Chapter 7

Translation of Foreign
Currency Financial Statements
 Translation of Financial Statements
• In today's global economy, many
companies have invested in operations in
foreign countries.
• In preparing consolidated financial
statements on a worldwide basis, the
foreign currency accounts prepared by
foreign operations must be restated into
the parent company's reporting currency
(US $ for US companies).
 Translation of Financial Statements
What happens when a US corporation owns a
foreign corporation?
Our subsidiaries are
If we control our required by local
subsidiaries, why regulations to use their
don’t they all use local currency. Their
the US Dollar as statements must be
their currency? translated to US $.
Translation of Financial Statements

In addition, many countries

have different accounting rules
that we must consider before
translating the sub’s financial
statements.
 Worldwide Consolidated Financial
Statements
To prepare worldwide consolidated financial
statements a U. S. parent must:
(1) convert the foreign GAAP financial statements
of its foreign operations into U.S. GAAP and
(2) translate the financial statements from the
foreign currency into U.S. dollars.
This conversion and translation process is required
whether the foreign operation is a branch, joint
venture, majority-owned subsidiary, or affiliate
accounted for under the equity method.
 A simple example
• Let’s say XYZ sold its product on account
at €10,000 on July 1. The €/$ spot rate
(DQ) is $ 1.00 on 1/1 and $1.10 on 7/1. On
12/31, it is $1.20.

• How much should we record for A/R(€) on

its balance sheet?
• How much should we record for Sales
revenue on its income statement?
 A simple example
• Let’s say XYZ has a 1000 euro current note
receivable (from sales on 1/1) on its books. The
euro/$ direct rate is $ 1.00 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

resulting adjustment be reported?
 Another simple example:
• Let’s 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 $ 0.90
• Should we record:
– No change?
– An decrease in value of $100,000?
– An decrease in value of $50,000?

And if we do report a change, where should the

resulting adjustment be reported?
 Primary conceptual issues
• Each financial statement item must be translated
using some, hopefully relevant, exchange rate.
• Which exchange rates should be used?
– the current exchange rate?
– the historical exchange rate?
– the average 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?
 Exchange rates
• Which exchange rates should be used?
– Current Exchange Rate – the exchange rate
which exists at the balance sheet date
– Historical Exchange Rates – the exchange
rate which existed at the time a transaction
occurred
• Average exchange rate – average-for-the-period
rates
 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”
(or Remeasurement Gain or Loss) is
debited or credited.
 Translation Adjustments
• How should the resulting translation
adjustment be reported on the
consolidated financial statements?
– Translation adjustments can be either
(1) reported as a gain or loss
(Remeasurement Gain or Loss) in income
statement, or
(2) deferred in OCI (stockholders' equity)
section of the balance sheet (Translation
Adjustments)
Which of the following items should be
shown as a component of comprehensive
income? (AICPA 2015)

A. Dividend paid to a shareholder.

B. Foreign-currency translation
adjustment.
C. Additional capital contribution.
D. Deferred revenue.
 Translation Adjustments
• Exposure to translation adjustments (or
Remeasurement Gain or Loss) 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 (or
gain – a credit entry)
• Liabilities translated at the current exchange
rate when the foreign currency is appreciating
generate negative translation adjustments (or
loss – a debit entry)
 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.
 Balance Sheet Exposure
Net
NetAsset
Asset Balance
Balance Sheet
Sheet Exposure
Exposure
When
Whenassets
assets translated
translatedatat current
current rates
rates >>
liabilities
liabilities translated
translatedat
at current
current rates.
rates.

Net
Net Liability
Liability Balance
Balance Sheet
Sheet Exposure
Exposure
When
Whenliabilities
liabilities translated
translatedat at current
current rates
rates >>
assets
assetstranslated
translatedat at current
current rates.
rates.
 Balance Sheet Exposure
• A net liability balance sheet exposure exists
and the foreign currency depreciates. Which
of the following statements is generally true?

