378 Planning and Forecasting historical exchange rates. These procedures are followed when translation (re- measurement) follows the temporal method. Translation under the all-current method and remeasurement under the temporal method are illustrated next. The All-Current Translation Method Illustrated Following the guidance in Exhibit 12.14, the all-current translation method is illustrated using the data below: 1. Foreign Sub is formed on January 1, 2002 with an initial funding from a stock issue that raised FC1,000 (FC = Foreign current units). 2. Selected exchange rates for 2002: Direct Exchange Rates At January 1, 2002 $0.58 Average for 2002 0.62 At December 31, 2002 0.66 The above rates indicate the amount of U.S. currency required to equal (buy) a single unit of the foreign currency. The increase in the rate across the year means that the dollar has lost value and that the foreign currency has appreciated. 3. The trial balance of Foreign Sub, both in FC and in U.S. dollars and translated following the all-current rule, is given in Exhibit 12.15. Those accounts that would have debit balances, assets and expenses, are EXHIBIT 12.15 Trial Balance in FC and translated US$ at December 31, 2002. Accounts FC Exchange Rates U.S.$ Cash $ 200 $0.66 $ 132 Accounts receivable 100 0.66 66 Inventory 300 0.66 198 Property and equipment 2,000 0.66 1,320 Cost of sales 600 0.62 372 SG&A expense 100 0.62 62 Tax provision 120 0.62 74 Totals $3,420 $2,224 Accounts payable $ 400 0.66 $ 264 Notes payable 1,020 0.66 673 Common stock 1,000 0.58 580 Retained earnings 0 0 Translation adjustment 0 87 Sales 1,000 0.62 620 Totals $3,420 $2,224 Global Finance 379 grouped first, and those with credit balances, liabilities, equities, and rev- enues, are grouped second. The totals of the two groupings of account balances must be equal, that is, in balance. Notice that this is only achieved in the U.S. dollar trial balance through introduction of a translation adjustment account, with a balance just sufficient to establish this equality. Without the addition of the $87 translation adjustment account balance, the total of the trans- lated assets and expenses, $2,224, exceeds the total of the translated lia- bilities, shareholders’ equity and sales accounts by $87. This translation adjustment can also be directly calculated as shown next: Beginning net assets (assets minus liabilities) FC1,000 times change in exchange rate from 1/1/02 to 12/31/02 (0.66 − 0.58) 0.08 $80 Net income FC180 times difference between end of year and average exchange rates (0.66 − 0.62) 0.04 7 Translation adjustment $87 The $80 component represents the growth in the beginning net assets due to appreciation in the value of Sub’s foreign currency. The $7 component is the additional net assets due to the translation of the income statement balances at the average rate for the year of $0.62 and balance sheet amounts at the end of year rate of $0.66. There is no retained earnings balance in the above trial bal- ance because 2002 is the first year of operation and the net income for the year is added to retained earnings through a later process of closing the books. The translated balance sheet and income statements are presented in Exhibits 12.16 and 12.17. They can be constructed from the translated data above. The translation of the FC data is presented again in these statements simply to reinforce the nature of the translation process. EXHIBIT 12.16 Translated income statement, year ending December 31, 2002. Income Statement FC Exchange Rates U.S.$ Sales $1,000 $0.62 $620 Less cost of sales 600 0.62 372 Gross margin 400 248 Less SG&A 100 0.62 62 Pretax profit 300 186 Less tax provision 120 0.62 74 Net income $ 180 $112 Other comprehensive income 87 Comprehensive income $199 380 Planning and Forecasting In the absence of dividends, the retained earnings in the balance sheet are simply the net income for the year. The translation adjustment of $87 is in- cluded in consolidated shareholders’ equity as accumulated other comprehen- sive income. The net assets of Foreign Sub are in a currency that appreciated across the year. This growth in net assets is captured in the process of transla- tion and represented, again, by the translation adjustment balance. It is com- mon for the translation adjustment in this case to be referred to as a translation gain. It resulted because the U.S. parent has a net investment (assets minus li- abilities) in a country whose currency appreciated against the U.S. dollar. If, instead, the FC had depreciated, then the translation adjustment would represent a negative balance in the initial accumulated other compre- hensive income for 2002. Also, in this circumstance it is common to see the translation adjustment referred to as a translation loss. With the translation completed, the above statements in Exhibit 12.16 and 12.17 would now be ready for consolidation with those of the U.S. parent. 