Chapter 8:�Translation of Foreign�Currency Financial�Statements

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• Conceptual issues of foreign currency financial statements translation
• Difference between balance sheet exposure and transaction exposure
• Methods of financial statement translation
• Temporal and current rate methods illustrated
• U.S. GAAP, IFRS, and other standards related to translation
• Hedging of balance sheet exposure

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�Chapter Topics �

Learning Objectives

1. Describe the conceptual issues involved in translating foreign currency financial statements
2. Explain balance sheet exposure and how it differs from transaction exposure
3. Describe the concepts underlying the current rate and temporal methods of translation
4. Apply the current rate and temporal methods of translation and compare the results of the two methods
5. Describe the requirements of applicable International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (GAAP)
6. Discuss hedging of balance sheet exposure

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Two conceptual issues

• Appropriate exchange rate to be used in translating each financial statement item
• How should the translation adjustment that inherently arises from the translation process be reflected in the consolidated financial statements

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Balance Sheet Exposure

• Assets and liabilities translated at the current exchange rate are exposed to risk of a translation adjustment
• When foreign currency appreciates, a net asset exposure results in a positive translation adjustment
• When foreign currency appreciates, a net liability exposure results in a negative translation adjustment
• Assets and liabilities translated at the historical exchange rate are not exposed to a translation adjustment

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Translation Methods

• Current/Noncurrent Method
• Current assets and liabilities are translated at the current exchange rate
• Noncurrent assets and liabilities and stockholders’ equity accounts are translated at historical exchange rates
• There is no theoretical basis for this method
• Method is seldom used in any countries and is not allowed by U.S. GAAP or IFRS

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Translation Methods

• Monetary/Nonmonetary Method
• Concerns with monetary assets and liabilities
• Translated at the current exchange rate
• Concerns with nonmonetary assets and liabilities and stockholders’ equity accounts
• Translated at historical exchange rates
• The translation adjustment measures the net foreign exchange gain or loss on current assets and liabilities as if these items were carried on the parent’s books

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Translation Methods

• Temporal Method
• Objective is to translate financial statements
• As if the subsidiary had been using the parent’s currency
• Items carried on subsidiary’s books at historical cost
• Including all stockholders’equity items, are translated at historical exchange rates
• Items carried on subsidiary’s books at current value are translated at current exchange rates
• Income statement items are translated at the exchange rate in effect at the time of the transaction

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Translation Methods

• Current Rate Method
• Objective is to reflect that the parent’s entire investment in a foreign subsidiary is exposed to exchange risk
• All assets and liabilities are translated at the current exchange rate
• Equity accounts are translated at historical exchange rates
• Revenues and expenses are translated at the exchange rate in effect at the date of accounting recognition

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Translation of Retained Earnings

• Stockholders’ equity items are translated at historical exchange rates under both the temporal and current rate methods
• This creates somewhat of a problem in translating retained earnings, which is a composite of many previous transactions:
• Revenues, expenses, gains, losses, and declared dividends occurring over the life of the company

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Complicating Aspects of the Temporal Method

• Keeping track of the historical rates for inventory, prepaid expenses, fixed assets, and intangible assets is necessary under temporal method and not under current rate method
• Translating these assets at historical rates makes application of the temporal method more complicated than the current rate method
• Calculation of Cost of Goods Sold (COGS)
• Application of the Lower of Cost or Market Rule
• Fixed Assets, Depreciation, Accumulated Depreciation

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DISPOSITION OF TRANSLATION ADJUSTMENT

• Translation gain or loss in net income
• Translation adjustment is considered to be a gain or loss analogous to the gains and losses arise from foreign currency transaction
• Should be reported in income in the period in which the fluctuation in exchange rate occurs
• Cumulative translation adjustment in stockholders’ equity
• The alternative to reporting the translation adjustment as a gain or loss in net income is to include it in stockholders’ equity as a component of other comprehensive income
• This treatment defers the gain or loss in stockholders’ equity until it is realized in some way

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Temporal and Current Rate Methods

Translation methods illustrated

• U.S. Inc. owns Juarez, SA, a subsidiary in Mexico which was established January 1, 2010
• Juarez’s balance sheet items as of 12/31/10, in pesos:

Cash 1,000 Accounts payable 2,000

Accounts rec. 2,000 Long-term debt 6,000

Inventory 2,500 Capital stock 3,000

Fixed assets 8,000 Retained earnings 1,500

Accum. depr. 1,000

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Temporal and Current Rate Methods

• Translation methods illustrated
• Juarez’s income statement items for 2010, in pesos:

