CHP 11

Multinational Business Finance
Fifteenth Edition, Global Edition
Chapter 11
Translation Exposure
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Learning Objectives
11.1 Describe how the process of consolidation of a
multinational firm’s foreign entities creates translation
exposure
11.2 Examine the two major methods of translation,
including their theoretical and practical differences
11.3 Understand how translation can potentially alter the
value of a multinational firm
11.4 Explore how to manage translation exposure,
including how one company uses swaps to do so

Translation Exposure (1 of 2)
• Translation exposure, also called accounting exposure,
arises because financial statements of foreign
subsidiaries—which are stated in foreign currency—must
be restated in the parent’s reporting currency for the firm
to prepare consolidated financial statements.
• The accounting process of translation, involves
converting these foreign subsidiaries financial statements
into U.S. dollar-denominated statements.

Translation Exposure (2 of 2)
• Translation exposure is the potential for an increase or
decrease in the parent’s net worth and reported net
income caused by a change in exchange rates since the
last translation.
• While the main purpose of translation is to prepare
consolidated statements, management uses translated
statements to assess performance (facilitation of
comparisons across many geographically distributed
subsidiaries).

Overview of Translation (1 of 4)
• Consolidation accounting is the process of combining the
financial results of all subsidiary companies into the
combined financial results of the parent company.
• Our purpose here, however, is not to discuss or detail
consolidation accounting, but rather the currency risk to
the multinational firm that arises from the currency
translation of foreign currency-denominated financial
statements of its foreign subsidiaries.
• We will use our example multinational firm Aidan
Corporation to demonstrate (see Exhibit 11.1).

Exhibit 11.1 Consolidation and Translation
of Financial Results for Aidan
For long description, see slide 33: Appendix 1

• Reporting currency is the currency that the reporting entity
uses to prepare its financial statements. Any other currency
used by an entity of this same multinational firm in its financial
statements is a foreign currency.
• Any distinct or separable business that prepares its financial
statements in any currency other than the reporting currency of
the parent company is considered a foreign entity.
• If the foreign subsidiary operates as an extension of the parent
company’s operations, it is classified as an integrated foreign
entity. If the foreign subsidiary operates completely separately
from the parent company, it is classified as a distinct or
separable operation.

• Functional currency is the currency of the primary
economic environment in which the subsidiary operates.
• All incorporated businesses will possess all three
traditional financial statements—the income statement,
balance sheet, and statement of cash flows. However,
only two of these statements need to be translated for
consolidation purposes: the income statement and the
balance sheet.

• If a foreign entity’s functional currency is the reporting
currency (the currency of the parent company used for
consolidated reporting purposes), the process for
preparing the financial statements is termed
remeasurement.
• If a foreign entity’s financial statements are maintained in
a functional currency, and that functional currency is
different from the reporting currency of the parent
company, the process for preparation of the financial
statements is termed translation. Any changes arising
from translation are termed cumulative translation
adjustment (CTA).
Translation Methods (1 of 7)
• Two basic methods for the translation of foreign
subsidiary financial statements are employed worldwide:
– Current rate method
– 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).

• 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
– Dividends (distributions) are translated at the rate in
effect on the date of payment
– Equity items, such as common stock and paid-in
capital accounts, are translated at historical rates

• Gains or losses caused by translation adjustments are
not included in the calculation of consolidated net income.
• Rather, translation gains or losses are reported
separately and accumulated in a separate equity reserve
account (on the B/S) with a title such as cumulative
translation adjustment (CTA).
• 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).

• Under the temporal method, specific assets are
translated at exchange rates consistent with the timing of
the item’s 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).

