CHAPTER 8CHAPTER 8

MEASURING MEASURING ACCOUNTING ACCOUNTING

EXPOSUREEXPOSURE

CHAPTER OVERVIEWCHAPTER OVERVIEW

I.I. ALTERNATIVE MEASURES OF ALTERNATIVE MEASURES OF

FOREIGN EXCHANGE FOREIGN EXCHANGE

EXPOSUREEXPOSURE

II.II. ALTERNATIVE CURRENCY ALTERNATIVE CURRENCY

TRANSLATION METHODSTRANSLATION METHODS

III.III. STATEMENT OF FINANCIAL STATEMENT OF FINANCIAL

ACCOUNTING STANDARDS NO. ACCOUNTING STANDARDS NO.

88

CHAPTER OVERVIEW (con’t)CHAPTER OVERVIEW (con’t)

IV.IV. STATEMENT OF FINANCIALSTATEMENT OF FINANCIAL

ACCOUNTING STANDARDS ACCOUNTING STANDARDS

NO.52NO.52

V.V. TRANSACTION EXPOSURETRANSACTION EXPOSURE

VI.VI. ACCOUNTING PRACTICE AND ACCOUNTING PRACTICE AND

ECONOMIC REALITYECONOMIC REALITY

PART I. ALTERNATIVE MEASURES PART I. ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSUREOF FOREIGN EXCHANGE EXPOSURE

I.I. ALTERNATIVE MEASURES OF FOREIGN ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSUREEXCHANGE EXPOSURE

A.A. Three Types of ExposureThree Types of Exposure

1.1. Accounting Exposure:Accounting Exposure:

when reporting and when reporting and consolidating financial consolidating financial

statements requires statements requires conversion from conversion from foreign to foreign to local currency.local currency.

ALTERNATIVE MEASURES OF ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSUREFOREIGN EXCHANGE EXPOSURE

2.2. Transaction Exposure: Transaction Exposure:

occurs from changes in the occurs from changes in the

value value of foreign currency of foreign currency

contracts as contracts as a result of a result of

exchange rate exchange rate

changes. changes.

ALTERNATIVE MEASURES OF ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSUREFOREIGN EXCHANGE EXPOSURE

3.3. Operating ExposureOperating Exposure

arises because exchange ratearises because exchange rate

changes alter the value of changes alter the value of futurefuture

revenues and costs.revenues and costs.

ALTERNATIVE MEASURES OF ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSUREFOREIGN EXCHANGE EXPOSURE

Economic ExposureEconomic Exposure

= Transaction + Operating= Transaction + Operating

ExposuresExposures

PART II. ALTERNATIVE CURRENCY PART II. ALTERNATIVE CURRENCY TRANSLATION METHODS TRANSLATION METHODS

I.I. FOUR METHODS OF TRANSLATIONFOUR METHODS OF TRANSLATION

A.A. Current/Noncurrent MethodCurrent/Noncurrent Method

1. 1. Current accounts use Current accounts use current exchange rate current exchange rate

for for conversion.conversion.

2. 2. Income statement Income statement accounts accounts use average use average exchange rate exchange rate for the for the period.period.

ALTERNATIVE CURRENCY ALTERNATIVE CURRENCY TRANSLATION METHODSTRANSLATION METHODS

B.B. Monetary/Nonmonetary MethodMonetary/Nonmonetary Method

1.1. Monetary accounts use Monetary accounts use current ratecurrent rate

2.2. Pertains toPertains to- cash- cash- accounts receivable- accounts receivable- accounts payable- accounts payable- long term debt- long term debt

ALTERNATIVE CURRENCY ALTERNATIVE CURRENCY TRANSLATION METHODSTRANSLATION METHODS

3.3. Nonmonetary accountsNonmonetary accounts

- use historical rates- use historical rates

- Pertains to - Pertains to

inventoryinventory

fixed assetsfixed assets

long term investmentslong term investments

4.4. Income statement accounts Income statement accounts

- use average exchange rate - use average exchange rate for the period.for the period.

ALTERNATIVE CURRENCY ALTERNATIVE CURRENCY TRANSLATION METHODSTRANSLATION METHODS

C.C. Temporal MethodTemporal Method

1.1. Similar to Similar to

monetary/nonmonetarymonetary/nonmonetary

method.method.

2.2. Use current method for Use current method for inventory.inventory.

ALTERNATIVE CURRENCY ALTERNATIVE CURRENCY TRANSLATION METHODSTRANSLATION METHODS

D.D. Current Rate MethodCurrent Rate Method

all statements use current all statements use current

exchange rate for exchange rate for

conversions.conversions.

PART III. STATEMENT OF FINANCIAL PART III. STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 8ACCOUNTING STANDARDS NO. 8

I.I. FASB NO. 8FASB NO. 8

A.A. Uniform conversion rules Uniform conversion rules establishedestablished

B.B. Temporal method utilizedTemporal method utilized

C.C. Translation gains or lossesTranslation gains or losses

1. Reported on income statement1. Reported on income statement

2. Result: net income greatly 2. Result: net income greatly affected by exchange rate affected by exchange rate volatility.volatility.

