Foreign Currency Translation - Modified.a
Foreign Currency Translation - Modified.a
Financial Statements
TRANSLATION OF FOREIGN CURRENCY
FINANCIAL STATEMENTS
Monetary/Nonmonetary Method
Monetary assets and liabilities are translated at the
current exchange rate.
Nonmonetary assets and liabilities and stockholders’
equity accounts are 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.
IN OUR EXAMPLE:
The receivable would be translated using the current
rate.
The land would be translated at the historical rate.
MONETARY/NON-MONETARY
Advantages
Easy to understand. Makes intuitive sense.
Usually not difficult to classify assets and
liabilities.
BUT WHAT IF:
A monetary asset/liability is booked at historical cost
(e.g. long term bonds)
A nonmonetary asset/liability is booked at current cost
(e.g., revalued property, plant and equipment)
MONETARY/NON-MONETARY METHOD
Disadvantages
Valuation basis in accounting doesn’t always
line up right with classification, producing
potentially meaningless values.
Thus some assets can disappear in the
presence of inflation while others are over or
under-reported.
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.
IN OUR EXAMPLE:
The receivable would be classified as current and
translated using the current rate.
The land would be classified as noncurrent and
translated at the historical rate.
CURENT/NONCURRENT
Advantages?
Simplistic. Requires no more characterization of
assets/liabilities than is already provided by the financial
statements
Seems to solve the monetary/non-monetary problem while
remaining more consistent with underlying accounting basis
being used.
CURRENT/NON-CURRENT METHOD
Disadvantages
Can still misspecify monetary assets/liabilities. Example:
inventories, noncurrent marketable equity securities.
Does not explicitly address the accounting problem. For
example, some current assets use historical cost basis. Some
noncurrent assets are booked at current value.
Thus some assets can still disappear in the presence of severe
inflation. Others can be severely over or undervalued.
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.
IN OUR EXAMPLE:
The receivable translated using the current rate.
If reported at historical cost, the land would be translated
at the historical rate.
If reported at fair value, the land would be translated at
the current rate.
TEMPORAL METHOD
Advantages
Lines up with valuation basis used in accounting. Thus the
numbers have most consistent internal meaning.
They will still be misspecified, however, but only to the
extent the underlying accounting numbers already are.
TEMPORAL METHOD
Disadvantages
Lotsof volatility in financial statements.
Mixing of valuations: does the sum make any sense?
For our purposes, because they are both called for in
current accounting standards on FX translation, we will
focus on:
Current
rate method
Temporal Method
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TRANSLATION METHODS
CURRENT RATE METHOD
Use
Usecurrent
currentexchange
exchangerates
ratesto
to
translate
translateall
allassets
assetsand
andliabilities.
liabilities.
Parent
Use
Usehistorical
historical(or
(oraverage)
average)
exchange
exchangerates
ratesto
totranslate
translateequity
equity
accounts.
accounts.
Use
Usehistorical
historical(or
(oraverage)
average)
exchange
exchangerates
ratesto
totranslate
translate
income
incomestatement
statementaccounts.
accounts.
Assumes
Assumes“net“netinvestment”
investment”in inaa
foreign
foreignoperation
operationisisexposed
exposedtoto
foreign
foreignexchange
exchangerisk
risk
Subsidiary
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TRANSLATION METHODS
TEMPORAL METHOD
Use historical exchange rates to translate
Use historical exchange rates to translate
assets Parent
assetsand
andliabilities
liabilitiescarried
carriedatathistorical
historicalcost.
cost.
Use current exchange rates to translate assets
Use current exchange rates to translate assets
and
andliabilities
liabilitiescarried
carriedatatcurrent
currentcost
costor orfuture
future
value.
value.
Use historical (or average) exchange rates to
Use historical (or average) exchange rates to
translate
translateequity,
equity,revenue,
revenue,andandexpense
expense
accounts.
accounts.
Objective is to produce a set of U.S. dollar
Objective is to produce a set of U.S. dollar
translated
translatedfinancial
financialstatements
statementsas asififthe
the
foreign
foreignsubsidiary
subsidiaryhadhadactually
actuallyused
usedU.S.
