chapter 16: multinational operations

CHAPTER 16MULTINATIONAL OPERATIONS

Presenter’s namePresenter’s titledd Month yyyy

Copyright © 2015 CFA Institute 2

PRESENTATION CURRENCY AND FUNCTIONAL CURRENCY

• Presentation currency: The currency in which the company presents (reports) its financial statements.

• Functional currency: The currency in which the company conducts its primary activity.

• Local currency: The currency used within the country in which the company operates.

• Often, presentation currency = functional currency = local currency.

• Often, functional currency of subsidiary ≠ functional and presentation currency of parent.


FOREIGN CURRENCY TRANSACTION EXPOSURE

Exporter ImporterGoods

Payment Currency?




?



• IMPORTER makes purchase denominated in foreign currency with timing difference between purchase date and payment date.

• Example: Finnish importer FinnCo makes credit purchase from MexCo.

• If the purchase is denominated in Mexican pesos, FinnCo has foreign currency transaction exposure.

• Downside risk to FinnCo: If value of peso increases relative to the euro during the time between the purchase date and payment date, FinnCo must spend more euros to settle its account payable in pesos.

• EXPORTER makes sale denominated in foreign currency with timing difference between sale date and payment receipt date.

• Example: Mexican exporter MexCo makes credit sale to FinnCo.

• If the sale is denominated in euros, MexCo has foreign currency transaction exposure.

• Downside risk to MexCo: If value of peso increases relative to euro during the time between the sale date and receipt of payment, MexCo can buy fewer pesos with the euros it receives.


CHANGES IN EXCHANGE RATES IMPACT ON SALES: EXAMPLE 1

• FinnCo sells goods to a customer in the United Kingdom for £10,000 with payment to be received in British pounds. Credit terms allow 45 days for receipt of payment. FinnCo’s functional and presentation currency is the euro.

• Exchange rate on the date of the transaction: £1 = €1.460

• Exchange rate on the date of payment: £1 = €1.475• Question: What is FinnCo’s foreign exchange gain or loss?



£ FX Rate €

Euro value of FinnCo’s receivable on transaction date 10,000 1.460 14,600

Euro value of FinnCo’s receivable on receipt date 10,000 1.475 14,750

FinnCo’s foreign exchange gain 150



• FinnCo sells goods to a customer in the United Kingdom for £10,000 with payment to be received in British pounds. Credit terms allow 45 days for receipt of payment.

• Exchange rate on the date of the transaction: £1 = €1.460• Exchange rate on the date of payment: £1 = €1.475• Assume that the transaction date was in November Year 1, the

payment date was in January Year 2, and the company has a 31 December year-end.

• Exchange rate on 31 December, Year 1: £1 = €1.480• Question: What is FinnCo’s foreign exchange gain or loss for

Year 1? And for Year 2?



Transaction date

Exchange rate: £1 = €1.460

Value of receivable: €14,600

Balance sheet date


Value of receivable:€14,800

Payment receipt date


Value of receivable:€14,750

Gain of €200 Loss of €50

Overall actual realized foreign currency gain = €150


CHANGES IN EXCHANGE RATES IMPACT ON SALES AND PURCHASES

Foreign CurrencyTransaction Type of Exposure Strengthens Weakens

Export sale Asset (account receivable) Gain Loss

Import purchase Liability (account payable) Loss Gain



Alternative 1

Report transaction gain as part of “other operating expenses, net.”

• Gross profit margin: no impact• Operating profit margin: higher• Net profit margin: no impact

Alternative 2

Report transaction gain as part of

“nonoperating expenses, net.”

• Gross profit margin: no impact• Operating profit margin: lower• Net profit margin: no impact

Where will FinnCo report the foreign currency transaction gain in Year 1?


IMPACT OF CHANGES IN EXCHANGE RATES: EXAMPLE DISCLOSURE

“Our exposure to foreign currency transaction gains and losses is the result of assets and liabilities, (including inter-company transactions) that are denominated in currencies other than the relevant entity’s functional currency.... Transaction gains and losses on these foreign exchange contracts are recognized each period in other income, net included on the consolidated statements of income. During the years ended December 31, 2011, 2010, and 2009, we recorded net realized and unrealized foreign currency transaction gains of $9 million and $13 million, and a transaction loss of $1 million, respectively.”

