Dr. P.V. Viswanath

pviswanath@pace.edu

Exchange Rate Exposure

P.V. Viswanath, 2005

• Translation Exposure
  • FASB 52
  • Leading and Lagging
  • Netting
  • In-house factoring
• Transactions Exposure
• Operating Exposure
• Further notes on Operating Exposure based on Maurice Levi (enter password for Classnotes site; then click on link of "Notes on Operating Exposure."

Translation Exposure:

FASB-52

(This section follows an excellent treatment by Reid W. Click and Joshua Coval, "The Theory and Practice of International Financial Management," Prentice Hall, 2002, Chapter 6)
Under general accepted accounting principles, the nature of financial reporting for a firm with foreign investments depends on the extent of overseas operations. Certainly, if the firm has a fully owned subsidiary, the firm will have to consolidate the financial statements of that overseas subsidiary into its financial statements. The question is that since the books of the subsidiary will be kept in foreign currency, how should the translation be done?

The method prescribed by FASB-52 is known as the current rate method. Under this method, all assets and liabilities on the balance sheet are valued using the exchange rate prevailing on the date of the balance sheet statement. All items in the equity account are translated at their appropriate historical rates, which were in effect when they were originally posted to the balance sheet. This transfers the impact of the exchange rate to the equity account. Since all items are translated at the current rate, the net exposure is simply the difference between total assets and total liabilities, i.e. the equity account. This is the only account that is assumed to be a long-term investment at risk.

One problem with this approach is that this could cause extreme variability in the net income figure. If we assume that exchange rate changes are transient, this would unnecessarily give an impression of a volatile business. To avoid this, FASB-52 prescribes that translation gains and losses shoudl bypass the income statement and be accumulated in a separate equity account in the balance sheet, called a "cumulative translation adjustment." However, if the foreign business is sold or discontinued, then the translation gains and losses are recognized.

Consider the following example; for simplicity, in this example there are no additional retained profits from one year to the next and the balance sheet remains unchanged. This allows us to focus on the impact of exchange rate changes on the balance sheet, without worrying about the income statement.

Example: Continental Labs, a US firm based in Seattle, operates a new wholly-owned subsidiary in France that produces and sells industrial chemicals. The subsidiary was started with FF 10,000 in capital when the exchange rate was FF5 = $1. Profits of FF 2,000 were retained in the first year of operation, when the exchange rate remained at FF5=$1. The balance sheet for the subsidiary at the beginning of the second year is shown in Column 1 of the accompanying Table 1. At the end of the second year, the balance sheet is completely unchanged, implying that there are no additonal retained profits. If the exchange rate remains at FF5 = $1, the translation of the balance sheet is the simple case shown in Column 2, where the total assets are valued at $24,000 and the total equity is valued at $2400. There are no foreign exchange gains or losses because the exchange rate does not change.

Table 1: Balance Sheet for Contiental Labs of France Translated Using the Current Rate Method

	1 French Francs	2 FF 5 = $1	3 FF6 = $1	4 FF 4 = $1
Assets
Cash	1000	2000	1667	2500
Accounts Receivable	6000	1200	1000	1500
Inventory	14000	2800	2333	3500
Plant and Equipment (net)	90000	18000	15000	22500
Total Assets	120000	24000	20000	30000
Liabilities and Equity
Accounts Payable	16000	3200	2667	4000
Current Debt	4000	800	667	100
Long-Term Debt	88000	17600	14666	22000
Total Liabilities	108000	21600	18000	27000
Capital Stock	10000	2000	2000	2000
Retained Earnings	2000	400	400	400
Cumulative Translation Adjustment			(400)	600
Total Equity	12000	2400	2000	3000
Total Liabilities and Equity	120000	24000	20000	30000

If the franc depreciates to FF6=$1, however, there wil be exchange losses because the net assets or equity will be worth less in US dollar terms. Assets and liabilities are translated at the current of FF6=$1, while while the equity accounts are translated at their historic rates of FF5=$1. Table 2 presents a translation exposure report for Continental Labs of France based on the balance sheet in Table 1. This report demonstrates that exposure is FF12,000, which is simply the total French franc assets minus the total liabilities, or the parent company's equity position in the subsidiary.

