Translation of Foreign Currency Financial Statements Chapter Eight Translation of Foreign Currency Financial Statements McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Recent International Acquisitions 8-2 Recent International Acquisitions France's Schneider Electric SA buys American Power Conversion Corp. for $6.1 Billion in Cash!! Cemex SA Buys Rinker Group Ltd. for $12.8 Billion! Wal-Mart Spends $1 Billion to Acquire Chinese merchandise Chain

Translation of Financial Statements 8-3 Translation of Financial Statements Our subsidiaries in other countries are required by local regulations to use the local currency where they are located. Their statements must be translated to US $. If we control our subsidiaries, why don’t they all use the U.S. $ as their currency?

Translation of Financial Statements 8-4 Translation of Financial Statements In addition, many countries have different accounting rules that we must consider before translating the sub’s financial statements.

Exchange Rates Used in Translation 8-5 Exchange Rates Used in Translation To translate a foreign subsidiary’s financial statements into U.S. $, we must use both: Historical Exchange Rates and Current Exchange Rates.

8-6 Exchange Rates Historical Exchange Rates – those which existed at the time a transaction occurred Current Exchange Rate – the exchange rate which exists at the balance sheet date

Translation Adjustments 8-7 Translation Adjustments The use of different exchange rates during translation means the resulting financial statements will not balance! To force the statements to balance, an account called “Translation Adjustment” is debited or credited.

Translation Adjustments 8-8 Translation Adjustments Exposure to translation adjustments is called “balance sheet,” “translation,” or “accounting” exposure. Assets translated at the current exchange rate when the foreign currency is appreciating (increasing in value relative to the US$) generate positive translation adjustments (a credit entry) Liabilities translated at the current exchange rate when the foreign currency is appreciating generate negative translation adjustments (a debit entry)

Balance Sheet Exposure 8-9 Balance Sheet Exposure Balance sheet items translated at current exchange rates change in $ value from one balance sheet to the next and are exposed to translation adjustments. Balance sheet items translated at historical exchange rates do not change in $ value from one balance sheet to the next and are NOT subject to balance sheet exposure.

Balance Sheet Exposure 8-10 Balance Sheet Exposure Net Asset Balance Sheet Exposure When assets translated at current rates > liabilities translated at current rates. Net Liability Balance Sheet Exposure When liabilities translated at current rates > assets translated at current rates.

Translation Methods Current Rate Method 8-11 Translation Methods Current 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 Parent Subsidiary

Translation Methods Temporal Method 8-12 Translation Methods Temporal 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 Parent Subsidiary

Translation of Retained Earnings 8-13 Translation of Retained Earnings 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.

Calculation of Cost of Goods Sold 8-14 Calculation of Cost of Goods Sold 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.

Fixed Assets and Accumulated Depreciation 8-15 Fixed Assets and Accumulated Depreciation Current Rate Method - translate fixed assets and accumulated depreciation 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.

8-16 Depreciation Expense 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.

Gain or Loss on the Sale of an Asset 8-17 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 Temporal Method - the gain must be computed indirectly, using different rates.

Disposition of Translation Adjustment 8-18 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)

Translation U.S. Accounting Rules 8-19 Translation U.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. 52 Recognized two types of subs: 8-20 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. Applies the “local currency perspective”. Uses current rate method. Translation adjustment appears in the equity section.

8-21 Functional Currency To determine whether a subsidiary is integrated with the parent or operates independently, SFAS 52 introduced the concept of functional currency. A company’s functional currency is the primary currency of the foreign entity’s operating environment.

Determining a Subsidiary’s Functional Currency 8-22 Determining a Subsidiary’s Functional Currency Indications that the Functional Currency is the Foreign Currency Indicator 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

Determining a Subsidiary’s Functional Currency 8-23 Determining a Subsidiary’s Functional Currency Indications that the Functional Currency is the Foreign Currency Indicator 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

Determining a Subsidiary’s Functional Currency 8-24 Determining a Subsidiary’s Functional Currency Indications that the Functional Currency is the Parent’s Currency Indicator 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

Determining a Subsidiary’s Functional Currency 8-25 Determining a Subsidiary’s Functional Currency Indications that the Functional Currency is the Parent’s Currency Indicator 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

Highly Inflationary Economies 8-26 Highly Inflationary Economies In highly inflationary economies, SFAS 52 mandates the use of the Temporal Method for translation. Why? Disappearing Plant Problem If the Current Method were used, the US $ equivalent would be VERY small due to the rapidly increasing exchange rate.

Defining “Highly Inflationary Economy” 8-27 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)

Current Rate Method Example 8-28 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 $.

Current Rate Method Example 8-29 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.

Current Rate Method Example 8-30 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 exchange rates were in effect during the year:

Current Rate Method Example 8-31 Current Rate Method Example Determine the appropriate exchange rates to use for each account.

Current Rate Method Example 8-32 Current Rate Method Example Weighted average rates are generally used for Sales, COGS, and other recurring expenses.

Current Rate Method Example 8-33 Current Rate Method Example The actual historical rate is used when we can identify it efficiently.

Current Rate Method Example 8-34 Current Rate Method Example

Current Rate Method Example 8-35 Current Rate Method Example Determine the appropriate exchange rates to use for each account.

Current Rate Method Example 8-36 Current Rate Method Example The beginning R/E is carried over from the prior year.

Current Rate Method Example 8-37 Current Rate Method Example The net income is taken from the income statement.

Current Rate Method Example 8-38 Current Rate Method Example Dividends are translated at the historical rate on the date of declaration.

Current Rate Method Example 8-39 Current Rate Method Example

Current Rate Method Example 8-40 Current Rate Method Example

Current Rate Method Example 8-41 Current Rate Method Example All assets and liabilities are translated at the current rate on the balance sheet date.

Current Rate Method Example 8-42 Current Rate Method Example Common Stock is translated at the historical rate at the time the stock was issued.

Current Rate Method Example 8-43 Current Rate Method Example The Ending R/E comes from the statement of retained earnings.

Current Rate Method Example 8-44 Current Rate Method Example 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

Current Rate Method Example 8-45 Current Rate Method Example

re-measurement of Financial Statements 8-46 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.

Nonlocal Currency Balances 8-47 Nonlocal Currency Balances If any accounts of the foreign subsidiary are denominated in a currency other than the local currency (or the US$), they would first have to be restated into the local currency Both the foreign currency balance and any related foreign exchange gain or loss would then be translated (or re-measured) into US$

Hedging Balance Sheet Exposure 8-48 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!

Disclosures Related to Translation 8-49 Disclosures Related to Translation An analysis of the change in the cumulative translation adjustment. May appear as other comprehensive income in the Statement of Shareholders’ Equity or as a separate disclosure in the Notes Many companies also include a description of the translation procedures in Note 1.

8-50 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

8-51 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????