Translation of Foreign Currency

Financial Statements

Conceptual issues of foreign currency

financial statements translation.
Balance sheet vs. transaction exposure.
Methods of financial statement translation.
Temporal and current rate methods
illustrated.
U.S. GAAP, IFRSs, and other standards related
to translation.
Hedging balance sheet exposure.

Foreign country operations usually prepare

financial statements using local currency as the
monetary unit.
These financial statements must be translated into
home country currency.
These operations also typically use local GAAP.
Financial statements must be translated into home
country GAAP.

Learning Objective 1

Primary conceptual issues

Each financial statement item must be translated

using some, hopefully relevant, exchange rate.
What rate should be used?
the current exchange rate?
The average exchange rate?
the historical exchange rate?

Given that any adjustment is, at the point of

translation, unrealized, how should the resulting
adjustment be recognized?
in current income?
in an equity account on the balance sheet?

Learning Objective 1

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.

Learning Objective 2

Lets say XYZ has a 1000 euro current note

receivable on its books. The euro/$ direct
rate is $ 1 on 1/1. On 12/31, it is $1.20.
Should we record:
No change?
An increase in value of $200?
An increase in value of $100?
And if we do report a change, where should the
offsetting gain be reported?

Lets say XYZ has land on its books that is

held by a subsidiary located in the EU. The
land was purchased on 1/1 for 1,000,000
euros when the euro/$ direct rate was $ 1.
On 12/31, it is $ .9091.
Should we record:
No change?
An decrease in value of $90,901?
An decrease in value of $45,450?

And if we do report a change, where should the

offsetting gain be reported?

Inflation differences caused the decline in the

value of the euro?
If the inflation differential was 10%, then:
Before, 1,000,000E=1,000,000$
Now, 1,000,000E=1,100,000$;
Thus the direct exchange rate would be .9091
(1,000,000/1,100,000).
Thus the TRUE value of the land, in euros, is now
1,100,000E. The valuation should be
1100000*.9091 = 1,000,000$, i.e., no change.

The receivable is a monetary asset.

The land is a non-monetary asset.

If inflation drives foreign exchange rate

movements, and monetary/non-monetary
assets are affected differently, how should FC
effects be accounted for?
Suppose, in the first case, the land is reported at
current cost instead of historical cost?

Current/noncurrent
Monetary/non-monetary
Temporal
Current rate

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 IFRSs.

Learning Objective 3

The
and
The
and

receivable would be classified as current

translated using the current rate.
land would be classified as noncurrent
translated at the historical rate.

Advantages?
Simplistic. Requires no more characterization of
assets/liabilities than is already provided by the
financial statements

Disadvantages?
Can mismatch exchange rate with valuation basis.
Example: inventories, noncurrent marketable equity
securities

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
parents books.

Learning Objective 3

The receivable would be translated using the

current rate.
The land would be translated at the historical
rate, even is it were considered impaired and
thus reported at fair value.

Advantages

Easy to understand. Makes intuitive sense.

Usually not difficult to classify assets and liabilities.

Disadvantages

Valuation basis in accounting doesnt always line up

right with classification, producing meaningless
values. Examples: impaired assets, fixed assets
revalued upwards, long term liabilities such as
bonds.

Temporal Method

Objective is to translate financial statements as if

the subsidiary had been using the parents
currency.
Items carried on subsidiarys books at historical
cost, including all stockholders equity items are
translated at historical exchange rates.
Items carried on subsidiarys 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.

Learning Objective 3

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.

Advantages
Lines up with valuation basis used in accounting.
Thus the numbers have most meaning.

Disadvantages
Lots of volatility in financial statements
Possibility of disappearing assets in inflationary
economies.

Current Rate Method

Objective is to reflect that the parents
entire investment in a foreign subsidiary is
expose to exchange 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.

Learning Objective 3

Advantages
Simple to do
Ratios are not distorted

Disadvantages
Can produce disparate results that are not
consistent with the economics that are really going
on.
What does the FC adjustment?

The receivable would be translated using the

current rate.
The land would be translated at the current
rate.

Translation methods illustrated

U.S.

Inc. owns Juarez, SA, a subsidiary in Mexico

which was established January 1, 2005.
Juarezs balance sheet items as of 12/31/05, in
pesos.
Cash
1,000
Accounts payable 2,000
Accounts rec. 2,000
Long-term debt 6,000
Inventory
2,500
Capital stock
3,000
Fixed assets 8,000
Retained earnings 1,500
Accum. depr. 1,000

Learning Objective 4

Translation methods illustrated

Juarezs

income statement items for 2005, in pesos.

20,000
Depr. exp
1,000
14,000
Interest exp.

Sales
COGS
500
S,G,&A exp.

Learning Objective 4

2,500

Income tax exp.

500

Translation methods illustrated

There

was no beginning inventory.

