Integrated vs self sustaining foreign subsidiary

CHAPTER 11 Translation Exposure

What gets measured gets managed.

—Anonymous

LEARNING OBJECTIVES

■ Examine how the process of consolidation of a multinational firm’s financial results creates translation exposure

■ Illustrate both the theoretical and practical differences between the two primary methods of translating or remeasuring foreign currency-denominated financial statements

■ Understand how translation can potentially alter the value of a multinational firm

■ Explore the costs, benefits, and effectiveness of managing translation exposure

Translation exposure, the second category of accounting exposures, arises because financial statements of foreign subsidiaries—which are stated in foreign currency—must be restated in the parent’s reporting currency so that the firm can prepare consolidated financial statements. Foreign subsidiaries of U.S. companies, for example, must restate foreign currency-denominated financial statements into U.S. dollars so that the foreign values can be added to the parent’s U.S. dollar-denominated balance sheet and income statement. Using our example U.S. firm, Ganado, this is shown conceptually in Exhibit 11.1. This accounting process is called translation. Translation exposure is the potential for an increase or decrease in the parent’s net worth and reported net income that is caused by a change in exchange rates since the last translation.

Although the main purpose of translation is to prepare consolidated financial statements, translated statements are also used by management to assess the performance of foreign subsidiaries. While such assessment by management might be performed using the local currency statements, restatement of all subsidiary statements into the single “common denominator” of one currency facilitates management comparison. This chapter reviews the predominate methods used in translation today, and concludes with the Mini-Case, McDonald’s, Hoover Hedges, and Cross-Currency Swaps, illustrating how one major multinational manages its investment and translation risks.

EXHIBIT 11.1 Ganado’s Cross-Border Investments and Consolidation

Overview of Translation

There are two financial statements for each subsidiary that must be translated for consolidation: the income statement and the balance sheet. Statements of cash flow are not translated from the foreign subsidiaries. The consolidated statement of cash flow is constructed from the consolidated statement of income and consolidated balance sheet. Because the consolidated results for any multinational firm are constructed from all of its subsidiary operations, including foreign subsidiaries, the possibility of a change in consolidated net income or consolidated net worth from period to period, as a result of a change in exchange rates, is high.

For any individual financial statement, internally, if the same exchange rate were used to remeasure each and every line item on the individual statement—the income statement and balance sheet—there would be no imbalances resulting from the remeasurement. But if a different exchange rate were used for different line items on an individual statement, an imbalance would result. Different exchange rates are used in remeasuring different line items because translation principles are a complex compromise between historical and current values. The question, then, is what is to be done with the imbalance?

Subsidiary Characterization

Most countries specify the translation method to be used by a foreign subsidiary based on its business operations. For example, a foreign subsidiary’s business can be categorized as either an integrated foreign entity or a self-sustaining foreign entity. An integrated foreign entity is one that operates as an extension of the parent company, with cash flows and general business lines that are highly interrelated with those of the parent. A self-sustaining foreign entity is one that operates in the local economic environment independent of the parent company. The differentiation is important to the logic of translation. A foreign subsidiary should be valued principally in terms of the currency that is the basis of its economic viability.

It is not unusual for a single company to have both types of foreign subsidiaries, integrated and self-sustaining. For example, a U.S.-based manufacturer, which produces subassemblies in the United States that are then shipped to a Spanish subsidiary for finishing and resale in the European Union, would likely characterize the Spanish subsidiary as an integrated foreign entity. The dominant currency of economic operation is likely the U.S. dollar. That same U.S. parent may also own an agricultural marketing business in Venezuela that has few cash flows or operations related to the U.S. parent company or U.S. dollar. The Venezuelan subsidiary may source all inputs and sell all products in Venezuelan bolivar. Because the Venezuelan subsidiary’s operations are independent of its parent, and its functional currency is the Venezuelan bolivar, it would be classified as a self-sustaining foreign entity.

Functional Currency

A foreign subsidiary’s functional currency is the currency of the primary economic environment in which the subsidiary operates and in which it generates cash flows. In other words, it is the dominant currency used by that foreign subsidiary in its day-to-day operations. It is important to note that the geographic location of a foreign subsidiary and its functional currency may be different. The Singapore subsidiary of a U.S. firm may find that its functional currency is the U.S. dollar (integrated subsidiary), the Singapore dollar (self-sustaining subsidiary), or a third currency such as the British pound (also a self-sustaining subsidiary).