• If these items were not restated but were instead carried at
historical cost, the temporal method becomes the
monetary/nonmonetary method of translation.
– Monetary assets and liabilities are translated at current
exchange rates
– Nonmonetary 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

• The U.S. differentiates foreign subsidiaries on the basis of functional
currency, not subsidiary characterization.
– If the financial statements of the foreign subsidiary are maintained in
U.S. dollars, translation is not required
– If the statements are maintained in the local currency, and the local
currency is the functional currency, they are translated by the current
rate method
– If the statements are maintained in local currency, and the U.S. dollar is
the functional currency, they are remeasured by the temporal method
– If the statements are in local currency and neither the local currency nor
the U.S. dollar is the functional currency, the statements must first be
remeasured into the functional currency by the temporal method, and
then translated into U.S. dollars by the current rate method
– See Exhibit 11.2

Exhibit 11.2 Flow Chart for U.S.
Translation Practices

• The accounting guidance for foreign currency reporting and
translation issues in the United States is found in Financial
Accounting Standards Board (FASB) Accounting Standards
Codification (ASC) Topic 830, Foreign Currency Matters.
• A large part of the rest of the world, however, more than 100
countries, use International Financial Reporting Standards
(IFRS).
• Exhibit 11.3 provides a summary of two of the major
differences including:
– Determination of functional currency
– Treatment in economies and currencies suffering
hyperinflation.
Exhibit 11.3 Differences Between U.S.
GAAP and IFRS Regarding Translation
Issue International Financial Reported U.S. Generally Accepted
Standards (I FRS) Accounting Principles (GAAP)
Article for guidance IAS 21 and IAS 29 ASC 830
Determination of International standards establish a U.S. practices require analysis of a
Functional hierarchy of indicators (primary and multitude of factors to determine the
Currency secondary) for determination of functional currency. These indicators
functional currency. are not ranked in any kind of a
hierarchical structure.
Hyperinflationary Even if the entity’s host country If the entity’s host country economy
Economies economy qualifies as qualifies as hyperinflationary, financial
hyperinflationary, the functional statements are remeasured as if the
currency is retained. parent company’s reporting currency
was the functional currency.
Blank Any financial amounts that are not Any exchange rate differences
already measured at the current rate calculated through remeasurement
of exchange at the end of the period, are therefore included in consolidated
those amounts should be indexed net income.
using a general price index, then
translated into the reporting currency
at the current rate.

Aidan Corporation’s Translation
Exposure (1 of 3)
• Using Aidan Corporation (see Exhibit 11.1), we now
explore the intricacies of translation exposure.
• Aidan Corporation’s sales and earnings, by operating unit
for 2014 and 2015, are described in Exhibit 11.4.

Exhibit 11.4 Aidan Corporation,
Selected Financial Results, 2014–2015

Exposure (2 of 3)
• The functional currency of Aidan’s Turkish subsidiary is
the Turkish lira, and the reporting currency of its parent,
Aidan Corporation, is the euro
– Plant and equipment and long-term debt and common
stock issued some time in the past when the
exchange rate was ₺5.2760/€
– Inventory currently on hand was purchased or
manufactured during the immediately prior quarter
when the average exchange rate was ₺5.2180/€

Exposure (3 of 3)
• As seen in Exhibits 11.5 and 11.6, the translation loss or
gain is larger under the current rate method because
inventory and net plant and equipment, as well as all
monetary assets, are deemed exposed.
• The managerial implications of this fact are very
important.
• Depending on the accounting method of the moment,
management might select different assets and liabilities
for reduction or increase—as a result impacting “real”
decisions.

Exhibit 11.5 Aidan Turkey’s Translation Loss
After Depreciation of the Turkish lira: Current
Rate Method

(a)
Euro retained earnings before depreciation are the cumulative sum of additions to retained
earnings of all prior years, translated at the exchange rates in each year.
(b)
Translated into euros at the same rate as before depreciation of the Turkish lira.
Exhibit 11.6 Aidan Turkey’s Translation Loss
After Depreciation of the Turkish lira: Temporal
Method

(a) Euro retained earnings before depreciation are the cumulative sum of additions to retained earnings of all prior
years, translated at the exchange rates in each year.
(b) Translated into euros at the same rate as before depreciation of the Turkish lira.
(c) Under the temporal method, the translation of €297,435 would be closed into retained earnings through the income
statement rather than left as a separate item as shown here. Ending retained earnings would actually be
€11,826,438 - €297,435 = €11,529,003

Managing Translation Exposure (1 of 4)
• Translation exposure poses risks to both consolidated
income and consolidated equity.
• Although many multinationals regularly manage the risks
arising from balance sheets—net equity investment in
subsidiaries—a number of firms have also hedged the
risks to their consolidated income arising from subsidiary
earnings.

