Two comments are appropriate here.
1. Fluctuations in reported earnings in the preceding example are reduced significantly under FASB 52 when the local currency is the functional currency, as compared with the case when the U.S. dollar is the functional currency.
2. Key financial ratios and relationships—such as net income-to-revenue, gross profit, and debt-to-equity—are the same when translated into dollars under FASB 52, using the local currency as the functional currency, as they are in the local currency financial statements. These ratios and relationships are significantly different if the dollar is used as the functional currency. The ratios appear at the bottom of Exhibit 10A.2.
EXHIBIT 10A.2 Translation of Sterling Ltd.’s Income Statement under FASB-52 (Millions)
EXHIBIT 10A.3 Translation of Sterling Ltd.’s Balance Sheet under FASB-52 (Millions)
(Shapiro 354)
Shapiro. Multinational Financial Management, 9th Edition. John Wiley & Sons. <vbk:9780470894385#outline(10)>.
CHAPTER 11 Measuring and Managing Economic Exposure
Let’s face it. If you’ve got 75% of your assets in the U.S. and 50% of your sales outside it, and the dollar’s strong, you’ve got problems.
Donald V. Fites
Executive Vice President Caterpillar Inc.
LEARNING OBJECTIVES
• To define economic exposure and exchange risk and distinguish between the two
• To define operating exposure and distinguish between it and transaction exposure
• To identify the basic factors that determine the foreign exchange risk faced by a particular company or project
• To calculate economic exposure given a particular exchange rate change and specific cost and revenue scenarios
• To describe the marketing, production, and financial strategies that are appropriate for coping with the economic consequences of exchange rate changes
• To explain how companies can develop contingency plans to cope with exchange risk and the consequences of their ability to rapidly respond to currency changes
• To identify the role of the financial executive in facilitating the operation of an integrated exchange risk management program
KEY TERMS
competitive exposure
currency of denomination
currency of determination
differentiated products
economic exposure
exchange risk
flow-back effect
market selection
operating exposure
outsourcing
plant location
price elasticity of demand
pricing flexibility
pricing strategy
product cycles
product innovation
production shifting
product sourcing
product strategy
real exchange rate
transaction exposure
Chapter 10 focused on the accounting effects of currency changes. As we saw in that chapter, the adoption of FASB-52 has helped to moderate the wild swings in the translated earnings of overseas subsidiaries. Nevertheless, the problem of coping with volatile currencies remains essentially unchanged. Fluctuations in exchange rates will continue to have “real” effects on the cash profitability of foreign subsidiaries—complicating overseas selling, pricing, buying, and plant-location decisions.
This chapter develops an appropriate definition of foreign exchange risk. It discusses the economic, as distinguished from the accounting, consequences of currency changes on a firm’s value and shows how economic exposure can be measured. This chapter also discusses the marketing, production, and financial management strategies that are appropriate for coping with the economic consequences of exchange rate changes.