1. Chapter 8: Translation of Foreign Currency Financial Statements

2. Chapter Topics
Conceptual issues of foreign currency financial statements translation
Difference between balance sheet exposure and transaction exposure
Methods of financial statement translation
Temporal and current rate methods illustrated
U.S. GAAP, IFRS, and other standards related to translation
Hedging of balance sheet exposure

3. Learning Objectives
Describe the conceptual issues involved in translating foreign currency financial statements
Explain balance sheet exposure and how it differs from transaction exposure
Describe the concepts underlying the current rate and temporal methods of translation
Apply the current rate and temporal methods of translation and compare the results of the two methods
Describe the requirements of applicable International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (GAAP)
Discuss hedging of balance sheet exposure

4. Two conceptual issues
Appropriate exchange rate to be used in translating each financial statement item
How should the translation adjustment that inherently arises from the translation process be reflected in the consolidated financial statements

5. Balance Sheet Exposure
Assets and liabilities translated at the current exchange rate are exposed to risk of a translation adjustment
When foreign currency appreciates, a net asset exposure results in a positive translation adjustment
When foreign currency appreciates, a net liability exposure results in a negative translation adjustment
Assets and liabilities translated at the historical exchange rate are not exposed to a translation adjustment

6. Translation Methods Current/Noncurrent Method
Current assets and liabilities are translated at the current exchange rate
Noncurrent assets and liabilities and stockholders’ equity accounts are translated at historical exchange rates
There is no theoretical basis for this method
Method is seldom used in any countries and is not allowed by U.S. GAAP or IFRS

7. Translation Methods Monetary/Nonmonetary Method
Concerns with monetary assets and liabilities
Translated at the current exchange rate
Concerns with nonmonetary assets and liabilities and stockholders’ equity accounts
Translated at historical exchange rates
The translation adjustment measures the net foreign exchange gain or loss on current assets and liabilities as if these items were carried on the parent’s books

8. Translation Methods Temporal Method
Objective is to translate financial statements
As if the subsidiary had been using the parent’s currency
Items carried on subsidiary’s books at historical cost
Including all stockholders’equity items, are translated at historical exchange rates
Items carried on subsidiary’s books at current value are translated at current exchange rates
Income statement items are translated at the exchange rate in effect at the time of the transaction

9. Translation Methods Current Rate Method
Objective is to reflect that the parent’s entire investment in a foreign subsidiary is exposed to exchange risk
All assets and liabilities are translated at the current exchange rate
Equity accounts are translated at historical exchange rates
Revenues and expenses are translated at the exchange rate in effect at the date of accounting recognition

10. Translation of Retained Earnings
Stockholders’ equity items are translated at historical exchange rates under both the temporal and current rate methods
This creates somewhat of a problem in translating retained earnings, which is a composite of many previous transactions:
Revenues, expenses, gains, losses, and declared dividends occurring over the life of the company

11. Complicating Aspects of the Temporal Method
Keeping track of the historical rates for inventory, prepaid expenses, fixed assets, and intangible assets is necessary under temporal method and not under current rate method
Translating these assets at historical rates makes application of the temporal method more complicated than the current rate method
Calculation of Cost of Goods Sold (COGS)
Application of the Lower of Cost or Market Rule
Fixed Assets, Depreciation, Accumulated Depreciation

12. DISPOSITION OF TRANSLATION ADJUSTMENT
Translation gain or loss in net income
Translation adjustment is considered to be a gain or loss analogous to the gains and losses arise from foreign currency transaction
Should be reported in income in the period in which the fluctuation in exchange rate occurs
Cumulative translation adjustment in stockholders’ equity
The alternative to reporting the translation adjustment as a gain or loss in net income is to include it in stockholders’ equity as a component of other comprehensive income
This treatment defers the gain or loss in stockholders’ equity until it is realized in some way

13. Temporal and Current Rate Methods
Translation methods illustrated
U.S. Inc. owns Juarez, SA, a subsidiary in Mexico which was established January 1, 2010
Juarez’s balance sheet items as of 12/31/10, in pesos:
Cash 1,000 Accounts payable ,000
Accounts rec ,000 Long-term debt ,000
Inventory 2,500 Capital stock 3,000
Fixed assets 8,000 Retained earnings ,500
Accum. depr ,000

