Post on 10-Apr-2018
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Chapter 14
Management ofTranslation Exposure
Management 3460Institutions and Practices in
International Finance
Fall 2003Greg Flanagan
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Chapter Objectives
define translation exposure.explain why we care about translation
explain the impact that unanticipated
changes in exchange rates may haveon the consolidated financialstatements of the multinational
company.
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Chapter Objectives
discuss and differentiate varioustranslation methods:
lcurrent/noncurrent
lmonetary/nonmonetaryltemporal
lcurrent rate
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Chapter Objectives (continued)
summarize the FASB statement 52discuss the management of
translation exposure.
evaluate the empirical analysis of thechange from FAS8 to FAS52.discuss the importance of translation
exposure in comparison with
economic and transaction exposure
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Definition
Translation Exposure the potentialthat the firms consolidated financialstatements can be affected bychanges in exchange rates.
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Why do we Care aboutTranslation?
managers, analysts and investors need someidea about the importance of the foreignbusiness a translated accounting data give anapproximate idea of this.
performance measurement for bonus plans,hiring, firing, and promotion decisions.
accounting value serves as a benchmark toevaluate valuation.
for income tax purposes. legal requirement to consolidate financial
statements.
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Current/Noncurrent Method
The underlying principal is that assets andliabilities should be translated based ontheir maturity.lcurrent assets translated at the spot rate.
lnoncurrent assets translated at thehistorical rate in effect when the item wasfirst recorded on the books.
generally accepted in the US from the 1930s
-1975, at which time FAS8 becameeffective.Short-term gains/losses will be recognized
long term will not be.
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Current/Noncurrent Method
Current assets/liabilitiestranslated atthe spot rate.
i.e. 2=$1 Noncurrent
assets/liabilitiestranslated at
the historicalrate in effectwhen the itemwas firstrecorded on the
books. i.e.3=$1
Balance Sheet Local Currency
Current/Noncurrent
Cash 2,100 $1,050
Inventory 1,500 $750
Net fixed assets 3,000 $1,000
Total Assets 6,600 $2,800Current liabilities 1,200 $600
Long-Term debt 1,800 $600
Common stock 2,700 $900
Retained earnings 900 $700
CTA -------- --------
Total Liabilities an
Equity
6,600 $2,800
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Monetary/NonmonetaryMethod
The underlying principle is that monetary accountshave a similarity because their value represents asum of money whose value changes as theexchange rate changes.
All monetary balance sheet accounts (cash,marketable securities, accounts receivable, etc.)of a foreign subsidiary are translated at the currentexchange rate.
All other (nonmonetary) balance sheet accounts(owners equity, land) are translated at the
historical exchange rate in effect when theaccount was first recorded. i.e. PPP
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Monetary/NonmonetaryMethod
All monetarybalance sheetaccounts aretranslated at thecurrent exchange
rate. i.e. 2=$1 All other balance
sheet accountsare translated atthe historical
exchange rate ineffect when theaccount was firstrecorded. i.e.
3=$1
Balance Sheet Local
Currency
Monetary/
Nonmonetary
Cash 2,100 $1,050
Inventory 1,500 $500
Net fixed assets 3,000 $1,000
Total Assets 6,600 $2,550Current liabilities 1,200 $600
Long-Term debt 1,800 $900
Common stock 2,700 $900
Retained earnings 900 $0
CTA -------- --------
Total Liabilities andEquity
6,600 $2,400
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Temporal Method
The underlying principal is that assets andliabilities should be translated based onhow they are carried on the firms books.
Balance sheet account are translated at the
current spot exchange rate if they arecarried on the books at their current value.
Items that are carried on the books at
historical costs are translated at thehistorical exchange rates in effect at thetime the firm placed the item on the books.
