CHAPTER 4

FX Translation Exposure

This chapter looks at FX translation exposure, which is the accounting impact of FX rate changes on the reported financial results, particularly the equity book value, of a firm that owns a foreign business operation. The accounting rules for FX translation often do not reflect a company’s real FX business exposure. Therefore, managers are often faced with the choice of focusing on real FX business exposure or FX accounting exposure.

Accounting for FX Translation

Accounting rules for the preparation of consolidated financial statements require a multinational parent to make a one-time choice of the functional currency for each overseas affiliate (branch, subsidiary, division, and so forth). The functional currency is the currency of the primary economic environment in which the entity generates and expends cash. For most affiliates, especially in developed economies, the functional currency is the currency of the entity’s country.

When the functional currency is the foreign affiliate’s local currency, the accounting treatment for FX rate changes is by the so-called modified closing rate method. Under this method, all the affiliate’s assets and liabilities are translated from their local currency to the parent’s currency at the current spot FX rate, whereas the affiliate’s equity is translated at a historical spot FX rate. This way, the translated values of the affiliate’s balance sheet will not equal out, and the resulting difference represents an (unrealized) FX translation gain or loss. FX translation gains and losses are booked in a special account in the parent’s consolidated equity, called the Cumulative Translation Adjustment (CTA) ,which is part of the broader equity account, Accumulated Other Comprehensive Income (AOCI).

Exhibit 4.1a Barcelona Supply AG

An example, shown in Exhibit 4.1a, considers the U.S. parent, International Materials Co., of the wholly owned Spanish subsidiary, Barcelona Supply, AG. The functional currency of Barcelona Supply is the euro. The total book value of Barcelona Supply’s assets in euros is €8m. Assume further that Barcelona Supply has €2m in euro- denominated debt. Barcelona Supply’s equity thus has a book value of €6m. Assume that the current spot FX rate is 1 $/€.

Barcelona Supply’s assets of €8 million and liabilities of €2m are translated into US dollars at the current spot rate, as $8m and $2m, respectively. Barcelona Supply’s equity of €6m is translated at its historical spot FX rate, assumed to be 1.25 $/€. So, Barcelona Supply’s equity is always translated as $7.50m. Barcelona Supply’s CTA at time 0 is thus $8m − 2m − 7.50m = −$1.50m.

The net investment item in bold font in Exhibit 4.1a is the net book value in US dollars of International Materials’ two equity entries for Barcelona Supply: $7.50m − 1.50m = $6m. International Materials’ net investment in Barcelona Supply is also equal to the net of Barcelona Supply’s translated assets minus its translated liabilities, $8m − 2m = $6m.

If the spot FX rate drops to 0.80 $/€ at the next accounting time (time 1), the new translation for Barcelona Supply is as shown in Exhibit 4.1b. Barcelona Supply’s book value of assets of €8m is translated as $6.40m, which is a book loss of $1.60m during the period, and Barcelona Supply’s book value of liabilities of €2m is translated as $1.60m, which is a book gain of $0.40m. So, there is a net FX translation loss of $1.20 million during the period.

Exhibit 4.1b Barcelona Supply AG

The accounting entries will show that Barcelona Supply’s translated equity is still $7.50m and that the new CTA amount for Barcelona Supply is $6.40m − 1.60m − 7.50m = −$2.70m. The new book value of International Materials’ net investment in Barcelona Supply is now $7.50m − 2.70m = $4.80m. The same answer is found by $6.40m − 1.60m = $4.80m, a drop of $1.20m from the net investment book value, $6 million. The $1.20m FX translation loss for the period is reflected as the change in the CTA (AOCI) account.

FX Translation Exposure

FX translation exposure is the impact of FX translation gains and losses on a parent’s balance sheet and is always “1” when translation is at the current spot FX rate. For example, we saw that the book value of International Materials’ net investment in Barcelona Supply drops by 20%, from $6m to $4.80m, when the euro depreciates by 20% versus the US dollar, from 1 $/€ to 0.80 $/€.

FX translation gains and losses are not included in a parent’s current reported earnings when a foreign currency is the functional currency of the affiliate. Basically, the FX translation gains and losses are reserved in the CTA (AOCI) account until the affiliate gets liquidated (if ever), at which time the accumulated FX translation gain or loss up to that point will get included in computation of the parent’s current earnings.