Table 2: Translation Exposure Report for Continental Labs of France based on the Current Rate Method

Cash	FF1000
Accounts Receivable	6000
Inventory	14000
Plant and Equipment (Net)	90000
Total Assets Exposed	FF120000
Accounts Payable	FF16000
Current Debt	4000
Long-term Debt	88000
Total Liabilities Exposed	FF108000
Net Assets Exposed	FF12000

The amount of translation exposure is, therefore measured simply as the difference between total assets and total liabilities.

How to deal with profits during the year:
If a foreign subsidiary is profitable in a given period, the income from the operation is partially exposed to exchange rate changes. Under the current method, all items in the income statement are translated at an appropriately-weighted average exchange rate to reflect conditions over the peroid. As a result, income is translated at the period average exchange rate and is therefore exposed to the extent that the end-of-period exchange rate is different from the period average exchange rate. Consider the following example that demonstrates this.

Example: Polydemic Enterprises is a US multinational corporation with operations all over the world. It recently opened a new subsidiary in Greece. The beginning exchange rate was 135 drachmas per dollar. Over the first quarter of operations, the drachma fell to 150 drachmas per dollar, and the period average exchange rate was 140 drachmas per dollar. The ending balance sheet is shown in Table 3 and the period's income statement is shown in Table 4. This translation at 140 drachmas per dollar is shown in the second column of Table 6-4.

Table 3: Polydemic-Greece's Balance Sheet in Drachmas and Translated into Dollars (figures in millions)

	1 Drachmas	2 Rate	3 Dollars
Assets
Cash	300.0	150	2.00
Receivables	112.5	150	0.75
Inventory	67.5	150	0.45
Plant and Equipment (Net)	405.0	150	2.70
Total Assets	885.0		5.90
Liabilities and Capital
Current Payables	140.0	150	0.93
Long-Term Debt	400.0	150	2.67
Common Stock	135.0	135	1.00
Retained Earnings	210.0	140	1.50
Cumulative Translation Adjustment			(0.20)
Total Liabilities and Capital	885.0		5.90

The translation of the balance sheet is shown in the third column of Table 3. All assets and liabilities are translated at the period-end exchange rate of 150 drachmas per dollar. The common stock is translated at the historical rate of 135 drachmas per dollar. The retained earnings are translated at the average exchange rate for the period in which they are earned, or 140 drachmas per dollar, and this rate will be the historical exchange rate for 210 drachmas of retained earnings into the future. The cumulative translation adjustment arises from two components. The first is the effect of drachma depreciation on the value of the capital stock:

($1/150 drachmas - $1/135)(135 drachmas) = -$0.01

and the second is the effect of drachma depreciation on retained earnings between the period average exchange rate and the end of the period exchange rate:

($1/150 drachmas = $1/140 drachmas)(210 drachmas) = -$0.01

so the total cumulative translation adjustment is a loss of $0.2.

Table 4: Polydemic-Greece's Income Statement in Drachmas & Translated into Dollars (figures in millions)

	1 Drachmas	2 Dollars
Revenue	3500	25.0
Cost of Goods Sold	2000	14.3
Depreciation of Plant and Equopment	1000	7.1
Office Expenses	80	0.6
Pre-tax Income	420	3.0
Income Taxes	210	1.5
Net Income	210	1.5

As shown in the example above, the translation adjustments are accumulated over time, until an activity is sold or disposed of. Accountants, therefore, need to keep records on all the historical exchange rates at which the items in the capital account are translated. It should be clear, then, that to construct a balance sheet in home currency units, the only information required is the beginning-of-period balance sheet in home currency units and the beginning-of-period exchange rate, the period's retained earnings and the average exchange rate, and the end-of-period exchange rate.