30 The Remeasurement of Statements (Temporal Translation) Illustrated This illustration of the remeasurement of the statements of a foreign sub- sidiary uses the same data as used in the illustration of the all-current transla- tion method. 31 However, some additional information is required: 1. Property and equipment were acquired when the exchange rate was $0.58. 2. Depreciation on this property and equipment of FC60 was included in SG&A expense. EXHIBIT 12.17 Translated balance sheet, December 31, 2002. Balance Sheet FC Exchange Rates U.S.$ Cash $ 200 $0.66 $ 132 Accounts receivable 100 0.66 66 Inventory 300 0.66 198 Property and equipment 2,000 0.66 1,320 Total assets $2,600 $1,716 Accounts payable $ 400 0.66 $ 264 Notes payable 1,020 0.66 673 Common stock 1,000 0.58 580 Accumulated OCI* 87 Retained earnings 180 112 Total liabilities and equity $2,600 $1,716 * OCI = Other comprehensive income. Global Finance 381 3. The ending inventory was acquired at the average exchange rate of $0.62, and cost of sales is also made up of goods that were acquired when the ex- change rate averaged $0.62. The previous trial balance is remeasured into the U.S. dollar as shown in Exhibit 12.18. The income statement and balance sheet, prepared with the re- measured trial balance data, are presented in Exhibits 12.19 and 12.20. 32 Notice how application of the remeasurement method sharply changes comprehensive income. Comprehensive income was $199 with translation under the all-current method but only $27 with the temporal method of re- measurement. This difference of $85 is explained as follows: All-current method comprehensive income $199 Reduction in depreciation under temporal method: FC60 (.62 − .58) 2* Translation gain under the all-current method $(87) Deduct remeasurement loss under temporal method 87 (174) Temporal method net income $ 27 *Depreciation was translated at $0.62 as part of SG&A under the all-current method. However, because the fixed assets, which give rise to the depreciation expense, are trans- lated at their historical exchange rate of $0.58, the depreciation component of SG&A is reduced by $2 with remeasurement under the temporal method. EXHIBIT 12.18 Remeasured trial balance, December 31, 2002. Accounts FC Exchange Rates U.S.$ Cash $ 200 $0.66 $ 132 Accounts receivable 100 0.66 66 Inventory 300 0.62 186 Property and equipment 2,000 0.58 1,160 Cost of sales 600 0.62 372 SG&A expense 40 0.62 25 Depreciation 60 0.58 35 Tax provision 120 0.62 74 Remeasurement loss 87 Totals $3,420 $2,137 Accounts payable $ 400 0.66 $ 264 Notes payable 1,020 0.66 673 Common stock 1,000 0.58 580 Retained earnings 0 0 Sales 1,000 0.62 620 Totals $3,420 $2,137 382 Planning and Forecasting The explanation for the remeasurement loss of $87 is that balance-sheet exposure changed from net asset under the all-current method to net a liability position under the temporal (remeasurement) method. Asset exposure in an appreciating foreign currency results in a gain. However, liability exposure in the same circumstance results in a loss. In the all-current example, all assets and liabilities are translated using the current rate. Asset exposure existed under the all-current method because assets exceeded liabilities. As a result, the appreciation of the foreign currency resulted in a growth (gain) in net as- sets. This gain of $87 was reported as other comprehensive income. Under the temporal method of remeasurement, balance sheet exposure is the net of monetary assets and liabilities. These balance sheet accounts are EXHIBIT 12.19 Remeasured income statement, year ended December 31, 2002. Accounts FC Exchange Rates U.S.$ Sales $1,000 $0.62 $620 Less Cost of sales 600 0.62 372 Gross margin 400 248 Less: SG&A 40 0.62 25 Depreciation 60 0.58 35 Remeasurement loss (Exhibit 12.18) 87 Pretax profit 300 101 Less: tax provision 120 0.62 74 Net income $ 180 $ 27 Other comprehensive income — Comprehensive income $ 27 EXHIBIT 12.20 Remeasured balance sheet, December 31, 2002. Balance sheet FC Exchange Rates U.S.$ Cash $ 200 $0.66 $ 132 Accounts receivable 100 0.66 66 Inventory 300 0.62 186 Property and equipment 2,000 0.58 1,160 Total assets $2,600 $1,544 Accounts payable$ $ 400 0.66 $ 264 Notes payable 1,020 0.66 673 Common stock 1,000 0.58 580 Retained earnings 180 (income statement) 27 Total liabilities and equity $2,600 $1,544 Global Finance 383 remeasured at the ever-changing current rate. However, none of the other non- monetary balance-sheet accounts creates exposure because their dollar value is frozen at fixed, historical exchange rates. In the above example, monetary liabilities (accounts payable of FC400 plus notes payable of FC1,020) are well in excess of monetary assets (cash of FC200 plus accounts receivable of FC100) and net liability exposure results. Appreciation of the