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CHAPTER 10 MANAGEMENT OF TRANSLATION EXPOSURESUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTERQUESTIONS AND PROBLEMSQUESTIONS1。 Explain the difference in the translation process between the monetary/nonmonetary method and the temporal method。Answer: Under the monetary/nonmonetary method, all monetary balance sheet accounts of a foreign subsidiary are translated at the current exchange rate。 Other balance sheet accounts are translated at the historical rate exchange rate in effect when the account was first recorded。 Under the temporal method， monetary accounts are translated at the current exchange rate. Other balance sheet accounts are also translated at the current rate, if they are carried on the books at current value。 If they are carried at historical value， they are translated at the rate in effect on the date the item was put on the books. Since fixed assets and inventory are usually carried at historical costs, the temporal method and the monetary/nonmonetary method will typically provide the same translation。2. How are translation gains and losses handled differently according to the current rate method in comparison to the other three methods， that is, the current/noncurrent method, the monetary/nonmonetary method， and the temporal method？Answer: Under the current rate method, translation gains and losses are handled only as an adjustment to net worth through an equity account named the “cumulative translation adjustment” account. Nothing passes through the income statement。 The other three translation methods pass foreign exchange gains or losses through the income statement before they enter on to the balance sheet through the accumulated retained earnings account。3。 Identify some instances under FASB 52 when a foreign entitys functional currency would be the same as the parent firms currency.Answer： Three examples under FASB 52, where the foreign entitys functional currency will be the same as the parent firms currency， are： i） the foreign entitys cash flows directly affect the parents cash flows and are readily available for remittance to the parent firm; ii) the sales prices for the foreign entitys products are responsive on a short-term basis to exchange rate changes， where sales prices are determined through worldwide competition； and， iii） the sales market is primarily located in the parents country or sales contracts are denominated in the parents currency.4。 Describe the remeasurement and translation process under FASB 52 of a wholly owned affiliate that keeps its books in the local currency of the country in which it operates, which is different than its functional currency.Answer: For a foreign entity that keeps its books in its local currency, which is different from its functional currency, the translation process according to FASB 52 is to: first, remeasure the financial reports from the local currency into the functional currency using the temporal method of translation, and second， translate from the functional currency into the reporting currency using the current rate method of translation。5. It is， generally, not possible to completely eliminate both translation exposure and transaction exposure. In some cases, the elimination of one exposure will also eliminate the other. But in other cases， the elimination of one exposure actually creates the other。 Discuss which exposure might be viewed as the most important to effectively manage， if a conflict between controlling both arises。 Also， discuss and critique the common methods for controlling translation exposure。Answer： Since it is， generally， not possible to completely eliminate both transaction and translation exposure, we recommend that transaction exposure be given first priority since it involves real cash flows. The translation process, on-theother hand, has no direct effect on reporting currency cash flows， and will only have a realizable effect on net investment upon the sale or liquidation of the assets. There are two common methods for controlling translation exposure: a balance sheet hedge and a derivatives hedge. The balance sheet hedge involves equating the amount of exposed assets in an exposure currency with the exposed liabilities in that currency, so the net exposure is zero. Thus when an exposure currency exchange rate changes versus the reporting currency, the change in assets will offset the change in liabilities. To create a balance sheet hedge， once transaction exposure has been controlled， often means creating new transaction exposure。 