Chapter 11-Translation Exposure

If a firm's subsidiary is using the local currency as the functional currency, which of the following is NOT a circumstance that could justify the use of a balance sheet hedge? A) The foreign subsidiary is about to be liquidated, so that the value of its Cumulative Translation Adjustment (CTA) would be realized. B) The firm has debt covenants or bank agreements that state the firm's debt/equity ratio will be maintained within specific limits. C) The foreign subsidiary is operating is a hyperinflationary environment. D) All of the above are appropriate reasons to use a balance sheet hedge.

D) All of the above are appropriate reasons to use a balance sheet hedge.

________ exposure is the potential for an increase or decrease in the parent company's net worth and reported net income caused by a change in exchange rates since the last transaction. A) Transaction B) Operating C) Currency D) Translation

D) Translation

A balance sheet hedge requires that the amount of exposed foreign currency assets and liabilities: A) have a 2:1 ratio of assets to liabilities. B) have a 2:1 ratio of liabilities to assets. C) have a 2:1 ratio of liabilities to equity. D) be equal

D) be equal.

The basic advantage of the ________ method of foreign currency translation is that foreign nonmonetary assets are carried at their original cost in the parent's consolidated statement while the most important advantage of the ________ method is that the gain or loss from translation does not pass through the income statement. A) monetary; current rate B) temporal; current rate C) temporal; monetary D) current rate; temporal

D) current rate; temporal

Generally speaking, translation methods by country define the translation process as a function of what two factors? A) size; location B) a firm's functional currency; location C) location; foreign subsidiary independence D) foreign subsidiary independence; a firm's functional currency

D) foreign subsidiary independence; a firm's functional currency

A foreign subsidiary's ________ currency is the currency used in the firm's day-to-day operations. A) local B) integrated C) notational dollar D) functiona

D) functional

Under the U.S. method of translation procedures, if the financial statements of the foreign subsidiary of a U.S. company are maintained in the local currency, and the local currency is the functional currency, then: A) the translation method to be used is not obvious. B) translation is accomplished through the temporal method. C) translation is not required. D) translation is accomplished through the current rate method.

D) translation is accomplished through the current rate method.

Exchange rate imbalances that are passed through the balance sheet affect a firm's reported income, but imbalances transferred to the income statement do not.

FALSE

If management anticipates an appreciation of the foreign currency, it should decrease net exposed assets to benefit from a gain.

FALSE

If management expects a foreign currency to depreciate, it could minimize translation exposure by increasing net exposed assets.

FALSE

It is highly unusual for a multinational firm to have both integrated foreign entities AND self-sustaining foreign entities

FALSE

The temporal rate method is the most prevalent method today for the translation of financial statements

FALSE

A foreign subsidiary's functional currency is the currency of the primary economic environment in which the subsidiary operates and in which it generates cash flows

TRUE

If the financial statements of the foreign subsidiary are maintained in the local currency and the U.S. dollar is the functional currency, they are remeasured by the temporal method.

TRUE

If the same exchange rate were used to remeasure every line on a financial statement, then there would be no imbalances from remeasuring.

TRUE

It is possible that efforts to decrease translation exposure may result in an increase in transaction exposure.

TRUE

It is possible to use different exchange rates for different line items on a financial statement.

TRUE

One possible reason for a balance sheet hedge could be because the firm has debt covenants or bank agreements that state the firm's debt/equity ratios will be maintained within specific limits

TRUE

One possible reason for a balance sheet hedge could be because the foreign subsidiary is about to be liquidated, so that value of its Cumulative Translation Adjustment (CTA) would be realized.

TRUE

The biggest advantage of the current rate method of reporting translation adjustments is the fact that the gain or loss goes directly to the reserve account on the consolidated balance sheet and does not pass through the consolidated income statement.

TRUE

The current rate method and the temporal method are two basic methods for translation that are employed worldwide.

TRUE

The current rate method is the most prevalent method today for the translation of financial statements.

TRUE

The temporal method of foreign currency translation gains or losses resulting from remeasurement are carried directly to current consolidated income and thus introduces volatility to consolidated earnings

TRUE

Translation gains or losses can be quite different from operating gains or losses not only in magnitude but also in sign.