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Temporal Method Items carried on
the books at theircurrent value aretranslated at thespot exchangerate. i.e. 2=$1
Items that arecarried on thebooks athistorical costsare translated atthe historical
exchange rates.i.e. 3=$1
Balance Sheet Local Currency
Temporal
Cash 2,100 $1,050
Inventory 1,500 $900
Net fixed assets 3,000 $1,000
Total Assets 6,600 $2,950
Current liabilities 1,200 $600Long-Term debt 1,800 $900
Common stock 2,700 $900
Retained earnings 900 $0
CTA -------- --------
Total Liabilities and
Equity
6,600 $2,400
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Current Rate Method
All balance sheet items (except forstockholders equity) are translated at thecurrent exchange rate.
Very simple method in application.
A plug equity account named cumulativetranslation adjustment is used to makethe balance sheet balance.
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Current Rate Method
All balance sheetitems (except forstockholdersequity) aretranslated at the
current exchangerate. i.e.2=$1 A plug equity
account namedcumulative
translationadjustment isused to make thebalance sheetbalance
Balance Sheet Local
Currency
Current
Rate
Cash 2,100.00 $1,050
Inventory 1,500.00 $750
Net fixed assets 3,000.00 $1,500
Total Assets 6,600.00 $3,300Current liabilities 1,200.00 $600
Long-Term debt 1,800.00 $900
Common stock 2,700.00 $900
Retained earnings 900.00 $360
CTA -------- $540
Total Liabilities
and Equity
6,600.00 $3,300
H V i T l i M h d
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How Various Translation MethodsDeal with a Changefrom 3 to 2 = $1
Balance Sheet Local
Currency
Current/
Noncurrent
Monetary/
Nonmonetary
Temporal Current
Rate
Cash 2,100 $1,050 $1,050 $1,050 $1,050
Inventory 1,500 $750 $500 $900 $750
Net fixed assets 3,000 $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities 1,200 $600 $600 $600 $600
Long-Term debt 1,800 $600 $900 $900 $900
Common stock 2,700 $900 $900 $900 $900
Retained earnings 900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540Total Liabilities
and Equity
6,600 $2,800 $2,550 $2,950 $3,300
Spot exchange rate
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Balance Sheet Local
Currency
Current/
Noncurrent
Monetary/
Nonmonetary
Temporal Current
Rate
Cash 2,100 $1,050 $1,050 $1,050 $1,050
Inventory 1,500 $750 $500 $900 $750
Net fixed assets 3,000 $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities 1,200 $600 $600 $600 $600
Long-Term debt 1,800 $600 $900 $900 $900
Common stock 2,700 $900 $900 $900 $900
Retained earnings 900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540
Total Liabilities
and Equity
6,600 $2,800 $2,550 $2,950 $3,300
How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1
Book value of inventoryat spot exchange rate
Bookvalue of
inventoryhistoric
rate
Current value of inventoryat spot exchange rate.
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Balance Sheet Local
Currency
Current/
Noncurrent
Monetary/
Nonmonetary
Temporal Current
Rate
Cash 2,100 $1,050 $1,050 $1,050 $1,050
Inventory 1,500 $750 $500 $900 $750
Net fixed assets 3,000 $1,000 $1,000 $1,000 $1,500Total Assets 6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities 1,200 $600 $600 $600 $600
Long-Term debt 1,800 $600 $900 $900 $900
Common stock 2,700 $900 $900 $900 $900
Retained earnings 900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540Total Liabilities
and Equity
6,600 $2,800 $2,550 $2,950 $3,300
