Motivation:  Until now, we have assumed that any currency exposure was short-term and associated with some aspect of foreign trade.  This Transaction Exposure is the value of existing contracts to buy or sell goods or services.  This exposure is usually associated with extension of trade credit and usually listed under accounts receivable or accounts payable.  More realistically, a MNC will have other assets and liabilities in another country.

Exposed Assets and Liabilities: all asset/liabilities that will have valuation changes if currency rates change.  Before we even decide whether to hedge exposure, we need to understand what the level of exposure is.

Example of exposed assets and liabilities: You have a retail chain (McDonald's of Mexico) in Mexico.  The chain's assets include real estate, inventory, cash (pesos), plus you owe your Mexican suppliers for 60 days worth of goods they have shipped, and a Mexican bank is holding a (peso) mortgage on some of the buildings.   You fear the Peso is about fall sharply.

What is at risk?  Certainly the pesos you are holding.  Probably the inventory as much of it is from Mexican sources and one could easily buy more after a devaluation.  What about the buildings?  Their real value may or may not be impacted by the Peso drop.  On the bright side: your liabilities (the payables and the bank debt) fall in dollar terms.  Maybe you won't lose much from the Peso fall if your liabilities are large enough to offset your exposure.

An easier example: You manage the Mex$ 1billion Mexico Fund.  All of your assets are exposed to a depreciation as they are fully invested in  Mexican stock and thus the peso.  Your exposure is the total NAV of the fund.

Translation or Accounting Exposure: equals the difference between exposed assets and liabilities.   The trick is to decide what is exposed and what is not.   Sometimes called balance sheet risk.

Operating or Economic Exposure: Changes in the economic value of an enterprise as a result of an exchange rate change.  This exposure is usually correlated to accounting exposure, but sometimes there is an inverse relationship.  These gains or losses are often measured by estimating the impact on future cash flow.

Note that Transaction Exposure is usually considered an example of both accounting and economic exposure, and one  usually observes that a loss recorded by an accounting measure equals the loss recorded by an economic measure.

Consider the McDonald's above, with the following balance sheet: Assume the peso is worth 10 cents and all monetary assets and liablilities are in pesos.
                                        In Pesos (Mex$ Billions)
                              Assets                                    Claims
Cash Equiv                10                 payables           20
Inventory                   30                 S.t. Debt            50
Plant/Equipment.      160                L.t. Debt            80                 Thus net worth is 50 billion or $ 5 billion (U.S.)

Income Statement  In Pesos (Mex$ Billions)
Revenues   200
Expenses  (100)
net income 100 or   $10 billion (U.S.)

1) Suppose the Peso crashes to eight cents in one day.  Does your Mexican investment lose 20 percent as well?
In the short term, probably yes:  We assume your revenues, expenses, and net income will stay the same in peso terms, but when translated to dollars, will fall to $8 billion.  If we assume this effect is permanent, then translating the new net worth, and getting  $4 billion, indicates an investment loss of $1 billion.  Here, the economic loss (cash flow) and accounting loss (net worth) are the same (20 percent).

2) Suppose the Peso falls to eight cents over one year, reflecting Mexican inflation of 25%.  PPP would predict the new spot to be eight cents.  (assume no U.S. inflation).   Here the real exchange rate is unchanged.
Do we use the same accounting procedure as in scenario (1)?  Is there a dramatic loss to the American parent MNC?
Over this time span, probably not.   We assume your revenues, expenses, and net income will rise in peso terms, by the rate of inflation, to give a net income of 125 billion pesos.  Converting the pesos to USD gives $10 billion, unchanged from a year ago.  The net worth, if maintained at historical cost (it usually is) stays the same in pesos, but is devalued in dollar terms.   So in this example, we have no real (economic) losses, but our accountants say the value of our Mexican assets is down by 20%.

3) Suppose the Peso crashes to eight cents in one day as in (1), but the subsidiary is not a McDonald's but "El Dorado Silver Mining Company".   Does your Mexican investment lose 20 percent as in (1)?
Assume most of the costs (labor, transportation, interest payments are unchanged pesos and thus fall in dollar terms.  The difference this time is that revenues should hold steady in dollar terms since silver is sold on the world market.  Thus, USD revenues hold at $20 billion, costs fall to $8 billion, net income rises from $10 to $12 billion!
Here, you have an economic gain, but still an accounting loss.

4) Finally, back to the McDonalds, suppose the Peso holds at ten cents over one year, in spite of Mexican inflation of 25%.  PPP would predict the new spot to be eight cents.  (assume no U.S. inflation), since the peso is still tens cents,  the real exchange rate of the peso has risen.
The income in peso terms should rise by 25%, but with a steady exchange rate, the return translated to the USD also rises 25%.  The accountants see no change in book value after translating the balance sheet so you have an economic gain and no accounting change.

