Translation Exposure Management.pdf 71394y

NPTEL International Finance Vinod Gupta School of Management, IIT.Kharagpur.

Module - 30 Translation/ing Exposure: Measurement and Management

Developed by: Dr. Prabina Rajib Associate Professor (Finance & s) Vinod Gupta School of Management IIT Kharagpur, 721 302 Email: [email protected]

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NPTEL International Finance Vinod Gupta School of Management, IIT.Kharagpur.

Lesson - 30 Translation/ing Exposure: Measurement and Management Highlights & Motivations: ing is the language of business. ing principles help a company in the process of recording, classifying, reporting and analyzing financial data. As we know, ing reports (Profit Loss or Income statement, Balance Sheet and Cash flow Statements) helps to measure a company’s performance. Translation/ing exposure results when an MNC/parent translates its subsidiary’s financial data to its home currency for consolidated financial reporting. Translation exposure does not directly affect cash flows, but companies are concerned with this exposure because of its potential impact on reported consolidated earnings. A detailed working of translation exposure is beyond scope of this module. Readers must consult a book on ing to get a detailed understanding of quantification of ing exposure.

Learning Objectives: This session covers the following: • Measurement of Translation Exposure o Current/Non-current Method. o Monetary/Non-Monetary Method o Current Rate •

US GAAP, Indian GAAP and Consolidation of s

•

Management of Translation Exposure o Balance Sheet Hedge o Derivatives Hedge

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NPTEL International Finance Vinod Gupta School of Management, IIT.Kharagpur.

30.1 Measurement of Translation Exposure Session 29 highlights that, if the foreign exchange rate changes, translation of financial statement gives rise to translation exposure. In other words, a firm’s value of items reported in financial statements may change because the exchange rate has changed from the last reporting date to the current reporting date. When consolidation of financial statements is done, values of assets and liabilities translated at the prevailing exchange rate changes. Values of assets and liabilities which are translated at the historical rate are not affected by the exchange rate movement. However, certain assets and liabilities which are reported as per the changed exchange rate, may decline or increase in value. Values of assets and liabilities whose value changes due to change in exchange rate is known as exposed items. Translation exposure is measured by the difference between exposed asset and exposed liabilities. Three different ing methods are used by companies to identify and record the exposed assets and liabilities. These are • Current/Non-Concurrent Method. • Monetary/Non-Monetary Method • Current Rate Current/ Non-Current method: Under this method, current assets and current liabilities of the foreign subsidiary to be converted at the current exchange rate (rate prevailing on the Balance sheet date) while all non-current items i.e, long term assets and liabilities are converted at historical rate (the exchange rate prevailing on the date of the acquisition of foreign asset or liabilities). The depreciation item, as it is a non-current item, is translated at the same historical rate at which the corresponding fixed asset in the balance sheet. Monetary/Non- Monetary Method: Under this method, all monetary items in the balance sheet i.,e short term debts, cash, marketable securities, s payables/receivables etc. are converted at exchange rate prevailing on the balance sheet date. All other non-monetary items such as inventory, long-term assets and long term liabilities are converted at historical rate. It is important to note here that inventory is converted at current exchange rate in “Current/Non-Current Method”, while it is

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converted at a historical rate (average) in “Monetary/Non-Monetary approach”. The depreciation item, like the “Current/Non-Current Method” is translated at the same historical rate at which the corresponding fixed asset in the balance sheet. This method is based on the fundamental premise that only monetary assets/liabilities are exposed to change exchange risk. Non monetary assets/liabilities are not exposed because according to the purchasing power parity theory, the effect of exchange rate fluctuations would be balanced by the inflation differential between both countries in the long run. Hence long term assets/liabilities with higher longevity should not treated as exposed asset/liabilities. Current Rate Method: All balance-sheet and income statement items are translated at the current rate. It is one of the simplest methods for converting s. As per the AS 11 requirement, if a foreign operation is treated as “integral foreign entity” then the consolidation of report should be done as the “Monetary/NonMonetary Method”.AS 11 require the assets and liabilities, both monetary and nonmonetary, of the non-integral foreign operation should be translated at the “current rate method”. Different countries have different ing requirement (known as Generally accepted ing Principles or GAAPs) for treating a foreign operation in different manner and also the method applicable for consolidating foreign operation. For a given company, translation exposure varies from country to country depending on which country’s GAAP has been used to prepare the consolidated statement. Indian companies like Infosys, ICICI Bank and Wipro with their ADRs ( American Depository Receipts1) listed in stock exchanges of USA is required to prepare their consolidated report as per US GAAP as well as Indian GAAP. The following Box 30.1 shows how different GAAPs have different impact on company’s financial figure