• Multinational companies that generate large proportions
of their profits offshore are particularly exposed to the
currency risks associated with translation of subsidiary
earnings.
• Many firms frequently hedge dividends declared from the
subsidiary to the parent company, when declared in a
foreign currency, which do not qualify for hedge
accounting.
• This means that the periodic valuation of the financial
derivatives (the hedges) end up impacting reporting
earnings more often than the underlying exposure (the
foreign subsidiary earnings).
• The main technique to minimize translation exposure is
called a balance sheet hedge, which requires an equal
amount of exposed foreign currency assets and liabilities
on a firm’s consolidated balance sheet.
• If this can be achieved for each foreign currency, net
translation exposure will be zero.
• If a firm translates by the temporal method, a zero net
exposed position is called monetary balance.
• Complete monetary balance cannot be achieved under
the current rate method.

• If a firm’s subsidiary is using the local currency as the
functional currency, the following circumstances could justify
when to use a balance sheet hedge:
– The foreign subsidiary is about to be liquidated, so that the
value of its CTA would be realized.
– The firm has debt covenants or bank agreements that
state the firm’s debt/equity ratios will be maintained within
specific limits.
– Management is evaluated on the basis of certain income
statement and balance sheet measures that are affected
by translation losses or gains.
– The foreign subsidiary is operating in a hyperinflationary
environment.
An Illustration of Using Cross-Currency Swaps
to Hedge Translation: McDonald’s (1 of 2)
• McDonald’s investment risks have grown as the company as grown

globally.
• In the United Kingdom, McDonald’s owns the majority of its
restaurants (versus the franchise arrangement). These investments
create three different British pound-denominated currency exposures
for the parent company (see Exhibit 11.7):
– The British subsidiary has equity capital, which is a British
pound-denominated asset of the parent company.
– The parent company provides intracompany debt in the form of a
four-year loan. The loan is denominated in British pounds, and
carries a fixed rate of interest.
– The British subsidiary pays a fixed percentage of gross sales in
royalties to the parent company. This too is pound-denominated.

Exhibit 11.7 McDonald’s Cross-
Currency Swap Strategy for the U.K
Because the British subsidiary makes all payments to the U.S. parent company in British pounds, McDonald’s U.S. is
long British pounds. By entering into a swap to pay pounds (£) and receive dollars ($), the swap creates an outflow
of £ serviced by the $ inflows. But the cross-currency swap has one additional major feature useful to McDonald’s: the
cross-currency swap has a large principal which is outstanding (bullet repayment) which acts as a counterweight–a
match–to the long-term investment in the U.K. subsidiary.

An Illustration of Using Cross-Currency Swaps
to Hedge Translation: McDonald’s (2 of 2)
• When the parent company makes an intracompany loan

to the British subsidiary, it must designate whether the
loan is “permanently invested” in that country.
• If the loan is not designated permanent, the foreign
exchange gains and losses related to the loan flow
directly to the parent company’s income statement.
• If the loan is designated as permanent (what McDonald’s
has chosen to date), then the foreign exchange gains and
losses related to the intracompany loan flow only to the
cumulative translation adjustment account (CTA) on the
company’s consolidated balance sheet.