TRUE

Under U.S. accounting and translation practices, use of the current rate method is termed "translation" while use of the temporal method is termed "remeasurement."

TRUE

Under the temporal rate method, specific assets and liabilities are translated at exchange rates consistent with the timing of the item's creation.

TRUE

Describe a balance sheet hedge and give at least two examples of when such a hedge could be justified.

A balance sheet hedge attempts to equalize the amount of assets and liabilities of a foreign subsidiary exposed to translation risk. Thus, the gain to the firm from a change in exchange rates will be perfectly offset by an equal and opposite loss. Firms may engage in balance sheet hedges under conditions of hyperinflation, or when the subsidiary is about to be liquidated and the value of the CTA account would be realized. The author on page 16 lists other examples.

Most countries specify the translation method to be used by a foreign subsidiary based on its business operations or the functional currency. Explain both subsidiary characterization criteria and the one adopted in the United States

A foreign subsidiary's business can be categorized as either an integrated foreign entity or a self-sustaining foreign entity. An integrated foreign entity is one that operates as an extension of the parent company, with cash flows and general business lines that are highly interrelated with those of the parent. A self-sustaining foreign entity is one that operates in the local economic environment independent of the parent company. The differentiation is important to the logic of translation. A foreign subsidiary should be valued principally in terms of the currency that is the basis of its economic viability. It is not unusual for a single company to have both types of foreign subsidiaries, integrated and self-sustaining. A foreign subsidiary's functional currency is the currency of the primary economic environment in which the subsidiary operates and in which it generates cash flows. In other words, it is the dominant currency used by that foreign subsidiary in its day-to-day operations. It is important to note that the geographic location of a foreign subsidiary and its functional currency may be different. The United States, rather than distinguishing a foreign subsidiary as either integrated or selfsustaining, requires that the functional currency of the subsidiary be determined. Management must evaluate the nature and purpose of each of its individual foreign subsidiaries to determine the appropriate functional currency for each. If a foreign subsidiary of a U.S.-based company is determined to have the U.S. dollar as its functional currency, it is essentially an extension of the parent company (equivalent to the integrated foreign entity designation used by most countries). If, however, the functional currency of the foreign subsidiary is determined to be different from the U.S. dollar, the subsidiary is considered a separate entity from the parent (equivalent to the self-sustaining entity designation).

A Canadian subsidiary of a U.S. parent firm is instructed to bill an export to the parent in U.S. dollars. The Canadian subsidiary records the accounts receivable in Canadian dollars and notes a profit on the sale of goods. Later, when the U.S. parent pays the subsidiary the contracted U.S. dollar amount, the Canadian dollar has appreciated 10% against the U.S. dollar. In this example, the Canadian subsidiary will record a: A) 10% foreign exchange loss on the U.S. dollar accounts receivable. B) 10% foreign exchange gain on the U.S. dollar accounts receivable. C) Since the Canadian firm is a U.S. subsidiary, neither a gain nor loss will be recorded. D) Any gain or loss will be recorded only by the parent firm.

A) 10% foreign exchange loss on the U.S. dollar accounts receivable.

The main technique to minimize translation exposure is called a/an ________ hedge. A) balance sheet B) income statement C) forward D) translation

A) balance sheet

The two basic methods for the translation of foreign subsidiary financial statements are the ________ method and the ________ method. A) current rate; temporal B) temporal; proper timing C) current rate; future rate D) none of the above

A) current rate; temporal

According to your authors, the main purpose of translation is: A) to prepare consolidated financial statements. B) to help management assess the performance of foreign subsidiaries. C) to act as an interpreter for managers without foreign language skills. D) none of the above

A) to prepare consolidated financial statements.