How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1
historic rate spot exchange rate
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Balance Sheet Local
Currency
Current/
Noncurrent
Monetary/
Nonmonetary
Temporal Current
Rate
Cash 2,100 $1,050 $1,050 $1,050 $1,050
Inventory 1,500 $750 $500 $900 $750
Net fixed assets 3,000 $1,000 $1,000 $1,000 $1,500Total Assets 6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities 1,200 $600 $600 $600 $600
Long-Term debt 1,800 $600 $900 $900 $900
Common stock 2,700 $900 $900 $900 $900
Retained earnings 900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540Total Liabilities
and Equity
6,600 $2,800 $2,550 $2,950 $3,300
How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1
spot rate
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Balance Sheet Local
Currency
Current/
Noncurrent
Monetary/
Nonmonetary
Temporal Current
Rate
Cash 2,100 $1,050 $1,050 $1,050 $1,050
Inventory 1,500 $750 $500 $900 $750
Net fixed assets 3,000 $1,000 $1,000 $1,000 $1,500Total Assets 6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities 1,200 $600 $600 $600 $600
Long-Term debt 1,800 $600 $900 $900 $900
Common stock 2,700 $900 $900 $900 $900
Retained earnings 900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540Total Liabilities
and Equity
6,600 $2,800 $2,550 $2,950 $3,300
How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1
spot ratehistorical rate
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Balance Sheet Local
Currency
Current/
Noncurrent
Monetary/
Nonmonetary
Temporal Current
Rate
Cash 2,100 $1,050 $1,050 $1,050 $1,050
Inventory 1,500 $750 $500 $900 $750
Net fixed assets 3,000 $1,000 $1,000 $1,000 $1,500Total Assets 6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities 1,200 $600 $600 $600 $600
Long-Term debt 1,800 $600 $900 $900 $900
Common stock 2,700 $900 $900 $900 $900
Retained earnings 900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540Total Liabilities
and Equity
6,600 $2,800 $2,550 $2,950 $3,300
How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1
historical rate
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Balance Sheet Local
Currency
Current/
Noncurrent
Monetary/
Nonmonetary
Temporal Current
Rate
Cash 2,100 $1,050 $1,050 $1,050 $1,050
Inventory 1,500 $750 $500 $900 $750
Net fixed assets 3,000 $1,000 $1,000 $1,000 $1,500Total Assets 6,600 $2,800 $2,550 $2,950 $3,300
Current liabilities 1,200 $600 $600 $600 $600
Long-Term debt 1,800 $600 $900 $900 $900
Common stock 2,700 $900 $900 $900 $900
Retained earnings 900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540Total Liabilities
and Equity
6,600 $2,800 $2,550 $2,950 $3,300
How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1
From income statement
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Balance Sheet Local
Currency
Current/
Noncurrent
Monetary/
Nonmonetary
Temporal Current
Rate
Cash 2,100 $1,050 $1,050 $1,050 $1,050
Inventory 1,500 $750 $500 $900 $750
Net fixed assets 3,000 $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 $2,800 $2,550 $2,950 $3,300Current liabilities 1,200 $600 $600 $600 $600
Long-Term debt 1,800 $600 $900 $900 $900
Common stock 2,700 $900 $900 $900 $900
Retained earnings 900 $700 $150 $550 $360
CTA -------- -------- -------- -------- $540
Total Liabilities
and Equity
6,600 $2,800 $2,550 $2,950 $3,300
How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1
Under the current rate method, a plug equity account namedcumulative translation adjustment makes the balance sheet balance.