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Appendix 1
Long Description for a diagram represents the process of consolidating
financials for Aidan Corporation.
Aidan corporation will regularly create a set of consolidated financial results, all
in euros, for reporting purposes. The financial results include an income
statement, a balance sheet, and a statement of cash flow. Aidan creates the
consolidated financials using data from the subsidiary financials that use local
currency. For example, Aidan Malaysia, Aidan Ireland, and Aidan Turkey each
produce subsidiary income statements, balance sheets, and statements of cash
flow. But the financials from Malaysia are in Malaysian ringgit. The financials
from Ireland are in euros, and the financials from Turkey are in Turkish lira.
Translation is the process of translating these different foreign currencies into
the home currency, so that the results can be consolidated. This process
creates translation exposure.
Return to presentation
Appendix 2
Long Description for a flowchart demonstrates the process of translation for US
firms.
The flowchart represents the US translation process as a series of actions

driven by yes or no questions. The following list describes the translation
process, as depicted in the diagram. First question, Is the local currency the
functional currency?
• If the answer is yes, translate to US dollars, using the current rate method.
• If the answer is no, proceed to the next question.
• Second question, Is the US dollar the functional currency?
• If the answer is yes, remeasure to US dollars, using the temporal method.
• If the answer is no, remeasure from the foreign currency to the functional
currency, using the temporal method. Then translate the functional currency
to US dollars, using the current rate method.
Appendix 3 (1 of 2)
Long Description for a table shows sales and earnings in local and Irish currencies.
The table is in two parts, showing results for Ireland, Malaysia, and Turkey. The first part shows sales
in local currency, then the average exchange rate, then those sales in millions of euros.
• Sales in Ireland for 2014 were 373.5 million euros, for 2015 were 400 million euros, a change of
7.1 percent.
• Sales in Malaysia for 2014 were 500 million Malaysian ringgit, for 2015 were 500 million Malaysian
ringgit, a change of 0 percent. Average exchange rate (MYR/€) for 2014 was 4.68, for 2015 was
4.59, a change of negative 1.9 percent. Malaysia sales in euros for 2014 were 106.8 million euros,
for 2015 were 108.9 million euros, a change of 2 percent.
• Sales in Turkey for 2014 were 885 million Turkish lira, for 2015 were 900 million Turkish lira, a
change of 1.7 percent. Average exchange rate ( ₺/€) for 2014 was 5.78, for 2015 was 6.28, a
change of 8.7 percent. Turkey sales in euros for 2014 were 153.1 million euros, for 2015 were
143.3 million euros, a change of negative 6.4 percent.
• Total sales of all three countries in 2014 were 633.4 million euros, for 2015 were 652.2 million
dollars, a change of 3 percent.

Appendix 3 (2 of 2)
• The second part shows earnings, in millions, in local currency, then the average exchange rates
(MYR/€ and ₺/€), then those earnings in millions of euros.
• Earnings in Ireland for 2014 were 37.6 million euros, for 2015 were 38.1 million euros, a change of
1.4 percent.
• Earnings in Malaysia for 2014 were 43.75 million Malaysian ringgit, for 2015 were 43.75 million
Malaysian ringgit, a change of 0 percent. Average exchange rate (MYR/€) for 2014 was 4.68, for
2015 was 4.59, a change of negative 1.9 percent. Malaysia earnings in euros for 2014 were 9.3
million euros, for 2015 were 9.5 million euros, a change of 2.2 percent.
• Earnings in Turkey for 2014 were 106.0 million Turkish lira, for 2015 were 107.1 million Turkish
lira, a change of one percent. Average exchange rate ( ₺/€) for 2014 was 5.78, for 2015 was 6.28,
a change of 8.7 percent. Turkey earnings in euros for 2014 were 18.3 million euros, for 2015 were
17.1 million euros, a change of negative 6.6 percent.
• Total earnings of all three countries in 2014 were 65.2 million euros, for 2015 were 64.7 million
euros, a change of negative 0.8 percent.
Appendix 4 (1 of 2)
Long Description for a table shows assets, liabilities, and net worth on December 31, 2015 and January 2, 2016
The table is presented in two sections, assets, then liabilities and net worth. The assets section is as follows.
• Cash in Turkish lire is 1,600,000. On December 31, 2015 the exchange rate in Turkish lire to euro was 5.2000.
Translated accounts in euros was 2,038,462. On January 2, 2016 the exchange rate in Turkish lire to euro was
6.0000. Translated accounts in euros was 1,766,667.
• Accounts receivable in Turkish lire is 30,200,000. On December 31, 2015 the exchange rate in Turkish lire to euro
was 5.2000. Translated accounts in euros was 5,807,692. On January 2, 2016 the exchange rate in Turkish lire to
euro was 6.0000. Translated accounts in euros was 5,033,333.
• Inventory in Turkish lire is 20,400,000. On December 31, 2015 the exchange rate in Turkish lire to euro was
5.2000. Translated accounts in euros was 3,923,077. On January 2, 2016 the exchange rate in Turkish lire to euro
was 6.0000. Translated accounts in euros was 3,400,000.
• Net plant and equipment in Turkish lire is 40,800,000. On December 31, 2015 the exchange rate in Turkish lire to
euro was 5.2000. Translated accounts in euros was 7,846,154. On January 2, 2016 the exchange rate in Turkish
lire to euro was 6.0000. Translated accounts in euros was 6,800,000.
• Total assets in Turkish lire is 102,000,000. Translated accounts on December 31, 2015 was 19,615,385 euros, on
January 2, 2016 was 17,000,000 euros.
The liabilities and net worth section is as follows.