Inventory, which is carried at cost, was acquired
evenly during the last quarter of 2005.
Purchases were made evenly throughout year.
Fixed assets were acquired on January 1, 2005.
Capital stock was sold on January 1, 2005.

Learning Objective 4

Translation methods illustrated

Relevant exchange rates (U.S.
peso)
January 1, 2005
Average for 2005
Average for 4th quarter 2005
December 31, 2005

Learning Objective 4

dollar per Mexican

$0.10
$0.095
$0.09
$0.08

Current Rate Method Income Statement

Income Statement 2005
Sales
1,900
COGS
1,330
Gross profit
570
S,G,&A
238
Depreciation expense
95
Interest expense
48
Income tax expense
47
Net income
142
Learning Objective 4

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 545 Retained earnings 142
Total assets
985 Cumulative
translation adj. (97)
Total liab. & S.E.
985

Learning Objective 4

Temporal Method Balance Sheet

Balance Sheet December 31, 2005

Cash
80
Accounts payable
160
Accounts Rec.
160
Long-term debt
480
Inventory
225
Capital stock
300
Fixed Assets, net
700
Retained
earnings 225
Total assets
1,165
Total liab. & S.E.
1,165
Learning Objective 4

Temporal Method Balance Sheet

Income Statement 2005

Sales
1,900
COGS
1,343
Gross profit
557
S,G,&A
238
Depreciation expense
100
Interest expense
48
Income tax expense
47
Remeasurement gain
101
Net income
225
Learning Objective 4

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

Translation methods illustrated Summary

Temporal Method

Primarily monetary assets and liabilities translated

at current rate.
This results in net liability asset exposure.
Net liability exposure and devaluing foreign
currency results in translation gain.
Translation gain included in current income.

Learning Objective 4

What is the appropriate current rate?

Translation gains/losses? Deferred or
booked? Shown in income or just equity?

USA
IFRS
Diversity seen in other nations

Pre-1965: Current/Noncurrent method

applied. Losses recognized into income.
Gains were deferred.
1965-1975: Single Rate method was also
allowed.
1975-1981: FAS 8, which required temporal
method to be used. All gains and losses taken
into income

1981-today: SFAS 52, which has the

following features:

Functional currency determines accounting.

If functional currency is the local currency- use
single current rate. Gains and losses routed directly
to stockholders equity.
If functional currency is US Dollar, use the temporal
method and fully recognize gains/losses into
earnings.
If functional currency is different from local
currency or US Dollar, do both.

U.S. GAAP under SFAS 52

Requires identification of functional currency.

Functional currency is the primary currency of
the foreign subsidiarys operating
environment.
The standard includes a list of indicators as
guidance for the foreign currency decision.

Learning Objective 5

Allows consideration of context.

In most cases, keeps impact of FC exchange
rate movements out of earnings.
Much more accepted by reporting community
than FAS 8 was.

From an investors viewpoint, is there any

economic difference, in substance, between
circumstances that distinguish the two
methods. If not, why have two different
kinds of accounting?
Inconsistent with the notion of
consolidation.
Numbers produced by SFAS 52 often lose
meaning.
Added risk of earnings management?

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 standards requirements pertaining to
hyperinflationary economies are substantially
different from SFAS 52.

Learning Objective 5

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.

Learning Objective 5

Hyperinflationary Economies -- IFRSs

IAS 21 and 29 use the term hyperinflationary
economies.
IAS 21 is not as specific in defining
hyperinflationary economies as 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. 5
Learning Objective

Companies that have foreign subsidiaries with

highly integrated operations use the temporal
method.
The temporal method requires translation gains
and losses to be recognized in income.
Losses negatively affect earnings, and both gains
and losses increase earnings volatility.

Learning Objective 6

These gains and losses result from the combination

of balance sheet exposure and exchange rate
fluctuations.
Companies can also hedge to offset the effects of
the translation adjustment to equity under the
current rate method.
Companies can hedge against gains and losses by
using foreign currency forward contracts, options,
and borrowings.

Learning Objective 6

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

How do we interpret reported FC gains and

losses, irrespective of where they show up?
Example: Company has a large subsidiary in
the EU. The subsidiary has a large net asset
position. The Euro depreciates more than
40%. Huge losses are reported.
The subsidiarys sales and profits skyrocket,
since they now seem more competitive to
customers than ever.

In a world of floating rate currency,

sometimes a weak currency is good, and a
strong currency is bad!
This explains why, when markets are tight or
declining, nations compete with each other in
a race to devalue their money the most!

All kinds of problems arise when the value

of money changes and is uncertain.
The economic impact of these changes vary
as a function of the inherent cause of the FC
movement and the type of holding
(asset/liability; monetary/non-monetary;
current/noncurrent).
Accounting limitations (e.g., historical cost)
mix with this uncertainty, making financial
reporting difficult at best.
The current paradigm is SFAS 52. This could
easily change at any time, as it has several
times before.