SFAS No. 52 APPUCATIONS IN INFLATIONARY AND NON-INFLATIONARY ENVIRONMENTS Ahmad Hosseini Sonoma State University Rohnert Park, California Alan Reinstein Wayne State Unversity Detroit, Michigan Introduction Overseas operations provide an increasing share of sales and profits for many American corporations. In its 1989 annual report, 3M reported that 45 percent of its sales were to foreign customers. Coca Cola reported that 80 percent of its total oper- ating income in 1990 attributable to the soft drink business was generated outside the United States. Many multinational companies (MNCs) now strive for 50 percent for- eign and 50 percent domestic sales. Companies such as Dow Chemical generate more than half of their profits from foreign sales, even though domestic sales exceed 50 percent of their total sales. MNC operations have been steadily growing. Exhibit I shows the trend in growth of sales by MNCs from 1977 to 1988 [24]. In 1988, sales of MNCs and their for- eign affiliates grew by 7.5 and 13.5 percent, respectively. Out of global sales of $4.022 trillion by MNCs, $1.194 trillion was reported by the foreign affiliates of the MNCs. Determining the best method of reporting transactions denominated in foreign currencies in financial statements continues to be a complex and important issue. Misstating reported foreign operations can impair the ability of MNCs to raise capital at home and abroad. Several studies have examined the implications of the current U.S. standard (e.g., [2], [14], [16]). Other studies have offered a decision-making frame- work for managing foreign currency transactions (e.g., [3], [8], [17), [19]). Since 1982, SFAS No. 52 has governed accounting for the foreign operations of U.S. based MNCs. Doupnik and Evans [5], surveying financial executives to deter- mine how MNC subsidiaries have applied the provisions of SFAS No. 52 in selecting their functional currency, showed that when the decision is complicated, management will be biased towards choosing the local currency as the functional currency. How- ever, they failed to examine several significant factors affecting how MNCs select functional currencies. Moreover, no published study has yet investigated the variety of related hedging techniques available under SFAS No. 52. After outlining briefly the history of U.S. currency translation and related hedg- ing standards, this study examines how U.S. MNCs with foreign operations apply key provisions of SFAS No. 52, such as selecting their functional currencies, in both in- flationary and non-inflationary environments. Then, based upon a study sent to 400 Fall 1992 Hosseini & Reinstein: SFAS No. 52 Applications Exhibit 1: Multinational Companies (MNCs) Trend of Sales by MNCs from 1977·1988 155 3000 2000 toOO o 1977 1982 1983 1984 1985 1986 1987 1988 hr • Parent Company • Affl1iate Companies randomly selected financial executives of 1,000 of the largest MNCs, conclusions are drawn on how these companies select their :functional currencies and perform various hedging techniques both in inflationary and non-inflationary environments. HIstory of Foreign Currency Translation Chapter 12 of Accounting Research Bulletin No. 43 [9] required current items to be translated at their current exchange rate and non-current items at their historical exchange rate. This process, known as the current/non-current method, was open to manipulation because it ignored the underlying attributes of the account to be trans- 156 Journal of Business Strategies Vol. 9 , No.2 Iated. For example, foreign long-term debt obligations were reported at historical exchange rates regardless of fluctuations in exchange rates. APB Opinion No.6 [10] allowed MNCs to use a monetary/non-monetary method to report the results of foreign operations. Monetary items such as accounts receiv- able were to be translated at their current exchange rate, non-monetary items at their historical exchange rate. However, this method ignored changes in the replacement values of non-monetary items (such as fixed assets or inventory), even when their underlying values declined dramatically. ARB No. 43 was succeeded by SFAS No.1 [11] which allowed MNCs to use either the monetary/non-monetary or the currentlnon-current method, providing certain disclosures were made. However, as the foreign operations of U.S. MNCs burgeoned, a new standard was introduced. In 1975, the Financial Accounting Standards Board (FASB) issued its Statement No.8 [12], which utilized the temporal translation method (described below). State- ment No. 8 produced distortions in the reports because it ignored exchange rate fluc- tuations, creating volatile reported earnings. In 1981, the FASB issued Statement No. 52 [13], which superseded Statement No. 8. The statement generally dampened the recognition of currency fluctuations and the need for hedging techniques, but broadened available methods of hedging. Statement No. 52, unlike all prior pronouncements relating to foreign currency transactions, also required management, within certain parameters, to select a functional currency to trans- late corporate international operations. TnmslatiOD Processes The temporal translation method of Statement No. 8 assumed that the overall objective of foreign currency translation was to measure and express corporate assets, liabilities, revenue and expenses of foreign operations in U.S. d01lars and required that such transactions be measured and disclosed in accordance with U.S. generally accepted accounting principles (GAAP). The theoretical underpinning of this method, known as the "Measurement Base" principle, is similar to that of the monetary/non-monetary approach of APB No. 6 [10]. All transactions were measured as if they occurred in U.S. d01lars, requiring the carrying of all fixed assets and inventory at past prices and historical rates. All gains or losses associated with translating foreign currency into U.S. d01lars were reported as a gain or loss on the parent company's income statement. Thus, a company could recognize a loss when a foreign currency weakened relative to the U.S. dollar. All currency fluctuations were recognized immediately on the income statement. 