PART IV. STATEMENT OF INANCIAL PART IV. STATEMENT OF INANCIAL ACCOUNTING STANDARDS NO. 52ACCOUNTING STANDARDS NO. 52

I.I. FASB NO. 52FASB NO. 52

A.A. Dissatisfaction with FASB No. 8Dissatisfaction with FASB No. 8true profitability often disguised bytrue profitability often disguised byexchange rate volatility.exchange rate volatility.

B.B. Balance sheet translation uses Balance sheet translation uses current rate method.current rate method.

STATEMENT OF INANCIAL STATEMENT OF INANCIAL ACCOUNTING STANDARDS NO. 52ACCOUNTING STANDARDS NO. 52

C.C. Income statement usesIncome statement uses

1. 1. Weighted average rate Weighted average rate during period during period oror

2. 2. The rate in effect when The rate in effect when revenue and revenue and

expensesexpensesincurred.incurred.

STATEMENT OF FINANCIAL STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 52ACCOUNTING STANDARDS NO. 52

D.D. Translation Gains or LossesTranslation Gains or Losses

1. 1. Recorded in separate equity Recorded in separate equity

account on balance sheet.account on balance sheet.

2. 2. Known as cumulative Known as cumulative

translation adjustment translation adjustment

account.account.

STATEMENT OF INANCIAL STATEMENT OF INANCIAL ACCOUNTING STANDARDS NO. 52ACCOUNTING STANDARDS NO. 52

E.E. New Distinction under FASB No. 52:New Distinction under FASB No. 52:

functional v. reporting currencyfunctional v. reporting currency1. 1. Functional currencyFunctional currency

for foreign subsidiary = the for foreign subsidiary = the currency used in the primary currency used in the primary

economic environment economic environment in which it in which it operates. operates.

STATEMENT OF INANCIAL STATEMENT OF INANCIAL ACCOUNTING STANDARDS NO. 52ACCOUNTING STANDARDS NO. 52

2. 2. Reporting currency Reporting currency

the currency the parent firm the currency the parent firm uses to prepare its uses to prepare its

financial financial statements.statements.

STATEMENT OF FINANCIAL STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 52ACCOUNTING STANDARDS NO. 52

3. If foreign subsidiary’s operations are 3. If foreign subsidiary’s operations are direct extension of parent firmdirect extension of parent firm

e.g. Hong Kong assembly plant e.g. Hong Kong assembly plant

whichwhich

sells all its products in the U.S. sells all its products in the U.S.

market. market.

PART V.PART V.TRANSACTION EXPOSURETRANSACTION EXPOSURE

I.I. WHEN DOES IT OCCUR?WHEN DOES IT OCCUR?

A. From the time of agreement to time ofA. From the time of agreement to time of

payment.payment.

B.B. Arises from possibility of exchange Arises from possibility of exchange rate rate

gains and losses from the gains and losses from the transaction.transaction.

TRANSACTION EXPOSURETRANSACTION EXPOSURE

II. MEASUREMENTII. MEASUREMENT

A. Currency by currencyA. Currency by currency

B.B. Equals the difference between Equals the difference between

1. The contractually-fixed invoice1. The contractually-fixed invoice

amount in a specific currencyamount in a specific currency

2. The final payment amount 2. The final payment amount

denominated in current exchange denominated in current exchange

rate for the specific currency.rate for the specific currency.

PART VI. ACCOUNTING PRACTICE PART VI. ACCOUNTING PRACTICE AND ECONOMIC REALITYAND ECONOMIC REALITY

I.I. Accounting v. Economic ExposureAccounting v. Economic Exposuremeasurement of exchange rate risk measurement of exchange rate risk indicates major difference exists.indicates major difference exists.

A. Accounting exposureA. Accounting exposurereflects past decisions of the firm.reflects past decisions of the firm.

ACCOUNTING PRACTICE AND ACCOUNTING PRACTICE AND ECONOMIC REALITYECONOMIC REALITY

B. Economic exposureB. Economic exposure

1. Focuses on future impact of 1. Focuses on future impact of

exchange rate changes. exchange rate changes.

2. Not all future cash flows appear on2. Not all future cash flows appear on

the firm’s balance sheet.the firm’s balance sheet.

ACCOUNTING PRACTICE AND ACCOUNTING PRACTICE AND ECONOMIC REALITYECONOMIC REALITY

II. Recommendations for International II. Recommendations for International Business ExecutivesBusiness Executives

A. There is no relationship betweenA. There is no relationship between

1. 1. Information from historical Information from historical accounting techniques, andaccounting techniques, and

2. 2. The firm’s actual operating The firm’s actual operating results.results.

ACCOUNTING PRACTICE AND ACCOUNTING PRACTICE AND ECONOMIC REALITYECONOMIC REALITY

B. Chief executives should:B. Chief executives should:

base management decisions on thebase management decisions on the

economic effects of exchange rate economic effects of exchange rate

change.change.