The United States, rather than distinguishing a foreign subsidiary as either integrated or self-sustaining, requires that the functional currency of the subsidiary be determined. Management must evaluate the nature and purpose of each of its individual foreign subsidiaries to determine the appropriate functional currency for each. If a foreign subsidiary of a U.S.-based company is determined to have the U.S. dollar as its functional currency, it is essentially an extension of the parent company (equivalent to the integrated foreign entity designation used by most countries). If, however, the functional currency of the foreign subsidiary is determined to be different from the U.S. dollar, the subsidiary is considered a separate entity from the parent (equivalent to the self-sustaining entity designation).

Translation Methods

Two basic methods for translation are employed worldwide: the current rate method and the temporal method . Regardless of which method is employed, a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured, but also designate where any imbalance is to be recorded, either in current income or in an equity reserve account in the balance sheet.

Current Rate Method

The current rate method is the most prevalent in the world today. Under this method, all financial statement line items are translated at the “current” exchange rate with few exceptions.

■ Assets and liabilities. All assets and liabilities are translated at the current rate of exchange; that is, at the rate of exchange in effect on the balance sheet date.

■ Income statement items. All items, including depreciation and cost of goods sold, are translated at either the actual exchange rate on the dates the various revenues, expenses, gains, and losses were incurred or at an appropriately weighted average exchange rate for the period.

■ Distributions. Dividends paid are translated at the exchange rate in effect on the date of payment.

■ Equity items. Common stock and paid-in capital accounts are translated at historical rates. Year-end retained earnings consist of the original year-beginning retained earnings plus or minus any income or loss for the year.

Gains or losses caused by translation adjustments are not included in the calculation of consolidated net income. Rather, translation gains or losses are reported separately and accumulated in a separate equity reserve account (on the consolidated balance sheet) with a title such as “cumulative translation adjustment” (CTA), but it depends on the country. If a foreign subsidiary is later sold or liquidated, translation gains or losses of past years accumulated in the CTA account are reported as one component of the total gain or loss on sale or liquidation. The total gain or loss is reported as part of the net income or loss for the period in which the sale or liquidation occurs.

Temporal Method

Under the temporal method , specific assets and liabilities are translated at exchange rates consistent with the timing of the item’s creation. The temporal method assumes that a number of individual line item assets, such as inventory and net plant and equipment, are restated regularly to reflect market value. If these items were not restated, but were instead carried at historical cost, the temporal method becomes the monetary/nonmonetary method of translation, a form of translation that is still used by a number of countries today. Line items include the following:

■ Monetary assets (primarily cash, marketable securities, accounts receivable, and long-term receivables) and monetary liabilities (primarily current liabilities and long-term debt). These are translated at current exchange rates. Nonmonetary assets and liabilities (primarily inventory and fixed assets) are translated at historical rates.

■ Income statement items. These are translated at the average exchange rate for the period, except for items such as depreciation and cost of goods sold that are directly associated with nonmonetary assets or liabilities. These accounts are translated at their historical rate.

■ Distributions. Dividends paid are translated at the exchange rate in effect on the date of payment.

■ Equity items. Common stock and paid-in capital accounts are translated at historical rates. Year-end retained earnings consist of the original year-beginning retained earnings plus or minus any income or loss for the year, plus or minus any imbalance from translation.

Under the temporal method, gains or losses resulting from remeasurement are carried directly to current consolidated income, and not to equity reserves. Hence, foreign exchange gains and losses arising from the translation process do introduce volatility to consolidated earnings.

U.S. Translation Procedures

The United States differentiates foreign subsidiaries based on functional currency, not subsidiary characterization. A note on terminology: Under U.S. accounting and translation practices, use of the current rate method is termed “translation” while use of the temporal method is termed “remeasurement.” The primary principles of U.S. translation are summarized as follows:

■ If the financial statements of the foreign subsidiary of a U.S. company are maintained in U.S. dollars, translation is not required.

■ If the financial statements of the foreign subsidiary are maintained in the local currency and the local currency is the functional currency, they are translated by the current rate method.

■ If the financial statements of the foreign subsidiary are maintained in the local currency and the U.S. dollar is the functional currency, they are remeasured by the temporal method.

■ If the financial statements of foreign subsidiaries are in the local currency and neither the local currency nor the dollar is the functional currency, then the statements must first be remeasured into the functional currency by the temporal method, and then translated into dollars by the current rate method.

