Translation of Foreign Currency Financial Statements

Translation of Foreign Currency Financial Statements

TRANSLATION OF FOREIGN CURRENCY FINANCIAL STATEMENTS

Conceptual issues of foreign currency financial statements translation.

Balance sheet vs. transaction exposure. Methods of financial statement

translation. Temporal and current rate methods

illustrated. U.S. GAAP, IFRSs, and other standards

related to translation. Hedging balance sheet exposure.

TRANSLATING FOREIGN CURRENCY FINANCIAL STATEMENTS -- CONCEPTUAL ISSUES

Foreign country operations of a MNC usually prepare financial statements using local currency as the monetary unit.

These operations also typically use local GAAP.

When these operations are consolidated by the MNC, the foreign operation’s financial statements must be translated into the currency and GAAP of the MNC.

TRANSLATING FOREIGN CURRENCY FINANCIAL STATEMENTS -- CONCEPTUAL ISSUES

Primary conceptual issues Each financial statement item must be

translated using some, hopefully relevant, exchange rate.

What rate should be used? the current exchange rate? The average exchange rate? the historical exchange rate?

Given that any adjustment is, at the point of translation, unrealized, how should the resulting adjustment be recognized? in current income? in an equity account on the balance sheet?

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.

A SIMPLE EXAMPLE

Let’s say XYZ has a 1000 euro current note receivable on its books. The euro/$ direct rate is $ 1 on 1/1. On 12/31, it is $.9091.

Should we record:No change? An decrease in value of $90.90?

And if we do report a change, where should the offsetting gain be reported?

ANOTHER SIMPLE EXAMPLE:

Let’s say XYZ has land on its books that is held by a subsidiary located in the EU. The land was purchased on 1/1 for 1,000,000 euros when the euro/$ direct rate was $ 1. On 12/31, it is $ .9091.

Should we record:No change? An decrease in value of $90,900?

And if we do report a change, where should the offsetting gain be reported?

THE QUESTION:

How do we account for these effects?

The matter is complex because the economic impact will vary depending on what type of asset is held and what is driving FX movements.

There is also an interaction with accounting imperfections and constraints.

THE CURRENT RATE METHOD:

The receivable would be translated using the current rate.

The land would be translated at the current rate.

TRANSLATION METHODS

Current Rate Method Presumes 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.

Stockholders’ equity accounts are translated at historical exchange rates.

Income statement items are translated at the exchange rate in effect at the time of the transaction.

CURRENT RATE METHOD

AdvantagesSimple to doRatios are not distorted

BUT WHAT IF: Inflation differences caused the decline in the

value of the euro? If the inflation differential was 10%, then:

Before, 1,000,000E=1,000,000$ Now, 1,100,000E=1,000,000$; Thus the direct exchange rate would be .9091

(1,000,000/1,100,000). Thus the current value of the land, in euros, is

now 1,100,000E. The valuation should be 1100000*.9091 = 1,000,000$, i.e., no change.

THE CURRENT RATE METHOD

DisadvantagesCan produce disparate results that

are not consistent with the economics that are really going on.

What does the FC adjustment mean? Possibility of disappearing assets in

inflationary economies.

THE PROBLEM:

The receivable is a monetary asset. The land is a non-monetary asset.

TRANSLATION METHODS

Monetary/Nonmonetary Method Monetary assets and liabilities are translated

at the current exchange rate. Nonmonetary assets and liabilities and

stockholders’ equity accounts are 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.

IN OUR EXAMPLE:

The receivable would be translated using the current rate.

The land would be translated at the historical rate.

MONETARY/NON-MONETARY

AdvantagesEasy to understand. Makes intuitive

sense.Usually not difficult to classify assets

and liabilities.

BUT WHAT IF:

A monetary asset/liability is booked at historical cost (e.g. long term bonds)

A nonmonetary asset/liability is booked at current cost (e.g., revalued property, plant and equipment)

MONETARY/NON-MONETARY METHOD

DisadvantagesValuation basis in accounting doesn’t

always line up right with classification, producing potentially meaningless values.

