McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4 Translation of Foreign Currency Financial Statements

7-2 Translation Methods Current Rate Method Current Rate Method  The fundamental concept underlying the current rate method is that parent's entire investment in a foreign operation is exposed to foreign exchange risk and the objective is to reflect this 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 (Average exchange rate ). Learning Objective 3

7-3 Current Rate Method Translation methods illustrated  U.S. Inc. owns Juarez, SA, a subsidiary in Mexico which was established January 1,  Juarez’s balance sheet items as of 12/31/05, in pesos. Cash 1,000Accounts payable2,000 Accounts rec. 2,000Long-term debt6,000 Inventory 2,500Capital stock3,000 Fixed assets 8,000Retained earnings1,500 Accum. depr. 1,000 Learning Objective 4

7-4  Translation methods illustrated  Juarez’s income statement items for 2005, in pesos.  Sales 20,000  COGS 14,000  S,G,&A exp. 2,500  Income tax exp. 500  Depreciation. exp 1,000  Interest exp. 500 Temporal Method COGS = Cost of Good Sold S,G,&A exp.= Selling and Administrative Expenses

7-5 Temporal and Current Rate Methods Other data.  There was no beginning inventory.  Inventory, which is carried at cost, was acquired evenly during the last quarter of  Purchases were made evenly throughout year.  Fixed assets were acquired on January 1,  Capital stock was sold on January 1, Learning Objective 4

7-6 Temporal and Current Rate Methods Translation methods illustrated Relevant exchange rates (U.S. dollar per Mexican peso) January 1, 2005$0.10 Average for 2005$0.095 Average for 4 th quarter 2005$0.09 December 31, 2005$0.08 Learning Objective 4

7-7 Current Rate Method Current Rate Method – Income Statement Income Statement – 2005 Exchange $US rate Sales20,000 $ ,900 COGS14,000 $ ,330 Gross profit S,G,&A 2,500 $ Depreciation expense 1000 $ Interest expense500 $ Income tax expense 500 $ Net income 142 Learning Objective 4

7-8 Current Rate Method Current Rate Method – Balance Sheet Balance Sheet – December 31, 2005 Cash 80 Accounts payable 160 Accounts Rec. 160 Long-term debt 480 Inventory 200 Capital stock 300 Fixed Assets, net 560 Retained earnings 142 Total assets 1000 Translation adj. (82) Total liab. & S.E Learning Objective 4

7-9 Current Rate Method Translation methods illustrated – Summary Current Rate Method  All assets and liabilities 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. Learning Objective 4

Example 2 On January 1, 2008, Trenten Systems, a U.S.-based company, purchased a controlling interest in Grant Management Consultants located in Zurich, Switzerland. Direct exchange rates for Swiss franc are: Dollars per Franc January 1, 2008 $.5987 December 31, Average for Dividend declaration and payment date.5810 Current Rate Method

7-11 Current Rate Method Grant Management Consultants Income Statement and retained earning Statement Revenue 75,000 Operating expenses: depreciation of (3,000) franc(30000) Net income 45,000 Dividends Increase in retained earning30000

7-12 Balance Sheet Jan. 1 Dec. 31 Cash and receivables 20,000 55,000 Net property, plant, equipment40,000 37,000 Total assets 60,000 92,000 Accounts payable30,000 32,000 Common stock 20,000 20,000 Retained earnings 10,000 40,000 Total liab. & equity 60,000 92,000 Current Rate Method

7-13 Required: Translate the year-end balance sheet and income statement of the foreign subsidiary using the current rate method of translation. Current Rate Method

Translate Income statement Current Rate Method

Translate Balance Sheet Current Rate Method

7-16

7-17 Disposition of translation adjustment  Tow issues related to the translation of foreign currency financial statement : 1.Selection of appropriate method. 2.Where the resulting translation adjustment should be reported in the consolidated financial statement.  There are tow prevailing schools of thought with regarded to these issues 1.Translation adjustment should be reported in the consolidated income statement 2.Translation adjustment should be reported in stock holder equity.

7-18 U.S. GAAP and IFRS Requirements 1- U.S. GAAP:-  Prior to 1975 there were no authoritative rules (different companies used different translation methods), that’s lead to lack of comparability.  : SFAS 8, Accounting for the Translation of Foreign Currency Transactions and Foreign Currency Financial Statements, which required temporal method to be used. All gains and losses taken into income.

7-19 U.S. GAAP and IFRS Requirements  1981-today: SFAS 52 Foreign Currency Translation, which has the following features:  To determine whether the foreign operations is: 1.Integrated with its parent or, 2.Self-contained, SFAS 52 Requires identification of functional currency.  The functional currency is the primarily currency of the foreign entity’s operating environment.  If functional currency is the local currency- use current rate methods Gains and losses routed directly to stockholder’s equity.  If functional currency is US Dollar, use the temporal method and fully recognize gains/losses into earnings (Income Statement).

7-20 Objective of Translation - SFAS No. 52:  Provide information regarding the exposed economic effects of an exchange rate change on an enterprise’s cash flows and equity [par. 4(a)].  Reflect in consolidated statements the financial results measured in their functional currencies in conformity with U.S. GAAP [par. 4(b)]

7-21 Functional Currency Concept  The standard includes a list of indicators as guidance for the foreign currency decision.  The concept is :  If there was close ties between the subsidiary and parents (integrated with) Functional currency is parent currency Use Temporal Method  If the subsidiary integrated with its local economy Functional currency is its country currency Use Current rate Method

7-22 Indicators  To determine if the subsidiary is integrated with its parent or self contain, SFAS No. 52 Foreign Currency Translation provide a list of indicators related with  Cash flow,  sales price,  sales market,  Expenses,  Financing,  Intercompany transactions.  See page 309

7-23 Highly Inflationary Economies – U.S. GAAP  SFAS 52 provides guidance on highly inflationary economies.  SFAS 52 defines such economies as those with 100% inflation over a period of three years.  SFAS 52 requires the use of the temporal method in these cases of significant inflation.

7-24 U.S. GAAP and IFRS Requirements 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 SFAS 52. Learning Objective 5

7-25 U.S. GAAP and IFRS Requirements Hyperinflationary Economies -- IFRSs  IAS 21 and 29 use the term hyperinflationary economies.  IAS 21 is not a specific in defining hyperinflationary economies as is SFAS 52.  IAS 21 requires restatement of the foreign financial statements for inflation per IAS 29, Financial Reporting in Hyperinflationary Economies.  IAS 21 then requires the use of the current rate method of translation on the restated financial statements.  IAS approach is substantially different from SFAS 52. Learning Objective 5

7-26 Translation Procedures Internationally Canada – very similar to U.S., however under the temporal method, some translations adjustments can be deferred and amortized. Mexico – standards are silent, but SFAS 52 is commonly followed. In cases where it is not, practice varies widely. Brazil – current rate method is used with gains and losses included in income. Japan – significantly different from U.S. GAAP and IFRSs, with cumulative translation adjustment reported as an asset or liability. Korea – only the current rate method is used. Learning Objective 7