foreign currency increased the dollar valuation of this net liability exposure and produced a remeasurement loss of $87. This remeasure- ment loss is included in computing conventional net income, and not in other comprehensive income as is the case under the all-current translation method. Beyond these separately reported income statement effects of translation gains and losses, the translated financial statements are affected in some other less obvious ways. These are discussed next. Other Effects of Statement Translation and Remeasurement The most noticeable effects of the statement translation and remeasurement are (1) the translation adjustment that is part of other comprehensive income under all-current translation and (2) the remeasurement gain or loss that is in- cluded in realized net income with statement remeasurement under the tem- poral method. Statement Relationships under Translation versus Remeasurement Significant differences in earnings resulted in the above example with transla- tion under the all-current method versus remeasurement under the temporal method. These results are due to (1) differences in currency exposure under the two methods and (2) differences in the location of translation-related gains and losses in the financial statements under the two methods. Translation ad- justments go to other comprehensive income under all-current translation, but remeasurement gains and losses are included in net income with remeasure- ment under the temporal method. Key statement relationships are affected by translation versus remeasure- ment. For example, both the current ratio (ratio of current assets to current liabilities) and the debt to equity ratios differ between the two methods. It is also common for gross margins to differ between the two methods. However, the simple nature of this constructed example results in the same gross mar- gins under each translation/remeasurement method. These measures are pre- sented in Exhibit 12.21. Noticeable in Exhibit 12.21 is the fact that the values of each of the mea- sures from the foreign-currency statements are preserved with translation under the all-current method. However, both the working capital and debt to equity measures differ from these values in the case of remeasurement under 384 Planning and Forecasting the temporal method. The working capital ratio differs because inventory is translated at a rate of only $0.62 under remeasurement, but at $0.65 with translation under the all-current method. The debt-to-equity ratio is higher with the remeasured statements because of the remeasurement loss under the temporal method, but a translation gain under the all-current method. Pre- serving the relationships of the foreign-currency statements in the translated statements is seen to be a desirable feature of translation under the all-current method. Effects of Exchange Rate Changes not Captured by Translation and Remeasurement It is common for firms to comment on the effects of exchange-rate changes on key financial statement items. In particular, the effects of exchange-rate changes on the growth or decline in sales are frequently commented upon in Management’s Discussion and Analysis (MD&A). The processes of translation and remeasurement summarize the joint ef- fects of currency exposure and exchange rate changes in a single summary sta- tistic. However, there are other effects associated with changing exchange rates that are not set out separately in any financial statement. For example, assume that the physical volume of sales and local-currency sales prices are unchanged for a foreign subsidiary. If the currency of the country in which the subsidiary is located depreciates in value, then the translated amount of sales revenue will decline. If the product being sold is manufactured in the foreign country, then there should also be a partially offsetting decline in cost of sales. 33 The disclosures in Exhibit 12.22 attempt to identify the effect of changing exchange rates on sales and profits. Galey & Lord’s disclosure identifies a com- mon concern about the dollar appreciating in value: it makes U.S. goods more ex- pensive in the export market. This point is echoed by Illinois Tool Works and its disclosure that its operating revenues were reduced each of the last three years because of the strengthening of the U.S. dollar. Revenue reductions associated with a strengthened dollar normally come from a combination of (1) foreign sales EXHIBIT 12.21 Key statement relationships under translation versus remeasurement. In the FC Measurement Statements Translation Remeasurement Working capital ratio a 1.50/1 1.50/1 1.45/1 Gross margin 40% 40% 40% Debt to equity b .86/1 .86/1 1.11/1 a Only the accounts payable are included in current liabilities. b Debt includes only the notes payable. Equity under the all-current method includes accumulated