1

ADRs and GDRs are discussed in detail in later sessions.

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Box 30.1: US GAAP, Indian GAAP and Consolidation of s Source: http://money.outlookindia.com/article.aspx?86427 Balance sheets of Indian companies have been much maligned for hiding more than they reveal. But the magic phrase "according to US GAAP" is changing all that. Several companies have begun publishing the impact of following the US Generally Accepted ing Principles (GAAP) on their s. In fact, a few have even gone beyond a mere US GAAP reconciliation, and publish their entire s according to US GAAP, like Infosys Technologies. What is US GAAP? Chartered ants' bodies lay out ing principles to be followed in a country, while preparing any statement of s. In India, ing standards are prepared by the Institute of Chartered ants of India. The ones set down by the US Federal ing Standards Bureau are used by US firms, and are recognised as one of the most stringent. ing standards take into a country's tax laws and company laws. Since these laws differ widely from country to country, ing standards also vary in their treatment of expenses and income. s prepared according to standards followed in various countries can result in widely different ing statements. How it's different. There are about 250 major and minor differences between the two ing standards. Important among these are the treatment of deferred taxes, depreciation and in ing for investments. Fundamentally though, the standards differ on two counts. One, under US GAAP, the notion of fair value predominates, whether in the valuation of investments or assets. Two, US GAAP insist on consolidation, which means adding up assets from all subsidiaries, associates and t ventures of the company in question. ING : A MATTER OF PRINCIPLE INFOSYS

RELIANCE

ICICI

Indian s

US GAAP

Indian s

US GAAP

Indian US GAAP s

EPS (Rs)

40.9

23.9

18.0

NA*

18.2

13.6

Net worth (Rs cr)

541.4

586.4

12,369.0

NA*

6,517.8

3,650.8

Net profit (Rs crore)

135.3

73.3

1,704.0

1,378.0

1,000.8

744.7

*Figures unavailable as Reliance only publishes a reconciliation between US GAAP income statements and Indian s.

Earnings figures. The impact of the difference between Indian standards and US GAAP comes through in the all-important earnings and return figures -- numbers that any investor looks at (See table: A Matter of ing Principles).

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NPTEL International Finance Vinod Gupta School of Management, IIT.Kharagpur.

Box 30.1 (Continued): US GAAP, Indian GAAP and consolidation of s Source: http://money.outlookindia.com/article.aspx?86427

US GAAP is more stringent and results in greater transparency, as it calls for greater disclosures. As a result, earnings of all Indian companies will be lower under US GAAP.For example, in the case of Infosys, while Indian s show a net profit of Rs 135 crore for 1998-99, US GAAP shows a much lower Rs 73 crore. Consolidated statements. This is a major change over Indian ing statements. US GAAP requires that a company add the s of its subsidiaries to its balance sheet. It defines a subsidiary as one in which a company has majority ownership and also has management and operational control. This is not compulsory under Indian ing, though many Indian companies do so voluntarily. Consolidated statements clearly spell out the total earnings of the company and that of its subsidiaries.

With the introduction of International ing standard (IAS), the difference in consolidation due to GAAP differences will vanish. The IAS 21 prescribes • How to include foreign currency transactions and foreign operations in the financial statements of an entity? • How to translate financial statements into a parent’s reporting currency? More details about IAS 21 is available at http://www.iasplus.com/standard/ias21.htm Details given in the Box 30.2 show some information about ing /translation risk faced by companies.

