Managing Translation Exposure To | Test Bank + Answers Ch.11

Chapter 11 Managing Translation Exposure to Currency Risk

Notes to instructors:

Answers to non-numeric multiple choice questions are arranged alphabetically, so that answers are randomly assigned to the five outcomes.

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1. Translation exposure refers to the impact of exchange rate changes on the parent firm’s consolidated financial statements.

2. Translation exposure is defined as change in the value of contractual cash flows due to unexpected changes in currency values.

This is transaction exposure.

3. Historical cost accounting is reliable, but is less relevant than fair value accounting.

4. When market prices are unavailable, historical costs are more reliable than market values.

5. Under ASC 830-30 Translation of Financial Statements, changes in the translated value of balance sheet items are placed in a contra account on the asset side of the balance sheet.

Under the current rate method of ASC 830-30, changes in the translated value of balance sheet items are placed into a cumulative translation adjustment (CTA) account under owners’ equity.

6. Most businesses maintain positive net working capital, so a foreign currency appreciation is more likely to be associated with a translation gain than a translation loss.

7. Under ASC 830-30 Translation of Financial Statements, translation gains or losses are reported on the balance sheet as a cumulative translation adjustment.

8. Under ASC 830-30 Translation of Financial Statements, translation gains and losses are not flowed through the income statement. Instead, they are accumulated in an account in the equity portion of the balance sheet.

9. According to ASC 830-30 Translation of Financial Statements, all income statement items are translated at the current exchange rate.

10. According to ASC 830-30 Translation of Financial Statements, all assets and liabilities are translated at the current exchange rate.

Common equity is translated at historical exchange rates.

11. Translation exposure is far more important than economic exposure to the value of the multinational corporation.

Translation exposure is only important if it involves cash flows or risk.

12. Finance theory states that the firm should only consider hedging risk exposures that are related to firm value.

13. The response of accounting standard setters to the growth of trading in financial derivatives in the 1990s was to place a moratorium on corporate reporting of derivatives transactions.

Standard setters required increased disclosure of derivatives transactions.

14. Accounting standard setters have failed to respond to the recent growth in derivatives usage for risk management purposes.

National and international standard setters required increased disclosure and have proposed new rules for accounting for derivatives.

Multiple Choice Select the BEST ANSWER

1. Net exposed assets equal ____.

a. assets less liabilities

b. exposed assets less exposed liabilities

c. shareholders’ equity

d. more than one of the above

e. none of the above

2. Which of the following is not a rule specified by ASC 830-30 Translation of Financial Statements?

a. All assets and liabilities (including common equity) are translated at the current exchange rate.

b. Dividends paid are translated at the current exchange rate.

c. Income statement items are translated at an exchange rate (or an exchange rate average) from the reporting period.

d. All of the above are elements of ASC 830-30.

e. None of the above is elements of ASC 830-30.

3. To maximize shareholder wealth, managers should only hedge translation exposure if it ____.

a. affects the total risk of the firm

b. involves accounting profits

c. involves cash flows

d. is convenient

e. none of the above

4. ASC 830-30 Translation of Financial Statements assumes the domestic currency values of the real assets of foreign subsidiaries are ____.

a. fully exposed to currency risk

b. negative related to the domestic currency

c. not exposed to currency risk

d. partially exposed to currency risk

e. positively related to the domestic currency

5. Which of the following is not an information-based reason for hedging translation exposure?

a. The quality of accounting information can be improved.

b. Meeting profit forecasts retains management’s credibility in the marketplace.

c. Information costs can be reduced in a perfect market.

d. Credit ratings are tied to accounting performance rather than cash flow.

e. Loan covenants are tied to accounting income.

6. Which of the following is not required by ASC 815 Derivatives and Hedging?

a. Derivatives are assets and liabilities that should be reported in financial statements.

b. Market value is the most relevant measure of value.

c. Only assets and liabilities should be reported as such. Income and expenses should be reported on the income statement.

d. Hedge transactions should be fully capitalized on the balance sheet.

e. ASC 815 requires each of the above.

7. ASC 815 Derivatives and Hedging values financial derivatives at ____.

a. book value

b. historical cost

c. historical exchange rates

d. market value

e. time value

8. Which of the following is a reasonable guideline for currency risk management?

a. All noncash currency risk exposures should be hedged with currency derivatives.

b. Do not hedge unless the purpose is to reduce translation exposure to currency risk.

c. Treasury should hold the managers of individual operating units responsible for the consequences of unexpected changes in currency values.

d. Treasury should quote market prices for currency hedges to individual units within the firm.

e. None of the above is a reasonable guideline.

9. Adverse selection costs arise from ____.

a. differential taxes

b. information asymmetries

c. large bid-ask spreads

d. the perfect market assumptions

e. transaction exposure to currency risk

Problems

1. Laupp Campfitters is the German subsidiary of a U.S. firm. Laupp’s balance sheet is shown below in euros and dollars at the historical and current exchange rate of $1.00/€.

Value at Translated value at $0.90/€ according to

Assets € value $1.00/€ the current rate method of FAS #52

Cash €40,000 $40,000

Accounts receivable €40,000 $40,000

Inventory €20,000 $20,000

Plant & equipment €700,000 $700,000

Total assets €800,000 $800,000

Liabilities

Accounts payable €100,000 $100,000

Long-term debt €600,000 $600,000

Net worth €100,000 $100,000

Total liabilities €800,000 $800,000

a. Translate this balance sheet into dollars at an exchange rate of $0.90/€ under the current rate method of ASC 830-30. Use the current exchange rate for inventory.

b. Identify exposed monetary assets, exposed monetary liabilities, and net exposed monetary assets under ASC 830-30.

c. Beginning with the above balance sheet, identify the translation gain or loss from a 30 percent depreciation of the euro under ASC 830-30.

Problem Solutions

1. a. Value at Translated value at $0.90/€ according to

Assets € value $1.00/€ the current rate method of ASC 830-30

Cash €40,000 $40,000 $36,000

Accounts receivable €40,000 $40,000 $36,000

Inventory €20,000 $20,000 $18,000

Plant & equipment €700,000 $700,000 $630,000

Total assets €800,000 $800,000 $720,000

Liabilities

Accounts payable €100,000 $100,000 $90,000

Long-term debt €600,000 $600,000 $540,000

Net worth €100,000 $100,000 $90,000

Total liabilities €800,000 $800,000 $720,000

b. Net exposed monetary assets = (Exposed monetary assets) – (Exposed monetary liabilities)

= ($40,000 + $40,000 + $20,000 + $700,000) – ($100,000 + $600,000) = $100,000

c. Translation gain or loss = (percentage spot rate change)(Net exposed assets)

= (–$0.30/€))[(€40k + €40k + €20k + €700k) – (€100k + €600k)]

= (–$0.30/€)(€100k) = –$30k