other comprehensive income. Global Finance 385 simply translating into fewer dollars as well as (2) declines in the volume of for- eign sales due to the weakening of the foreign currency. The Philip Morris disclosures highlight the value of diversification in for- eign sales by currency. Whereas revenues and profits were reduced by the de- preciation of Western European and Latin American currencies, the Japanese yen appreciated and offset, but not fully, these negative effects. Notice that Philip Morris identifies the net effect of the appreciation and depreciation of foreign currencies on both revenues and income. Praxair provides sufficient detail to reconcile its actual percentage growth or decline in sales to the results in the absence of changes in exchange rates. Notice that Praxair’s sales declined by 4% in 1999, and that the decline was largely explained by currency depreciation in South America. However, ex- plaining the behavior of sales in 1998 is more involved. The information dis- closed by Praxair for 1998 is summarized here: EXHIBIT 12.22 Exchange rate effects on sales and profit growth. Galey & Lord Inc. (1999) In addition to the direct effects of changes in exchange rates, which are a changed dollar value of the resulting sales and related expenses, changes in exchange rates also affect the volume of sales or the foreign currency sales price as competitors products become more or less attractive. Illinois Tool Works Inc. (1999) The strengthening of the U.S. dollar against foreign currencies in 1999, 1998 and 1997 resulted in decreased operating revenues of $59 million in 1999, $122 million in 1998 and $166 million in 1997 and decreased net income by approximately 1 cent per diluted share in 1999 and 4 cents per diluted share in 1998 and 1997. Philip Morris Companies Inc. (1999) Currency movements decreased operating revenues by $782 million ($517 million, after excluding excise taxes) and operating companies income by $46 million during 1999. Declines i n operating revenues and operating companies income arising from the strength of the U.S. dollar against Western European and Latin American currencies were partially mitigated by currency favorabilities recorded against the Japanese yen and other Asian currencies. Praxair Inc. (1999) The sales decrease of 4% in 1999 as compared to 1998 was due primarily to unfavorable currency translation effects in South America. Excluding the impact of currency, sales grew by 2%. The productivity improvements and currency translation impacts resulted in an $18 million decrease in selling, general, and administrative expenses despite the increase due to acquisitions. Sales for 1998 were flat when compared to 1997, primarily because sales volume growth of 4% and price increases of 2% were offset by negative currency translation effects. SOURCES : Companies’ annual reports. The year following each company name designates the annual re- port from which each example is drawn. 386 Planning and Forecasting Disclosed sales growth 0% Breakdown of Sales-Change Components Vol ume +5% Price changes +2% Currency depreciation −7% Sales growth 0% The Praxair zero change in sales revenue in 1998 could be interpreted in a manner that is too negative. After all, in the face of the zero growth in actual dollar sales revenue, Praxair was able to increase prices and still improve sales volume by 5%. Disclosure of quantitative details on the effects of the three el- ements, volume, price and currency makes it possible to develop a much better understanding of Praxair’s 1998 business performance. In the case of positive revenue growth, increases from volume or price adjustments should be preferred to growth resulting from favorable exchange- rate movements. Revenue growth driven by changes in exchange rates may prove to be only temporary. Sustained revenue growth, in the absence of vol- ume growth and /or price increases, would require ongoing strengthening of foreign currencies—not a very likely prospect. The effects of changes in exchange rates on sales and profits can be con- trolled to some extent by management. As with most foreign-currency expo- sure, management can elect to control or hedge this risk through operational arrangements and currency derivatives. Much discussion of these matters has already been provided. However, the focus of the next section is on the man- agement of currency risks associated with foreign subsidiaries. MANAGING THE CURRENCY RISK OF FOREIGN SUBSIDIARIES It is a common view that translation-related currency risk associated with the statements of foreign subsidiaries is quite different from currency risk associ- ated with foreign-currency transactions. Transactional exposure has the clear potential to expand or contract the cash flows associated with foreign-currency asset and liability balances. If a U.S. firm holds a Japanese yen account receiv- able and the yen falls in value, then there is a loss of cash inflow. If a Japanese firm has an account payable in the U.S. dollar and the yen strengthens, then a smaller cash outflow is required to discharge this liability. There are no identifiable cash inflows or outflows in the case of transla- tion gains or losses that result from either statement translation or remeasure- ment. A study of both U.S. and U.K. multinationals found that “it was generally agreed that translation exposure management was a lesser concern” (less than transaction exposure management). 