Yahoo! Inc., Annual Report (2011)


TRANSLATING SUBSIDIARIES’ SALES INTO THE PARENT COMPANY’S PRESENTATION CURRENCY

• In most cases, a foreign subsidiary will operate primarily in the currency of the country where it is located, which will differ from the currency in which the parent company presents its financial statements.

• To prepare worldwide consolidated financial statements, the parent company must translate the foreign currency financial statements of their foreign subsidiaries into the parent company’s presentation currency.


TRANSLATING SUBSIDIARIES’ SALES INTO THE PARENT COMPANY’S PRESENTATION CURRENCY

For example, assume the US subsidiary of a German company keeps its books in US dollars, and the South African subsidiary of the German company keeps its books in South African rands. The German parent company must prepare consolidated financial statements in euros.• Revenues are translated at the exchange rate that existed when the

transactions took place. For practical reasons, a rate that approximates the exchange rates at the dates of the transactions, such as an average exchange rate, may be used.

• If the US dollar and South African rand appreciate against the euro over the course of a given year, the amount of sales translated into euro will be greater than if the subsidiaries’ currencies weaken against the euro.


TRANSLATING FOREIGN CURRENCY FINANCIAL STATEMENTS INTO THE PARENT COMPANY’S

PRESENTATION CURRENCY

In consolidated financial statements, the assets, liabilities, revenues, and expenses of both domestic and foreign subsidiaries are added to those of the parent company.Overall, two questions must be addressed:

1. What exchange rate should be used for each line item?2. Where should the translation adjustment be reported?


WHAT EXCHANGE RATE SHOULD BE USED FOR EACH LINE ITEM?

• Current rate method: Use spot exchange rate on balance sheet date for all assets and liabilities.

• Temporal method: –Use spot exchange rate on balance sheet date for all monetary

assets and liabilities (and for all non-monetary assets and liabilities that are measured at their current value).

–Use historical exchange rate for non-monetary assets and liabilities that are measured at historical cost.


WHAT EXCHANGE RATE SHOULD BE USED FOR EACH LINE ITEM?

When the subsidiary’s functional currency is different from the parent’s functional currency:• All assets and liabilities: Translate at

current exchange rate (current rate method)

• Equity accounts: Translate at historical exchange rates

• Revenues and expenses: Translate at average exchange rate, which approximates exchange rate on transaction date

When the subsidiary’s functional currency is the same as the parent’s functional currency:• Monetary assets and liabilities:

Translate at current exchange rate• Non-monetary assets and liabilities:

- Historical cost at historical exchange rates

- Current value at valuation date exchange rate

• Equity accounts: Translate at historical exchange rates

• Revenues and expenses: - Not related to non-monetary assets,

translate at average exchange rate- Related to non-monetary assets,

use historical exchange rate.


WHERE SHOULD THE TRANSLATION ADJUSTMENT BE REPORTED?

When the subsidiary’s functional currency is different from the parent’s functional currency:• Unrealized translation gain/loss

is accumulated as a separate component of the parent’s equity.

When the subsidiary’s functional currency is the same as the parent’s functional currency:• Translation adjustment is

reported as a gain or loss in the parent’s net income.


FACTORS CONSIDERED IN DETERMINING THE FUNCTIONAL CURRENCY

The functional currency is • the currency that influences sales prices for goods and services.• the currency of the country whose competitive forces and regulations

mainly determine the sales price of the entity’s goods and services.• the currency that mainly influences labor, material, and other costs of

providing goods and services.• the currency in which funds from financing activities are generated.• the currency in which receipts from operating activities are usually

retained.


TRANSLATING FOREIGN CURRENCY FINANCIAL STATEMENTS: EXAMPLE

Balance Sheet Item USD Exchange Rate (€) EURCash $3,000 1.00 €3,000Inventory 12,000 1.00 12,000Total $15,000 €15,000

Notes payable $5,000 1.00 €5,000Common stock 10,000 1.00 10,000Total $15,000 €15,000

Translation worksheet for Amerco (US subsidiary), 31 December 20X1Exchange rate is €1.00 = US$1.00



Balance Sheet Item USD Exchange Rate (€) EURCash $ 3,000 ? €?Inventory 12,000 ? ?Total $15,000 €?

Notes payable $5,000 ? ?Common stock 10,000 1.00 10,000Total $15,000 €?

Translation worksheet for Amerco (US subsidiary), 31 March 20X2No transactions. Current exchange rate is €0.80 = US$1.00.