In some cases, usually for an emerging market affiliate, a U.S. parent elects to make the functional currency the US dollar. A typical example is an affiliate in a less developed country, such as a maquiladora in Mexico, which is a cheap labor part of the production process. If a foreign entity’s functional currency is the US dollar, any asset or liability that is carried on the entity’s local currency books at historical cost is translated into US dollars at the historical FX rate at the time the item was recorded; any asset or liability that is carried on the entity’s local currency books at fair value is translated at the current spot FX rate. Under this accounting method, which is the called the temporal method, there is FX accounting exposure only for the fair value accounts, and the gains and losses must be included in the parent’s current reported earnings. The economic reasoning behind this treatment is that the US dollar is the primary economic environment in which the entity generates and expends cash, so the impact of FX changes figure directly into the entity’s short-run profitability.

Hedging FX Exposure

Although FX translation exposure affects the book value of a parent’s equity, FX translation exposure does not necessarily reflect FX business exposure. Often, there will be some overlap between FX translation exposure and FX business exposure, but sometimes a firm can have FX translation exposure without having any FX business exposure, and vice versa, and sometimes a firm can have a negative FX operating exposure and a positive FX translation exposure.

To see these points, it may be useful to first think about a U.S. company that produces and incurs all operating costs in the United States and exports to the Eurozone. With no operational hedging, the company has substantial FX business exposure to the euro. There is no FX translation exposure because the company does not own an asset in the Eurozone. Say the company decides to stop producing export products in the United States, but instead builds a plant in the Eurozone to make the same products. Now the company will have lower FX operating exposure because of the operational hedging, but now will also have FX translation exposure because of owning a foreign asset. The FX business and translation exposures are in the same (positive) direction, but are not necessarily equal. As we have seen, there are many determinants of a firm’s FX business exposure, but FX translation exposure is always “1.”

It may also be useful to think about a U.S. company that imports finished goods from Japan for sale in the United States. If the imports are priced in yen, the company has a negative FX business exposure to the yen. But the company has no FX translation exposure because there is no foreign asset. Next assume that the U.S. company buys the Japanese business that makes the product, or builds a factory in Japan to make the same product. The U.S. firm’s FX operating exposure is still negative because the operating costs are still incurred in yen. But now there is an FX translation exposure to the yen because of owning a foreign asset. And the FX translation exposure is “1.” That is, if the yen depreciates versus the US dollar, the U.S. firm’s business value rises, but the book value of the foreign asset drops, and vice versa.

Academic advice is that companies should ignore FX translation exposure, because it is only about accounting book values and not real variables, such as cash flow and business value. If a company uses financial instruments to hedge the FX translation exposure on its balance sheet, and FX business exposure is not “1,” a “real” FX exposure is created where one did not exist before.

Despite the academic advice, many firms do hedge FX translation exposure. A recent study found that 47% of 622 companies from 25 countries hedge FX translation exposure.¹ The primary reason is that FX translation exposure creates volatility in a firm’s equity book value, which in turn creates volatility in the firm’s “debt ratio” (the ratio of debt to book value of total capital), an important factor in a company’s credit rating and a firm’s debt covenants. On the other hand, many firms do not mind the volatility in equity book value, and thus do not hedge FX translation exposure.²

Summary Action Points

• The book value of a parent’s net investment into a foreign affiliate is subject to an accounting treatment that results in FX translation exposure to a currency.

• FX translation exposure is fundamentally different from FX equity exposure, which is based on real cash flows and business values, rather than book values.

• There are pros and cons of hedging FX exposure. Academics tend to recommend that companies should ignore FX translation exposure, but should hedge FX operating and business exposure to reduce the likelihood and costs of financial distress.

Glossary

Accumulated Other Comprehensive Income (AOCI): An equity account used to reserve valuation changes that are not included in current earnings.

Cumulative Translation Adjustment (CTA): A subaccount of the AOCI account that reflects FX translation gains/losses.

FX Translation Exposure: The impact of FX changes on the reported home currency values of the book value of a firm’s net investment in a foreign affiliate.

Functional Currency: The currency in which a foreign entity’s books are kept, chosen by the parent under accounting rules.

Maquiladora: A foreign affiliate in a less developed country that uses cheap labor to assemble products for a developed market with parts imported from the foreign market.

Modified Closing Rate Method: Under this method, all an affiliate’s assets and liabilities are translated at the current spot FX rate and owners’ equity is translated with historical rates. The resulting difference is booked in a special equity account called the cumulative translation adjustment (CTA).