Thus some assets can disappear in the presence of inflation while others are over or under-reported.

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.

IN OUR EXAMPLE:

The receivable would be classified as current and translated using the current rate.

The land would be classified as noncurrent and translated at the historical rate.

CURENT/NONCURRENT

Advantages? Simplistic. Requires no more characterization of

assets/liabilities than is already provided by the financial statements

Seems to solve the monetary/non-monetary problem while remaining more consistent with underlying accounting basis being used.

CURRENT/NON-CURRENT METHOD Disadvantages

Can still misspecify monetary assets/liabilities. Example: inventories, noncurrent marketable equity securities.

Does not explicitly address the accounting problem. For example, some current assets use historical cost basis. Some noncurrent assets are booked at current value.

Thus some assets can still disappear in the presence of severe inflation. Others can be severely over or undervalued.

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.

IN OUR EXAMPLE:

The receivable translated using the current rate.

If reported at historical cost, the land would be translated at the historical rate.

If reported at fair value, the land would be translated at the current rate.

TEMPORAL METHOD

Advantages Lines up with valuation basis used in accounting.

Thus the numbers have most consistent internal meaning.

They will still be misspecified, however, but only to the extent the underlying accounting numbers already are.

TEMPORAL METHOD

Disadvantages Lots of volatility in financial statements. Mixing of valuations: does the sum make any

sense?

For our purposes, because they are both called for in current accounting standards on FX translation, we will focus on: Current rate method Temporal Method

Parent

Subsidiary

TRANSLATION METHODSCURRENT RATE METHODCURRENT RATE METHOD

Use current exchange rates to translate all assets and liabilities.

Use historical (or average) exchange rates to translate equity accounts.

Use historical (or average) exchange rates to translate income statement accounts.

Assumes “net investment” in a foreign operation is exposed to foreign exchange risk

Use current exchange rates to translate all assets and liabilities.

Use historical (or average) exchange rates to translate equity accounts.

Use historical (or average) exchange rates to translate income statement accounts.

Assumes “net investment” in a foreign operation is exposed to foreign exchange risk

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Parent

Subsidiary

TRANSLATION METHODSTEMPORAL METHODTEMPORAL METHOD

Use historical exchange rates to translate assets and liabilities carried at historical cost.

Use current exchange rates to translate assets and liabilities carried at current cost or future value.

Use historical (or average) exchange rates to translate equity, revenue, and expense accounts.

Objective is to produce a set of U.S. dollar translated financial statements as if the foreign subsidiary had actually used U.S. dollars

Use historical exchange rates to translate assets and liabilities carried at historical cost.

Use current exchange rates to translate assets and liabilities carried at current cost or future value.

Use historical (or average) exchange rates to translate equity, revenue, and expense accounts.

Objective is to produce a set of U.S. dollar translated financial statements as if the foreign subsidiary had actually used U.S. dollars

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TRANSLATION OF RETAINED EARNINGS

Since R/E is a composite of many previous transactions, translating R/E requires special attention.

Since R/E is a composite of many previous transactions, translating R/E requires special attention.

At the end of the first year of operations:

Ending R/E from year 1, becomes Beginning R/E in Year 2.

At the end of the first year of operations:

Ending R/E from year 1, becomes Beginning R/E in Year 2.

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CALCULATION OF COST OF GOODS SOLD

Current Rate Method - translate using the weighted average rate for the current

period.

Current Rate Method - translate using the weighted average rate for the current

period.

Temporal Method - decompose COGS into its component parts and translate each

part using the appropriate rate

Apply Lower-of-Cost-or-Market using the foreign exchanges rates.

Temporal Method - decompose COGS into its component parts and translate each

part using the appropriate rate

Apply Lower-of-Cost-or-Market using the foreign exchanges rates.