US DollarExchange Rate (€) Euro

Change in Euro Value since 31 Dec 20X1

Cash $3,000 0.80 C €2,400 –€ 600Inventory 12,000 0.80 C 9,600 –2,400Total $15,000 €12,000 –€3,000

Notes payable $5,000 0.80 C €4,000 –€1,000Common stock 10,000 1.00 H 10,000 0Subtotal $15,000 €14,000 –€1,000Translation adjustment –2,000 –2,000Total €12,000 –€3,000




US DollarExchange Rate (€) Euro

Change in Euro Value since 31

Dec 20X1Cash $ 3,000 0.80 C € 2,400 –€600Inventory 12,000 1.00 H 12,000 0Total $15,000 €14,400 –€600

Notes payable $5,000 0.80 C €4,000 –€1,000Common stock 10,000 1.00 H 10,000 0Subtotal $15,000 €14,000 –€1,000Translation adjustment 400 400Total €14,400 –€600


CHANGES IN EXCHANGE RATES IMPACT ON TRANSLATION ADJUSTMENT

Foreign Currency (FC)

Balance Sheet Exposure Strengthens Weakens

Net asset Positive translation adjustment

Negative translation adjustment

Net liability Negative translation adjustment

Positive translation adjustment


EFFECTS OF TRANSLATION METHOD ON FINANCIAL RATIOS

• Receivables turnover (sales/receivables) is the same under both current and temporal methods.- Sales are translated at the average exchange rate under both.- Receivables are translated at the current exchange rate under

both.• Current ratio (current assets/current liabilities) differs.

- Inventory is translated at the current exchange rate under the current method, but the historical exchange rate under the temporal method.

- If the subsidiary’s currency appreciates relative to the parent, the current ratio will be higher under the current method than the temporal.


RATIOS UNDER LOCAL CURRENCY VS. RATIOS IN TRANSLATED CURRENCY: CURRENT METHOD

• Underlying relationships in a subsidiary’s local currency financial statement are preserved when- ratios involve only the balance sheet (e.g., current ratio, debt-to-

assets ratio, debt-to-equity ratio). - ratios involve only the income statement (e.g., interest coverage ratio,

gross profit margin, operating profit margin, net profit margin).• Underlying relationships in a subsidiary’s local currency financial

statement are distorted when ratios involve amounts from both the balance sheet and income statement because

- assets and liabilities are translated using the current exchange rate. - revenues and expenses are translated using the average exchange

rate.- equity accounts are translated at historical exchange rates.


RATIOS UNDER LOCAL CURRENCY VS. RATIOS IN TRANSLATED CURRENCY: TEMPORAL METHOD

• Underlying relationships in a subsidiary’s local currency financial statement are preserved when both numerator and denominator use the historical exchange rate (e.g., Inventory turnover = Cost of goods sold/Inventory).

• Otherwise, underlying relationships in a subsidiary’s local currency financial statement are distorted because of the following:- Monetary assets and liabilities are translated at current exchange rate.- Non-monetary assets and liabilities

- Historical cost translated at historical exchange rates.- Current value translated at valuation date exchange rate.

- Revenues and expenses - Not related to non-monetary assets, translated at average exchange rate.- Related to non-monetary assets, translated at historical rate.

- Equity accounts are translated at historical exchange rates.


SUBSIDIARIES OPERATING IN HYPERINFLATIONARY ECONOMIES

• For a subsidiary in a hyperinflationary economy, translating local foreign currency financial statements into the parent’s presentation currency requires the following:

• Under IFRS• First, restate the subsidiary’s local currency financial statements for

local inflation.• Then, translate the inflation-restated foreign currency financial

statements into the parent’s presentation currency using the current exchange rate.

• Under US GAAP • Use the temporal method to translate the subsidiary’s local currency

financial statements.• Include the resulting translation adjustment as a gain or loss in

determining net income.


SUBSIDIARIES OPERATING IN HYPERINFLATIONARY ECONOMIES: EXAMPLE

• Assume a US company established a subsidiary in Turkey on 1 January 2000 (at which time Turkey was highly inflationary).

• The US parent sent the subsidiary US$1,000 on 1 January 2000 to purchase a piece of land at a cost of TL542,700,000 (TL542,700/US$ × US$1,000 = TL542,700,000).

• Assuming no other assets or liabilities, what are the annual and cumulative translation gains or losses given the following data?

