved for each foreign currency, net accounting exposure will be zero.

The hedging technique should be a standard technique responding to anticipated currency changes on the basis of costs and benefits. Based on the hedging strategy, the cost factor should analytically be evaluated. If a depreciation is likely : (i) it may incur transaction cost in case of selling local currency forward, (ii) it may loose sale and profits in case the credit is tightened, (iii) it may cost higher interest rate in case of borrowing locally, (iv) it may have financing and holding costs in case of increasing imports of hard currency goods, (v) it may cause the credit reputation in case of delaying payment of accounts payable, (vi) it may cause operational problems in case of reducing levels of local currency cash and marketable securities. And so will be the reverse situation in case of anticipated appreciation of the currency.

On the basis of the cost-and-benefit based strategy, managers can adopt any of the following steps to manage their translation exposure effectively :-

Adjusting Fund Flows.

Entering into Forward Contracts.

Exposure Netting.


References


Eli Bartov, "Foreign Currency Exposure of Multinational Firms : Accounting Measures
and Market Valuation", Contemporary Accounting Research, 1997

Collins and Salatka, "Noisy Accounting Earnings Signals and Earnings Response
Co-efficients : The Case of Foreign Current Accounting", Contemporary
Accounting Research, 1994

P.A. Belk and M. Glaum, "The Management of Foreign Exchange Risk in U.K.
Multinationals : An Empirical Investigation", Accounting and Business
Researh, 21 (Winter), 1990

Houston, Carol Olson, "Translation Exposure Hedging Post SFAS No. 52", Journal of
International Financial Management and Accounting, Vol 2, Nos 2 & 3,
Summer & Autumn 1990

Michael Adler and Bernard Dumas, "Exposure to Currency Risk : Definition and
Measurement", Financial Management, 13, No. 2 (Summer) 1984

Hakins, Ferris and Selling, "International Financial Reporting and Analysis : A
Contextual Emphasis", 1996

Thomas I. Selling and George H. Sorter, "FASB Statement No. 52 and Its Implications
for Financial Statement Analysis", Financial Analysts Journal 39, May-June
1983

Raj Aggarwal, "Analyzing Multinational Company Financial Statement : Role of the
New Accounts Translation Standard", Southern Business Review 4 (Spring)
1978

Kirt C. Butler, "Multinational Finance", South Weston College Publishing, Thomson
Learning, 2000

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