'Ibis practice often produced large, unpredictable, and uncontrollable variations in net income. Allenman [1] found that these provisions caused ITT's quarterly net income in 1981 to fluctuate from a drop of 119 percent to an improvement of 109 percent. The large swings in income resulted in widespread dissatisfaction in the financial community, often requiring expensive and time-consuming hedging techniques to mini- Fall 1992 Hosseini & Reinstein: SFAS No. 52 Applications 157 mize these fluctuations. A 1978 sulVey of 117 executives experienced with SFAS No. 8 found 60 who strongly wished to repeal it and 24 who wanted to modify it sub- stantially [25]. SFAS No. 52 Statement No. 52 shifted from a temporal method to a "functional currency" per- spective of recognizing foreign transactions and operating results in the currency used to generate and expend cash. Financial statements now provide information compat- ible with foreign currency rate changes, while still reflecting world-wide economic results consistent with GMP. The translation process begins with choosing the functional currency and restating the financial statements of the foreign subsidiary in accordance with GMP. At this stage, if the entity's functional currency is its local reporting currency, the entity's translated financial statement is consolidated or accounted for under the equity method of accounting. If the entity's records are not maintained in the functional currency, the entity's records are restated in terms of its functional currency using the temporal method of translation. That is, the currency denomination of the related accounts is restated---but not their actual valuation. Specifically, cash is measured as the amount owned at the balance sheet date; receivables and payables at amounts expected to be received or paid in the future; and all other assets and liabilities at the value that occurred after these items were acquired or incurred. The entity's remeasured financial statements are first translated into the reporting currency using the current rate method. The translated financial statements are then consolidated or accounted for under the equity method. Exhibit D charts the transla- tion procedure under SFAS No. 52. The flowchart assists in determining the transla- tion procedure to be adopted once the functional currency has been determined. First, the currency in which the financial statement is maintained is determined. If the currency is U.S. dollars, then no translation is required. If currency is foreign, the functional currency determines which of the following translation procedures need to be adopted. 1) Translation when local currency is the functional currency. Translation is car- ried out by the current rate method. 2) Translation when local currency is not the functional currency. a) u.s. Dollar is the functional currency. Financial statements are translated to dollars using the temporal method originally advocated by SFAS No.8. b) Foreign currency is the functional currency. When a foreign entity's records are not maintained in its functional currency, remeasurement of the statement into the functional currency is required. Next, as in step 1 above, the statement is translated using the current rate method. 158 Journal of Business Strategies Vol. 9 , No.2 Exhibit 2: Cbart of Translation Procedures for Financial Statements of Foreign Subsidiaries Financial Statement of a Foreign Subsidiary of an MNC I Is Statement Drawn Out in Foreign Currency? / " Yes No Determine the Functional Currency of the MNC No Translation Required I 1 Is Local Currency the Functional Currency? / I Yes Translate to Dollars No (* • Current Rate Method) Is Dollar the Functional Currency? No .."" ............ Yes Remeasure from Local to Functional Translate to Change Currency (·Temporal Method) then from Foreign Currency translate to Dollars ("Current Rate Method) to Functional Currency (·Temporal Method) Translation Rules-FASB 52 Account Type Monetary AssetlLiabilities Non-Monetary AssetslLiabs Shareholders Equity Revenues Expenses: Monetary Expenses: Non-Monetary ·Temporal Method Current Rate Historical Rate Historical Rate Average Rate of Period Average Rate of Period Historical Rate • ·Current Rate Method Current Rate Current Rate Historical Rate Average Rate for Period Average Rate for Period Average Rate for Period Functional currency designations of a company's foreign operations are a key fea- ture of SFAS No. 52 for two reasons. The functional currency determines: (1) the method used to translate foreign operations into U.S. dollars and (2) the extent to which changes in exchange rates affect consolidated operating results. Fall 1992 Hosseini & Reinstein: SFAS No. 52 Applications 159 Subsidiaries should report translation gains or losses on the income statement when selecting the U.S. dollar as functional currency and "suspend" them on the balance sheet when using a local functional currency. Each foreign entity's financial statements should be recorded in that entity's functional currency and then adjusted, if necessary, to conform with U.S. GAAP. The entity's financial statement must then be translated into the parent company's reporting currency (usually the U.S. dollar). Thus, each foreign subsidiary must identify its functional currency and generally it is the currency in which the entity operates and generates cash flows. If the entity operates in only one country, the functional currency is obvious. But if it operates in two or more countries, the determination of the functional currency may be difficult. The pronouncement describes three situations