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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.
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.
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!
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.
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.
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.
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.
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.
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.
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
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.
. MANAGING ACCOUNTING EXPOSURE :
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.
and Salatka, "Noisy Accounting Earnings Signals and Earnings Response
P.A. Belk and M. Glaum, "The Management
of Foreign Exchange Risk in U.K.
Houston, Carol Olson,
"Translation Exposure Hedging Post SFAS No. 52", Journal of
Michael Adler and Bernard Dumas, "Exposure to Currency Risk :
Hakins, Ferris and Selling, "International Financial Reporting
and Analysis : A
Thomas I. Selling
and George H. Sorter, "FASB Statement No. 52 and Its Implications
Raj Aggarwal, "Analyzing Multinational Company Financial Statement
: Role of the
Kirt C. Butler, "Multinational Finance",
South Weston College Publishing, Thomson
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