International accounting Frederick D. S. Choi Gary K. Meek Chapter 6: Foreign Currency Translation

Learning objective: Describe the nature of foreign currency transactions done in the spot, forward, and swap markets. Understand the foreign currency translation terms. Explain the difference between a translation gain or loss and a transaction gain or loss. Comprehend alternative foreign currency translation methods that exist and their rationale.

Learning objective: Evaluate which of the available foreign currency translation methods are best under which specific business and currency market conditions. Compare and contrast the financial statement effects of the temporal versus the current rate method of foreign currency translation. Understand the relationship between foreign currency translation and inflation. Appreciate how foreign currency translation is handled outside the United States.

Foreign Currency Transactions

Foreign Currency Transactions

Single-Transaction Perspective

Two-Transaction Perspective Under a two-transaction perspective, collection of the foreign currency receivable is considered a separate event from the sale that gave rise to it.

Example 1 On September 1, 2015, Cormorant Company purchased merchandise from Osaka Company of Japan for 20,000,000 yen payable on October 1, 2015. The spot rate for yen was $0.0079 on September 1 and the spot rate was $0.0077 on October 1.  Required:   Did the exchange rate strength or weaken from September to October and what are the implications for Cormorant’s business? What journal entry did Cormorant record on September 1, 2015? What journal entry did Cormorant record on October 1, 2015?

Example 2 On October 15, 2015, Ibis Corporation, a French company, ordered merchandise listed on the Internet for 20,000 Euros from Spoonbill Corporation, a US corporation, which immediately accepted the order. The Euro rate was $1.20 US on October 15. On November 15, 2015 Spoonbill shipped the goods and billed Ibis the purchase price of 20,000 Euros when the Euro rate was $1.30 US. Ibis paid the bill on December 10, 2015. Three days later Spoonbill exchanged the 20,000 Euros for US dollars when the Euro rate was $1.28US. Required: Compute the foreign currency gains or losses on the December 31, 2015 financial statements and show your calculations.

Example 3 On November 1, 2013, the Penguin Corporation, a US corporation, purchased an extruding machine from Shearwater Corporation, a UK company. The purchase price was $10,000 and Penguin agreed to pay in pounds on February 1, 2014. Both corporations are on a calendar year accounting period. Assume that the spot rates for the British pound on November 1, 2013, December 31, 2013, and February 1, 2014, are $1.60, $1.62, and $1.66, respectively. Required:  Record the November 1, December 31, and February 1 transactions in the General Journals of Penguin Corporation and Shearwater Corporation. If no entry is required on a particular date, indicate “No entry” in the General Journal.

FOREIGN CURRENCY TRANSLATION Companies operating internationally use a variety of methods to express, in terms of their domestic currency, the assets, liabilities, revenues, and expenses that are stated in a foreign currency.

Single Rate Method The single rate method, long popular in Europe, applies a single exchange rate, the current or closing rate, to all foreign currency assets and liabilities. Foreign currency revenues and expenses are generally translated at exchange rates prevailing when these items are recognized. For convenience, however, revenues and expenses are typically translated by an appropriately weighted average of current exchange rates for the period.

CURRENT–NONCURRENT METHOD Multiple Rate Methods CURRENT–NONCURRENT METHOD a foreign subsidiary’s current assets (assets that are usually converted to cash within a year) and current liabilities (obligations that mature within a year) are translated into their parent company’s reporting currency at the current rate. Noncurrent assets and liabilities are translated at historical rates.

CURRENT–NONCURRENT METHOD Multiple Rate Methods CURRENT–NONCURRENT METHOD Income statement items (except for depreciation and amortization charges) are translated at average rates applicable to each month of operation or on the basis of weighted averages covering the whole period being reported. Depreciation and amortization charges are translated at the historical rates in effect when the related assets were acquired.

CURRENT–NONCURRENT METHOD Multiple Rate Methods CURRENT–NONCURRENT METHOD Unfortunately, this method does not often square with reality. Using the year-end rate to translate current assets implies that all foreign currency cash, receivables, and inventories are equally exposed to exchange risk; that is, will be worth more or less in parent currency if the exchange rate changes during the year.

MONETARY–NONMONETARY METHOD Multiple Rate Methods MONETARY–NONMONETARY METHOD a balance sheet classification scheme to determine appropriate translation rates. Monetary assets and liabilities; that is, claims to and obligations to pay a fixed amount of currency in the future are translated at the current rate. Nonmonetary items—fixed assets, long-term investments, and inventories are translated at historical rates. Income statement items are translated under procedures similar to those described for the current–noncurrent framework.