where the choice of the functional currency is easily determined. First, if a foreign subsidiary is a self-contained entity, with its operations integrated within a country, the functional currency should be that country's currency. Second, if a foreign subsidiary is little more than a sales branch of the U.S. parent corporation, then the functional currency should be the U.S. dollar. According to the pronouncement, if the subsidiary is domiciled in a country having a highly inflationary economy (defined as having more than 100 percent cumulative inflation in three years or less, e.g., in the mid-1980s, Brazil, Argentina or Mexico), then the U.S. dollar must serve as the functional currency. However, the Statement anticipated that the choice of the functional currency could be difficult because a foreign subsidiary's characteristics may not be delineated clearly, requiring considerable management judgment in selecting the appropriate functional currency. The FASB asked management to consider all relevant economic facts and circumstances in making this selection, including: 1. Primary sources of the entity's cash flow (e.g., inparent's or subsidiary's cur- rency). 2. Sales price sensitivity to short-term fluctuations in exchange rates (e.g., influ- enced by local operating factors or by exchange rate changes or other interna- tional factors). 3. Nature of the sales market for the entity's products (e.g., for subsidiary's or parent's market). 4. Sources of expenses (e.g., goods acquired locally or from parent). 5. Primary source of financing for the foreign operation (e.g., acquired locally or from parent; denominated in local or parent's currency). 6. The volume of intercompany transactions and arrangements (e.g., minor or major volume of transactions between parent and subsidiary). 160 Journal of Business Strategies Vol. 9 , No.2 Hedges and Other Means of Minimizing the Impact of Exchange Gains and Losses As MNCs agree to exchange, at future specified dates, currencies of different coun- tries, exposed asset and liability positions may arise. To minimize any adverse im- pact of currency fluctuations on these positions, MNCs often agree to exchange cur- rencies at predetermined rates on specific future dates. MNCs generally use these forward exchange contracts to hedge their investments or commitments. If the MNC uses the U.S. dollar as functional currency, exchange rates gains and losses generally accrue only from foreign-denominated transactions or balances, such as Italian lira re- ceivables included in French franc financial statements and the translation of monetary accounts such as cash, receivables, payables and debt. However, exchange gains and losses resulting from U.S. dollar-denominated transactions included in foreign finan- cial statements are exactly offset by the translation process and, therefore, do not af- fect income. To minimize the impact of these exchange gains and losses, a forward exchange contract could be used to sell Italian liras at a future date, thereby creating a Swiss franc liability to offset exactly the foreign receivable in the French financial statements. In addition, if a wholly owned French company holds net monetary as- sets of, say, 100,000 francs, a corporation might choose to liquidate franc assets or purchase franc liabilities of 100,000 francs. When the local currency is the functional currency, foreign denominated transac- tions including U.S. dollar trade accounts contained in overseas financial statements will produce exchange gains and losses in income. These foreign denominated trans- actions, particularly U.S. dollar accounts, are most likely to occur on intercompany activity between a multinational corporation's affiliated companies. To minimize this exchange impact, forward exchange contracts typically are purchased to permit the company to buy foreign currency forward at a fixed rate. The provisions of SFAS No. 52 permit any foreign currency transaction, including those denominated in currencies moving in tandem, to hedge a commitment, whereas SFAS No. 8 only permitted forward exchange contracts denominated in the same currency. Statement of Research Propositions The research questions in this study were motivated primarily by prior findings on how MNCs' subsidiaries applied the provisions of SFAS No. 52 in selecting their functional currency. The following are the research hypothesis: H1: MNCs select their functional currencies using similar bases in inflationary environments and similar basis in non-inflationary environments. H2: MNCs selecting functional currencies weight indicatOIS used in the selection similarly in countries with similar economic conditions (i.e., inflationary/non- inflationary environments). Fall 1992 Hosseini & Reinstein: SFAS No. 52 Applications 161 H3: Provisions of SFAS No. 52 have significantly altered the use of forward ex- change contracts, by broadening the spectrum of allowable hedging techniques. Sample Selection and Survey Instrument A questionnaire was developed based upon Statement No. 52 to examine how financial executives of MNCs select functional currencies and hedging techniques. The survey instrument was modified through in-depth interviews with five corporate trea- surers, comptrollers and others responsible for making these functional currency selec- tions, one banker and six academicians. Revised questionnaires were sent to 400 randomly selected financial executives of the 1,000 largest U.S. MNCs as determined by Fortune magazine and cross-listed with Dun and Bradstreet's Principal International Business. The World Mark.eting Directory. Follow-up questionnaires were sent out 30 days after the first mailing. A total of 109 valid responses were received, a 27 percent response rate. The responses were tested for a non-response bias by Oppenheim's (1968) early- late hypothesis. The results indicate no significant (p.