518 CHAPTER 13. MEASURING EXPOSURE TO EXCHANGE RATES
The Current/Non-Current Method
The Current/Non-Current Method for translating the financial statements of foreign
subsidiaries is one that was commonly used in theusuntil the mid-1970s. As its
name suggests, whether an item is translated at the closing exchange rate or the
historical rate depends on its time to maturity. Thus, according to this method,
current (i.e. short-term) assets and liabilities in the balance sheet are translated
at the closing exchange rate, while non-current items, such as long-term debt, are
translated at the historical rate. The logic underlying this is that the value of short-
term assets and liabilities is fixed, or at least quite sticky, inaudterms, so that its
hcvalue changes proportionally with the exchange rate. For example, the future
value of aaudT-bill is fixed inaudnominal terms; and, in the short-term, goods
prices are sticky and therefore quasi-fixed inaudterms, too. Long-term assets and
liabilities, in contrast, will not be realized in the short run—and by the time they
are realized, the closing exchange rate change may very well turn out to have been
undone by later, opposite changes in the spot rate. That is, the effect of a closing
exchange rate change on the realization value of long-term assets and liabilities is
very uncertain. As accountants hesitate to recognize gains or losses that are very
uncertain, the Current/Non-Current Method simply prefers to classify the long-term
assets and liabilities as unexposed.
Thus, under the Current/Non-Current Method, translation at the closing rate is
restricted to only the short-term assets and liabilities. Thus, exposure is given by
the difference in short-term assets and liabilities, that is, Net Working Capital.
Example 13.10
In Table 13.5, we assume that long-term debt was issued and long-term assets (plant
and equipment) were bought in early 2007, at which time the exchange rate was
mtl/aud0.325. Thus, these items are recorded at their historical values (indi-
cated as italicized text) and are not affected by the exchange rate. It follows that
net exposure equals short-term assets minus short-term liabilities, or net working
capital—aud500. The effect of the exchange-rate change from 0333 to 0.300 is a
drop in net worth ofaud 500 ×(− 0 .033) =−mtl 16 .5.
Evaluation- The assumption underlying this method seems to be that there is mean-
reversion in exchange rates; that is, exchange rate fluctuations tend to be
undone in the medium run, which (if true) means that they affect short-term
assets only. However, as discussed in Chapter 11, there is little empirical sup-
port for this view (except for the small movements of exchange rates around
a central parity): typically, changes in exchange rates are not undone in the
medium run, and floating exchange rates behave like random walks. - Most firms have positive net working capital and would therefore be deemed
to be positively exposed (losing value, that is, following a devaluation of the
host currency). Yet economic logic says that the true effect on economic value