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Box 30.2: Translation risk – Balance sheet Source: http://www.trelleborg.com/annualreport2009/eng/Governanceandresponsibility/Financialriskmanagement.html

In connection with the translation of Group investments in foreign subsidiaries to SEK, there is a risk that changes in exchange rates will affect the consolidated balance sheet. Policy: Investments in foreign subsidiaries and associated companies may be hedged in a range of between 0 and 100 percent of the investment’s value (which, because of the tax effect, implies a maximum hedge ratio of 70 percent). A decision to hedge follows an overall evaluation of foreign-exchange levels and the effects on the financial net, liquidity and taxes, as well as on the Group’s debt/equity ratio. At year-end 2009, the Group’s net investments in foreign subsidiaries and associated companies amounted to approximately SEK 19,541 M (19,492). The net investments have increased due to changes in the capital structure and accrued profits of foreign operations which have overcompensated negative translation differences. Translation differences in 2009 amounted to SEK -454 M (1,184), calculated after hedging through loans and derivative instruments with deductions for estimated taxes. At year-end 2009, 44 percent (48) of net investments had been hedged. If SEK appreciates by 1 percent in relation to all currencies in which the Trelleborg Group has foreign net investments, there would be a negative change in shareholders’ equity of SEK 108 M (neg: 102) before consideration of possible tax effects.

14.1 Management of Translation exposure: Companies employ two methods to manage to manage translation exposure. These two methods are • •

Balance Sheet Hedge Derivatives Hedge

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Balance Sheet Hedge: In this, the parent identifies items in Balance sheet of the subsidiary which assets and liabilities are exposed to changes in foreign exchange when the parent prepares the consolidated s i.e, parent identifies exposed asset and exposed liabilities. As part of the balance sheet hedge, the parent creates an equal amount of liability in a foreign currency as that of exposed asset. The amount of liability matches the exposed asset and the currency denomination of liability matches the currency of exposed asset. When exchange rate moves, the positive (negative) benefit of favourable (unfavourable) movement of exchange rate gets nullified by matching assets and liabilities denominated in common currency. Similarly the parent creates equal amount of assets as that of its exposed liability in the same currency denomination to that of the exposed liability. If exchange rate movement, negatively affects its liability it would positively affect the assets. For balance sheet hedge, a parent company • Decreases soft-currency assets and increase soft-currency liabilities. • Increase hard-currency assets and decrease hard-currency liabilities. Hard currency is a currency which is expected to appreciate in near future while soft currency is a currency which is expected to depreciate in future. However, it is worth stressing here that creating foreign currency asset and liabilities for managing translation exposure gives rise to transaction exposure. As foreign exchange rate can move in a diametrically different direction in the next reporting time, a company may once again have to readjust its foreign current asset liability as part of the balance sheet hedge. Hence companies normally companies prefer to give precedence to the management of transaction exposure rather than managing translation exposure. Derivatives Hedge: In a derivatives hedge, parent anticipates what would be the extent of net exposed asset in the consolidated report well before the actual preparation of the financial report. Depending on the anticipated amount of net exposed asset and the parent expectation regarding the future exchange rate, the parent enters into forward contract. In a sense, the forward contract is a speculative one as the parent does not know the exact amount of exposed asset until the consolidated report is prepared.

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Multiple Choice Questions: 1. A U.S. company has an in Spain. This has exposed assets of 200 million Lira and exposed liabilities of 300 million Lira. If the exchange rate appreciates from $0.0004 per peso to $0.0005 per Lira, what is the company's translation gain or loss? a. -$10,000 b. -$15,000 c. +$10,000 d. +$15,000 2. Which is the easiest method for preparation of consolidation of financial s. a. Current/Non-Concurrent Method. b. Monetary/Non-Monetary Method c. Current Rate Method d. All of the above 3. Which of the following is not a translation method? e. current/noncurrent f. monetary/nonmonetary g. permanent h. Current 4. Which activity(ies) is not part of the balance sheet hedge undertaken to manage ing exposure? a. Increase hard currency liability b. Increase soft currency assets c. Create an exposure in a new currency d. All of above. e. None of these.