14. Temporal and Current Rate Methods
Translation methods illustrated
Juarez’s income statement items for 2010, in pesos:
Sales 20, Depr. exp ,000
COGS 14,000 Interest exp
S,G,&A exp ,500 Income tax exp

15. Temporal and Current Rate Methods
Translation methods illustrated
There was no beginning inventory
Inventory, which is carried at cost, was acquired evenly during the last quarter of 2010
Purchases were made evenly throughout year
Fixed assets were acquired on January 1, 2010
Capital stock was sold on January 1, 2010

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

17. Temporal and Current Rate Methods
Current Rate Method – Income Statement
Income Statement – 2010
Sales ,900
COGS ,330
Gross profit
S,G,&A
Depreciation expense
Interest expense
Income tax expense
Net income

18. Temporal and Current Rate Methods
Current Rate Method – Balance Sheet
Balance Sheet – December 31, 2010
Cash Accounts payable
Accounts Rec Long-term debt
Inventory Capital stock
Fixed Assets, net Retained earnings
Total assets Cumulative translation adj. (97)
Total liab. & S.E

19. Temporal and Current Rate Methods
Temporal Method – Income Statement
Income Statement – 2010
Sales ,900
COGS ,343
Gross profit
S,G,&A
Depreciation expense
Interest expense
Income tax expense
Remeasurement gain
Net income

20. Temporal and Current Rate Methods
Temporal Method – Balance Sheet
Balance Sheet – December 31, 2010
Cash Accounts payable
Accounts Rec Long-term debt 480
Inventory Capital stock
Fixed Assets, net Retained earnings
Total assets 1, Total liab. & S.E ,165

21. Temporal and Current Rate Methods
Translation methods illustrated – Summary
Current Rate Method
All assets and liabilities are 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
Temporal Method
Primarily monetary assets and liabilities are translated at current rate
This results in net liability exposure
Net liability exposure and devaluing foreign currency result in translation gain
Translation gain included in current income

22. U.S. GAAP
FASB ASC 830, Foreign Currency Matters( formerly SFAS 52, Foreign Currency Translation) is the relevant accounting standard
Requires identification of functional currency
Functional currency is the primary currency of the foreign subsidiary’s operating environment
The standard includes a list of indicators as guidance for the foreign currency decision
When functional currency is U.S. Dollar, temporal method is required
When functional currency is foreign currency, current rate method is required

23. U.S. GAAP Requirements Highly Inflationary Economies – U.S. GAAP
U.S. GAAP defines such economies as those with cumulative 100% inflation over a period of three years (with compounding—average of 26% per year for three years in a row)
Temporal method required—translation gains/losses reported in income

24. 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 U.S. GAAP

25. IFRS Requirements Hyperinflationary Economies – IFRS
IAS 21 and 29 use the term hyperinflationary economies
IAS 21 is not as specific in defining hyperinflationary economies as is U.S. GAAP, but does suggest that a cumulative three-year rate approaching or exceeding 100% is evidence
IAS 21 requires restatement of the foreign financial statements for inflation per IAS 29
IAS 21 then requires the use of the current exchange rate to translate the restated financial statements, including all balance sheet accounts as well as all income statement accounts
IAS approach is substantially different from U.S. GAAP

26. Hedging Balance Sheet Exposure
Companies that have foreign subsidiaries with highly integrated operations use the temporal method
Temporal method requires translation gains and losses to be recognized in income
Losses negatively affect earnings, and both gains and losses increase earnings volatility
These gains and losses result from the combination of balance sheet exposure and exchange rate fluctuations
Foreign exchange gains and losses on foreign currency borrowings or foreign currency derivatives employed to hedge translation based exposure (under the current rate method)

27. Hedging Balance Sheet Exposure
Companies can hedge against gains and losses by using foreign currency forward contracts, options, and borrowings

28. End of Chapter 8