522 CHAPTER 13. MEASURING EXPOSURE TO EXCHANGE RATES
- Under this method, a 15% devaluation means a 15% decrease in the net value
of the investment. Economically, one expects that a devaluation of, say, 15
percent leads to a value loss of 15 percent only if all subsequent cash flows are
unaffected (inhcterms), which assumes a very closed economy. So, again,
this method is unlikely to capture the true economic effect.
To translate the income statement, one translates all items at either the closing
exchange rate or the average exchange rate of the reporting period. The first method
is chosen for consistency with the balance sheet translation. The second method is
based on the argument that expenses that have been made gradually over the year
should be translated at the average exchange rate. (Curiously, this argument does
not seem to apply to expenses that end up capitalized into balance-sheet items.)
Profits, the argument goes, are realized gradually over the year, and should be
translated at an average rate. This, of course, contradicts the translation of the
balance sheet at a single exchange rate.
13.4.4 Accounting Exposure:CFO’s Summary
As we have seen, there are various methods to translate a subsidiary’s balance
sheet into the parent’s currency. Many regulating bodies favor the Closing Rate
Method. For example, theusFinancial Accounting Standards Board has essentially
imposed this method (FASB#52, 1982) for most operations, and allows the old
Temporal Method only for foreign operations closely integrated with the domestic
headquarters. Similar rules were issued soon thereafter in theukand Canada. The
International Accounting Standards Committee has likewise come out in favor of
the Closing Rate Method (IASC#21, 1983—a text that, unlikeFASB#52, is well-
written, lucid, and short), again except for closely related operations, where the
Temporal Method is imposed.
However, theIASCcan provide recommendations only; it has no statutory power
to impose accounting rules anywhere. In continental Europe there is no consensus
as to what method is to be followed. For example, in many countries (including,
until the early nineties, Italy and Belgium), consolidation was not mandatory and,
therefore, not regulated, while in other countries (including Germany), the obliga-
tion to consolidate was not extended to foreign subsidiaries. TheEC7th Directive,
passed in 1983 and implemented in most member states by the early nineties, im-
poses consolidation but does not prescribe any particular translation method. The
only requirement is that the notes to the accounts should disclose the method that
was used. Only underifrs, theiasrules do apply; but in theeu ifrsis mandatory
only for listed companies and financials. Other companies can use traditional local
gaap, which typically leaves considerable discretion.
with true(er) recent valuations, the result remains hard to interpret. But at least the translation
procedure no longer adds to that problem.