© The McGraw-Hill Companies, Inc., 2004 Slide 10-1 McGraw-Hill/Irwin Chapter Ten Translation of Foreign Currency Financial Statements

© The McGraw-Hill Companies, Inc., 2004 Slide 10-2 McGraw-Hill/Irwin International Acquisitions

© The McGraw-Hill Companies, Inc., 2004 Slide 10-3 McGraw-Hill/Irwin If we control our subsidiaries, why don’t they all use the U.S. $ as their currency? 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 $. Translation of Financial Statements

© The McGraw-Hill Companies, Inc., 2004 Slide 10-4 McGraw-Hill/Irwin In addition, many countries have different accounting rules that we must consider before translating the sub’s financial statements. Translation of Financial Statements

© The McGraw-Hill Companies, Inc., 2004 Slide 10-5 McGraw-Hill/Irwin To translate a foreign subsidiary’s financial statements into U.S. $, we must use both: Historical Exchange Rates, and Current Exchange Rates. Exchange Rates Used in Translation

© The McGraw-Hill Companies, Inc., 2004 Slide 10-6 McGraw-Hill/Irwin 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. 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.

© The McGraw-Hill Companies, Inc., 2004 Slide 10-7 McGraw-Hill/Irwin Balance Sheet Exposure Balance sheet items translated at current exchange rates change in $ value from one balance sheet to the next 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.

© The McGraw-Hill Companies, Inc., 2004 Slide 10-8 McGraw-Hill/Irwin Balance Sheet Exposure Net Asset Balance Sheet Exposure When assets translated at current rates > liabilities translated at current rates. 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. Net Liability Balance Sheet Exposure When liabilities translated at current rates > assets translated at current rates.

© The McGraw-Hill Companies, Inc., 2004 Slide 10-9 McGraw-Hill/Irwin Parent Subsidiary Current Rate Method 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. * Historical is the rate applicable at the time that the transaction occurred. 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. * Historical is the rate applicable at the time that the transaction occurred.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Temporal Method 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. (most liabilities are carried at current or future value) Use historical* (or average) exchange rates to translate equity, revenue, and expense accounts. 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. (most liabilities are carried at current or future value) Use historical* (or average) exchange rates to translate equity, revenue, and expense accounts. * Certain expenses are related to assets carried at historical costs which in turn are translated at historical rates. These expenses MUST therefore be translated at historical rates e.g. cost of goods sold, depreciation & amortization.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin 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. At the end of the first year of operations: Ending R/E from year 1, becomes Beginning R/E in Year 2.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Calculation of Cost of Goods Sold Current Rate Method - translate using the weighted average rate for the current period = simple! 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.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Fixed Assets and Accumulated Depreciation fixed assetsaccumulated 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.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin 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.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Gain or Loss on the Sale of an Asset Current Rate Method - translate the gain/loss using the historical rate in effect on the date of sale Temporal Method - the gain must be computed indirectly, using different rates.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Disposition of Translation Adjustment – 4 possible combinations Current Method  Translation Adjustment is reported on the Balance Sheet via “Other Comprehensive Income”  Adjustment is reported on the Income Statement as a Translation Gain or (Loss) Temporal Method  Translation Adjustment is reported on the Balance Sheet via “Other Comprehensive Income”  Adjustment is reported on the Income Statement as a Translation Gain or (Loss) Current Method  Translation Adjustment is reported on the Balance Sheet via “Other Comprehensive Income”  Adjustment is reported on the Income Statement as a Translation Gain or (Loss) Temporal Method  Translation Adjustment is reported on the Balance Sheet via “Other Comprehensive Income”  Adjustment is reported on the Income Statement as a Translation Gain or (Loss)

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Translation U.S. Accounting Rules SFAS No. 1 (1974) – Disclosure of Foreign Currency Translation Information SFAS No. 8 (1975) - Accounting for Translation of Foreign Currency Transactions and Foreign Currency Financial Statements – temporal method with gain/loss in income SFAS No. 52 (1981) - Foreign Currency Translation. – gave additional treatment: current method with gain/loss in equity SFAS No. 130 (1998) SFAS No. 1 (1974) – Disclosure of Foreign Currency Translation Information SFAS No. 8 (1975) - Accounting for Translation of Foreign Currency Transactions and Foreign Currency Financial Statements – temporal method with gain/loss in income SFAS No. 52 (1981) - Foreign Currency Translation. – gave additional treatment: current method with gain/loss in equity SFAS No. 130 (1998)

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Applies the “local currency perspective”. Use current rate method. Translation adjustment appears in the equity section. Applies the “local currency perspective”. Use 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.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Functional Currency 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.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Functional Currency functional currency To determine whether a subsidiary is integrated with the parent or operates independently, SFAS 52 introduced the concept of functional currency. U.S. Dollar Use the Temporal Method for translation. Local Currenc y Use the Current Rate Method for translation.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Determining a Subsidiary’s Functional Currency Exh. 10-2

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Highly Inflationary Economies In highly inflationary economies, SFAS 52 mandates the use of the Temporal Method for translation. Disappearing Plant Problem If the Current Method were used, the US $ equivalent would be VERY small due to the rapidly increasing exchange rate. Disappearing Plant Problem If the Current Method were used, the US $ equivalent would be VERY small due to the rapidly increasing exchange rate.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Current Rate Method Example News Co., is a wholly owned foreign sub of ATG Corporation. News 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 $. News Co., is a wholly owned foreign sub of ATG Corporation. News 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 $.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Current Rate Method Example News 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, 2007, the R/E balance was translated at $350,000. Inventory was acquired evenly throughout the year. News 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, 2007, the R/E balance was translated at $350,000. Inventory was acquired evenly throughout the year.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Current Rate Method Example The Dec. 31, 2007 translation adjustment had a debit balance of $69,841. Dividends were declared on March 15, 2007, and equipment was sold on October 1, The following exchange rates were in effect during the year:

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Current Rate Method Example Determine the appropriate exchange rates to use for each account.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Current Rate Method Example Weighted average rates are generally used for Sales, COGS, and other recurring expenses.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Current Rate Method Example The actual historical rate is used when we can identify it efficiently.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Current Rate Method Example

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Determine the appropriate exchange rates to use for each account. Current Rate Method Example

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Current Rate Method Example The beginning R/E is carried over from the prior year.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Current Rate Method Example The net income is taken from the income statement.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Current Rate Method Example Dividends are translated at the historical rate on the date of declaration.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Current Rate Method Example

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Current Rate Method Example

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Current Rate Method Example All assets and liabilities are translated at the current rate at the balance sheet date.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Current Rate Method Example Common Stock is translated at the historical rate at the time the stock was issued.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Current Rate Method Example The Ending R/E comes from the statement of retained earnings.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin 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 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 McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Current Rate Method Example

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Remeasurement of Financial Statements If the sub’s functional currency is the U.S. $, then any balances denominated in the local currency, must be remeasured. Remeasurement requires the application of the temporal method. The remeasurement gain/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 remeasured. Remeasurement requires the application of the temporal method. The remeasurement gain/loss appears on the income statement.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Disclosures Related to Translation An analysis of the change in the cumulative translation adjustment.  can be on the Statement of Retained Earnings or in the Notes Many companies also include a description of the translation procedures in Note 1. An analysis of the change in the cumulative translation adjustment.  can be on the Statement of Retained Earnings or in the Notes Many companies also include a description of the translation procedures in Note 1.