Which of the following primary principles of U.S. translation procedures is NOT true? A) If the financial statements of the foreign subsidiary of a U.S. company are maintained in U.S. dollars, translation is not required. B) If the financial statements of the foreign subsidiary are maintained in the local currency and the local currency is the functional currency, they are translated by the temporal method. C) If the financial statements of the foreign subsidiary are maintained in the local currency and the U.S. dollar is the functional currency, they are remeasured by the temporal method. D) All of the above are true

B) If the financial statements of the foreign subsidiary are maintained in the local currency and the local currency is the functional currency, they are translated by the temporal method

________ gains and losses are "realized" whereas ________ gains and losses are only "paper." A) Translation; transaction B) Transaction; translation C) Translation; operating D) none of the above

B) Transaction; translation

If the parent firm and all subsidiaries denominate all exposed assets and liabilities in the parent's reporting currency this will ________ exposure but each subsidiary would have ________ exposure. A) maximize translation; no transaction B) eliminate translation; transaction C) maximize transaction; no translation D) eliminate transaction; translation

B) eliminate translation; transaction

Historical exchange rates may be used for ________, while current exchange rates may be used for ________. A) fixed assets and current assets; income and expense items B) equity accounts and fixed assets; current assets and liabilities C) current assets and liabilities; equity accounts and fixed assets D) equity accounts and current liabilities; current assets and fixed assets

B) equity accounts and fixed assets; current assets and liabilities

If the British subsidiary of a European firm has net exposed assets of £125,000, and the pound increases in value from €1.40/£ to €1.44/£, the European firm has a translation: A) loss of €5,000. B) gain of €5,000. C) gain of £5,000. D) loss of £5,000.

B) gain of €5,000

A/An ________ subsidiary is one in which the firm operates as an extension of the parent company with cash flows highly interrelated with the parent. A) self-sustaining foreign B) integrated foreign entity C) foreign D) none of the above

B) integrated foreign entity

If the European subsidiary of a U.S. firm has net exposed assets of €750,000, and the euro drops in value from $1.30/euro to $1.20/€ the U.S. firm has a translation: A) gain of $75,000. B) loss of $75,000. C) gain of $625,000. D) loss of €576,923.

B) loss of $75,000.

If the European subsidiary of a U.S. firm has net exposed assets of €200,000, and the euro increases in value from $1.22/€ to $1.26/€ the U.S. firm has a translation: A) gain of $8,000. B) loss of $8,000. C) gain of $252,000. D) loss of €252,000.

B) loss of $8,000.

If the British subsidiary of a European firm has net exposed assets of £250,000, and the pound drops in value from €1.35/£ to €1.30/£, the European firm has a translation: A) gain of €12,500. B) loss of €12,500. C) loss of £12,500. D) gain of £12,500.

B) loss of €12,500.

Translation exposure measures: A) changes in the value of outstanding financial obligations incurred prior to a change in exchange rates. B) the potential for an increase or decrease in the parent company's net worth and reported net income caused by a change in exchange rates since the last consolidation of international operations. C) an unexpected change in exchange rates impact on short run expected cash flows. D) none of the above

B) the potential for an increase or decrease in the parent company's net worth and reported net income caused by a change in exchange rates since the last consolidation of international operations.

Under U.S. accounting and translation practices, use of the current rate method is termed ________ while use of the temporal method is termed ________. A) translation; the same B) translation; remeasurement C) remeasurement; the same D) remeasurement; translation

B) translation; remeasurement

If a firm's balance sheet has an equal amount of exposed foreign currency assets and liabilities and the firm translates by the temporal method, then: A) the net exposed position is called monetary balance. B) the change is value of liabilities and assets due to a change in exchange rates will be of equal but opposite direction. C) Both A and B are true. D) none of the above

C) Both A and B are true

The ________ determines accounting policy for U.S. firms. A) Securities and Exchange Commission (SEC) B) Federal Reserve System (Fed) C) Financial Accounting Standards Board (FASB) D) General Agreement on Tariffs and Trade (GATT)

C) Financial Accounting Standards Board (FASB)

________ occur as a result of changes in the value of currency, whereas ________ occur as a result of ongoing business activities. A) Operating gains or losses; translation gains or losses B) Swap losses; translation gains or losses C) Translation gains or losses; operating gains or losses D) all of the above

C) Translation gains or losses; operating gains or losses

Translation exposure may also be called ________ exposure. A) transaction B) operating C) accounting D) currency

C) accounting

Gains or losses caused by translation adjustments when using the current rate method are reported separately on the: A) consolidated statement of cash flow. B) consolidated income statement. C) consolidated balance sheet. D) none of the above

C) consolidated balance sheet.