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How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1
Sales translate at average exchange rate over the period, 2.50 = $1
Income StatementLocal
CurrencyCurrent/
NoncurrentMonetary/
NonmonetaryTemporal Current
Rate
Sales 10,000 $4,000 $4,000 $4,000 $4,000
COGS 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation 1,000 $333 $333 $333 $400
Net operating incom 1,500 $667 $1,167 $667 $600
Income tax (40%) 600 $267 $467 $267 $240Profit after tax 900 $400 $700 $400 $360
$300 -$550 $150
Net income 900 $700 $150 $550 $360
Dividends 0 $0 $0 $0 $0
Addition to Retained
Earnings 900 $700 $150 $550 $360
Foreign exchange gain (loss)
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Income Statement
Local
Currency
Current/
Noncurrent
Monetary/
Nonmonetary
Temporal Current
Rate
Sales 10,000 $4,000 $4,000 $4,000 $4,000
COGS 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation 1,000 $333 $333 $333 $400
Net operating incom 1,500 $667 $1,167 $667 $600
Income tax (40%) 600 $267 $467 $267 $240
Profit after tax 900 $400 $700 $400 $360
$300 -$550 $150
Net income 900 $700 $150 $550 $360
Dividends 0 $0 $0 $0 $0
Addition to Retained
Earnings 900 $700 $150 $550 $360
Foreign exchange gain (loss)
How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1
Translate at 2.50 = $1 Translate at new exchange rate, 2.00 = $1
How Various Translation
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Income Statement
Local
Currency
Current/
Noncurrent
Monetary/
Nonmonetary
Temporal Current
Rate
Sales 10,000 $4,000 $4,000 $4,000 $4,000
COGS 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation 1,000 $333 $333 $333 $400
Net operating incom 1,500 $667 $1,167 $667 $600
Income tax (40%) 600 $267 $467 $267 $240
Profit after tax 900 $400 $700 $400 $360
$300 -$550 $150
Net income 900 $700 $150 $550 $360
Dividends 0 $0 $0 $0 $0
Addition to Retained
Earnings 900 $700 $150 $550 $360
Foreign exchange gain (loss)
How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1
Translate at 3 = $1 Translate at average exchange rate, 2.5 = $1
How Various Translation
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Income Statement
Local
Currency
Current/
Noncurrent
Monetary/
Nonmonetary
Temporal Current
Rate
Sales 10,000 $4,000 $4,000 $4,000 $4,000
COGS 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation 1,000 $333 $333 $333 $400
Net operating incom 1,500 $667 $1,167 $667 $600Income tax (40%) 600 $267 $467 $267 $240
Profit after tax 900 $400 $700 $400 $360
$300 -$550 $150
Net income 900 $700 $150 $550 $360
Dividends 0 $0 $0 $0 $0
Addition to Retained
Earnings 900 $700 $150 $550 $360
Foreign exchange gain (loss)
How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1
14.1Note the effect on after-tax profit.
How Various Translation
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Income Statement
Local
Currency
Current/
Noncurrent
Monetary/
Nonmonetary
Temporal Current
Rate
Sales 10,000 $4,000 $4,000 $4,000 $4,000
COGS 7,500 $3,000 $2,500 $3,000 $3,000
Depreciation 1,000 $333 $333 $333 $400
Net operating incom 1,500 $667 $1,167 $667 $600
Income tax (40%) 600 $267 $467 $267 $240
Profit after tax 900 $400 $700 $400 $360
$300 -$550 $150
Net income 900 $700 $150 $550 $360
Dividends 0 $0 $0 $0 $0
Addition to Retained
Earnings 900 $700 $150 $550 $360
Foreign exchange gain (loss)
How Various TranslationMethods Deal with a Changefrom 3 to 2 = $1
14.1
Note the effect that foreign exchange gains (losses) has on net income.
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FAS8 superseded
Essentially the temporal method, with somesubtleties,
lsuch as translating inventory athistorical rates (a hassle).
Required taking foreign exchange gains andlosses through the income statement.
This lead to variability in reported earnings
(irritated corporate executives).
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The Mechanics of FAS52
Function CurrencylThe currency that the business is
conducted in.
Reporting CurrencylThe currency in which the MNC
prepares its consolidated
financial statements.
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The Mechanics of FAS52Two-Stage Process
First, determine in which currency the foreignentity keeps its books.lIf the local currency in which the foreign entity
keeps its books is not the functionalcurrency, remeasurement into the functionalcurrency is required.
Second, when the foreign entitys functional
currency is not the same as the parentscurrency, the foreign entitys books aretranslated using the current rate method.
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Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved.14-31
Current Rate
Translation
Parents Currency
Foreignentitys books
kept in?
Pare
nts
Currency
FunctionalCurrency?