■ U.S. translation practices, summarized in Exhibit 11.2, have a special provision for translating statements of foreign subsidiaries operating in hyperinflation countries. These are countries where cumulative inflation has been 100% or more over a three-year period. In this case, the subsidiary must use the temporal method.

A final note: The selection of the functional currency is determined by the economic realities of the subsidiary’s operations, and is not a discretionary management decision on preferred procedures or elective outcomes. Since many U.S.-based multinationals have numerous foreign subsidiaries, some dollar-functional and some foreign currency-functional, currency gains and losses may be passing through both current consolidated income and/or accruing in equity reserves.

International Translation Practices

Many of the world’s largest industrial countries use International Accounting Standards Committee (IASC), and therefore the same basic translation procedure. A foreign subsidiary is an integrated foreign entity or a self-sustaining foreign entity; integrated foreign entities are typically remeasured using the temporal method (or some slight variation thereof); and self-sustaining foreign entities are translated at the current rate method, also termed the closing-rate method.

EXHIBIT 11.2 Flow Chart for U.S. Translation Practices

Ganado Corporation’s Translation Exposure

Ganado Corporation, first introduced in Chapter 1 and shown in Exhibit 11.3, is a U.S.-based corporation with a U.S. business unit as well as foreign subsidiaries in both Europe and China. The company is publicly traded and its shares are traded on the New York Stock Exchange (NYSE).

Each subsidiary of Ganado—the United States, Europe, and China—will have its own set of financial statements. Each set of financials will be constructed in the local currency (renminbi, dollar, euro), but the subsidiary income statements and balance sheets will also be translated into U.S. dollars, the reporting currency of the company for consolidation and reporting. As a U.S.-based corporation whose shares are traded on the NYSE, Ganado will report all of its final results in U.S. dollars.

Translation Exposure: Income

Ganado Corporation’s sales and earnings by operating unit for 2009 and 2010 are described in Exhibit 11.4.

■ Consolidated sales. For 2010, the company generated $300 million in sales in its U.S. unit, $158.4 million in its European subsidiary (€120 million at $1.32/€), and $89.6 million in its Chinese subsidiary (Rmb600 million at Rmb6.70/$). Total global sales for 2010 were $548.0 million. This constituted sales growth of 2.8% over 2009.

■ Consolidated earnings. The company’s earnings (profits) fell in 2010, dropping to $53.1 million from $53.2 million in 2009. Although not a large fall, Wall Street would not react favorably to a fall in consolidated earnings.

EXHIBIT 11.3 Ganado Corporation: A U.S. Multinational

EXHIBIT 11.4 Ganado Corporation, Selected Financial Results, 2009–2010

A closer look at the sales and earnings by country, however, yields some interesting insights. Sales and earnings in the U.S. unit rose, sales growing 7.1% and earnings growing 1.4%. Since the U.S. unit makes up more than half of the total company’s sales and profits, this is very important. The Chinese subsidiary’s sales and earnings were identical in 2009 and 2010 when measured in local currency, Chinese renminbi. The Chinese renminbi, however, was revalued against the U.S. dollar by the Chinese government, from Rmb6.83/$ to Rmb6.70/$. The result was an increase in the dollar value of both Chinese sales and profits.

The European subsidiary’s financial results are even more striking. Sales and earnings in Europe in euros grew from 2009 to 2010. Sales grew 1.7% while earnings increased 1.0%. But the euro depreciated against the dollar, falling from $1.40/€ to $1.32/€. This depreciation of 5.7% resulted in the financial results of European operations falling in dollar terms. As a result, Ganado’s consolidated earnings, as reported dollars, fell in 2010. One can imagine the discussion and debate within Ganado, and among the analysts who follow the firm, over the fall in earnings reported to Wall Street.

Translation Exposure: Balance Sheet

Let us continue the example of Ganado, focusing here on the balance sheet of its European subsidiary. We will illustrate translation by both the temporal method and the current rate method, to show the arbitrary nature of a translation gain or loss. The functional currency of Ganado Europe is the euro, and the reporting currency of its parent, Ganado Corporation, is the U.S. dollar.

Our analysis assumes that plant and equipment and long-term debt were acquired, and common stock issued, by Ganado Europe sometime in the past when the exchange rate was $1.2760/€. Inventory currently on hand was purchased or manufactured during the immediately prior quarter when the average exchange rate was $1.2180/€. At the close of business on Monday, December 31, 2010, the current spot exchange rate was $1.2000/€. When business reopened on January 3, 2011, after the New Year holiday, the euro had dropped in value versus the dollar to $1.0000/€.