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FIXED ASSETS AND ACCUMULATED DEPRECIATION

Current Rate Method - translate fixed fixed assetsassets and accumulated accumulated

depreciationdepreciation using the spot rate as of the balance sheet date.

Current Rate Method - translate fixed fixed assetsassets and accumulated accumulated

depreciationdepreciation using the spot rate as of the balance sheet date.

Temporal Method - fixed assets acquired at different

times will be translated using their respective historical

translation rates. Accumulated depreciation uses the same

historical rates as the related asset.

Temporal Method - fixed assets acquired at different

times will be translated using their respective historical

translation rates. Accumulated depreciation uses the same

historical rates as the related asset.

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DEPRECIATION EXPENSE

Current Rate Method - translate depreciation expense using the weighted-average rate for the

current period

Current Rate Method - translate depreciation expense using the weighted-average rate for the

current period

Temporal Method - translate depreciation expense using the various historical rates related to the underlying

assets.

Temporal Method - translate depreciation expense using the various historical rates related to the underlying

assets.

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GAIN OR LOSS ON THE SALE OF AN ASSET

Current Rate Method - translate the gain or loss using the historical rate in effect

on the date of sale

Current Rate Method - translate the gain or loss using the historical rate in effect

on the date of sale

Temporal Method - the gain must be computed indirectly, using different rates.

Temporal Method - the gain must be computed indirectly, using different rates.

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DISPOSITION OF TRANSLATION ADJUSTMENT

Current Method Translation

Adjustment is reported on the Balance Sheet.

Temporal Method Adjustment is

reported on the Income Statement as a Translation Gain or (Loss)

Current Method Translation

Adjustment is reported on the Balance Sheet.

Temporal Method Adjustment is

reported on the Income Statement as a Translation Gain or (Loss)

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TRANSLATIONU.S. ACCOUNTING RULES

SFAS No. 8 (1975) - Accounting for Translation of Foreign Currency Transactions and Foreign Currency Financial Statements.

SFAS No. 52 (1981) - Foreign Currency Translation.

SFAS No. 130 (1998)

SFAS No. 8 (1975) - Accounting for Translation of Foreign Currency Transactions and Foreign Currency Financial Statements.

SFAS No. 52 (1981) - Foreign Currency Translation.

SFAS No. 130 (1998)

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Applies the “local currency perspective”.

Uses current rate method.

Translation adjustment appears in the equity section.

Applies the “local currency perspective”.

Uses current rate method.

Translation adjustment appears in the equity section.

SFAS NO. 52 Recognized two

types of subs: Subs that do

most of their transactions in U.S. $

Subs that operate relatively independently of their U.S. parents.

Temporal method still applies.Temporal method still applies.

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FUNCTIONAL CURRENCY

To determine whether a subsidiary is integrated with the parent or operates independently, SFAS 52 introduced the concept

of functional currencyfunctional currency.

To determine whether a subsidiary is integrated with the parent or operates independently, SFAS 52 introduced the concept

of functional currencyfunctional currency.

A company’s A company’s functional currencyfunctional currency is the is the primary currency of the foreign entity’s primary currency of the foreign entity’s

operating environment. operating environment.

A company’s A company’s functional currencyfunctional currency is the is the primary currency of the foreign entity’s primary currency of the foreign entity’s

operating environment. operating environment.

