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

2. 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.

3. 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.

9. Foreign Currency Transactions

10. Foreign Currency Transactions

11. Single-Transaction Perspective

12. 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.

13. Example 1
On September 1, 2015, Cormorant Company purchased merchandise from Osaka Company of Japan for 20,000,000 yen payable on October 1, The spot rate for yen was $ on September 1 and the spot rate was $ 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?

14. 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 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, 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.

15. 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, 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.

16. 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.

17. 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.

18. 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.

19. 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.

20. 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.

21. 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.

22. 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).

23. 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.

24. 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.

25. 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.

26. 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.

27. 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.

28. 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.

29. 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.

30. 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.

31. 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.

32. 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.

33. 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.

34. 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.

35. 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:

36. 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.

37. 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:

38. 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.

39. 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.

41. 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

42. … 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

43. 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

44. Translate financial statement: Example 3

45. Translate financial statement: Example 4

46. Translate financial statement: Example 4 (cont.)

47. 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

48. 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

49. 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

50. Translate financial statement: Example 5

51. Translate financial statement: Example 5 (cont.)

52. 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

53. 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

54. 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

55. Example 6

56. Example 6 (cont.)

57. Example 6 …

58. Example 6 …

59. Example 6 …

60. Example 7

61. Example 7 (cont.)

62. Example 7…

63. Example 7…

64. Example 7…

65. 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

66. 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.

67. 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

68. 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

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

70. 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

71. 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

72. 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

73. 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.

74. 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.