Current Rate Method.

Exhibit 11.5 illustrates translation loss using the current rate method. Assets and liabilities on the pre-depreciation balance sheet are translated at the current exchange rate of $1.2000/€. Capital stock is translated at the historical rate of $1.2760/€, and retained earnings are translated at a composite rate that is equivalent to having each past year’s addition to retained earnings translated at the exchange rate in effect that year.

The sum of retained earnings and the CTA account must “balance” the liabilities and net worth section of the balance sheet with the asset side. For this example, we have assumed the two amounts used for the December 31 balance sheet. As shown in Exhibit 11.5, the “just before depreciation” dollar translation reports an accumulated translation loss from prior periods of $136,800. This balance is the cumulative gain or loss from translating euro statements into dollars in prior years.

After the depreciation, Ganado Corporation translates assets and liabilities at the new exchange rate of $1.0000/€. Equity accounts, including retained earnings, are translated just as they were before depreciation, and as a result, the cumulative translation loss increases to $1,736,800. The increase of $1,600,000 in this account (from a cumulative loss of $136,800 to a new cumulative loss of $1,736,800) is the translation loss measured by the current rate method.

This translation loss is a decrease in equity, measured in the parent’s reporting currency, of “net exposed assets.” An exposed asset is an asset whose value drops with the depreciation of the functional currency and rises with an appreciation of that currency. Net exposed assets in this context are exposed assets minus exposed liabilities. Net exposed assets are positive (“long”) if exposed assets exceed exposed liabilities. They are negative (“short”) if exposed assets are less than exposed liabilities.

EXHIBIT 11.5 Ganado Europe’s Translation Loss after Depreciation of the Euro: Current Rate Method

Temporal Method.

Translation of the same accounts under the temporal method shows the arbitrary nature of any gain or loss from translation. This is illustrated in Exhibit 11.6. Monetary assets and monetary liabilities in the pre-depreciation euro balance sheet are translated at the current rate of exchange, but other assets and the equity accounts are translated at their historic rates. For Ganado Europe, the historical rate for inventory differs from that for net plant and equipment because inventory was acquired more recently.

Under the temporal method, translation losses are not accumulated in a separate equity account but passed directly through each quarter’s income statement. Thus, in the dollar balance sheet translated before depreciation, retained earnings were the cumulative result of earnings from all prior years translated at historical rates in effect each year, plus translation gains or losses from all prior years. In Exhibit 11.6, no translation loss appears in the pre-depreciation dollar balance sheet because any losses would have been closed to retained earnings.

The effect of the depreciation is to create an immediate translation loss of $160,000. This amount is shown as a separate line item in Exhibit 11.6 to focus attention on it for this example. Under the temporal method, this translation loss of $160,000 would pass through the income statement, reducing reported net income and reducing retained earnings. Ending retained earnings would, in fact, be $7,711,200 minus $160,000, or $7,551,200. Whether gains and losses pass through the income statement under the temporal method depends upon the country.

EXHIBIT 11.6 Ganado Europe’s Translation Loss after Depreciation of the Euro: Temporal Method

GLOBAL FINANCE IN PRACTICE 11.1 Foreign Subsidiary Valuation

The value contribution of a subsidiary of a multinational firm to the firm as a whole is a topic of increasing debate in global financial management. Most multinational companies report the earnings contribution of foreign operations either individually or by region when they are significant to the total earnings of the consolidated firm. Changes in the value of a subsidiary as a result of the change in an exchange rate can be decomposed into those changes specific to the income and the assets of the subsidiary.

Subsidiary Earnings

The earnings of the subsidiary, once remeasured into the home currency of the parent company, contributes directly to the consolidated income of the firm. An exchange rate change results in fluctuations in the value of the subsidiary’s income to the global corporation. If the individual subsidiary in question constitutes a relatively significant or material component of consolidated income, the multinational firm’s reported income (and earnings per share, EPS) may be seen to change purely as a result of translation.

Subsidiary Assets

Changes in the reporting currency value of the net assets of the subsidiary are passed into consolidated income or equity. If the foreign subsidiary was designated as “dollar functional,” remeasurement results in a transaction exposure, which is passed through current consolidated income. If the foreign subsidiary was designated as “local currency functional,” translation results in a translation adjustment and is reported in consolidated equity as a translation adjustment. It does not alter reported consolidated net income.