Appendix 4 (2 of 2)
• Accounts payable in Turkish lire is 8,000,000. On December 31, 2015 the exchange rate in Turkish lire to euro was
• Short term bank debt in Turkish lire is 10,600,000. On December 31, 2015 the exchange rate in Turkish lire to euro
• Long term debt in Turkish lire is 10,600,000. On December 31, 2015 the exchange rate in Turkish lire to euro was
• Common stock in Turkish lire is 10,800,000. On December 31, 2015 the exchange rate in Turkish lire to euro was
• Retained in Turkish lire is 62,000,000. On December 31, 2015 the exchange rate in Turkish lire to euro was
5.2000. Note, euro retained earnings before depreciation are the cumulative sum of additions to retained earnings
of all prior years, translated at exchange rates in each year. Translated accounts in euros was 11,923,076. On
January 2, 2011 the exchange rate in Turkish lire to euro was 5.2000. Note, translated into euros at the same rate
as before depreciation of the Turkish lira. Translated accounts in euros was 11,923,076.
• Translation adjustment, or C, T, A, for translated accounts for December 31, 2015 was negative 29,918 euros.
Translation adjustment for translated accounts for January 2, 2016 was negative 1,836,748 euros.
• Total liabilities and net worth in Turkish lire is 102,000,000. Translated accounts on December 31, 2015 was
19,615,385 euros, on January 2, 2016 was 17,000,000 euros.
Appendix 5 (1 of 2)
Long Description for a table shows assets, liabilities, and net worth on December 31, 2015 and January 2, 2016.
The table is presented in two sections, assets, then liabilities and net worth. The assets section is as follows.
• Cash in Turkish lire is 10,600,000. On December 31, 2015 the exchange rate in Turkish lire to euro was 5.2000.
Translated accounts in euros was 2,038,462. On January 2, 2016 the exchange rate in Turkish lire to euro was
6.0000. Translated accounts in euros was 1,766,667.
• Accounts receivable in Turkish lire is 30,200,000. On December 31, 2015 the exchange rate in Turkish lire to euro
• Inventory in Turkish lire is 20,400,000. On December 31, 2015 the exchange rate in Turkish lire to euro was
• Net plant and equipment in Turkish lire is 40,800,000. On December 31, 2015 the exchange rate in Turkish lire to
euro was 5.2760. Translated accounts in euros was 7,733,131. On January 2, 2016 the exchange rate in Turkish
lire to euro was 5.2760. Translated accounts in euros was 7,733,131.
• Total assets in Turkish lire is 102,000,000. Translated accounts on December 31, 2015 was 19,488,829 euros, on
January 2, 2016 was 18,442,675 euros.
The liabilities and net worth section is as follows.
• Accounts payable in Turkish lire is 8,000,000. On December 31, 2015 the exchange rate in Turkish lire to euro was
• . Copyright © 2021 Pearson Education Ltd. All Rights Reserved