Multiple Rate Methods MONETARY–NONMONETARY METHOD Note, however, that the monetary–nonmonetary method also relies on a classification scheme to determine appropriate translation rates. This may lead to inappropriate results. For example, this method translates all nonmonetary assets at historical rates, which is not reasonable for assets stated at current market values (such as investment securities and inventory and fixed assets written down to market).

MONETARY–NONMONETARY METHOD Multiple Rate Methods MONETARY–NONMONETARY METHOD Multiplying the current market value of a nonmonetary asset by a historical exchange rate yields an amount in the domestic currency that is neither the item’s current equivalent nor its historical cost. This method also distorts profit margins by matching sales at current prices and translation rates against cost of sales measured at historical costs and translation rates.

Multiple Rate Methods TEMPORAL METHOD In the temporal method, monetary items such as cash, receivables, and payables are translated at the current rate. Nonmonetary items are translated at rates that preserve their original measurement bases. Specifically, assets carried on the foreign currency statements at historical cost are translated at the historical rate.

Multiple Rate Methods TEMPORAL METHOD When nonmonetary items abroad are valued at historical cost, the translation procedures resulting from the temporal method are virtually identical to those produced by the monetary–nonmonetary method. The two translation methods differ only if other asset valuation bases are employed, such as replacement cost, market values, or discounted cash flows.

Multiple Rate Methods The current rate method presumes that the entire foreign operation is exposed to exchange rate risk since all assets and liabilities are translated at the year-end exchange rate. The current–noncurrent rate method presumes that only the current assets and liabilities are so exposed, while the monetary–nonmonetary method presumes that monetary assets and liabilities are exposed. In contrast, the temporal method is designed to preserve the underlying theoretical basis of accounting measurement used in preparing the financial statements being translated.

Which Is Best? The object of translation is to change the unit of measure for financial statements of foreign subsidiaries to the domestic currency, and to make the foreign statements conform to accounting principles generally accepted in the country of the parent company. We think these objectives are best achieved by translation methods that use historical rates of exchange.

Which Is Best? The temporal principle is appropriate, as it changes a measurement in foreign currency into a measurement in domestic currency without changing the basis of measurement. The temporal translation method is easily adapted to processes that make accounting adjustments during the translation.

Which Is Best? When this is so, adjustments for differences between two or more sets of accounting concepts and practices are made along with the translation of currency amounts. For example, inventories or certain liabilities may be restated according to accounting practices different from those originally used. The temporal principle can accommodate any asset valuation framework, be it historical cost, current replacement price, or net realizable values.

Which Is Best? The current rate method is also useful when the accounts of an independent company are translated for the convenience of foreign stockholders or other external user groups.

Which Is Best? It is also appropriate when price-level-adjusted account are translated to another currency. If reliable price-level adjustments are made in a given set of accounts and if domestic price-level changes for the currency are reflected closely in related foreign exchange rate movements, the current rate translation of price-level adjusted data yields results that are comparable to translating historical cost accounts under the historical rate translation method.

Appropriate Current Rate Thus far we have referred to rates of exchange used in translation methods as either historical or current. Average rates are often used in income statements for expediency. The choice of an appropriate exchange rate is not clear-cut because several exchange rates are in effect for any currency at any time. There are buying and selling (bid and ask) rates, spot rates and forward rates, official rates and free-market rates, and so on.

Appropriate Current Rate We believe that an appropriate translation rate should reflect economic and business reality as closely as possible. The free-market rate quoted for spot transactions in the country where the accounts to be translated originate is a rate that appropriately measures current transaction values.

Translation Gains and Losses Exclusion of translation adjustments in current income is generally advocated because these adjustments merely result from a restatement process. Changes in the domestic currency equivalents of a foreign subsidiary’s net assets are unrealized and have no effect on the local currency cash flows generated by the foreign entity. Therefore, it would be misleading to include such adjustments in current income. Under these circumstances, translation adjustments are accumulated separately as a part of consolidated equity.

Translation When Local Currency Is the Functional Currency If the functional currency is the foreign currency in which the foreign entity’s records are kept, its financial statements are translated to dollars using the current rate method. Resulting translation gains or losses are disclosed in a separate component of consolidated equity. This preserves the financial statement ratios as calculated from the local currency statements. The following current rate procedures are used:

Translation When Local Currency Is the Functional Currency 1. All foreign currency assets and liabilities are translated to dollars using the exchange rate prevailing as of the balance sheet date; capital accounts are translated at historical rates. 2. Revenues and expenses are translated using the exchange rate prevailing on the transaction date, although weighted average rates can be used for expediency. 3. Translation gains and losses are reported in a separate component of consolidated stockholders’ equity. These exchange adjustments do not go into the income statement until the foreign operation is sold or the investment is judged to have permanently lost value.