This is not wise since real cash flow losses can result. A derivatives hedge is not really a hedge， but rather a speculative position， since the size of the “hedge” is based on the future expected spot rate of exchange for the exposure currency with the reporting currency. If the actual spot rate differs from the expected rate, the “hedge may result in the loss of real cash flows.PROBLEMS1。 Assume that FASB 8 is still in effect instead of FASB 52。 Construct a translation exposure report for Centralia Corporation and its affiliates that is the counterpart to Exhibit 10.7 in the text。 Centralia and its affiliates carry inventory and fixed assets on the books at historical values。Solution： The following table provides a translation exposure report for Centralia Corporation and its affiliates under FASB 8, which is essentially the temporal method of translation. The difference between the new report and Exhibit 10。7 is that nonmonetary accounts such as inventory and fixed assets are translated at the historical exchange rate if they are carried at historical costs. Thus， these accounts will not change values when exchange rates change and they do not create translation exposure。Examination of the table indicates that under FASB 8 there is negative net exposure for the Mexican peso and the euro, whereas under FASB 52 the net exposure for these currencies is positive. There is no change in net exposure for the Canadian dollar and the Swiss franc. Consequently， if the euro depreciates against the dollar from 1。1000/1。00 to 1.1786/$1.00, as the text example assumed, exposed assets will now fall in value by a smaller amount than exposed liabilities, instead of vice versa。 The associated reporting currency imbalance will be $239，415， calculated as follows:Reporting Currency Imbalance=-3,949,00001.1786/$1.00 - -3,949,00001.1000/$1.00 = $239,415.Translation Exposure Report under FASB 8 for Centralia Corporation and its Mexican and Spanish Affiliates， December 31， 2005 （in 000 Currency Units）Canadian DollarMexicanPesoEuroSwissFrancAssetsCashCD200Ps 6，000 825SF 0Accounts receivable09，0001，0450Inventory0000Net fixed assets0 0 0 0 Exposed assetsCD200Ps15，000 1,870SF 0LiabilitiesAccounts payableCD 0Ps 7，000 1,364SF 0Notes payable017，0009351,400Longterm debt 0 27,000 3,520 0 Exposed liabilitiesCD 0Ps51,000 5，819SF1，400 Net exposureCD200(Ps36，000)（3，949）(SF1，400)2。 Assume that FASB 8 is still in effect instead of FASB 52。 Construct a consolidated balance sheet for Centralia Corporation and its affiliates after a depreciation of the euro from 1.1000/$1.00 to 1.1786/1。00 that is the counterpart to Exhibit 10。8 in the text。 Centralia and its affiliates carry inventory and fixed assets on the books at historical values。Solution： This problem is the sequel to Problem 1. The solution to Problem 1 showed that if the euro depreciated there would be a reporting currency imbalance of $239,415。 Under FASB 8 this is carried through the income statement as a foreign exchange gain to the retained earnings on the balance sheet。 The following table shows that consolidated retained earnings increased to $4,190,000 from 3,950，000 in Exhibit 10。8. This is an increase of $240,000, which is the same as the reporting currency imbalance after accounting for rounding error。Consolidated Balance Sheet under FASB 8 for Centralia Corporation and its Mexican and Spanish Affiliates， December 31, 2005： Post-Exchange Rate Change (in 000 Dollars)Centralia Corp.(parent）Mexican AffiliateSpanish AffiliateConsolidated Balance SheetAssetsCash 950a 600 700 2,250Accounts receivable 1，450b9008873,237Inventory 3，000 1，5001,5006,000Investment in Mexican affiliate c Investment in Spanish affiliated - - Net fixed assets9,0004，6004，000 17，600 Total assets29,087Liabilities and Net WorthAccounts payable$1，800$ 700b$1，157 3,657Notes payable2,2001,7001,043e4,943Long-term debt7,1102，7002，98712,797Common stock3,500c d 3,500Retained earnings4,190c -d 4，190 Total liabilities and net worth$29，087aThis includes CD200,000 the parent firm has in a Canadian bank， carried as $150,000. CD200,000/（CD1。3333/$1.00） = 150，000。b1,750,000 - $300,000 （= Ps3,000,000/（Ps10.00/$1.00） intracompany loan = $1，450,000.c，dInvestment in affiliates cancels with the net worth of the affiliates in the consolidation.eThe Spanish affiliate owes a Swiss bank SF375，000 （ SF1.2727/1。00 = 294，649). This is carried on the books,after the exchange rate change, as part of 1,229,649 = 294，649 + 935，000. 1,229，649/(1。1786/$1.00） = $1,043,313。3。 In Example 10.2, a forward contract was used to establish a derivatives “hedge” to protect Centralia from a translation loss if the euro depreciated from 1。1000/1。00 to 1.1786/$1。00. Assume that an overthe-counter put option on the euro with a strike price of 1。