In this case, a continuing translation exposure is created during the year, as the firm generates profits, which will be recognized in the income statement using an average exchange rate for the year, while they will be incorporated into retained earnings using the end-of-period exchange rate

Exceptions to the Principal Features of FASB-52

Case 1: In certain cases, foreign operations are considered not to be self-contained units. Here are two examples -- one, where a foreign operation that functions as just a sales office for the parent simply imports goods and sells them in the foreign market. In this instance, the operation is clearly an integral part of the parent's operations. The second case is that of re-export facilities located abroad. If the nature of the operation is to import inputs from the parent, perform some light manufacturing or assembling, and re-export finished products to the US, then the operation is considered an integral part of the parent's operations.

Case 2:If a firm's operations are located in highly inflationary countries, then the local currency is not a very effective functional currency. Revenues and costs measured in such a local currency and translated into dollars using a given exchange rate are unlikely to reflect the true dollar value of operations.

In these two cases, FASB-52 provides for translation of the financial statements using the temporal method, in which all monetary assets and liabilities are translated at the current exchange rate and non-monetary assets and liabilities are translated at historical exchange rates. The main difference between this method and the monetary/nonmonetary method is that inventory is considered a monetary asset if it is valued on the balance sheet at market value but is considered a non-monetary asset if it is value at historical cost.

The main implication is that foreign exchange gains or losses associated with monetary assets and liabilities are considered to have an important impact on the parent company's value, and they recorded in the income statement as they occur. In the case of an inflationary country, it would again not make sense to carry translation losses in a "temporary" account in the balance sheet, since they are not really temporary -- the local currency would be expected to consistently depreciate. In these two cases, currency gains and losses are considered imoprtant components of doing business in a given time period, and are therefore to be realized as they occur.

Leading and Lagging:
Leading refers to prepaying import payments or receiving early payment for exports;
Lagging relates to delaying import payments or receiving late payment on exports. Most countries set limits on the time period that intracompany accounts can be prepaid or delayed and establishing guidelines on the interest that should be charged.

Used for:

• Shifting Liquidity
• Facilitating Exposure Management
• Reducing Financing Costs

Netting:
Netting is a technique for settling intracompany obligations. Under a netting arrangement, creditor and debtor positions are offset within a corporate group, with the net amount transferred from the net debtors to the net creditors.
The savings are in the reduced costs of executing a foreign exchange transaction, as well as in reduced currency conversion costs, as well as float times.

Exposure netting does not involve actual netting. Rather, if there is the potential for actual netting, then there is no real exchange exposure, whether or not the netting is actually done.

Hedging can be done through selective use of the invoice currency. Thus, if invoicing is done in the stronger currency (or the home currency, as may be relevant), there is no exchange rate exposure.

In-house factoring:

Reinvoicing Center:

Transactions Exposure

Operating Exposure

This note is based, partially, on Eugene Flood and Donald R. Lessard, “On the Measurement of Operating Exposure to Exchange Rates: A Conceptual Approach,” Financial Management, Spring 1986.

As far as operating exposure is concerned, only real exchange rate changes are relevant.
Competitive effect: sensitivity of the local currency cashflows to exchange rate changes
Conversion effect: one-for-one mapping of local currency flows to dollar flows.
A real exchange rate can affect

• Competitive position on the revenue side
• Cost of the firms’ inputs relative to competitors.

Information re contractual exposure can be found in the firm’s financial statements – not so, operating exposure. The exposed items are future revenues, costs, and profits.
Assessing these exposures requires an analysis of the firm’s competitive environment.

The impact of the firm’s competitive position on its operating exposure:
Operating exposure is determined by:
The structure of the markets in which the company sells its products
The structure of the markets in which the company (and its competitors) purchases its inputs.

Market structure will determine:

• The currency habitat of the price of goods; currency habitat is that currency in which the price of the good tends to be the most stable.
• Quantity impacts (unit sales or purchases)

Currency Habitat:

Assume Perfect Competition and Law of one price.
Assume Canadian and US setup.