Temporal Method: Any asset or liability that is carried on the affiliate’s local currency books at fair value is translated at the current spot FX rate. Any asset or liability of the foreign affiliate that is carried on the affiliate’s local currency books at historical cost is translated into US dollars at the historical FX rate at the time the item was recorded. Used when the home currency is the functional currency.

Translation: The conversion of accounting items from one currency into another.

Problems

1. The U.S. multinational, Newberg Metals Co., wholly owns the German firm, Giessen Fabrikation, and the euro is the functional currency. Giessen has a total asset book value of €10m, euro-denominated debt of €3m, and thus an equity book value of €7m. Assume a current spot FX rate of 1.25 $/€ and a historical spot FX rate for Giessen’s equity of 1 $/€. (a) Find Giessen’s CTA. (b) Find the book value of Newberg’s net investment in Giessen. (c) If the spot FX rate rises to 1.50 $/€, find the new CTA, the new book value of Newberg’s net investment in Giessen, and the FX translation gain/loss. (d) Show that the book value of Newberg’s net investment in Giessen has an FX translation exposure to the euro of 1.

2. Rochester Corporation is a U.S. manufacturer. Rochester’s sales are entirely in the Eurozone. Rochester buys a plant in the Eurozone, and sells the production capacity in the United States, to produce the instruments closer to the market. Assume that the expected cash flow (in US dollars) does not change. Circle a, b, c, or d: From the US dollar perspective with the euro as the exposure currency: (a) Rochester’s FX operating exposure is higher and FX translation exposure is higher; (b) Rochester’s FX operating exposure is lower and FX translation exposure is lower; (c) Rochester’s FX operating exposure is higher and FX translation exposure is lower; (d) Rochester’s FX operating exposure is lower and FX translation exposure is higher.

3. A U.S. firm projects future operating cash flows, in US dollars, of $2m initially and a constant perpetual growth rate of 5% per annum. Assume the discount rate is 10%. Assume that the FX business exposure to the euro is 3. (a) Find the intrinsic business value. (b) Find the new intrinsic business value if the euro depreciates by 10% versus the US dollar? (c) Assume that the time-0 total book value of all assets (in the United States and Europe) is $25m. In US dollars, the book value of the net investment in Eurozone assets is $10m. The functional currency is the euro. If the FX price of the euro drops by 10%, what is the FX translation gain or loss?

Answers to Problems

1. (a) Giessen’s assets of €10m and liabilities of €3m are translated into US dollars at the current spot FX rate, as $12.5m and $3.75m, respectively. Giessen’s equity of €7m is translated at its historical spot FX rate, as $7m. Giessen’s CTA at time 0 is thus $12.5m − 3.75m − 7m = $1.75m.
(b) The net book value of Giessen’s two equity entries is $7m + 1.75m = $8.75m, which is the book value of Newberg’s net investment in Giessen, also equal to translated assets minus translated liabilities, $12.5m − 3.75m = $8.75m.
(c) Giessen’s assets of €10m and liabilities of €3m are translated at the current spot rate, as $15m and $4.5m, respectively. Giessen’s equity of €7m is translated at its historical spot FX rate, as $7m. Giessen’s CTA at time 1 is $15m − 4.5m − 7m = $3.5m. The net book value in of Giessen’s two equity entries is $7m + 3.5m = $10.5m, which is the new book value of Newberg’s net investment in Giessen, and equal to the net of Giessen’s translated assets minus its translated liabilities, $15m − 4.5m = $10.5m. There is an FX translation gain on Newberg’s net investment of $10.5m − 8.75m = $1.75m. This gain is the same as the change in the CTA account, $3.50m − 1.75m = $1.75m.
(d) The FX translation gain of $1.75m is a 20% increase in the book value of Newberg’s net investment in Giessen, given the time 0 level of $8.75m. Since the euro appreciates by 20% versus the US dollar in the FX change from 1.25 $/€ to 1.50 $/€, the FX translation exposure to the euro is 1.

2. The answer is (d): FX operating exposure is lower because of operational hedging, but FX translation exposure is higher because of owning a foreign asset.

3. (a) $2m/(0.10 − 0.05) = $40m.
(b) $40m(1 − 0.30) = $28m.
(c) $10m(−0.10) = −$1m.

Discussion Question

1. Explain how an overseas subsidiary may not cause its multinational parent to have any FX business exposure, but would cause the parent to have FX translation exposure. (Hint: Recall the Vulcan Materials scenario box in Chapter 2.)