356 Planning and Forecasting
For clarification and to indicate their order of treatment in the subse-
quent discussion, the issues raised above are enumerated below, without dis-
tinction between those that are mainly financial reporting as opposed to
managerial issues:
- Financial reporting of foreign-currency denominated transactions.
- Risk management alternatives for foreign-currency denominated trans-
actions. - Translation of the financial statements of foreign subsidiaries.
- Managing the currency risk of foreign subsidiaries.
- Dealing with differences between U.S. and foreign accounting policies.
- Evaluation of the performance of foreign subsidiaries and their
management. - Assessing the ef fects of inf lation on the financial performance of foreign
subsidiar ies. - Complying with U.S. restrictions on business practices associated with
foreign subsidiaries and governments.
FINANCIAL REPORTING OF FOREIGN-CURRENCY
DENOMINATED TRANSACTIONS
When a U.S. company buys from or sells to a foreign firm, a key issue is the cur-
rency in which the transaction is to be denominated.^3 In the case of Fashion-
house, its purchases from Danish suppliers were invoiced to Fashionhouse in
the Danish krone. This creates a risk, which is born by Fashionhouse and not its
Danish supplier, of a foreign exchange transaction lossshould the dollar fall in
value. Alternatively, a gain would result should the dollar increase between the
time the furniture is dropped on the dock in Copenhagen and the required
payment date. With a fall in the value of the dollar, the Fashionhouse dollar
cost for the furniture will be more than the dollar obligation it originally
recorded. Fashionhouse is said to have liability exposurein the Danish krone.
If, instead, Fashionhouse had been invoiced in the U.S. dollar, then it would
have had no currency risk. Rather, its Danish supplier would bear the currency
risk associated with a claim to U.S. dollars, in the form of a U.S. dollar account
receivable. If the dollar were to decrease in value, the Danish supplier would
incur a foreign exchange transaction loss, or a gain should the dollar increase
in value. The Danish firm would have asset exposure in a U.S. dollar account
receivable.
The essence of foreign-currency exposure or currency risk is that existing
account balances or prospective cash f lows can expand or contract simply as a
result of changes in the values of currencies. A summary of foreign exchange
gains and losses, by type of exposure, due to exchange rate movements is pro-
vided in Exhibit 12.1. To illustrate some of the computational aspects of the