In the case of Ganado, the translation gain or loss is larger under the current rate method because inventory and net property, plant, and equipment, as well as all monetary assets, are deemed exposed. When net exposed assets are larger, gains or losses from translation are also larger. If management expects a foreign currency to depreciate, it could minimize translation exposure by reducing net exposed assets. If management anticipates an appreciation of the foreign currency, it should increase net exposed assets to benefit from a gain.

Depending on the accounting method, management might select different assets and liabilities for reduction or increase. Thus, “real” decisions about investing and financing might be dictated by which accounting technique is used, when in fact, accounting impacts should be neutral.

As illustrated in Global Finance in Practice 11.1, transaction, translation, and operating exposures can become intertwined in the valuation of business units—in this case, the valuation of a foreign subsidiary.

Managing Translation Exposure

“Covering P&L translation risk is more complex to hedge and therefore not done by corporates to the same extent as transactional risk,” says Francois Masquelier, chairman of the Association of Corporate Treasurers of Luxembourg. “Of course, reported earnings can have positive or negative effects depending on what the currency does vis-à-vis your functional currency. If you have losses in the US then it can reduce those losses (when USD is weaker versus EUR), but if you have profit it can reduce that contribution to the earnings before interest, tax, depreciation and amortisation and therefore your net profit.”

—“Translation risk hits corporate earnings,” FX Week, 09 May 2014.

The main technique to minimize translation exposure is called a balance sheet hedge. At times, some firms have attempted to hedge translation exposure in the forward market. Such action amounts to speculating in the forward market in the hope that a cash profit will be realized to offset the noncash loss from translation. Success depends on a precise prediction of future exchange rates, for such a hedge will not work over a range of possible future spot rates. In addition, the profit from the forward “hedge” (i.e., speculation) is taxable, but the translation loss does not reduce taxable income.

Balance Sheet Hedge

A balance sheet hedge requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet. If this can be achieved for each foreign currency, net translation exposure will be zero. A change in exchange rates will change the value of exposed liabilities in an equal amount but in a direction opposite to the change in value of exposed assets. If a firm translates by the temporal method, a zero net exposed position is called “monetary balance.” Complete monetary balance cannot be achieved under the current rate method because total assets would have to be matched by an equal amount of debt, but the equity section of the balance sheet must still be translated at historic exchange rates.

The cost of a balance sheet hedge depends on relative borrowing costs. If foreign currency borrowing costs, after adjusting for foreign exchange risk, are higher than parent currency borrowing costs, the balance sheet hedge is costly, and vice versa. Normal operations, however, already require decisions about the magnitude and currency denomination of specific balance sheet accounts. Thus, balance sheet hedges are a compromise in which the denomination of balance sheet accounts is altered, perhaps at a cost in terms of interest expense or operating efficiency, in order to achieve some degree of foreign exchange protection.

To achieve a balance sheet hedge, Ganado Corporation must either (1) reduce exposed euro assets without simultaneously reducing euro liabilities, or (2) increase euro liabilities without simultaneously increasing euro assets. One way to achieve this is to exchange existing euro cash for dollars. If Ganado Europe does not have large euro cash balances, it can borrow euros and exchange the borrowed euros for dollars. Another subsidiary could also borrow euros and exchange them for dollars. That is, the essence of the hedge is for the parent or any of its subsidiaries to create euro debt and exchange the proceeds for dollars.

Current Rate Method.

Under the current rate method, Ganado should borrow as much as €8,000,000. The initial effect of this first step is to increase both an exposed asset (cash) and an exposed liability (notes payable) on the balance sheet of Ganado Europe, with no immediate effect on net exposed assets. The required follow-up step can take two forms: (1) Ganado Europe could exchange the acquired euros for U.S. dollars and hold those dollars itself, or (2) it could transfer the borrowed euros to Ganado Corporation, perhaps as a euro dividend or as repayment of intracompany debt. Ganado Corporation could then exchange the euros for dollars. In some countries, local monetary authorities will not allow their currency to be freely exchanged.

An alternative would be for Ganado Corporation or a sister subsidiary to borrow the euros, thus keeping the euro debt entirely off Ganado’s books. However, the second step is still essential to eliminate euro exposure; the borrowing entity must exchange the euros for dollars or other unexposed assets. Any such borrowing should be coordinated with all other euro borrowings to avoid the possibility that one subsidiary is borrowing euros to reduce translation exposure at the same time as another subsidiary is repaying euro debt. (Note that euros can be “borrowed,” by simply delaying repayment of existing euro debt; the goal is to increase euro debt, not to borrow in a literal sense.)