U.S.
dollars
dollars
Subsidiary
-31
tt
rr
aa
nn
TRANSLATION OF RETAINED EARNINGS
ss
aa
cc
tt At
At the
the end
end of
of the
the first
first year
year of
of
ii operations:
operations:
oo
nn
ss
,,
tt
rr
aa
nn
ss
ll
aa Ending
Ending R/E
R/E from
from year
year 1,
1, becomes
becomes
tt
ii Beginning
Beginning R/E
R/E in
in Year
Year 2.
2.
nn
gg
-32
Apply
Apply Lower-of-Cost-or-Market
Lower-of-Cost-or-Market using
using the
the
foreign
foreign exchanges
exchanges rates.
rates.
-33
Temporal
Temporal Method
Method -- fixed
fixed
assets
assets acquired
acquired atat different
different
times
times will
will be
be translated
translated using
using
their
their respective
respective historical
historical
translation
translation rates.
rates. Accumulated
Accumulated
depreciation
depreciation usesuses the
the same
same
historical
historical rates
rates as
as the
the related
related
-34
DEPRECIATION EXPENSE
Current
Current Rate
Rate Method
Method -- translate
translate
depreciation
depreciation expense
expense using
using the the
weighted-average
weighted-average rate
rate for
for the
the
current
current period
period
Temporal
Temporal Method
Method -- translate
translate
depreciation
depreciation expense
expense using
using
the
the various
various historical
historical rates
rates
related
related to
to the
the underlying
underlying
assets.
assets.
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DISPOSITION OF TRANSLATION
ADJUSTMENT
Current
CurrentMethod
Method
Translation Adjustment
Translation Adjustmentisis
reported
reportedon
onthe
theBalance
Balance
Sheet.
Sheet.
Temporal
TemporalMethod
Method
Adjustment is reported
Adjustment is reportedon
on
the
theIncome
IncomeStatement
Statementasasaa
Translation
TranslationGain
Gainoror(Loss)
(Loss)
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TRANSLATION
U.S. ACCOUNTING RULES
SFAS
SFASNo.
No.88(1975)
(1975)--
Accounting
Accountingfor
forTranslation
Translationof
of
Foreign
ForeignCurrency
CurrencyTransactions
Transactions
and
andForeign
ForeignCurrency
Currency
Financial
FinancialStatements.
Statements.
SFAS
SFASNo.
No.52
52(1981)
(1981)--Foreign
Foreign
Currency
CurrencyTranslation.
Translation.
SFAS
SFASNo.
No.130
130(1998)
(1998)
-38
SFAS NO. 52
Recognized two
types of subs: Temporal
Temporalmethod
methodstill
stillapplies.
applies.
Subs that do most
of their
transactions in
U.S. $ Applies
Appliesthe
the“local
“localcurrency
currency
Subs that operate perspective”.
perspective”.
relatively Uses
Usescurrent
currentrate
ratemethod.
method.
independently of Translation
Translationadjustment
adjustment
appears
appearsin
inthe
theequity
equitysection.
their U.S. section.
parents.
-39
FUNCTIONAL CURRENCY
To
Todetermine
determinewhether
whetheraasubsidiary
subsidiaryis
isintegrated
integratedwith
withthe
theparent
parent
or
oroperates
operatesindependently,
independently,SFAS
SFAS52 52introduced
introducedthe
theconcept
concept
of
offunctional
functionalcurrency.
currency
currency.
currency
AAcompany’s
company’sfunctional
functionalcurrency
currencyisisthe
the
primary
primarycurrency
currencyof
ofthe
theforeign
foreignentity’s
entity’s
operating
operatingenvironment.
environment.