1393/$1。00 (or $0.8777/1.00） can be purchased for $0。0088 per euro. Show how the potential translation loss can be “hedged with an option contract.Solution: As in example 10.2， if the potential translation loss is $110,704， the equivalent amount in functional currency that needs to be hedged is 3，782,468。 If in fact the euro does depreciate to 1。1786/1。00 ($0。8485/1.00), 3,782，468 can be purchased in the spot market for $3,209,289. At a striking price of 1。1393/1。00， the 3,782,468 can be sold through the put for $3,319,993， yielding a gross profit of 110,704。 The put option cost 33,286 （= 3,782，468 x $0.0088）. Thus, at an exchange rate of 1。1786/1.00, the put option will effectively hedge 110,704 $33,286 = $77,418 of the potential translation loss. At terminal exchange rates of 1。1393/1.00 to 1.1786/$1。00， the put option hedge will be less effective. An option contract does not have to be exercised if doing so is disadvantageous to the option owner. Therefore， the put will not be exercised at exchange rates of less than 1.1393/$1.00 (more than $0.8777/1.00）， in which case the “hedge” will lose the 33，286 cost of the option.MINI CASE: SUNDANCE SPORTING GOODS, INC.Sundance Sporting Goods， Inc。， is a U。S。 manufacturer of high-quality sporting goods-principally golf, tennis and other racquet equipment， and also lawn sports, such as croquet and badminton- with administrative offices and manufacturing facilities in Chicago， Illinois. Sundance has two wholly owned manufacturing affiliates， one in Mexico and the other in Canada. The Mexican affiliate is located in Mexico City and services all of Latin America. The Canadian affiliate is in Toronto and serves only Canada. Each affiliate keeps its books in its local currency, which is also the functional currency for the affiliate. The current exchange rates are: 1。00 = CD1。25 = Ps3。30 = A1.00 = 105 = W800. The nonconsolidated balance sheets for Sundance and its two affiliates appear in the accompanying table。Nonconsolidated Balance Sheet for Sundance Sporting Goods, Inc。 and Its Mexican and Canadian Affiliates, December 31, 2005 （in 000 Currency Units）Sundance, Inc。（parent）MexicanAffiliateCanadianAffiliateAssetsCash$ 1,500Ps 1，420CD 1,200Accounts receivable 2，500a2,800e1，500fInventory 5,0006，2002,500Investment in Mexican affiliate2，400b-Investment in Canadian affiliate 3，600c- Net fixed assets12,000 11，200 5,600 Total assets$27,000Ps21，620CD10，800Liabilities and Net WorthAccounts payable$ 3，000Ps 2，500aCD 1，700Notes payable4，000d4，2002，300Longterm debt9,0007，0002,300Common stock5，0004,500b2，900cRetained earnings 6，000 3，420b 1，600c Total liabilities and net worth27，000Ps21,620CD10,800aThe parent firm is owed Ps1,320,000 by the Mexican affiliate. This sum is included in the parents accounts receivable as $400，000， translated at Ps3.30/1.00. The remainder of the parents (Mexican affiliates) accounts receivable (payable） is denominated in dollars (pesos).bThe Mexican affiliate is wholly owned by the parent firm. It is carried on the parent firms books at $2,400,000. This represents the sum of the common stock (Ps4，500,000) and retained earnings （Ps3,420，000） on the Mexican affiliates books, translated at Ps3。30/$1。00.cThe Canadian affiliate is wholly owned by the parent firm. It is carried on the parent firms books at 3，600,000。 This represents the sum of the common stock （CD2,900,000) and the retained earnings （CD1，600，000） on the Canadian affiliates books， translated at CD1.25/$1.00.dThe parent firm has outstanding notes payable of 126，000，000 due a Japanese bank。 This sum is carried on the parent firms books as $1，200，000, translated at 105/1.00。 Other notes payable are denominated in U.S。 dollars。 eThe Mexican affiliate has sold on account A120,000 of merchandise to an Argentine import house. This sum is carried on the Mexican affiliates books as Ps396,000， translated at A1.00/Ps3.30。 Other accounts receivable are denominated in Mexican pesos。fThe Canadian affiliate has sold on account W192，000,000 of merchandise to a Korean importer。 This sum is carried on the Canadian affiliates books as CD300，000, translated at W800/CD1。25。 Other accounts receivable are denominated in Canadian dollars。You joined the International Treasury division of Sundance six months ago after spending the last two years receiving your MBA degree. The corporate treasurer has asked you to prepare a report analyzing all aspects of the translation exposure faced by Sundance as a MNC. She has also asked you to address in your analysis the relationship between the firms translation exposure and its transaction exposure。 