Temporal Method.

If translation is by the temporal method, the much smaller amount of only €800,000 need be borrowed. As before, Ganado Europe could use the proceeds of the loan to acquire U.S. dollars. However, Ganado Europe could also use the proceeds to acquire inventory or fixed assets in Europe. Under the temporal method, these assets are not regarded as exposed and do not drop in dollar value when the euro depreciates.

When Is a Balance Sheet Hedge Justified?

If a firm’s subsidiary is using the local currency as the functional currency, the following circumstances could justify when to use a balance sheet hedge:

■ The foreign subsidiary is about to be liquidated, so that value of its CTA would be realized.

■ The firm has debt covenants or bank agreements that state the firm’s debt/equity ratios will be maintained within specific limits.

■ Management is evaluated based on certain income statement and balance sheet measures that are affected by translation losses or gains.

■ The foreign subsidiary is operating in a hyperinflationary environment.

If a firm is using the parent’s home currency as the functional currency of the foreign subsidiary, all transaction gains/losses are passed through to the income statement. Hedging this consolidated income to reduce its variability may be important to investors and bond rating agencies. In the end, accounting exposure is a topic of great concern and complex choices for all multinationals. As demonstrated by Global Finance in Practice 11.2 , despite the best of intentions and structures, business itself may dictate hedging outcomes.

GLOBAL FINANCE IN PRACTICE 11.2 When Business Dictates Hedging Results

GM Asia, a regional subsidiary of GM Corporation, U.S., held major corporate interests in a variety of countries and companies, including Daewoo Auto of South Korea. GM had acquired control of Daewoo’s automobile operations in 2001. The following years had been very good for the Daewoo unit, and by 2009, GM Daewoo was selling automobile components and vehicles to more than 100 countries.

Daewoo’s success meant that it had expected sales (receivables) from buyers all over the world. What was even more remarkable was that the global automobile industry now used the U.S. dollar more than ever as its currency of contract for cross-border transactions. This meant that Daewoo did not really have dozens of foreign currencies to manage, just one, the U.S. dollar. So Daewoo of Korea had, in late 2007 and early 2008, entered into a series of forward exchange contracts. These currency contracts locked in the Korean won value of the many dollar-denominated receivables the company expected to receive from international automobile sales in the coming year. In the eyes of many, this was a conservative and responsible currency hedging policy; that is, until the global financial crisis and the following global collapse of automobile sales.

The problem for Daewoo was not that the Korean won per U.S. dollar exchange rate had moved dramatically; it had not. The problem was that Daewoo’s sales, like all other automobile industry participants, had collapsed. The sales had not taken place, and therefore the underlying exposures, the expected receivables in dollars by Daewoo, had not happened. But GM still had to contractually deliver on the forward contracts. It would cost GM Daewoo Won 2,300 billion. GM’s Daewoo unit was now broke, its equity wiped out by currency hedging gone bad. GM Asia needed money, quickly, and selling interests in its highly successful Chinese and Indian businesses was the only solution.

SUMMARY POINTS

■ Translation exposure results from translating foreign currency-denominated statements of foreign subsidiaries into the parent’s reporting currency to prepare consolidated financial statements.

■ A foreign subsidiary’s functional currency is the currency of the primary economic environment in which the subsidiary operates and in which it generates cash flows. In other words, it is the dominant currency used by that foreign subsidiary in its day-to-day operations.

■ Technical aspects of translation include questions about when to recognize gains or losses, the distinction between functional and reporting currency, and the treatment of subsidiaries in hyperinflation countries.

■ Translation gains and losses can be quite different from operating gains and losses, not only in magnitude but also in sign. Management may need to determine which is of greater significance prior to deciding which exposure is to be managed first.

■ The main technique for managing translation exposure is a balance sheet hedge. This calls for having an equal amount of exposed foreign currency assets and liabilities.

■ Even if management chooses to follow an active policy of hedging translation exposure, it is nearly impossible to offset both transaction and translation exposure simultaneously. If forced to choose, most managers will protect against transaction losses because they impact consolidated earnings.