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DETERMINING A SUBSIDIARY’S
FUNCTIONAL CURRENCY
Indications that the
Functional Currency is the
Indicator
Foreign Currency
Cash Flows Primarily in FC and do
not affect parent’s
cash flows
DETERMINING A SUBSIDIARY’S
FUNCTIONAL CURRENCY
Indications that the
Functional Currency is the
Indicator
Foreign Currency
Expenses Primarily local costs
DETERMINING A SUBSIDIARY’S
FUNCTIONAL CURRENCY
Indications that the
Functional Currency is the
Indicator
Parent’s Currency
Cash Flows Directly impact
parent’s cash flows on
a current basis
DETERMINING A SUBSIDIARY’S
FUNCTIONAL CURRENCY
Indications that the
Functional Currency is the
Indicator Parent’s Currency
Expenses Primarily costs for
components obtained from
parent’s country
In
Inhighly
highlyinflationary
inflationaryeconomies,
economies,SFAS
SFAS52
mandates
mandatesthetheuse
useofofthe
theTemporal
52
TemporalMethod
Method
Why?
for translation.
for translation.
Disappearing
DisappearingPlant
PlantProblem
Problem
IfIfthe
theCurrent
CurrentMethod
Methodwere
wereused,
used,the
theUS
US$$
equivalent
equivalentwould
wouldbebeVERY
VERYsmall
smalldue
duetoto
the
therapidly
rapidlyincreasing
increasingexchange
exchangerate.
rate.
-45
Determine
Determine the
the
appropriate
appropriate
exchange
exchange rates
rates
to
to use
use for
for each
each
account.
account.
-52
Weighted
Weighted
average
average rates
rates
are
are generally
generally
used
used for
for
Sales,
Sales, COGS,
COGS,
and
and other
other
recurring
recurring
expenses.
expenses.
-53
The
The actual
actual historical
historical
rate
rate is
is used
used when
when we we
can
can identify
identify itit
efficiently.
efficiently.
-54
Determine
Determine the
the
appropriate
appropriate
exchange
exchange rates
rates
to
to use
use for
for each
each
account.
account.
-56
The
The beginning
beginning R/ER/E
is
is carried
carried over
over from
from
the
the prior
prior year.
year.
-57
The
The net
net income
income is
is
taken
taken from
from the
the
income
income statement.
statement.
-58
Dividends
Dividends are
are
translated
translated at
at
the
the historical
historical
rate
rate on
on the
the date
date
of
of declaration.
declaration.
-59
All
All assets
assets
and
and liabilities
liabilities
are
are translated
translated
at
at the
the current
current
rate
rate onon the
the
balance
balance sheet
sheet
date.
date.
-62
Common
Common Stock Stock
is
is translated
translated at at
the
the historical
historical
rate
rate atat the
the time
time
the
the stock
stock was
was
issued.
issued.
-63
The
The Ending
Ending R/E
R/E comes
comes
from
from the
the statement
statement of
of
retained
retained earnings.
earnings.
-64
RE-MEASUREMENT OF FINANCIAL
STATEMENTS
If
Ifthe
thesub’s
sub’sfunctional
functionalcurrency
currencyisisthe
the
U.S.
U.S.$,$,then
thenany
anybalances
balances
denominated
denominatedin inthe
thelocal
localcurrency,
currency,
must
mustbebere-measured.
re-measured.
re-measurement
re-measurementrequires
requiresthe
the
application
applicationof ofthe
thetemporal
temporalmethod.
method.
The
There-measurement
re-measurementgain gainor
orloss
loss
appears
appearson onthe
theincome
incomestatement.
statement.
-67
SUMMARY
Because many US firms have significant financial
investments in foreign countries, the translation of
foreign currency financial statements is an important
accounting challenge
The two primary methods used are the temporal and
current rate methods
SFAS 52 established translation through the use of the
current rate method when the foreign operation’s
functional currency is a foreign currency
re-measurement through the temporal method is
appropriate when the operation’s functional currency is
the US$, or in the case of a highly inflationary economy
-70
POSSIBLE CRITICISMS
Some critics contend that the functional currency
decision can be quite subjective.
Others argue that having two fundamentally different
approaches to translation creates confusion.
Reporting unrealized gains and losses as an element of
the balance sheet is controversial.