Assume the lumber industry.
Suppose the marginal producers and consumers are in Canada.
Then, the C$ will be the habitat currency, the natural currency. If the Canadian currency depreciates 10%, the Canadian price will not change; hence the US prices will decrease by 10%. A firm in the US in this industry, even if all its customers are in the US will experience operating exposure. This is because the US $ price will fluctuate when the exchange rate changes.

Suppose the marginal producers and consumers are in the US; then the US$ will be the natural currency. If the Canadian currency depreciates 10%, the US$ price will remain constant; the Canadian price will have to increase 10% because the dollar revenue from any sale will have to remain the same; the dollar price must remain the same. Hence the Canadian price times the exchange rate must remain the same. If the C$ depreciates, for this to happen, the Canadian price must rise. Thus, even if you had a company that invoiced in C$ and sold to Canadian customers, it would have no exchange rate exposure.

In the above two cases, the natural currency price is not affected by the exchange rate change. Both marginal producers and consumers are in the same country and the exchange rate is extraneous to the determination of the natural currency price. Now, however, let us consider a case where supply/demand elasticities are relevant.

Suppose coal is only produced in the US, and all consumers are Canadian. Furthermore, let the market be characterized by perfect competition. When the Canadian dollar depreciates, at every C$ price, the US$ price is lower, hence the supply of coal is lower.

Note that in this case, the depreciation in the C$ causes the Canadian $ price to rise, but it will not rise by the same amount as the depreciation. The quantity sold will drop, as well. Whether the revenue will rise or drop will depend on the price elasticity of demand.

In the figure above, the supply curve remains constant because it is presented in US$. However, the demand curve will change. At each US$ price, the C$ price is higher, hence the amount demanded by Canadians will be lower. In this case, the price in US$ will drop; however, the price drop will be less than the percentage depreciation in the Canadian $.

In the above graph, note that the supply elasticity is zero. Hence the quantity sold does not change. Price absorbs the entire effect of the exchange rate change.

The net result, therefore, depends on two factors: one, the extent to which the law of one price holds, and two, the relevant demand/supply elasticities.
The Law of One Price will hold for easily transportable goods that are widely traded; to the extent that this does not hold for a good, the law of one price will not hold.
Other factors are the extent of product differentiation across countries – if there is a lot of product differentiation, then consumers will perceive the goods in different countries to be different, and hence, a drop in the price of one good will not necessarily lead to a drop in the price of a similar good in another country.
Also, the ability of the seller to bundle different goods together and thus obtain a degree of monopoly power affects the operation of the law of one price. Finally, other relevant factors are – the absence of barriers to trade, such as tariffs, quotas, etc.

This can be seen in the following table. The y-axis indicates the extent of application of the law of one price. The upper half indicates contexts where the law of one price holds to a lesser extent, and hence firms face local-currency denominated marginal revenue curves.

The x-axis indicates the marginal pricing factor. This reflects the relative importance of producer cost and consumer demand considerations that depend on, inter alia, the competitive structure of the industry, the price elasticity of demand, the range of complements and substitutes and the relevant cross-elasticities, and the structure of costs. This last refers to operating leverage. If operating leverage is high, marginal considerations are less important and pricing is dictated primarily by demand considerations. Alternatively, we can think of the marginal pricing factor as indicating situations where supply elasticities are more important that demand elasticities, while at the right end of the axis, the reverse is true.

From Flood and Lessard, “On the Measurement of Operating Exposure to Exchange Rates: A Conceptual Approach,” Financial Management, Spring 1986.

Suppose we have a US firm selling luxury cars in France. If we accept the assumption that luxury car pricing is likely to be local and does not respond to international effects, exchange rate fluctuations are not likely to affect local pricing to any great extent. This may be, for example, because local firms will not respond to exchange rate driven changes in operating costs. Furthermore, because of the cost structure of the car industry, local demand considerations will be paramount in pricing. Hence, even if the local currency depreciates, the US firm is likely to have to keep the local price constant. As a result, the currency depreciation will flow through, pretty much, to the revenues of the US firm.

On the other hand, the local price of oil is likely to adjust to worldwide impacts in oil prices.