the majority of its inputs from abroad and ships the bulk of the output outside of the
host country will have the dollar as its functional currency. If the functional currency
is the dollar, foreign currency items on its balance sheet will have to be restated into
dollars and any gains and losses are moved through the income statement. If the func-
tional currency is determined to be the local currency, however, a second issue arises:
whether the entity operates in a high-inflation environment. High-inflation countries
are defined as those whose cumulative three-year inflation rate exceeds 100%. In that
case, essentially the same principles as in FAS 8 are followed. In the case in which
the cumulative inflation rate falls short of 100%, the foreign affiliate’s books are to
be translated using the current exchange rate for all items, and any gains or losses are
to go directly as a charge or credit to the equity accounts.
FAS 52 and subsequent edicts on hedge accounting and accounting for derivatives
contain a number of other fairly complex provisions regarding the treatment of hedge
contracts, the definition of transactional gains and losses, and the accounting for in-
tercompany transactions. In essence, it allows management much more flexibility to
present the impact of exchange rate variations in accordance with perceived eco-
nomic reality; by the same token, such flexibility provides greater scope for manipu-
lation of reported earnings, and it reduces comparability of financial data for differ-
ent firms. Companies’ abuse of derivatives in the 1990s led to a revised standard,
called FAS 133. This statement established accounting and reporting standards for de-
rivative instruments, including certain derivative instruments embedded in other con-
tracts (collectively referred to as derivatives), and for hedging activities. It requires
that an entity recognize all derivatives as either assets or liabilities in the statement of
financial position and measure those instruments at fair value. If certain conditions
are met, a derivative may be specifically designated as (a) a hedge of the exposure to
changes in the fair value of a recognized asset or liability or an unrecognized firm
commitment, (b) a hedge of the exposure to variable cash flows of a forecasted trans-
action, or (c) a hedge of the foreign currency exposure of a net investment in a for-
eign operation. The purpose of this is simple—to clarify situations in which a com-
pany’s earnings are fluctuating as a result of what is, in effect, speculation—but its
application has proved controversial. See Exhibit 6.4 and the chapter on this subject.
(c) Critique of the Accounting Model of Exposure. Even with the stronger logic of
FAS 52 and the discipline of FAS 133, users of accounting information must be
aware that there are three systemic sources of error that can mislead those responsi-
ble for exchange risk management:
- Accounting data do not capture all commitments of the firm that give rise to ex-
change risk. - Because of the historical cost principle, accounting values of assets and liabil-
ities do not reflect the respective contribution to total expected net cash flow of
the firm. - Translation rules do not distinguish between expected and unexpected ex-
change rate changes.
Conceptually, though, it is important to determine the time frame within which the
firm cannot react to (unexpected) rate changes by raising prices; changing markets
for inputs and outputs; and/or adjusting production and sales volumes. Sometimes, at
6.4 IDENTIFYING EXPOSURE 6 • 13