Date Exchange Rates YearInflation Rate

(%)01 Jan 2000 TL542,700 = US$1 31 Dec 2000 TL670,800 = US$1 2000 3831 Dec 2001 TL1,474,525 = US$1 2001 6931 Dec 2002 TL1,669,000 = US$1 2002 45



• A Turkish subsidiary of a US parent has one asset: A piece of land at an original cost of TL542,700,000. The US parent sent the subsidiary US$1,000. What are the annual and cumulative translation gains or losses under IFRS?

Date

Inflation Rate(%)

Restated Carrying

Value in TL

Current Exchange Rate TL/$

Translated Amount in

US$

Annual Translation

Gain (Loss)

Cumulative Translation

Gain (Loss)

01/01/00 542,700,000 542,700 $1,000 N/A N/A31/12/00 38 748,926,000 670,800 1,116 $116 $11631/12/01 69 1,265,684,940 1,474,525 858 (258) (142)31/12/02 45 1,835,243,163 1,669,000 1,100 242 100



• A Turkish subsidiary of a US parent has one asset: A piece of land at an original cost of TL542,700,000. The US parent sent the subsidiary US$1,000. What are the annual and cumulative translation gains or losses under US GAAP?

DateCarrying

Value in TL

Historical Exchange

Rate

Translated Amount in

US$

Annual Translation Gain (Loss)

Cumulative Translation Gain (Loss)

01/01/00 542,700,000 542,700 $1,000 N/A N/A

31/12/00 542,700,000 542,700 1,000 N/A N/A

31/12/01 542,700,000 542,700 1,000 N/A N/A

31/12/02 542,700,000 542,700 1,000 N/A N/A


MULTINATIONAL OPERATIONS AND EFFECTIVE TAX RATE

• Effective tax rate: Tax expense divided by pretax accounting profits• Statutory tax rate: The income tax rate in the company’s home tax jurisdiction.• Required disclosures include a reconciliation schedule explaining reasons for

the differences between the statutory tax rate and the company’s effective tax rate.

• When a company earns profits outside its home country and incurs taxes at foreign tax rates that differ from its home country statutory tax rate, the effect will be shown in the reconciliation schedule.


COMPONENTS OF SALES GROWTH AND SUSTAINABILITY

Excerpt from General Mills 2011 Annual ReportMD&A



Excerpt from General Mills 2011 Annual ReportSupplementary Schedule



A B C DContributions from volume growth 8 1 1 6Contributions from price increases 1 8 1 3Foreign currency exchange 1 1 8 1Net sales growth 10 10 10 10

Hypothetical Companies’ Components of International Sales Growth (percentage points)


CURRENCY FLUCTUATIONS—POTENTIAL IMPACT ON FINANCIAL RESULTS

• As discussed, a multinational company’s sales denominated in currencies other than the company’s functional currency give rise to exchange risks.

• Over the medium to long term, a company can create a “natural hedge” by more closely matching the currency of its expenses with the currency of its sales—for example,– by making more of its purchases in the same currencies as the sales, and/or – by locating its manufacturing facilities in the country of sales.

• Over shorter time frames, a company can hedge currency risks in the financial markets.


CURRENCY FLUCTUATIONS—POTENTIAL IMPACT ON FINANCIAL RESULTS

• For example, BMW AG faces exchange risks arising from sales of vehicles outside the Eurozone.

• BMW measures currency risk using a “cash-flow-at-risk” model. – Identify forecasted foreign currency transaction exposure.– Exposures are compared with all hedges that are in place to determine

unhedged risk positions. – The potential negative impact on earnings is computed based on exchange

rate volatility and probability distributions.• BMW discloses the potential negative earnings impact of unfavorable changes

in exchange rates.


SUMMARY

• Fluctuations in foreign exchange rates cause the translated values of foreign currency assets and liabilities to change, giving rise to foreign exchange differences that must be reflected in the financial statements.

• For export sales (or import purchases), any change in the functional currency value of the foreign currency account receivable (or account payable) that occurs between the transaction date and the settlement date is recognized as a foreign currency transaction gain or loss in net income.

• For translating foreign subsidiaries’ financial statements into the parent company’s presentation currency, either the current method or the temporal method is used.

• Companies typically disclose information about the impact of foreign currency on sales growth and sensitivity of profits to currency fluctuations.

chapter 16: multinational operations

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