A. There is no translation adjustment.

B. There is a positive translation adjustment.
C. There is a negative translation adjustment.
D. There is a remeasurement loss.
E. There is a remeasurement gain.
 Translation Methods
• Translation methods differ on the basis
of which accounts are translated at the
current exchange rate and which are
translated at a historical exchange rate.
• The dominant methods currently in use
are
– Current rate method
– Temporal method
 Current Rate Method
• Balance sheet exposure under the current
rate method is equal to the foreign entity's net
assets (stockholders' equity).
• Assets and liabilities are translated at the
current exchange rate
• Equity is translated at historical rates.
• Translating all assets at the current rate does
maintain underlying ratios and relationships
that exist in the foreign currency statements.
• Translating assets which are carried at cost
using the current exchange rate results in a
translated value which is NOT easily
interpretable
– It is neither a current value nor a historical cost.
 Current Rate Method
• Revenues and expenses which occur
evenly throughout the period are
USUALLY translated at the average
exchange rate.
– Income items, such as gains and losses,
which are the result of a discrete event, are
translated at the actual exchange rate on the
date of occurrence.
• Appreciation in the foreign currency
results in a positive translation adjustment.
• Depreciation results in a negative
translation adjustment.
 Current Rate Method
(Summary)
•• Use
Use current
current exchange
exchange rates rates to to
translate
translate all
all assets
assets and and liabilities.
liabilities.
•• Use
Use historical
historical exchange
exchange rates rates to to
translate
translate equity
equity accounts.
accounts.
•• Use
Use average
average (or (or historical)
historical)
exchange
exchange rates
rates toto translate
translate income
income
statement
statement accounts.
accounts.
•• Assumes
Assumes “net
“net investment”
investment” in in aa foreign
foreign
operation
operation is
is exposed
exposed to to foreign
foreign
exchange
exchange risk.
risk.
A company's foreign subsidiary operation maintains its
financial statements in the local currency. The foreign
operation's capital accounts would be translated to
the functional currency of the reporting entity using
which of the following rates? (AICPA 2014)

A. Historical exchange rate.

B. Functional exchange rate.
C. Weighted-average exchange rate.
D. Current exchange rate at the balance sheet date.

The contributed capital accounts of a foreign subsidiary are translated into

the currency of the reporting entity using historical exchange rates, the rates
in effect when the capital was contributed to the entity.
A foreign subsidiary's functional currency is its local
currency, which has not experienced significant
inflation. The weighted average exchange rate for
the current year would be the appropriate exchange
rate for translating
(AICPA 2009)

Salaries Sales to
expense external customers
A. Yes Yes
B. Yes No
C. No Yes
D. No No
 Temporal Method
• The objective of the temporal method is
– to produce a set of U.S. dollar translated financial
statements as if the foreign subsidiary had actually
used U.S. dollars
• Assets and liabilities carried at current or future
value (monetary items) are remeasured at the
current exchange rate.
• Assets and liabilities carried at cost (non-
monetary items) and stockholders' equity items
are translated at a historical exchange rate.
– By translating some assets at the current exchange
rate and others at historical rates the temporal method
distorts financial ratios calculated in the foreign
currency.
Monetary vs. Non-Monetary
 Temporal Method
• Most income statement items are
translated at average rates.
• COGS, depreciation, and amortization
expense are usually translated at relevant
historical exchange rates.
• Balance sheet exposure under the temporal
method is defined as cash, marketable
securities, and receivables minus total
liabilities.
– A net liability exposure often exists.
 Temporal Method
• When a net liability balance sheet
exposure exists, depreciation of the
foreign currency results in a
remeasurement gain and appreciation of
the foreign currency results in a
remeasurement loss.
• Reporting a translation loss when the
foreign currency appreciates is thought to
be inconsistent with economic reality.
 Fixed Assets and Accumulated
Depreciation
Current
Current Rate
Rate Method translate fixed
Method -- translate fixed assets
assets and and
accumulated
accumulated depreciation
depreciation using
using the
the spot
spot rate
rate as
as of
of
the
the balance
balance sheet
sheet date.
date.

