1. Chapter Eight Translation of Foreign Currency Financial Statements McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 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 8-2

3. 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. 8-3

4. 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) 8-4

5. 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. 8-5

6. Parent Subsidiary 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. 8-6

7. Parent Subsidiary Translation Methods - TEMPORAL METHOD  Use historical exchange rates to translate assets and liabilities carried at historical cost.  Use current exchange rates to translate those 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 financial statements as if the foreign subsidiary had actually used U.S. dollars 8-7

8. Translation of Retained Earnings Translating R/E requires special attention, because it is the composite of many prior transactions. 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. 8-8

9. 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. 8-9

10. 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. 8-10

11. 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. 8-11

12. 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. 8-12

13. 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) 8-13

14. Functional Currency To determine whether a subsidiary is integrated with the parent or operates independently, we look at the functional currency. A company’s functional currency is the primary currency of the foreign entity’s operating environment. 8-14

15. Highly Inflationary Economies In highly inflationary economies, the Temporal Method for translation is required. Disappearing Plant Problem If the Current Method were used, the US $ equivalent would be VERY small due to the rapidly increasing exchange rate. Why? 8-15

16. Remeasurement of Financial Statements  If the sub’s functional currency is the US $, then any balances denominated in the local currency, must be remeasured.  Remeasurement requires the application of the temporal method.  The remeasurement gain or loss appears on the income statement. 8-16