Translation Exposure

When a multinational firm has one or more foreign subsidiaries with assets and liabilities denominated in a foreign currency, it faces translation exposure. For example, if a U.S.-based multinational firm operates a subsidiary in Spain, the peseta (Ptas.) value of the subsidiary's assets and liabilities must be translated into the home (U.S. $) currency when the parent firm prepares its consolidated financial statements. When the translation occurs, there can be gains or losses, which must be recognized in the financial statements of the parent.

Current accounting standards are set forth in Statement of Financial Accounting Standards Number 52. The major provisions of this standard are:

• Current assets, unless covered by forward exchange contracts, and fixed assets are translated into dollars at the rate of exchange prevailing on the date of the balance sheet.

• Current and long-term liabilities payable in foreign currency are translated into dollars at the rate of exchange prevailing on the date of the balance sheet.

Table 3 – 6. Effect of a Decrease in the Exchange Rate on American Products' Balance Sheet

	EXCHANGE RATE
	$0.80 (U.S.)=$1.00 (Canadian)		$0.75 (U.S.) = $1.00 (Canadian)
	$(Canadian)	$(U.S.)	$ (Canadian)	$(U.S.)
Assets	$12,000,000	$9,600,000	$12,000,000	$9,000,000
Liabilities	8,000,000	6,400,000	8,000,000	6,000,000
Net equity position	$ 4,000,000	$3,200,000	$ 4,000,000	$3,000,000

• Income statement items are translated either at the rate on the date of a particular transaction or at a weighted average of the exchange rates for the period of the income statement.

• Dividends are translated at the exchange rate on the date the dividend is paid.

• Equity accounts, including common stock and contributed capital in excess of par value, are translated at historical rates.

• Gains and losses to the parent from translation are not included in the parent's calculation of net income, nor are they included in the parent's retained earnings. Rather they are reported in a separate equity account named "Cumulative foreign currency translation adjustments" or a similar title. Gains or losses in this account are not recognized in the income statement until the parent's investment in the foreign subsidiary is sold or liquidated.

A decline in the value of a foreign currency relative to the U.S. dollar reduces the conversion value of the foreign subsidiary's liabilities, as well as its assets. Therefore, the parent company's risk exposure depends on the foreign subsid­iary's net equity position (that is, assets minus liabilities). Thus, on the books of the parent company, the subsidiary's creditors in effect bear part of the decline in the value of the subsidiary's assets.

The impact of a decrease in the exchange rate on the firm's balance sheet can be illustrated with the following example. American Products has a subsidiary, Canadian Products, with total assets of $12 million (Canadian) and total liabilities of $8 million (Canadian). Based on an exchange rate of $0.80 (U.S.) per dollar (Canadian), the net equity position of the Canadian subsidiary on American Products' balance sheet as shown in Table 3-6 is $3.2 million (U.S.). Suppose now that the exchange rate declines to $0.75 (U.S.) per dollar (Canadian) and all other things remain the same. As can be seen in the table, the net equity position of the Canadian subsidiary on American Products' balance sheet declines to $3 million (U.S.), resulting in a $200,000 currency exchange loss.

Managing Translation Exposure. In general, when a foreign subsidiary's assets are greater than its liabilities, currency exchange losses will occur when the exchange rate decreases. The opposite effects are true for increases in the exchange rate. A company can hedge and manage its balance sheet translation exposure by financing its foreign assets with debt denominated in the same currency.

For example, in March 1985, Hercules Inc., a Wilmington, Delaware-based chemicals and plastics manufacturer, issued 10.125 percent 7-year notes. Instead of being denominated in U.S. dollars, as is usual for securities of U.S. companies, these notes are denominated in European Currency Units (ECU). The ECU is a composite currency whose value is based on the weighted value of ten European currencies. The Hercules debt issue totaled ECU 50 million, or about $33 million, based on the exchange rate between the U.S. dollars and the ECU at the time of issuance.

The Hercules financial managers apparently had a choice between whether to issue ECU-denominated or U.S. dollar-denominated debt. They chose the ECU-denominated debt in order to hedge the company's European assets. For example, if the value of the ECU drops compared to the U.S. dollar value, presumably the U.S. dollar value of Hercules's European assets also decreases. However, if this happens the U.S. dollar amount of both the interest and principal that Hercules has to pay decreases. The Hercules management stated that although the weight of the various currencies in the ECU did not exactly match the relationship of Hercules's European assets, the ECU-denominated debt issue did make a reasonably good hedge overall.

A multinational company also can minimize its exchange rate risk, as well as the risk of expropriation or nationalization of its assets by a foreign government, by developing a portfolio of foreign investments. Rather than making all its direct investments in foreign subsidiaries that are located in one particular country, the firm can spread its foreign investments among a number of different countries, thus limiting the risk of incurring large losses within any one country.