Short Questions: 1. 2. 3. 4.

Why consolidation of ing reports leads to Translation exposure? What are the different method of preparing the consolidated report ? How a company can calculate net exposed asset? In your view, management of which exposure ( transaction vs. translation) should be the priority of a parent company and why ?

Answer to Multiple Choice Questions: 1. 2. 3. 4. 5. 6.

c d c a b c

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NPTEL International Finance Vinod Gupta School of Management, IIT.Kharagpur.

References: 1. ing exposure, Multinational Business Finance, Eiteman, Moffett, Stonehill and Pandey, 10th Edition, Pearson Education, ISBN, 81-7758-449-9. 2. Different ing Standards for different activities of an organization http://www.mca.gov.in/Ministry/notification/notification_comp_Acct.html 3. Translation Exposure : http://www.blackwellpublishing.com/kim/StudyGuide/CH10sguide.doc 4. AS 21 Consolidates Financial Statements, Source: http://www.mca.gov.in/Ministry/notification/pdf/AS_21.pdf 5. Tata Motors has several t venture, subsidiary and associate companies: (Source: http://www.tatamotors.com/our_world/associates.php) 6. Some information regarding Nestle’s global consolidation of s Source:http://www.nestle.com/Resource.axd?Id=E378CCA5-9052-43F4-B8FBBC6AD1319100 7. US GAAP, Indian GAAP and consolidation of s. Source: http://money.outlookindia.com/article.aspx?86427 8. Translation risk – Balance Sheet : Source: http://www.trelleborg.com/annualreport2009/eng/Governanceandresponsibility/Financialriskmanagement.html

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Annexure14.1 Comparison of Tata Motors B/S ( Standalone vs. Consolidated) Tata Motors Ltd (Standalone) Year SOURCES OF FUNDS : Share Capital Reserves Total Equity Share Warrants Equity Application Money Total Shareholders Funds Secured Loans Unsecured Loans Total Debt Total Liabilities APPLICATION OF FUNDS : Gross Block Less : Accumulated Depreciation Less:Impairment of Assets Net Block Lease Adjustment Capital Work in Progress Investments Current Assets, Loans & Advances Inventories Sundry Debtors Cash and Bank Loans and Advances Total Current Assets Less : Current Liabilities and Provisions Current Liabilities Provisions Total Current Liabilities Net Current Assets Miscellaneous Expenses not written off Deferred Tax Assets Deferred Tax Liability Net Deferred Tax Total Assets Contingent Liabilities http://www.capitaline.com

Tata Motors Ltd (Consolidated) (Rs in Crs) Mar 09 514.05 11,716.10 0 0 12,230.15 5,251.65 7,913.91 13,165.56 25,395.71

13,905.17 6,259.90 0 7,645.27 0 6,954.04 12,968.13 2,229.81 1,555.20 1,141.82 4,764.86 9,691.69

Year SOURCES OF FUNDS : Share Capital Reserves Total Equity Share Warrants Equity Application Money Total Shareholders Funds Minority Interest Secured Loans Unsecured Loans Total Debt Total Liabilities APPLICATION OF FUNDS : Gross Block Less: Accumulated Depreciation Net Block Lease Adjustment Capital Work in Progress Investments Current Assets, Loans & Advances Inventories Sundry Debtors Cash and Bank Loans and Advances Total Current Assets Less : Current Liabilities and Provisions

(Rs in Crs) Mar 09 514.05 5,426.59 0 0 5,940.64 403.03 13,705.50 21,268.35 34,973.85 41,317.52 62,188.03 33,269.05 28,918.98 0 10,533.00 1,257.40 10,154.68 4,800.13 4,121.34 13,287.89 32,364.04

