Foreign exchange gains and losses can result from both transaction and translation exposure. Transaction gains and losses result from either unhedged or partially hedged foreign-currency exposure.37 This exposure is created by items such as accounts receivable and accounts payable resulting from sales and purchases denominated in foreign currencies. As foreign-currency exchange rates change, the value of the foreign-currency assets and liabilities will expand and contract. This results, in turn, in foreign currency transaction gains and losses. This is the essence of the concept of currency exposure.
Translation gains and losses result from either unhedged or partially hedged exposure associated with foreign subsidiaries. Translation exposure depends on the mix of assets and liabilities of the foreign subsidiary. In addition, the character of the operations of the foreign subsidiary and features of the foreign economy are also factors in determining both exposure and the translation method applied. There are two possible statement translation methods, and of the two only one results in translation gains or losses that appear as part of net income. With the other method, the translation adjustment will be reported as part of other comprehensive income.38
Foreign-currency gains and losses can also result from the use of various currency contracts, such as forwards, futures, options, and swaps, entered into for both hedging and speculation. It is not uncommon to observe foreign exchange gains and losses year after year in a company's income statement. The amounts of these items, however, as well as whether they are gains or losses are often very irregular, making them candidates for nonrecurring classification.
To illustrate, a portion of a note titled "foreign currency translation" from the 1993 annual report of Dibrell Brothers Inc. follows:
Net gains and losses arising from transaction adjustments are accumulated on a net basis by entity and are included in the Statement of Consolidated Income, Other Income—Sundry for gains, Other Deductions—Sundry for losses. For 1993, the transaction adjustments netted to a gain of $4,180,000. The transaction adjustments were losses of $565,000 and $206,000 for 1992 and 1991, respectively, and were primarily related to the Company's Brazilian operations.39
The gains and losses disclosed above appeared as adjustments, reflecting either their noncash or nonoperating character, in the operating activities of Dibrell's statement of cash flows. The effect of the 1993 currency exchange gain is also referenced in Dibrell's MD&A as part of the comparison of earnings in 1993 to those in 1992.40
While appearing in each of the past three years, Dibrell's foreign-currency gains and losses were far from stable—two years of small losses followed by a year with a large gain. One way to gauge the significance of these exchange items is to compute their contribution to the growth in income before income taxes, extraordinary items, and cumulative effect of accounting changes. This computation is outlined for 1993 in Exhibit 2.24.
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