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Translation Exposure

An Example

1 Preliminary Statements
Table 1 provides the balance sheets as of December 31, 2001, and December 31, 2002,
for Pacotilles du Rhône, Inc., (PRI), a French subsidiary of a U.S. corporation. PRI has
been acquired on December 31, 2001, time at which the exchange rate was $0.89068/E. The
exchange rate on December 31, 2002, was $1.04862/E, and the average exchange rate for 2002
was $0.94486/E (these values come from http://pacific.commerce.ubc.ca/xr/data.html).

Pacotilles du Rhône, Inc.


2001 and 2002 Balance Sheets (in millions of E)
Assets Liabilities and Owners’ Equity
2001 2002 2001 2002
Cash 54 190 Payables 275 310
Receivables 320 430 Current Debt 130 150
Inventory 195 240 Long-term debt 160 460
Current assets 569 860 Total liabilities 565 920
Fixed assets 880 1,280 Common stock 230 230
Accum. depr. (150) (360) Ret. earnings 504 630
Net fixed asset 730 920 Total equity 734 860
Total 1,299 1,780 Total 1,299 1,780

Table 1: Pre-translation balance sheets for Pacotilles du Rhône.

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Pacotilles du Rhône, Inc.
2002 Income Statement
(in millions of E)
Revenues 1,290
Cost of goods sold (540)
Other expenses (414)
Depreciation expense (210)
Net income 126

Table 2: Pre-translation 2002 income statement for Pacotilles du Rhône.

2 Translation Using the Current-Rate Method


Under the current-rate method, all income statement items are translated using the average
exchange rate for the income statement period, i.e. $0.944645/E, as shown in Table 3. From
this income statement, translated retained earnings for 2002 are $120, which is the change
in retained earnings that will appear on the translated balance sheet.

Pacotilles du Rhône, Inc.


2002 Income Statement, Current-Rate Translation
Item E Rate $
Revenues 1,290 $0.94486/E 1,219
Cost of goods sold (540) $0.94486/E (510)
Other expenses (414) $0.94486/E (391)
Depreciation expense (210) $0.94486/E (198)
Net income 126 120

Table 3: 2002 income statement translated using the current-rate method.

For the balance sheet, the current-rate method translates all assets and all liabilities at
the exchange rate in effect on the balance sheet date. That is, all assets and liabilities on the
2001 balance sheet have been translated at the rate $0.89068/E, and all assets and liabilities
on the 2002 balance sheet have been translated at the rate $1.04862/E. All equity items are

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translated at their historical rate. Since no common stock is issued in 2002, the rate used
to translate common stock in each year is the rate in effect on December 31, 2001, which
is $0.89068/E. This gives E230 × $0.89068/E = $205. For retained earnings, the amount
on the 2001 balance sheet is translated at the December 31, 2001, exchange rate, which
gives E504 × $0.89068/E = $449. The change in retained earnings has to be consistent
with the income statement, so accumulated retained earnings for 2002 are 449 + 120 = $569.
Imbalances due to translation are recorded in a different account, the cumulative translation
adjustment (CTA) account. Since all the 2001 balance sheet items are translated at the
same rate, there is no need for adjusment and thus the CTA account shows a zero balance
in 2001. On the other hand, since the 2002 balance sheet items are not all translated at the
same rate, the CTA account shows a positive balance in 2002 due to the euro appreciation.
The translated balance sheets are depicted in Table 4.

Pacotilles du Rhône, Inc.


2001 and 2002 Balance Sheets, Current-Rate Translation
Assets Liabilities and Owners’ Equity
2001 2002 2001 2002
Cash 48 199 Payables 245 325
Receivables 285 451 Current Debt 116 157
Inventory 174 252 Long-term debt 142 482
Current assets 507 902 Total liabilities 503 964
Fixed assets 784 1,342 Common stock 205 205
Accum. depr. (134) (377) Ret. earnings 449 569
Net fixed asset 650 965 Total equity 654 774
CTA 0 129
Total 1,157 1,867 Total 1,157 1,867

Table 4: Balance sheets translated using the current-rate method.

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2.1 Calculating the Translation Gain (Loss)

Let Si and S̄i denote the exchange rate (in home currency per foreign currency) on year i’s
balance sheet and the average exchange rate during year i, respectively, and let N Ai = Ai −Li
and ∆N Ai,i+1 denote net assets in year i’s balance sheet and the change in net assets from
year i to year i + 1, respectively. Under the current-rate method, the translation gain for
year i, denoted T Gi , is given by

 
T Gi = Si − Si−1 N Ai−1 + Si − S̄i ∆N Ai−1,i .

Note that this gives the change in CTA, not the CTA balance, except for the first year of
operations. The translation gain in the present example is

 
T G2002 = S2002 − S2001 N A2001 + S2002 − S̄2002 ∆N A2001,2002

= (1.04862 − 0.89068)(1, 299 − 565) + (1.04862 − 0.94486)(1, 780 − 920 − 734)


| {z }
734
= 0.15794 × 734 + 0.10376 × 126

= 129.

3 Translation Using the Temporal Method


Under the temporal method, all monetary assets (cash and accounts receivable in the present
example) and all monetary liabilities (accounts payable, current debt and long-term debt in
the present example) are translated using the exchange rate in effect on the balance sheet
date, which is $0.89068/E for 2001 and $1.04862/E for 2002. On the income statement,
revenues and other expenses are translated at the 2002 average exchange rate, which is
$0.94486/E. All other items have to be treated separately.