9,122.37 1,877.26 10,999.63 -1,307.94

Current Liabilities Provisions Total Current Liabilities Net Current Assets Miscellaneous Expenses not written off

24,102.57 7,059.20 31,161.77 1,202.27 86.08

2.02 1,144.89 2,010.70 -865.81 25,395.71 15,524.91

Deferred Tax Assets Deferred Tax Liability Net Deferred Tax Total Assets Contingent Liabilities http://www.capitaline.com

1,605.10 2,285.31 -680.21 41,317.52 6,220.54

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Annexure 14.2: US GAAP Impact on Some Indian Companies Consolidated Report. http://www.indianexpress.com/ie/daily/20000716/ibu16034.html JULY 15: The application of US generally accepted ing principles (GAAP) has had a mixed impact on the bottomlines of Indian companies. While HCL Infosystems and Hughes Software's balance sheets look much healthier, Infosys Technologies and ICICI's profits have taken a beating. Infosys Technologies' net profit under US GAAP comes to $61.34 million (Rs 273 crore), which is nearly 10 per cent (Rs 29 crore) lower than its $67.77 million (Rs 301 crore) net profit under the Indian GAAP for the year ended March 2000. In ICICI's case, its $167.40 million (Rs 745 crore) net profit as per US GAAP is 25 per cent (Rs 256 crore) lower than its net profit of $225 million (Rs 1001 crore) during the year ended March 1999. However, the picture is completely different in the case of HCL Infosystems and Hughes Software who are already following the stringent ing policies which has boosted their bottomlines when profit is calculated as per US GAAP norms. HCL's net profit of Rs 34.92 crore as per Indian GAAP vaults to Rs 57.14 crore when calculated under the US GAAP for the year ended June 1999 as a result of adjustments on of accrued income on lease, depreciation and extended warranty income. Similarly, Hughes Software's profit of Rs 17.81 crore as per Indian GAAP is much lower when compared to its profit of Rs 23.53 crore under US GAAP for the year ended March 1999. Infosys' profits were down under US GAAP on of deferred tax liability of $0.08 million, provision for retirement benefits to employees ($0.74 million) and employee stock-based compensation ($0.51 million). Similarly, ICICI's profits slipped under US GAPP norms because of provision on of allowance for credit losses, amortisation of fees, deferred tax adjustments, preference dividend payment and inter-company elimination. These are the findings of a study done by the Centre for ing Research and Education, a research body promoted by the All India Chartered ants Society. ing treatment under US ing practices is stringent as compared to Indian ing standards. Material differences exist between the financial statements prepared according to Indian and the US GAAP. Material differences arise due to provision for deferred taxes, ing for stock-based compensation (ESOP) and valuation of short-term investments, which are market to market and adjusted against retained earnings.

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"Major differences occur on of consolidation of s of subsidiaries, which is currently not followed under the Indian GAAP. As a result, the impact of subsidiaries which are making losses is not reflected in the s under the Indian GAAP," Centre for ing Research and Education's vice-chairman Vinod Rustagi told the Financial Express. "There is a need to provide for deferred taxes, amortisation of deferred stock compensation, consolidation of s and provision for diminution in the value of current investments so as to present a true and fair picture of the company," he said. Experts feel that with more and more corporates looking for a listing on US bourses, sooner or later, they will have to follow the US ing policies to reflect the actual financial picture. This would result in a scaling down of the profits as shown under the Indian GAAP. A company has to accept all the principles under the US GAAP before being eligible for listing at any of the US stock exchanges. Non-US companies with ed securities in the US may issue financial statements under US GAAP or another comprehensive basis of ing principles provided reconciliation to the US GAAP is provided in the note to s. Copyright © 2000 Indian Express Newspapers (Bombay) Ltd. http://www.pwc.com/en_GX/gx/ifrsreporting/pdf/Illustrative_IFRS_corporate_consolidated_financial_statements_2009.pdf

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