Translation When the Parent Currency Is the Functional Currency When the parent currency is a foreign entity’s functional currency, its foreign currency financial statements are remeasured to dollars using the temporal method. All translation gains and losses resulting from the translation process are included in determining current period income. Specifically:

Translation When the Parent Currency Is the Functional Currency 1. Monetary assets and liabilities and nonmonetary assets valued at current market prices are translated using the rate prevailing as of the financial statement date; other nonmonetary items and capital accounts are translated at historical rates. 2. Revenues and expenses are translated using average exchange rates for the period except those items related to nonmonetary items (e.g., cost of sales and depreciation expense), which are translated using historical rates. 3. Translation gains and losses are reflected in current income.

Translation When Foreign Currency Is the Functional Currency A foreign entity may keep its records in on foreign currency when its functional currency is another foreign currency. In this situation, the financial statements are first remeasured from the local currency into the functional currency (temporal method) and then translated into U.S. dollars using the current rate method. Assume a German parent company owns a wholly-owned affiliate in Mexico. The Mexican affiliate subcontracts most of its production to Brazilian vendors. Hence, the Mexican affiliate’s functional currency is deemed to be the Brazilian real.

Example 1: For each of the 12 accounts listed in the table below, select the correct exchange rate to use when either remeasuring or translating a foreign subsidiary for its US parent company. Codes C = Current exchange rate H = Historical exchange rate A = Average exchange rate

… Example 1: Accounts receivable Marketable debt securities   US dollar is the functional Currency The foreign currency is the functional 1. Accounts receivable 2. Marketable debt securities carried at cost 3. Inventories carried at cost 4. Deferred income 5. Goodwill 6. Other paid-in capital 7. Depreciation 8. Refundable deposits 9. Common stock 10. Accumulated depreciation on Buildings 11. Deferred income tax liabilities 12. Accounts payable

Translate financial statement: Example 2   The following assets of Oriole Corporation’s Romanian subsidiary have been converted into US dollars at the following exchange rates: Current Rates Historical Accounts receivable $ 850,000 875,000 Trademark 600,000 575,000 Property plant and equipment 1,200,000 900,000 Totals 2,650,000 2,350,000 If the functional currency of the subsidiary is the US dollar, the assets should be reported in the consolidated financial statements of Oriole Corporation and Subsidiary in the total amount of

Translate financial statement: Example 3

Translate financial statement: Example 4

Translate financial statement: Example 4 (cont.)

Translation Working Papers Example 4 … Searle Corporation Translation Working Papers   Debits Cash 220,000 x $1.58 = $ 347,600 Accounts receivable 52,000 82,160 Inventory 59,000 93,220 Building 400,000 632,000 Land 100,000 158,000 Depreciation expense 7,500 x $1.56 11,700 Other expenses 110,000 171,600 Cost of goods sold 343,200 Total debits 1,839,480 Credits Accumulated depreciation 11,850 Accounts payable 111,000 175,380 Common stock 450,000 x $1.50 675,000 Sales revenue 600,000 936,000 Retained earnings Total credits 1,798,230 Credit differential 41,250

Example 4 … Sales revenue $ 936,000 Expenses: Cost of goods sold ( Searle Corporation Translated Income Statement For the Year Ended December 31, 20X5   Sales revenue $ 936,000 Expenses: Cost of goods sold ( 343,200 ) Depreciation expense 11,700 Other expenses 171,600 Net income 409,500

Translated Balance Sheet Example 4 … Searle Corporation Translated Balance Sheet December 31, 20X5   Cash $ 347,600 Accounts receivable 82,160 Inventory 93,220 Building-net 620,150 Land 158,000 Total assets 1,301,130 Accounts payable 175,380 Common stock 675,000 Retained earnings 409,500 Accumulated comprehensive income 41,250 Total liabilities & equities

Translate financial statement: Example 5

Translate financial statement: Example 5 (cont.)