MINI-CASE McDonald’s, Hoover Hedges, and Cross-Currency Swaps1

McDonald’s Corporation (NYSE: MCD) is one of the world’s most well known and valuable brands. But as McDonald’s has grown and expanded globally, so have the investment risks associated with is investment in more than 100 countries. Like most multinational firms, it considers its equity investment in foreign affiliates capital at risk—risk of loss, nationalization, and currency valuation. McDonald’s has been quite innovative in its hedging of these combined currency risks over time, finding new ways to construct old solutions—Hoover Hedges—but doing so with cross-currency swaps.

Hoover Hedges

A multinational firm that establishes a foreign subsidiary puts capital at risk, a long-time fundamental of international business. Financially, when the parent company creates and invests in a foreign subsidiary it creates an asset, its foreign investment in a foreign subsidiary, which corresponds to the equity investment on the balance sheet of the foreign subsidiary. But the equity investment in the foreign subsidiary is now in local currency, the currency of the foreign business environment. If this is the predominant currency of this subsidiary’s business, it is termed the functional currency of the subsidiary. Going forward, as the exchange rate between the two country currencies changes, the parent company’s equity investment is subject to foreign exchange risk.

Many multinationals have attempted to hedge this equity investment exposure with what can be described as a balance sheet hedge. Since the parent company possesses a long-term asset in the foreign currency, the company tries to hedge this by creating a matching long-term liability in the same currency. A long-term loan in the currency of the foreign subsidiary has typically been used. The loan itself is often structured as a bullet repayment loan, in which interest payments are made over time but the entire principal is due in a single final payment at maturity. In this way, the principal on the long-term loan acts as a match to the long-term equity investment.

1Copyright © 2015 Thunderbird School of Global Management, Arizona State University. All rights reserved. This case was prepared by Professor Michael H. Moffett for the purpose of classroom discussion only and not to indicate either effective or ineffective management. Although McDonald’s is a real company, the actors and actions in this mini-case are fictional.

These hedges are typically referred to as Hoover Hedges following the court case of Hoover Company (a vacuum cleaner manufacturer) versus the U.S. Internal Revenue Service2. The primary issue in the case was whether the gains and losses from short sales in foreign currency that the Hoover Company used as hedges were to be considered ordinary losses, business expenses, or capital losses and gains, for tax purposes. Although borrowing in the local currency is frequently used, there are a number of other potential hedges of equity investments including short sales and the use of traditional foreign currency derivatives like forward contracts and currency options.

McDonald’s Business Forms

McDonald’s has structured its business in a variety of different ways depending on marketplace. In the United States the company has utilized a franchising structure where it awards a franchise to a private investor. That investor then has exclusive rights over the sale and distribution of McDonald’s products and services within the designated franchise zone. McDonald’s corporation will own the land and building, but the franchisee is responsible for the investment in all equipment and furnishings required for the restaurant under the franchise agreement—from the paint-in—as they describe it. This structure allows McDonald’s to expand with a lower level of capital investment (the franchisee is investing a significant portion), and at the same time create a financial incentive for the franchisee to remain focused and committed to the restaurant’s success and profitability. In return McDonald’s earns a royalty from the franchise’s sales, typically 5% to 5.5% of sales.

Alternatively, in markets in which the company wishes more direct control, and is willing to make substantially larger capital investments itself, it uses the more common form of direct ownership. Although having to put up all the capital needed for the establishment of the business, it gains more direct control over operations. Much of McDonald’s international expansion has been structured under this more common direct ownership approach, but at the risk of substantial amounts of capital as the company sought to gain a major presence in a growing number of countries.

The British Subsidiary and Currency Exposure

In the United Kingdom McDonald’s owns the majority of its restaurants. These investments create three different British pound-denominated currency exposures for the parent company.

1. The British subsidiary has equity capital, which is a British pound-denominated asset of the parent company.

2. The parent company provides intracompany debt in the form of a four-year loan. The loan is denominated in British pounds, and carries a fixed rate of interest.

3. The British subsidiary pays a fixed percentage of gross sales in royalties to the parent company. This too is pound-denominated.

An additional technical detail further complicates the situation. When the parent company makes an intracompany loan to the British subsidiary, it must designate—according to U.S. accounting and tax law practices—whether the loan is considered to be “permanently invested” in that country. Although on the surface it seems illogical to consider four years permanent, the loan itself could simply be continually rolled over by the parent company and never actually be repaid.