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DETERMINING A SUBSIDIARY’S FUNCTIONAL CURRENCY

Cash Flows Primarily in FC and do not affect parent’s cash flows

Sales Price Not affected on short-term basis by changes in exchange rate

Sales Market Active local sales market

Indications that theIndications that theFunctional Currency is theFunctional Currency is theForeign CurrencyForeign Currency

IndicatorIndicator

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Expenses Primarily local costs

Financing Primarily denominated in FC and FC cash flows adequate to service obligations

inter-company transactions Low volume of inter-company transactions, not extensive interrelationships with parent’s operations

Indications that theIndications that theFunctional Currency is theFunctional Currency is theForeign CurrencyForeign Currency

IndicatorIndicator

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Cash Flows Directly impact parent’s cash flows on a current basis

Sales Price Affected on a short-term basis by changes in exchange rate

Sales Market Sales market mostly in parent’s country or sales denominated in parent’s currency

Indications that theIndications that theFunctional Currency is theFunctional Currency is theParent’s CurrencyParent’s Currency

IndicatorIndicator

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Expenses Primarily costs for components obtained from parent’s country

Financing Primarily from parent or denominated in parent’s currency or FC cash flows not adequate to service obligations

inter-company transactions High volume of inter-company transactions and extensive interrelationships with parent’s operations

Indications that theIndications that theFunctional Currency is theFunctional Currency is theParent’s CurrencyParent’s CurrencyIndicatorIndicator

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HIGHLY INFLATIONARY ECONOMIES

In highly inflationary economies, SFAS 52 In highly inflationary economies, SFAS 52 mandates the use of the mandates the use of the Temporal MethodTemporal Method

for translation.for translation.

In highly inflationary economies, SFAS 52 In highly inflationary economies, SFAS 52 mandates the use of the mandates the use of the Temporal MethodTemporal Method

for translation.for translation.

Disappearing Plant ProblemDisappearing Plant ProblemIf the Current Method were used, the US $ If the Current Method were used, the US $

equivalent would be VERY small due to equivalent would be VERY small due to the rapidly increasing exchange rate.the rapidly increasing exchange rate.

Disappearing Plant ProblemDisappearing Plant ProblemIf the Current Method were used, the US $ If the Current Method were used, the US $

equivalent would be VERY small due to equivalent would be VERY small due to the rapidly increasing exchange rate.the rapidly increasing exchange rate.

Why?Why?

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DEFINING “HIGHLY INFLATIONARY ECONOMY” Remember, SFAS 52 mandates use of the

temporal method, with re-measurement gains or losses reported in income!!!

A “highly inflationary economy” is one having a cumulative three-year inflation exceeding 100%

(With compounding, this is about 26% inflation per year for three straight years)

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CURRENT RATE METHOD EXAMPLE Duzy Co., is a wholly owned

foreign sub of Maly Corporation. Duzy Co.’s transactions and financial statements are denominated in the local (functional) currency, the Pater (PT).

Using the following information, translate their statements into US $.

Duzy Co., is a wholly owned foreign sub of Maly Corporation. Duzy Co.’s transactions and financial statements are denominated in the local (functional) currency, the Pater (PT).

Using the following information, translate their statements into US $.

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CURRENT RATE METHOD EXAMPLE Duzy Co.’s common stock was

issued in 1992 when the exchange rate was $1.00 = 1.20 PT.

Fixed assets were acquired in 1993 when the exchange rate was $1.00 = 1.10 PT.

As of Jan. 1, 2008, the R/E balance was translated at $350,000.

Inventory was acquired evenly throughout the year.

Duzy Co.’s common stock was issued in 1992 when the exchange rate was $1.00 = 1.20 PT.

Fixed assets were acquired in 1993 when the exchange rate was $1.00 = 1.10 PT.

As of Jan. 1, 2008, the R/E balance was translated at $350,000.

Inventory was acquired evenly throughout the year.

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CURRENT RATE METHOD EXAMPLE

The Dec. 31, 2008 translation adjustment had a debit balance of $69,841.

Dividends were declared on March 15, 2008, and equipment was sold on October 1, 2008.

The following direct exchange rates were in effect during the year:

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Note: The following example uses a division process and indirect rates. This may seem to differ from what is described in your text. But there is no real difference.

For example, if translation of $ 1,000 PT is made using the Oct1st direct rate of $ 1.25, the same translation can be made using the indirect rate, which is the inverse, i.e., 1 $ = .80PT.