Translation Working Papers Example 5… Searle Corporation Translation Working Papers   Debits Cash 75,000 x $1.65 = $ 123,750 Accounts receivable 362,000 597,300 Inventory 41,000 67,650 Building 400,000 660,000 Land 100,000 165,000 Depreciation expense 10,000 x $1.63 16,300 Other expenses 133,000 216,790 Cost of goods sold 380,000 619,400 Total debits 2,466,190 Credits Accumulated depreciation 17,500 28,875 Accounts payable 154,750 255,338 Common stock 450,000 x $1.50 675,000 Sales revenue 616,250 1,004,487 Retained earnings 262,500 409,500 Accumulated comprehensive income 41,250 Total credits 2,414,450 Credit differential 51,740

Example 5… Sales revenue $ Expenses: Cost of goods sold ( 619,400 ) Searle Corporation Translated Income Statement for the year ended December 31, 20X6   Sales revenue $ 1,004,487 Expenses: Cost of goods sold ( 619,400 ) Depreciation expense 16,300 Other expenses 216,790 Net income 151,997 Retained earnings, January 1, 20X6 409,500 Retained earnings, December 31, 20X6 561,497

Translated Balance Sheet Example 5… Searle Corporation Translated Balance Sheet December 31, 20X6   Cash $ 123,750 Accounts receivable 597,300 Inventory 67,650 Building-net 631,125 Land 165,000 Total assets 1,584,825 Accounts payable 255,338 Common stock 675,000 Retained earnings 561,497 Accumulated comprehensive income ($41,250 + $51,740) 92,990 Total liabilities & equities

Example 6

Example 6 (cont.)

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Example 7

Example 7 (cont.)

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Example 8 On January 1, 20X4, Pearl Corporation, a US firm, acquired a 70% interest in Segar Corporation, a foreign company, for $120,000, when Segar’s stockholders’ equity consisted of 300,000 local currency units (LCU) and retained earnings of 100,000 LCU. At the time of the acquisition, Segar’s assets and liabilities were fairly valued except for a patent that did not have any recorded book value. All excess purchase cost was attributed to the patent, which had an estimated economic life of 10 years at the date of acquisition. The exchange rate for LCUs on January 1, 20X4 was $.40.   A summary of changes in Segar’s stockholders’ equity during 20X4 and the exchange rates for LCUs is as follows: LCU Rates Dollars Stockholders’ equity 1/1/X4 400,000 $ .40C 160,000 Net income 100,000 .42A 42,000 Dividends 12/1/X4 ( 50,000 ) .43C 21,500 Equity adjustment 17,500 12/31/X4 450,000 .44C 198,000

Example 8 … Required: Determine the following: 1.   1. Fair value of the patent from Pearl’s investment in Segar on January 1, 20X4. 2. Patent amortization for 20X4. 3. Unamortized patent at December 31, 20X4. 4. Equity adjustment from the patent. 5. Income from Segar for 20X4. 6. Investment in Segar balance at December 31, 20X4.

Example 8 … Patent Fair Value Cost of 70% interest $ 120,000   Cost of 70% interest $ 120,000 Book value acquired 400,000 LCU x $.40 x 70% = ( 112,000 ) Patent in dollars 8,000 Patent in LCU = $8,000/$.40 per LCU = 20,000

Example 8 … Patent amortization for 20X4   Patent: 20,000 LCU/10 years = 2,000 LCU per year 2,000 LCU per year x $.42 equals amortization of: $ 840

Example 8 … Unamortized patent   Patent (20,000 LCU – 2,000 LCU) x $.44 = $ 7,920

Example 8 … Equity adjustment from patent   Beginning patent (from Req. 1) $ 8,000 Patent amortization (from Req. 2) ( 840 ) Subtotal 7,160 Ending goodwill 18,000 LCU x $.44 = 7,920 Equity adjustment 760

Example 8 … Income from Segar Equity in income ($42,000 x 70%) $   Equity in income ($42,000 x 70%) $ 29,400 Less: Patent amortization ( 840 ) 28,560

Example 8 … Investment in Segar balance at December 31, 20X4   Cost, January 1, 20X4 $ 120,000 Add: Income for 20X4 (from Req. 5) 28,560 Less: Dividends ($21,500 x 70%) ( 15,050 ) Add: Equity adjustment from patent (from Req. 4) 760 Add: Equity adjustment from translation ($17,500 x 70%) 12,250 Investment balance, December 31, 20X4 146,520 Check: Book value: $198,000 x 70% = 138,600 Unamortized patent (from Req. 3) 7,920 Investment balance

FOREIGN CURRENCY TRANSLATION AND INFLATION Use of the current rate to translate the cost of nonmonetary assets located in inflationary environments will eventually produce domestic currency equivalents far below their original measurement bases.

FOREIGN CURRENCY TRANSLATION AND INFLATION At the same time, translated earnings would be greater because of correspondingly lower depreciation charges. Such translated results could easily mislead rather than inform. Lower dollar valuations would usually understate the actual earning power of foreign assets supported by local inflation, and inflated return on investment ratios of foreign operations could create false expectations of future profitability.