If an imbalance results from the accounting method used for translation, the imbalance is taken either to ________ or ________. A) the bank; the post office B) depreciation; the market for foreign exchange swaps C) current income; equity reserves D) current liabilities; equity reserves

C) current income; equity reserves

Consider two different foreign subsidiaries of Georgia-Pacific Wood Products Inc. The first subsidiary mills trees in Canada and ships its entire product to the Georgia-Pacific U.S. The second subsidiary is also owned by the parent firm but is located in Japan and retails tropical hardwood furniture that it buys from many different sources. The first subsidiary is likely a/an ________ foreign entity with most of its cash flows in U.S. dollars, and the second subsidiary is more of a/an ________ foreign entity. A) domestic; integrated B) self-sustaining; domestic C) integrated; self-sustaining D) self-sustaining; integrated

C) integrated; self-sustaining

Under the U.S. method of translation procedures, if the financial statements of the foreign subsidiary of a U.S. company are maintained in the local currency, and the U.S. dollar is the functional currency, then: A) translation is not required. B) translation is accomplished through the current rate method. C) translation is accomplished through the temporal method. D) none of the above

C) translation is accomplished through the temporal method.

Under the U.S. method of translation procedures, if the financial statements of the foreign subsidiary of a U.S. company are maintained in U.S. dollars: A) translation is accomplished through the current rate method. B) translation is accomplished through the temporal method. C) translation is not required. D) the translation method to be used is not obvious.

C) translation is not required.

The two methods for the translation of foreign subsidiary financial statements are the current rate and temporal methods. Briefly, describe how each of these methods translates the foreign subsidiary financial statements into the parent company's consolidated statements. Identify when each technique should be used and the major advantage(s) of each.

The current rate method translates almost all line items from the foreign subsidiary to the parent consolidated statements at the current exchange rate. This is the most commonly used method in the world today. Assets and liabilities are translated at current exchange rate and items found on the income statement are translated at the actual exchange rate on the date of transaction, or as an average over the statement period where appropriate. Equity accounts are translated at historical costs. Any gains or losses caused by translation adjustments are typically placed into a special reserve account (such as a CTA). Thus, gains or losses do not go through the income statement and do not increase the volatility of net income. This is perhaps the biggest advantage to using the current rate method. By contrast, the temporal method assumes that several individual financial statement items are periodically restated to reflect their market value. The temporal method translates individual line items based on monetary/nonmonetary criteria where monetary assets such as cash and marketable securities are translated at current exchange rates, but nonmonetary assets such as fixed assets are translated at historical rates. The gains or losses that result from translation remeasurement are recorded on the consolidated income statement and impact upon the volatility of net income. The temporal method of using historical costs may be more consistent with the practice of carrying domestic items at cost on the financial statements.

The value contribution of a subsidiary of a multinational firm to the firm can be reported in the income statement or balance sheet of the consolidated firm. Explain the reporting of the changes in the value of a subsidiary as a result of the change in an exchange rate — changes to the income and the assets of the subsidiary — in the consolidated financial statements of the parent company

The earnings of the subsidiary, once remeasured into the home currency of the parent company, contributes directly to the consolidated income of the firm. An exchange rate change results in fluctuations in the value of the subsidiary's income to the global corporation. If the individual subsidiary in question constitutes a relatively significant or material component of consolidated income, the multinational firm's reported income (and earnings per share, EPS) may be seen to change purely as a result of translation. Changes in the reporting currency value of the net assets of the subsidiary are passed into consolidated income or equity. If the foreign subsidiary was designated as "dollar functional," remeasurement results in a transaction exposure, which is passed through current consolidated income. If the foreign subsidiary was designated as "local currency functional," translation results in a translation adjustment and is reported in consolidated equity as a translation adjustment. It does not alter reported consolidated net income.