Appendix 5 (2 of 2)
• Short term bank debt in Turkish lire is 10,600,000. On December 31, 2015 the exchange rate in Turkish lire to euro
• Long term debt in Euros is 10,600,000. On December 31, 2015 the exchange rate in Turkish lire to euro was
• Common stock in Turkish lire is 10,800,000. On December 31, 2015 the exchange rate in Turkish lire to euro was
• Retained in Turkish lire is 62,000,000. On December 31, 2015 the exchange rate in Turkish lire to euro was
5.2425. Note, euro retained earnings before depreciation are the cumulative sum of additions to retained earnings
of all prior years, translated at exchange rates in each year. Translated accounts in euros was 11,826,438. On
January 2, 2016 the exchange rate in Turkish lire to euro was 5.2425. Note, translated into euros at the same rate
as before depreciation of the Turkish lira. Translated accounts in euros was 11,826,438.
• Translation gain or loss for translated accounts for January 2, 2015 was negative 297,435 euros. Under the
temporal method, the translation of €297,435 would be closed into retained earnings through the income statement
rather than left as a separate item as shown here. Ending retained earnings would actually be €11,826,438 -
€297,435 = €11,529,003.
• Total liabilities and net worth in Turkish lire is 102,000,000. Translated accounts on December 31, 2015 was
19,488,829 euros, on January 2, 2016 was 18,442,675 euros.
Appendix 6
Long Description for a diagram represents the cross currency swap strategy used by the
McDonald’s Corporation in the U S and the UK.
The cross currency swap strategy allows McDonald’s U S based parent company to
protect against overexposure to British pounds. McDonald’s U K has equity owned by the
US parent company. In connection with this equity, McDonald’s U K sends royalty
payments and dividends to McDonald’s U S, and these royalty payments increase the
pound denominated assets that the U S parent company holds as the result of investment
in the UK subsidiary. The US parent company also gives loans to the U K subsidiary. The
loans are liabilities for McDonald’s U K, and the UK subsidiary sends interest payments in
pounds to the US parent company, once more adding to its pound denominated assets.
At the same time, the U S company has liabilities in the form of debt in U S dollars. So,
McDonald’s US and McDonald’s UK perform a currency swap in which the U S company
pays pounds and receives dollars to protect against the increased exposure to British
pounds resulting from the incoming interest payments, royalty payments, and dividends.

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Multinational Business Finance

Fifteenth Edition, Global Edition

Slides in this presentation contain hyperlinks.

Copyright © 2021 Pearson Education Ltd. All Rights Reserved

Copyright © 2021 Pearson Education Ltd. All Rights Reserved

Copyright © 2021 Pearson Education Ltd. All Rights Reserved

Copyright © 2021 Pearson Education Ltd. All Rights Reserved

Copyright © 2021 Pearson Education Ltd. All Rights Reserved

For long description, see slide 33: Appendix 1

Copyright © 2021 Pearson Education Ltd. All Rights Reserved

Copyright © 2021 Pearson Education Ltd. All Rights Reserved

Copyright © 2021 Pearson Education Ltd. All Rights Reserved

Copyright © 2021 Pearson Education Ltd. All Rights Reserved

Copyright © 2021 Pearson Education Ltd. All Rights Reserved

Copyright © 2021 Pearson Education Ltd. All Rights Reserved

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For long description, see slide 34: Appendix 2

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Copyright © 2021 Pearson Education Ltd. All Rights Reserved

For long description, see slide 35: Appendix 3

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For long description, see slide 37: Appendix 4

For long description, see slide 39: Appendix 5

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Copyright © 2021 Pearson Education Ltd. All Rights Reserved

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• McDonald’s investment risks have grown as the company as grown

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For long description, see slide 41: Appendix 6

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• When the parent company makes an intracompany loan

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This work is protected by United States copyright laws and is

Copyright © 2021 Pearson Education Ltd. All Rights Reserved

The flowchart represents the US translation process as a series of actions

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The liabilities and net worth section is as follows.

Copyright © 2021 Pearson Education Ltd. All Rights Reserved

The liabilities and net worth section is as follows.

• . Copyright © 2021 Pearson Education Ltd. All Rights Reserved

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