After performing a forecast of future spot rates of exchange, you decide that you must do the following before any sensible report can be written.a。 Using the current exchange rates and the nonconsolidated balance sheets for Sundance and its affiliates, prepare a consolidated balance sheet for the MNC according to FASB 52。b。 i。 Prepare a translation exposure report for Sundance Sporting Goods， Inc., and its two affiliates. ii. Using the translation exposure report you have prepared， determine if any reporting currency imbalance will result from a change in exchange rates to which the firm has currency exposure。 Your forecast is that exchange rates will change from 1。00 = CD1.25 = Ps3.30 = A1。00 = 105 = W800 to $1.00 = CD1。30 = Ps3。30 = A1。03 = 105 = W800。c. Prepare a second consolidated balance sheet for the MNC using the exchange rates you expect in the future. Determine how any reporting currency imbalance will affect the new consolidated balance sheet for the MNC。d。 i。 Prepare a transaction exposure report for Sundance and its affiliates。 Determine if any transaction exposures are also translation exposures. ii。 Investigate what Sundance and its affiliates can do to control its transaction and translation exposures. Determine if any of the translation exposure should be hedged。Suggested Solution to Sundance Sporting Goods, Inc.Note to Instructor： It is not necessary to assign the entire case problem。 Parts a。 and b.i. can be used as self-contained problems， respectively, on basic balance sheet consolidation and the preparation of a translation exposure report.a。 Below is the consolidated balance sheet for the MNC prepared according to the current rate method prescribed by FASB 52。 Note that the balance sheet balances。 That is， Total Assets and Total Liabilities and Net Worth equal one another。 Thus, the assumption is that the current exchange rates are the same as when the affiliates were established。 This assumption is relaxed in part c。Consolidated Balance Sheet for Sundance Sporting Goods, Inc. its Mexican and Canadian Affiliates，December 31, 2005： PreExchange Rate Change (in 000 Dollars）Sundance, Inc.(parent)MexicanAffiliateCanadianAffiliateConsolidatedBalance SheetAssetsCash$ 1，500 430$ 960 2,890Accounts receivable2，100a849e1，200f4,149Inventory5,0001,8792，0008,879Investment in Mexican affiliate-b-Investment in Canadian affiliatec-Net fixed assets12,0003,3944,48019,874 Total assets $35，792Liabilities and Net WorthAccounts payable 3,000 358a$1,360 4,718Notes payable4,000d1，2731，8407,113Long-term debt9,0002，1211，84012,961Common stock5，000bc5，000Retained earnings6，000b-c 6，000 Total liabilities and net worth 35,792a2，500,000 400,000 （= Ps1,320，000/（Ps3。30/$1。00）) intracompany loan = $2，100,000.b，cThe investment in the affiliates cancels with the net worth of the affiliates in the consolidation.dThe parent owes a Japanese bank 126,000，000. This is carried on the books as $1，200,000 (=126，000，000/（105/1.00).eThe Mexican affiliate has sold on account A120，000 of merchandise to an Argentine import house. This is carried on the Mexican affiliates books as Ps396,000 (= A120,000 x Ps3。30/A1。00)。fThe Canadian affiliate has sold on account W192，000，000 of merchandise to a Korean importer。 This is carried on the Canadian affiliates books as CD300,000 (= W192,000，000/(W800/CD1。25).b. i。 Below is presented the translation exposure report for the Sundance MNC。 Note， from the report that there is net positive exposure in the Mexican peso, Canadian dollar, Argentine austral and Korean won。 If any of these exposure currencies appreciates （depreciates) against the U。S. dollar, exposed assets denominated in these currencies will increase （fall） in translated value by a greater amount than the exposed liabilities denominated in these currencies。 There is negative net exposure in the Japanese yen。 If the yen appreciates （depreciates） against the U.S。 dollar, exposed assets denominated in the yen will increase (fall) in translated value by smaller amount than the exposed liabilities denominated in the yen。Translation Exposure Report for Sundance Sporting Goods， Inc。 and its Mexican and Canadian Affiliates, December 31， 2005 (in 000 Currency Units)JapaneseYenMexicanPesoCanadian DollarArgentine AustralKoreanWonAssetsCash 0Ps 1,420CD 1，200A 0W 0Accounts receivable02,4041，200120192,000Inventory06,2002,50000Fixed assets 0 11,200 5，600 0 0 Exposed assets 0Ps21,224CD10，500A120W192，000Liabilities Accounts payable 0Ps 1,180CD 1，700A 0W 0Notes payable126，0004,2002,30000Long-term debt 0 7，000 2，300 0 0 Exposed liabilities126，000Ps12,380CD 6，300A 0W 0 Net exposure(126,000)Ps 8，844CD 4,200A
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