Sales 20,000 Depr. exp. 1,000

COGS 14,000 Interest exp. 500

S,G,&A exp. 2,500 Income tax exp. 500

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Temporal and Current Rate Methods

• Translation methods illustrated
• There was no beginning inventory
• Inventory, which is carried at cost, was acquired evenly during the last quarter of 2010
• Purchases were made evenly throughout year
• Fixed assets were acquired on January 1, 2010
• Capital stock was sold on January 1, 2010

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Temporal and Current Rate Methods

• Translation methods illustrated
• Relevant exchange rates (U.S. dollar per Mexican peso):

January 1, 2010 $0.10

Average for 2010 $0.095

Average for 4th quarter 2010 $0.09

December 31, 2010 $0.08

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Temporal and Current Rate Methods

• Current Rate Method – Income Statement

Income Statement – 2010

Sales 1,900

COGS 1,330

Gross profit 570

S,G,&A 238

Depreciation expense 95

Interest expense 48

Income tax expense 47

Net income 142

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Temporal and Current Rate Methods

• Current Rate Method – Balance Sheet

Balance Sheet – December 31, 2010

Cash 80 Accounts payable 160

Accounts Rec. 160 Long-term debt 480

Inventory 200 Capital stock 300

Fixed Assets, net 545 Retained earnings 142

Total assets 985 Cumulative translation adj. (97)

Total liab. & S.E. 985

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Temporal and Current Rate Methods

• Temporal Method – Income Statement

Income Statement – 2010

Sales 1,900

COGS 1,343

Gross profit 557

S,G,&A 238

Depreciation expense 100

Interest expense 48

Income tax expense 47

Remeasurement gain 101

Net income 225

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Temporal and Current Rate Methods

• Temporal Method – Balance Sheet

Balance Sheet – December 31, 2010

Cash 80 Accounts payable 160

Accounts Rec. 160 Long-term debt 480

Inventory 225 Capital stock 300

Fixed Assets, net 700 Retained earnings 225

Total assets 1,165 Total liab. & S.E. 1,165

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Temporal and Current Rate Methods

• Translation methods illustrated – Summary
• Current Rate Method
• All assets and liabilities are translated at current rate
• This results in net asset exposure
• Net asset exposure and devaluing foreign currency results in translation loss
• Translation adjustment included in equity
• Temporal Method
• Primarily monetary assets and liabilities are translated at current rate
• This results in net liability exposure
• Net liability exposure and devaluing foreign currency result in translation gain
• Translation gain included in current income

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U.S. GAAP

• FASB ASC 830, Foreign Currency Matters( formerly SFAS 52, Foreign Currency Translation) is the relevant accounting standard
• Requires identification of functional currency
• Functional currency is the primary currency of the foreign subsidiary’s operating environment
• The standard includes a list of indicators as guidance for the foreign currency decision
• When functional currency is U.S. Dollar, temporal method is required
• When functional currency is foreign currency, current rate method is required

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U.S. GAAP Requirements

• Highly Inflationary Economies – U.S. GAAP
• U.S. GAAP defines such economies as those with cumulative 100% inflation over a period of three years (with compounding—average of 26% per year for three years in a row)
• Temporal method required—translation gains/losses reported in income

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IFRS

• IAS 21, The Effects of Changes in Foreign Exchange Rates is the relevant accounting standard
• Uses the functional currency approach developed by the FASB
• The standard includes a list, similar to the FASB list, of indicators as guidance for the foreign currency decision
• The standard’s requirements pertaining to hyperinflationary economies are substantially different from U.S. GAAP

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IFRS Requirements

• Hyperinflationary Economies – IFRS
• IAS 21 and 29 use the term hyperinflationary economies
• IAS 21 is not as specific in defining hyperinflationary economies as is U.S. GAAP, but does suggest that a cumulative three-year rate approaching or exceeding 100% is evidence
• IAS 21 requires restatement of the foreign financial statements for inflation per IAS 29
• IAS 21 then requires the use of the current exchange rate to translate the restated financial statements, including all balance sheet accounts as well as all income statement accounts
• IAS approach is substantially different from U.S. GAAP

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Hedging Balance Sheet Exposure

• Companies that have foreign subsidiaries with highly integrated operations use the temporal method
• Temporal method requires translation gains and losses to be recognized in income
• Losses negatively affect earnings, and both gains and losses increase earnings volatility
• These gains and losses result from the combination of balance sheet exposure and exchange rate fluctuations
• Foreign exchange gains and losses on foreign currency borrowings or foreign currency derivatives employed to hedge translation based exposure (under the current rate method)

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Hedging Balance Sheet Exposure

• Companies can hedge against gains and losses by using foreign currency forward contracts, options, and borrowings

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End of Chapter 8

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