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Use Excel to understand how multinational companies manage currency translation risks.
When corporate earnings growth was in the double digits in 2006, favorable foreign currency translation was only a small part of the earnings story But now, in a season of lower earnings coupled with volatility in currency exchange rates, currency translation gains represent a far greater portion of the total.
Using the concept that a picture is worth a thousand words-and a worksheet even more-this article uses Excel and real-world examples to explain why multinational companies are increasingly experiencing and managing what is often referred to as accounting risk caused by foreign currency exchange rate (FX) fluctuations. The article is designed to help the reader create the worksheet shown in Exhibit 3, and then use it to see firsthand how FX fluctuations affect both the balance sheet and income statement, and how currency translation adjustments (CTAs) may be hedged.
Accounting for translation risks can be very complex. This article addresses only the basics and provides some tools to help the reader understand the issues and find additional resources.
THE BALANCE SHEET PLUG
Today "managing the balance sheet" goes far beyond watching the current asset-to-liability ratio. FX rate fluctuations may have a significant effect on assets, liabilities and equity beyond the effects that flow through the income statement. Globalization has changed the old accounting rule that debits equal credits (no plugging is permitted). Years ago, net income became just one part of comprehensive income (CI), and the equity part of the accounting equation became: Equity = Stock + Other Comprehensive Income + Retained Earnings. Other comprehensive income (OCI) contains items that do not flow through the income statement. The currency translation adjustment in other comprehensive income is taken into income when a disposition occurs.
The financial statements of many companies now contain this balance sheet plug. As shown in Exhibit 1, eBay's currency translation adjustments (CTA) accounted for 34% of its comprehensive income booked to equity for 2006. General Electric's CTA was a negative $4.3 billion in 2005 and a positive $3.6 billion in 2006. The CTA detail may appear as a separate line item in the equity section of the balance sheet, in the statement of shareholders' equity or in the statement of...