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    Types of Foreign Exchange Exposure: Changes in Exchange Rates Can Effect Firm Value Through

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    Fatim Zohra Essaaf
    Translation exposure arises when a company must restate the financial statements of foreign subsidiaries into the parent company's reporting currency for consolidated financial statements. There are two main methods for translating foreign financial statements - the current rate method and the temporal method. The current rate method is more common and translates assets and liabilities at the current exchange rate, while gains or losses are recorded directly in a reserve account. The temporal method translates specific assets based on their creation date and records gains or losses directly in current income. A balance sheet hedge, where equal foreign currency assets and liabilities offset each other, can minimize translation exposure.

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    Types of Foreign Exchange Exposure: Changes in Exchange Rates Can Effect Firm Value Through

    Uploaded by

    Fatim Zohra Essaaf
    156 views8 pages
    Translation exposure arises when a company must restate the financial statements of foreign subsidiaries into the parent company's reporting currency for consolidated financial statements. There are two main methods for translating foreign financial statements - the current rate method and the temporal method. The current rate method is more common and translates assets and liabilities at the current exchange rate, while gains or losses are recorded directly in a reserve account. The temporal method translates specific assets based on their creation date and records gains or losses directly in current income. A balance sheet hedge, where equal foreign currency assets and liabilities offset each other, can minimize translation exposure.

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    Translation Exposure risk

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    Translation Exposure

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    Translation exposure arises when a company must restate the financial statements of foreign subsidiaries into the parent company's reporting currency for consolidated financial statements. There are two main methods for translating foreign financial statements - the current rate method and the temporal method. The current rate method is more common and translates assets and liabilities at the current exchange rate, while gains or losses are recorded directly in a reserve account. The temporal method translates specific assets based on their creation date and records gains or losses directly in current income. A balance sheet hedge, where equal foreign currency assets and liabilities offset each other, can minimize translation exposure.

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    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    156 views8 pages

    Types of Foreign Exchange Exposure: Changes in Exchange Rates Can Effect Firm Value Through

    Uploaded by

    Fatim Zohra Essaaf
    Translation exposure arises when a company must restate the financial statements of foreign subsidiaries into the parent company's reporting currency for consolidated financial statements. There are two main methods for translating foreign financial statements - the current rate method and the temporal method. The current rate method is more common and translates assets and liabilities at the current exchange rate, while gains or losses are recorded directly in a reserve account. The temporal method translates specific assets based on their creation date and records gains or losses directly in current income. A balance sheet hedge, where equal foreign currency assets and liabilities offset each other, can minimize translation exposure.

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    © All Rights Reserved
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    of 8

    Types of Foreign Exchange Exposure

    Changes in exchange rates can effect firm value through:

    Example
    A Taiwanese company has the following USD exposures:
    1. Owns a factory in Texas worth US$5 million.
    2. Agreement to buy goods worth US$2 million.
    3. Biggest competitor is a US company.
    What happens if the NT dollar appreciates?
    1. NT$ value of US factory goes down (translation).
    2. NT$ cost of buying goods goes down (transaction).
    3. Global competitiveness of Taiwanese company
    decreases (operating).

    Translation Exposure
    Translation exposure, also called accounting exposure, arises
    because financial statements of foreign subsidiaries which
    are stated in foreign currency must be restated in the parents
    reporting currency for the firm to prepare consolidated
    financial statements.
    Translation exposure is the potential for an increase or decrease
    in the parents net worth and reported net income caused by a
    change in exchange rates since the last translation.
    The accounting process of translation, involves converting
    these foreign subsidiaries financial statements into home
    currency-denominated statements.

    Translation Methods
    Two basic methods for the translation of foreign subsidiary
    financial statements are employed worldwide:
    The current rate method
    The temporal method
    Regardless of which method is employed, a translation
    method must not only designate at what exchange rate
    individual balance sheet and income statement items are
    remeasured, but also designate where any imbalance is to
    be recorded (current income or an equity reserve account).

    Current Rate Method


    The current rate method is the most prevalent in
    the world today.
    Assets and liabilities are translated at the current rate of
    exchange.
    Income statement items are translated at the exchange
    rate on the dates they were recorded or an appropriately
    weighted average rate for the period.
    The biggest advantage of the current rate method is that
    the gain or loss on translation does not pass through the
    income statement but goes directly to a reserve account
    (reducing variability of reported earnings).
    5

    Temporal Method
    Under the temporal method, specific assets are
    translated at exchange rates consistent with the timing
    of the items creation.
    This method assumes that a number of individual line
    item assets such as inventory and net plant and
    equipment are restated regularly to reflect market
    value.
    Gains or losses resulting from remeasurement are
    carried directly to current consolidated income, and
    not to equity reserves (increased variability of
    consolidated earnings).

    Monetary / Non-monetary Method


    If these items were not restated but were instead carried at
    historical cost, the temporal method becomes the
    monetary/non-monetary method of translation.
    Monetary assets and liabilities are translated at current
    exchange rates.
    Non-monetary assets and liabilities are translated at
    historical rates.
    Income statement items are translated at the average
    exchange rate for the period.
    Dividends (distributions) are translated at the exchange rate
    on the date of payment.
    Equity items are translated at historical rates.
    7

    Managing Translation Exposure


    The main technique to minimize translation exposure is
    called a balance sheet hedge.
    A balance sheet hedge requires an equal amount of
    exposed foreign currency assets and liabilities on a firms
    consolidated balance sheet.
    If this can be achieved for each foreign currency, net
    translation exposure will be zero.
    These hedges are a compromise in which the denomination
    of balance sheet accounts is altered, perhaps at a cost in
    terms of interest expense or operating efficiency, to
    achieve some degree of foreign exchange protection.

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