The point of the above, besides serving as an exercise suitable for an exam, is to demonstrate the difficulty of coming up with accurate accounting methods that will work reasonably well for different companies and different exchange rate shifts.  This difficulty, in essence, ultimately caused the accountants to throws up their hands and cry, "forget it, just bury the change in the balance sheet": hence FASB 52.

Four Approaches to Measuring Accounting Exposure: You may remember the story about four blind men coming upon a tame elephant for the first time: one feels the trunk and says "it is like a snake", another touches a leg and says, "it is like a tree", ... well you get the idea:  All of the attempts to get at the "essence" of the elephant were incomplete.  The four theoretical methods below are a bit like the blind men.

The four methods vary in that they judge what is and what is not exposed differently.   Only two of these methods are consistently used by MNCs.

1) Most Common: Current Method where all Assets and Liabilities are considered exposed and thus revalued annually to the current exchange rates.   This is a very easy method: the only effect a currency change has is on the assets that are not offset by liabilities such as debt, thus only net assets or equity is affected.

Example:  A French subsidiary of Exxon has FF 100 million in assets and FF 60 million in liabilities: the net translation exposure is also the net worth or FF 40 million.   Suppose the FF falls from 16 cents to 14 cents,  then the translation loss is $.02/FF  times FF 40 million or $800,000.

A) Any gain (loss) in net worth (Assets-Liab) often shows up as a gain (loss) on the Income Statement. This is the case with British Firms.   Unfortunately, then, volatile currencies probably make the earnings stream look "noisier" than is probably warranted.
B)   U.S. firms use FASB-52, where the loss is not reported on the income statement.  FASB-52 is essentially the Current Method, but where changes in net worth are entered as a Balance Sheet item (not affecting net income), sometimes called a "Cumulative Translation Adjustment".   Reported earnings appear much less risky.

Other Methods:

2) Some U.S. Firms formerly used the Current / Noncurrent Method: Firm revalues Current Assets and Liabilities. These items presumably "turn over" at least once a year. Long-term items are not adjusted (remain at the Historical Exchange Rate).        (too many historical exchange rates to keep up with (e.g. problems dealing with depreciation)

3) Monetary / Nonmonetary: Monetary items are readjusted (Cash, Accts. Receivables, Debts). Real Assets are presumed to keep previous value (inventory, fixed assets). A good method if rate change follows PPP (rate changes are nominal only, not real), but not if there is a real rate changes.     Question: In a Devaluation, Why should a building hold its value?

4) Temporal Method: (basis of old FASB 8). Similar to Monetary /Nonmonetary, based on historical cost. Major difference is that INVENTORY may be revalued to current exchange rate.  Under FASB-8, companies revalued their monetary-based items, plus inventories annually and then were required to list net gains or losses in valuation in the Income Statement. Made the income stream appear overly volatile. Firms hated it.

 FASB 52  link to summary of FASB52 replaced FASB-8, and
1) Kept exchange rate risk on Balance sheet,
2) Used the simplest accounting method (Current),
3) Only modified the income statement if the rate change impacted current cash flows (a indication of an economic impact).

Ex. Your firm is owed one million Euros.  After a ten percent depreciation, this asset is worth a lot less than before. The income effect of this drop would show up as lower revenue if the trade credit is paid off in the accounting period.  However, there is no income effect if the trade credit is not yet due.   If the Euro drop is reversed soon thereafter, there would never be any impact on the impact statement.  Thus, an advantage to the FASB-52 approach is that if the rate change is simply "noise" or temporary, the balance sheet item simply reverses at some future time and the income statement appears more stable than under, say any of the other reporting approaches .

Reporting Currency: This is the currency that the MNC headquarters uses to consolidate its global operations.  Usually the currency of the nation where the headquarters is located.   Schlumberger is an exception (probably a lot of others) as they use the dollar although the firm is French.

Functional Currency: Each subsidiary (in a different country) will have to annually convert its accounting statement from its currency into the reporting currency.  If subsidiary does most of its business in the Local Currency, then they simply use the current method under FASB 52.   An example was the McDonalds in Mexico, where most activities are in Pesos.

1) In contrast, if most business is done in another currency: keep the books in dollars and use FASB-8. Translation gains (losses) show up on the income statement.  ex. Assembly plant across the border in Mexico "maquiladoras". Here, the factory takes in imported parts, assembles them, and ships the finished good to the U.S.  It is a Mexican firm mostly in location and labor force but it functions little differently than if the firm was sited across the border.   Any cash (or debts) in Pesos is subject to currency risk, but not much else.
2) Also, if host country currency is experiencing very high inflation, (where the local currency is basically an unreliable measure of value) use the dollar as functional currency even if you are running a local operation like a McDonalds (the workers probably wish they were getting paid in dollars).  Again, use FASB 8.