If the loan was not considered permanent, the foreign exchange gains and losses related to the loan flow directly to the parent company’s income statement, according to Financial Accounting Standard #52, the primary standard for U.S. foreign currency reporting. If, however, the loan is designated as permanent, the foreign exchange gains and losses related to the intracompany loan would flow only to the cumulative translation adjustment account (CTA), a segment of consolidated equity on the company’s consolidated balance sheet. To date, McDonald’s has chosen to designate the loan as permanent. The functional currency of the British subsidiary for consolidation purposes is the local currency, the British pound.

Cross-Currency Swap Hedging

Anka Gopi is an assistant manager in Treasury—and a McDonald’s shareholder. She is currently reviewing the existing hedging strategy employed by McDonald’s against the pound exposures.

McDonald’s has been hedging the rather complex British pound exposure by entering into a cross-currency U.S. dollar—British pound sterling cross-currency swap. The current swap is a seven-year swap to receive dollars and pay pounds. Like all cross-currency swaps, the agreement requires McDonald’s (U.S.) to make regular pound-denominated interest payments and a bullet principal repayment (notional principal) at the end of the swap agreement.

Exhibit A provides a brief map of how the cross-currency swap strategy works. The cross-currency swap serves as a hedge of both the regular royalty and interest payments in British pounds made to the U.S. parent, and the outstanding swap notional principal in British pounds serves as a hedge of the equity investment by McDonald’s U.S. in the British subsidiary. According to accounting practice, a company may elect to take the interest associated with a foreign currency-denominated loan and carry that directly to the parent company’s consolidated income. This had been done in the past and McDonald’s had benefitted from the inclusion.

2The Hoover Company, Petitioner v. Commissioner of Internal Revenue, Respondent, 72 T.C. 206 (1979). United States Tax Court, Filed April 24, 1979.

EXHIBIT A McDonald’s Cross-Currency Swap Strategy for the U.K.

Issues for Discussion

One of Anka’s concerns is that under FAS #133, Accounting for Derivative Instruments and Hedging Activities, the firm has to mark-to-market the entire cross-currency swap position, including principal, and carry this to other comprehensive income (OCI). This has proven a bit troublesome in the past because cross-currency swaps are subject to so much volatility in value when marked-to-market, a direct result of the large notional principal bullet repayment feature they typically carry.

Anka wondered how important OCI was to investors. OCI was a measure of “below the line income,” income required under U.S. GAAP and reported in the footnotes to the financial statements. It was below net income (and therefore below earnings and earnings per share as reported to the markets), and included a variety of adjustments arising from consolidated equity (such as these gains and losses associated with hedging instruments and positions).

Anka Gopi wished to reconsider the current hedging strategy. She begins by listing the pros and cons of the current strategy, comparing these to alternative strategies, and then deciding what if anything should be done about it at this time.

Mini-Case Questions

1. How does the cross-currency swap effectively hedge the three primary exposures McDonald’s has relative to its British subsidiary?

2. How does the cross-currency swap hedge the long-term equity position in the foreign subsidiary?

3. To what degree, if at all, Should Anka—and McDonald’s—worry about OCI?

QUESTIONS

These questions are available in MyFinanceLab.

1. Translation. What does the word translation mean? Why is translation exposure called an accounting exposure?

2. Causation. What activity gives rise to translation exposure?

3. Converting Financial Assets. In the context of preparing consolidated financial statements, are the words translate and convert synonyms?

4. Subsidiary Characterization. What is the difference between a self-sustaining foreign subsidiary and an integrated foreign subsidiary?

5. Functional Currency. What is a functional currency? What do you think a “non-functional currency” would be?

6. Functional Currency Designation. Can or should a company change the functional currency designation of a foreign subsidiary from year to year? If so, when would it be justified?

7. Translation Methods. What are the two basic methods for translation used globally?

8. Current Versus Historical. One of the major differences between translation methods is which balance sheet components are translated at which exchange rates, current or historical. Why would accounting practices ever use historical exchange rates?

9. Translating Assets. What are the major differences in translating assets between the current rate method and the temporal method?

10. Translating Liabilities. What are the major differences in translating liabilities between the current rate method and the temporal method?

11. Earnings or Equity. Where do you think that most companies would prefer currency translation imbalances or adjustments to go—earnings or consolidated equity? Why?

12. Translation Exposure Management. What are the primary options firms have to manage translation exposure?

13. Accounting or Cash Flow. A U.S.-based multinational company generates more than 80% of its profits (earnings) outside the U.S. in the euro zone and Japan, and both the euro and the yen fall significantly in value versus the dollar as occurred in the second half of 2014. Is the impact on the firm only accounting or does it alter cash flow, or both?