514 CHAPTER 13. MEASURING EXPOSURE TO EXCHANGE RATES
forward contract would already triggerM2Mcashflows while there are no roughly-
matchingM2Ms for a hedgee yet. Thus, again, the hedge would add uncertainty
to the reported results even though it actually stabilizes cash flows. To solve this,
IFRScould have decided to start booking the hedgee transaction at the date offirm
commitment—presumably also the date the hedge is undertaken—rather than the
date of the invoice or transfer of ownership, but that would have been a major
change in accounting practices. For this reason,IFRSconcocts an account ‘firm
commitments’, which just absorbs any gains and losses in the forward contract
during this initial period. For this to be possible, the hedge must be immediately
designed as such, and linked to the specific transaction.
Example 13.8
Kayblan Whyerusorders glass fiber cables wortheur1m on October 15. The wares
are shipped and invoiced on November 15. On December 31 the A/P is marked to
market, and it is paid on January 15. In Table 13.4 I show the entries—as numbers
in columns that stand for accounts, not as debits and credits, because columns are
easier to follow. The columns on forwards and firm commitments are relevant only
if Kayblan does hedge.
*
This finishes our brief discussion on updating the book values of contractual
exposures. But these are only part of the balance-sheet items that might be affected.
As mentioned already, also a subsidiary’sP&LandA&Lstatements may have to be
translated, for consolidation of the accounts, for instance. We first list some of the
reasons why the financial statements of a subsidiary need to be translated into the
currency of the parent firm. Next we describe the four main translation methods.
We conclude with a discussion of the relevance of translation exposure.
13.4.2 Why Firms Need to Translate Financial Statements
If some of the subsidiaries of a firm are located abroad, their financial statements are
typically maintained in terms of the local currency, which is foreign to the parent.
There are a number of reasons why the financial statements of the subsidiary may
need to be translated into other currencies—most often, the parent company’s home
currency:
- Taxes Translation is often necessary for tax purposes, notably if the tax au-
thorities of the parent’s home country have to review the subsidiaries’ financial
statements to establish the tax basis (as explained in Chapter 20). Taxes in
the parent’s home country, on income earned by the foreign subsidiary are, of
course, payable in home currency. This means that the foreign income has to
be translated into the home currency. Also, capital gains arising from exchange
rate changes may be taxable; if so, to compute the capital gain, one needs to
translate the value of the foreign subsidiary into home currency terms. Thus,