Firms have income statements and balance sheets. The balance sheets reflect the valuation of the assets and liabilities of the firm. Changes in those valuations can represent capital gains or losses which may have to be reported in the income statements. An exogenous factor such as a change in interest rates may change the value of assests and liabilities and generate a capital gain or loss. But this capital gain or loss is not connected with any decision about the operation of the company. Once the capital gain or loss occurs there is nothing that can be done about it. The capital gain or loss may alter expectations of future gains or losses and some action might be possibly be warranted, but typically the exogenous changes are deviations from expected conditions and these deviations are in their nature unpredictable. So the capital gains and losses are something that occurs for the company but they are not something that it can or should do anything about.
These changes in the valuation of assets and liabilities are particularly a problem in international operations because fluctuations in exchange rates can generate paper gains and losses for the parent company. The valuation of assets and liabilities in foreign operations must be translated into the home country currency. The fluctuations in currency exchange rates could generate significant gains or losses and the entry of these into the income statement could produce a distorted impression of what is happening to the company.
It should be noted at this point that there is a natural hedge against translation risk exposure. It is essentially the same as the natural hedge against operating risk exposure; i.e., reduce the net exposure by balancing the positive and negative factors. In the case of translation risk exposure this means balancing the value of the assets and liabilities held in the foreign country. If there are no net assets in the foreign country there is no translation risk exposure. This can be achieved fairly easily if there are no restrictions on capital movements. The foreign assets can be mortgaged and the proceeds of the loan converted to the home country currency.
The practice concerning these translation or accounting gains or losses is to include them nominally in the income statement but in such a way that the operating characteristics are not disguised or distorted. The difficulty in understanding the procedures is that they are intended to provide for the inclusion of the translation gains or losses in a way that makes them insignificant for decision-making.
The two methods for carrying out the translation of foreign accounts are:
Under the Current-Rate Method the net gain is not included in the consolidated income statement of the parent company. Instead the net gain gain goes into a special reserve account on the consolidated balance sheet and labeled Cumulative Translation Adjustment, CTA.
Under the Temporal-Rate Method the net gain does go into the consoliated income statement but since no fluctuations in the value of fixed assets occur the effect on net income is moderated. Because the Temporal-Rate Method uses different exchange rates for different account items there is a problem in the consistency of the accounts.
The accounting rules of the U.S. specifies some circumstance under which each of the two methods must be used. For example in Hyperinflation countries, ones experience 100% inflation over a three-year period, the accounts of foreign affliates must be translated using the Temporal-Rate Method.
Most countries' accounting practice distinguishes between to two types of foreign affliates:
Integrated foreign affiliates should translate their accounts using the Temporal-Rate Method. Self-sustaining foreign affiliates should translate their accounts using the Current-Rate Method.
The rules are also affected by the nature of the functional currency of the affiliate. The functional currency of an entity is the dominant currency used in its daily operations.
The U.S. accounting practice rules are based upon functional currency rather than the distinction between integrated and self-sustaining foreign affiliates. The U.S. rules are:
The natural hedge against translation risk exposure, which is also known as the balance sheet hedge, can be affected by which of the two translation methods the company is required to use.
In summary, the methods for translating financial accounts of foreign affiliates are designed in such a way as to comply with the requirement that such translation occur but to do so that the translated balance sheet items do not distort the picture of the parent company's operations as given by its consolidated income statement.