Page 181 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes Under the generally accepted US accounting principles, the net monetary asset position of a
subsidiary is used to measure its parent’s foreign exchange exposure. The net monetary asset
position is monetary assets such as cash and accounts receivable minus monetary liabilities such
as accounts payable and long-term debt. Let us understand this with the help of the following
example.
A US parent company has a single wholly-owned subsidiary in France. This subsidiary has
monetary assets of 200 million francs and monetary liabilities of 100 million francs. The exchange
rate declines from FFr 4 per dollar to FFr 5 per dollar.
The potential foreign exchange loss on the company’s exposed net monetary assets of 100 million
francs would be $5 million
Monetary assets FFr 200 million
Monetary liabilities FFr 100 million
Net exposure FFr 100 million

Pre-devaluation rate (FFr 4=$1) FFr 100 million = $25.0 million
Post-devaluation rate (FFr 5 – $1) FF100 million = $20.0 million
Potential exchange loss $.5.0 million
The translation of gains and losses does not involve actual cash flows—these gains or losses are
purely on paper, i.e., they are of an accounting nature.

11.1 Translation Methods

Four methods of foreign currency translation have been developed in various countries.
1. Current rate method of FAS No. 52 (1982 present)

2. Monetary/non-monetary method
3. Temporal method
4. Current/non-current method

The first two methods are allowed by the US accounting standard.
11.1.1 Current Rate Method

The current rate method is the simplest and the most popular method all over the world. This
method was adopted in 1981. According to FASB 52 firms must use the current rate method to
translate foreign currency denominated assets and liabilities. Under this method, all balance
sheet and income items are translated at the current rate of exchange, except for stockholders’
equity which is translated at historical rate. Income statement items, including depreciation and
cost of goods sold, are translated at either the actual exchange rate on the dates the various
revenues and expenses were incurred or at the weighted average exchange rate for the period.
Dividends paid are translated at the exchange rate prevailing on the date the payment was
made. The common stock account and paid-in-capital accounts are translated at historical rates.
Further, gains or losses caused by translation adjustment are not included in the net income but
are reported separately and accumulated in a separate equity account known as Cumulative
Translation Adjustment (CTA). Thus CTA account helps in balancing the balance sheet balance,
since translation gains or losses are not adjusted through the income statement.

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