34 The Wharton survey results on hedging (Exhibit 12.10) found the management of the volatility of cash flows as the major objective of hedging. However, it is very common for disclosures of transaction-related currency hedging to cite the goal of protecting cash flows. Global Finance 387 The reduced level of currency risk-management in the case of translation exposure is explained largely by the absence of direct cash flow and earnings risk. There is a somewhat greater effort to manage remeasurement-related risk because, unlike under the all-current method, remeasurement gains and losses are included in net income. Some companies do hedge translation exposure even though the translation adjustments are only included in other comprehen- sive income, with this element generally going straight to shareholders’ equity. However, the absence of an impact on earnings under all-current translation makes it less likely that this exposure will be hedged. Prior to the issuance of SFAS No. 52, Foreign Currency Translation, SFAS No. 8, Accounting for the Translation of Foreign Currency Transactions and Foreign Financial Statements, required all firms to use the temporal method and to include all translation gains and losses in the computation of net income. 35 As a result, one would expect the hedging of translation exposure to have declined after the issuance of Statement No. 52. Under SFAS No. 52, most translation is by the current-rate method and translation adjustments are omitted from conventional net income. Available evidence supports this view. For example, Houston and Mueller note: “In particular, firms that must no longer include all translation gains or losses arising from their foreign opera- tions in their income statements are more likely to have stopped or reduced hedging translation exposure.” 36 To gain some insight into translation hedging practices, disclosures of translation-hedging policies by a number of firms are presented in Exhibit 12.23. The examples in Exhibit 12.23 are selective and do not represent the relative fre- quency with which translation exposure is hedged. Rather, the disclosures are simply designed to present some of the matters that appear to influence deci- sions on the hedging of translation exposure. Notice that AGCO does not hedge its translation exposure. However, it attempts to achieve what could be called a natural hedge by the device of fi- nancing its foreign operations with local borrowings. Increasing local-currency borrowings reduces the net investment in the subsidiary—assets minus liabili- ties—and with it translation exposure. This example suggests a potential for mis- interpretation of company statements about their translation hedging. AGCO apparently means that it does not use currency derivatives to hedge translation exposure. However, it does attempt to reduce exposure by other means. Becton Coulter indicates occasional hedging of translation exposure. Note the reference to the hedge of the market (exchange rate) risk of a sub- sidiary’s net-asset position. Again, in the case of translation with the all- current method, exposure is approximated by a subsidiary’s net-asset position, that is, assets minus liabilities. Becton Coulter must be making reference to subsidiaries translated using the all-current method because it indicates that any gains or losses on hedges of translation exposure are included in accumu- lated other comprehensive income. This is also the location of the translation gains and losses that result from the all-current translation method. The gains and losses on the hedges of this translation exposure are included in other com- prehensive income and offset, respectively, translation losses and gains. . Statements Translation Remeasurement Working capital ratio a 1.50/1 1.50/1 1.45/1 Gross margin 40% 40% 40% Debt to equity b .86/1 .86/1 1.11/1 a Only the accounts payable are included in current. Exchange Rates U.S.$ Sales $1,000 $0.62 $620 Less Cost of sales 600 0.62 372 Gross margin 400 248 Less: SG&A 40 0.62 25 Depreciation 60 0.58 35 Remeasurement loss (Exhibit 12.18) 87 Pretax profit. sales 600 0.62 372 SG&A expense 40 0.62 25 Depreciation 60 0.58 35 Tax provision 120 0.62 74 Remeasurement loss 87 Totals $3,420 $2,137 Accounts payable $ 400 0.66 $ 264 Notes payable 1,020