To use the direct rate, one multiplies the # of PT by 1.25; 1.25 x 1000 = $ 1,250.

To use the indirect rate, one divides the # of PT by the indirect rate, .80; 1000/.80 = $ 1,250.


The following indirect exchange rates were in effect during the year:

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Determine the appropriate

exchange rates to use for each

account.



account.

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Weighted average rates are generally

used for Sales, COGS,

and other recurring expenses.

Weighted average rates are generally

used for Sales, COGS,

and other recurring expenses.

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The actual historical rate is used when we

can identify it efficiently.

The actual historical rate is used when we

can identify it efficiently.

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account.



account.


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The beginning R/E is carried over from

the prior year.

The beginning R/E is carried over from

the prior year.

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The net income is taken from the

income statement.

The net income is taken from the

income statement.

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Dividends are translated at the historical

rate on the date of declaration.

Dividends are translated at the historical

rate on the date of declaration.

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All assets and liabilities are translated at the current

rate on the balance sheet

date.

All assets and liabilities are translated at the current

rate on the balance sheet

date.

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Common Stock is translated at the historical

rate at the time the stock was

issued.

Common Stock is translated at the historical

rate at the time the stock was

issued.

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The Ending R/E comes from the statement of

retained earnings.

The Ending R/E comes from the statement of

retained earnings.

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The translation adjustment is:

The difference between Net Assets at current rates and

Net Assets at historical rates added to the

translation adjustment balance at the beginning of

the year:

$41,511 + $69,841 = $111,352

The translation adjustment is:

The difference between Net Assets at current rates and

Net Assets at historical rates added to the

translation adjustment balance at the beginning of

the year:

$41,511 + $69,841 = $111,352

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RE-MEASUREMENT OF FINANCIAL STATEMENTS

If the sub’s functional currency is the U.S. $, then any balances denominated in the local currency, must be re-measured.

re-measurement requires the application of the temporal method.

The re-measurement gain or loss appears on the income statement.

If the sub’s functional currency is the U.S. $, then any balances denominated in the local currency, must be re-measured.

re-measurement requires the application of the temporal method.

The re-measurement gain or loss appears on the income statement.

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NONLOCAL CURRENCY BALANCES

If any accounts of the foreign subsidiary are denominated in a currency other than the local currency (or the US$), they would first have to be restated into the local currency

Both the foreign currency balance and any related foreign exchange gain or loss would then be translated (or re-measured) into US$

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HEDGING BALANCE SHEET EXPOSURE Translation adjustments and re-measurement

gains or losses arise from:(1)Exchange rate changes and(2)Balance sheet exposure

Balance sheet exposure can be hedged, either through derivatives such as forward contracts or foreign currency options or through the use of such non-derivative instruments as foreign currency borrowings

Ironically, in seeking to avoid unrealized translation adjustments, realized foreign exchange gains and losses can occur!

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SUMMARY Because many US firms have significant

financial investments in foreign countries, the translation of foreign currency financial statements is an important accounting challenge

The two primary methods used are the temporal and current rate methods

SFAS 52 established translation through the use of the current rate method when the foreign operation’s functional currency is a foreign currency

re-measurement through the temporal method is appropriate when the operation’s functional currency is the US$, or in the case of a highly inflationary economy

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POSSIBLE CRITICISMS Some critics contend that the functional

currency decision can be quite subjective. Others argue that having two fundamentally

different approaches to translation creates confusion.

Reporting unrealized gains and losses as an element of the balance sheet is controversial.

WHAT DO YOU THINK????

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Thus we see a myriad of measurement

problems arise when the value of money changes and is uncertain.

The economic impact of FX changes vary as a function of the cause of the change and the type of exposure (asset/liability; monetary/non-monetary).

Accounting limitations (e.g., historical cost) mix with this uncertainty.

The current standard is SFAS 52. This could easily change at any time, as it has several times before.

Documents

Translation of Foreign Currency Financial Statements