Temporal
Temporal MethodMethod -- fixed
fixed assets
assets acquired
acquired at at
different
different times
times will
will be
be translated
translated using
using their
their respective
respective
historical
historical translation rates. Accumulated
translation rates. Accumulated
depreciation
depreciation usesuses the
the same
same historical
historical rates
rates as
as the
the
related
related asset.
asset.
 Depreciation Expense

Current
Current Rate
Rate Method translate depreciation
Method -- translate depreciation
expense
expense using
using the
the average
average rate
rate for
for the
the current
current period
period

Temporal
Temporal Method translate depreciation
Method -- translate depreciation
expense
expense using
using the
the various
various historical
historical rates
rates related
related to
to
the
the underlying
underlying assets.
assets.
 Calculation of Cost of Goods Sold

Current
Current RateRate Method
Method -- translate
translate using
using the
the average
average
rate
rate for
for the
the current
current period.
period.
Temporal
Temporal MethodMethod -- decompose
decompose COGS
COGS into
into its
its
component
component partsparts and
and translate
translate each
each part
part using
using the
the
appropriate
appropriate raterate
Beginning Inventory × Historical Rate
+ Purchases × Average Rate
- Ending Inventory × Historical Rate
= COGS
When
When applying
applying LCNRV,
LCNRV, use
use the
the current
current foreign
foreign
exchanges
exchanges rates.
rates.
 Translation of Retained Earnings
Since
SinceR/E
R/Eisisaa composite
composite of of many
manyprevious
previoustransactions,
transactions,
translating
translatingR/E
R/Erequires
requires special
specialattention.
attention.
At
At the
the end
end of
of the
the first
first year
year of
of operations:
operations:
Net Income from the translated Net Income
=
in FC income statement in US $
Dividends in historical exchange Dividends in
x =
- FC rate when declared US $
Ending R/E Ending R/E
in FC in US $

Ending
Ending R/E
R/E from
from year
year 1,
1, becomes
becomes Beginning
Beginning R/E
R/E in
in
Year
Year 2.
2.
 Translation Methods:
Temporal and Current Rate
Two major translation methods are currently used: (1) the current
rate (closing rate) method and (2) the temporal method.
 Disposition of Translation Adjustment

•• Current
Current Method
Method
–– Translation
TranslationAdjustment
Adjustment isis reported
reported on
on the
the
Balance
Balance Sheet
Sheet (Equity
(Equity Section).
Section).
•• Temporal
Temporal Method
Method
–– Adjustment
Adjustment is
is reported
reported on
on the
the Income
Income
Statement
Statement asas aa Remeasurement
Remeasurement
(Translation)
(Translation) Gain
Gain or
or Loss.
Loss.
History of Translation Accounting in USA
• 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: ASC 830
 ASC 830
• 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.
Functional Currency
To
Todetermine
determinewhether
whether aa subsidiary
subsidiaryisis
integrated
integratedwith
withthe
theparent
parent or
or operates
operates
independently,
independently,ASCASC830
830introduced
introducedthe
the
concept
concept of
of functional
functional currency.
currency.

U.S.
U.S. Local
Local
Dollar
Dollar Currency
Currency

Use the Temporal Use the Current

Method for Rate Method for
translation. translation.
Determining a Subsidiary’s Functional
Currency
A foreign subsidiary of a U.S. parent
company should measure its assets,
liabilities and operations using
(AICAP 2015)

A. The subsidiary's local currency.

B. The subsidiary's functional
currency.
C. The U.S. dollar.
D. The best available spot rate.
A company from the United Kingdom uses
British pounds in its normal operations, reports
in the European Union in euros, and reports in
the United States in U.S. dollars. The company
is owned by a private equity firm in Japan.
What is the company's functional currency?
(AICPA 2018)
A. The Euro.
B. The British pound.
C. The U.S. dollar.
D. The Japanese yen.
A company’s functional currency is the currency it uses in the primary economic environment
in which it operates, i.e., the currency it uses in its normal operations.
 ASC 830 (SFAS 52)
• Functional currency determines
accounting.
• If functional currency is the local
currency
– Use single current rate.
– Gains and losses routed directly to
stockholder’s equity.
• If functional currency is US Dollar
– Use the temporal method
– Fully recognize gains/losses into earnings.
 Highly Inflationary Economies
In
In highly
highlyinflationary
inflationary
economies,
economies,ASC ASC830
830mandates
mandates
the
theuse
useof
of the
the Temporal
Temporal Method
Method
for
fortranslation.
translation.