Local currency TemporalRemeasurement
Parents currency
Nonparent
Currency
Third currency
The Mechanics of FAS52
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Highly InflationaryEconomies
Highly inflationary economiesover100% over three years
Foreign entities are required toremeasure financial statementsusing the temporal method as if thefunctional currency were the
reporting currency.
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Management of TranslationExposure
Translation Exposure vs. TransactionExposure
Hedging Translation Exposure
lBalance Sheet Hedge
lDerivatives Hedge
Translation Exposure vs. OperatingExposure
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Translation Exposure versusTransaction Exposure
Translation ExposurelThe effect that unanticipated changes in
exchange rates has on the firms consolidatedfinancial statements a accounting issue.
Transaction ExposurelA effect that unanticipated changes in
exchange rates has on the firms cash flowsa
finance issue.It is generally not possible to eliminate both
translation exposure and transaction exposure.
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Hedging TranslationExposure
If the managers of the firm wish tomanage their accounting numbers aswell as their business, they have two
methods for dealing with translationexposure.
lBalance Sheet Hedge
lDerivatives Hedge
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Balance Sheet Hedge
Eliminates the mismatch between netassets and net liabilitiesdenominated in the same currency.
May create transaction exposure,however.
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Derivatives Hedge
An example would be the use offorward contracts with a maturity ofthe reporting period to attempt to
manage the accounting numbers.However, using a derivatives hedge
to control translation exposure really
involves speculation about foreignexchange rate changes.
T l ti E
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Translation Exposure versusOperating Exposure
The effect that unanticipated changesin exchange rates has on the firmsongoing operations.
Operating (economic) exposure is asubstantive issue with which themanagement of the firm should
concern itself with.
E i i l A l i f th
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Empirical Analysis of theChange from FAS8 to FAS52
There did not appear to be a revaluation offirms values following the change.
This suggests that market participants do
not react to cosmetic earnings changes.Other researchers have found similar
results when investigating otheraccounting changes.
This highlights the futility of attempting tomanage translation gains and losses.
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Relevance of Translation(Accounting) Exposure
Should the exchange rate effect be shownas part of the reporting period, or shouldit just be mentioned on the balancesheet, as an unrealized gain or loss?
Most of the gains are not realized a keepgains/losses out of income statement.
Translation sounds great, but none of the
three methods produces the trueeconomic value.
f
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Relevance of Translation(Accounting) Exposure
Should we worry about translation exposureat all?
If so, should we worry what the best
translation method is?choice doesn't affect any real cashflow
except for taxes.
only correct method is economic valueanyway
a simplicity/consistency: Current rate method.
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ECONOMIC EXPOSURE: ACCOUNTING EXPOSURE:
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ECONOMIC EXPOSURE:
1. A forward looking concept: it focuses onfuture cashflows.2. Involves real cashflows, not just accounting
figures.
3. Relates to changes in the economic value(or, in an efficient market, the market value)of the firm.4. Contractual exposure depends on the firmsportfolio of FC engagements undertaken inthe past. Operating exposure depends on theenvironment (especially the market structureand the input-output mix) and on the firm'sstrategic response (e.g., relocation ofproduction, changes in the marketing mix orfinancial structure, etc.).
5. Also exists for firms without foreignsubsidiaries, such as exporting firms, import-competing firms, and notablypotentialimport-competing firms.
ACCOUNTING EXPOSURE:
1. A backward-looking concept: it reflects pastdecisions as reflected in the subsidiary's assets andliabilities.
2. A change in an accounting value due totranslation is not a "realized" gain or loss; nochange in the cash situation is involved exceptpossibly through taxation effects.3. Changes the firm's accounting value, but notnecessarily its market value.
4. Depends on the accounting rules chosen. This isbecause the subsidiary's own internal rules affectits accounting values (e.g., type of depreciation, orinventory valuation methods) and also because thetranslation process itself can be done in differentways (see below).
5. Accounting exposure only exists in the case offoreign direct investment, since pure exporting orimport-substituting firms have no foreignsubsidiaries.