(i) Fixed Assets Fixed assets are translated at their historical rate. For fixed assets in
the Dec. 31, 2001, balance sheet, this gives

E880 × $0.89068/E = $784.

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For fixed assets in the Dec. 31, 2002, balance sheet, net new investments in 2002 are
translated at the average exchange rate for that period, which gives

E880 × $0.89068/E + (E1, 280 − E880) × $0.94486/E = $784 + $378 = $1, 162.
| {z }
net investment

(ii) Depreciation Depreciation expense in 2002 consists of the depreciation of assets ac-
quired on Dec 31, 2001, and depreciation of assets acquired during 2002. The exchange
rate used for 2002 depreciation expense is then a weighted average of the exchange rates
used for fixed assets, sometimes called “blended rate”. This rate is obtained as follows:

× $0.89068/E + × $0.94486/E = $0.90761/E.


880 400
blended rate =
1, 280 1, 280
The translated 2002 depreciation expense is then

E210 × $0.90761/E = $191.

Translated 2001 accumulated depreciation is

E150 × $0.89068/E = $134,

and translated 2002 accumulated depreciation is

$134 + $191 = $325.

(iii) COGS In 2002, COGS is E540. From this amount, E195 was taken from the firm’s
inventory on Dec. 31, 2001, which is translated at the rate $0.89068/E, and 540−195 =
E345 has been purchased in 2002, which is translated at the average exchange rate for
the period, i.e. $0.94486/E. Translated 2002 COGS is then

E195 × $0.89068/E + 345 × $0.94486/E = $500.

(iv) Inventory 2001 inventory is translated at its historical rate, which is $0.89068/E in
this case, and thus

translated 2001 inventory = E195 × $0.89068/E = $174.

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Given the inventory on Dec. 31, 2001, the inventory on Dec. 31, 2002, and the 2002
COGS, we can find 2002 purchases as follows:

2002 purchases = 240


|{z} + 540
|{z} − 195
|{z} = E585.
2002 inv. 2002 COGS 2001 inv.
2002 purchases are translated at the 2002 average exchange rate, $0.94486/E, and
translated 2002 inventory is obtained as follows:

2002 inv. = 174


|{z} + |585 × {z
0.94486} − 500
|{z} = $227.
tr. 2001 inv. tr. 2001 pur. tr. 2002 COGS

(v) Retained Earnings Under the temporal method, accumulated retained earnings in-
clude any imbalance from the balance sheet, and thus the income statement has to
be adjusted such that the difference between the 2002 accumulated retained earnings
and the 2001 accumulated retained earnings is consistent with the net income on the
translated income statement. The difference between translated accumulated retained
earnings being
545 − 449 = $96,

the translated 2002 net income has to be adjusted downward by $41.

The 2002 income statement and the 2001-2002 balance sheets translated using the tem-
poral method are depicted in tables 5 and 6.

3.1 Calculating the Translation Gain (Loss)

As before, let Si and S̄i denote the exchange rate (in home currency per foreign currency)
on year i’s balance sheet and the average exchange rate during year i, respectively, and let
N M Ai = M Ai − M Li and ∆N M Ai,i+1 denote net monetary assets in year i’s balance sheet
and the change in net monetary assets from year i to year i + 1, respectively. Under the
temporal method, the translation gain for year i, denoted T Gi , is given by
 
T Gi = Si − Si−1 N M Ai−1 + Si − S̄i ∆N M Ai−1,i .

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In the present example, we have

N M A2001 = 54 + 320 − 565 = − 191,


N M A2002 = 190 + 430 − 920 = − 300,
∆N M A2001,2002 = − 300 − (−191) = − 110,

and thus the translation gain for 2002 is

 
T G2002 = S2002 − S2001 N M A2001 + S2002 − S̄2002 ∆N M A2001,2002

= (1.04862 − 0.89068)(−191) + (1.04862 − 0.94486)(−110)

= −$41.

Note that we have a translation loss under the temporal method, whereas the current-rate
method gave us a translation gain. This arises because there are more assets than liabilities
but less monetary assets than monetary liabilities.

Pacotilles du Rhône, Inc.


2002 Income Statement, Temporal Translation
Item E Rate $
Revenues 1,290 $0.94486/E 1,219
Cost of goods sold (540) (500)
Other expenses (414) $0.94486/E (391)
Depreciation expense (210) $0.90761/E (191)
Net income
before adjustment 126 137
Translation loss (0) (41)
Net income 126 96

Table 5: 2002 income statement translated using the temporal method.

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Pacotilles du Rhône, Inc.
2001 and 2002 Balance Sheets, Temporal Translation
Assets Liabilities and Owners’ Equity
2001 2002 2001 2002
Cash 48 199 Payables 245 325
Receivables 285 451 Current Debt 116 157
Inventory 174 227 Long-term debt 142 482
Current assets 507 877 Total liabilities 503 964
Fixed assets 784 1,162 Common stock 205 205
Accum. depr. (134) (325) Ret. earnings 449 545
Net fixed asset 650 837 Total equity 654 750
Total 1,157 1,714 Total 1,157 1,714

Table 6: Balance sheets translated using the temporal method.