Disappearing
DisappearingPlant Plant Problem
Problem
IfIf the
the Current
Current Method
Method were
were
used,
used, the theUS
US$$equivalent
equivalent
would
wouldbe beVERY
VERYsmall
small due
dueto
to
the
therapidly
rapidlyincreasing
increasing
exchange
exchangerate. rate.
 Highly Inflationary Economies
•A country has a highly inflationary economy
when its cumulative three year inflation
exceeds 100 percent.
•With compounding, it equates to an
average of approximately 26 percent per
year for three years in a row.
•A country may or may not be classified as
highly inflationary, depending on its most
recent three-year experience with inflation.
 Current Rate Method Example
•• News
News Co.,
Co., is
is aa wholly
wholly owned
owned foreign
foreign sub
sub of of
ATG
ATG Corporation.
Corporation. News News Co.’s
Co.’s transactions
transactions and and
financial
financial statements
statements are are denominated
denominated in in the
the
local
local (functional)
(functional) currency,
currency, the
the Pater
Pater (PT).
(PT).
•• Using
Using the
the following
following information,
information, translate
translate their
their
statements
statements intointo US
US $.
$.
 Current Rate Method Example
•• News
News Co.’s
Co.’s common
common stock
stock was
was issued
issued in
in 2012
2012
when
when the
the exchange
exchange rate
rate was
was $1.00
$1.00 == 1.20
1.20 PT.
PT.
•• Fixed
Fixed assets
assets were
were acquired
acquired inin 2013
2013 when
when thethe
exchange
exchange rate
rate was
was $1.00
$1.00 == 1.10
1.10 PT.
PT.
•• As
As of
of Jan.
Jan. 1,
1, 2018,
2018, the
the R/E
R/E balance
balance waswas
translated
translated at
at $350,000.
$350,000.
•• Inventory
Inventory was
was acquired
acquired evenly
evenly throughout
throughout thethe
year.
year.
 Current Rate Method Example
• Dividends were declared on March 15, 2018, and
equipment was sold on October 1, 2018.
• The following exchange rates were in effect during the
year:

Jan 1, 2018 $1.00 = .90 PT

Mar 15, 2018 $1.00 = .86 PT
Oct 1, 2018 $1.00 = .80 PT
Dec 31, 2018 $1.00 = .98 PT
Weighted Avg. Rate $1.00 = .85 PT
 Remeasurement of Financial
Statements
•• IfIf the
the sub’s
sub’s functional
functional currency
currency is is
the
the U.S.
U.S. $,
$, then
then any
any balances
balances
denominated
denominated in in the
the local
local currency,
currency,
must
must be be remeasured.
remeasured.
•• Remeasurement
Remeasurement requires requires the
the
application
application of of the
the temporal
temporal method.
method.
•• The
The remeasurement
remeasurement gain gain or
or loss
loss
appears
appears on on the
the income
income statement.
statement.
 Hedging Balance Sheet Exposure
Translation adjustments and re-measurement
gains / losses arise from:
(1) Exchange rate changes and
(2) Balance sheet exposure
Balance sheet exposure can be hedged,
through derivatives (forward contracts or
foreign currency options) or through
nonderivative instruments (foreign currency
borrowings)

Ironically, in seeking to avoid unrealized

translation adjustments, realized foreign
exchange gains and losses can occur!
 IFRS and Translations
• IFRS and US GAAP are consistent on
most points, however,
• IFRS has a hierarchy of characteristics for
determining the functional currency, and
• The method used to translate statements
from a hyperinflationary country differs.
 IFRS 9 – Financial Instruments
• IFRS 9 allows hedge accounting for hedges of
net investments in a foreign operation.
• A gain or loss on the hedging instrument is
recognized in Accumulated Other Comprehensive
Income (AOCI) along with the translation
adjustment being hedged.
• Under both IFRS and U.S. GAAP, the cumulative
translation adjustment and cumulative net gain
or loss on the net investment hedge are
transferred from AOCI to net income when the
foreign subsidiary is sold or otherwise disposed
of.
 Disclosures Related to Translation
• Current standards require firms to present an
analysis of the change in the cumulative
translation adjustment account in the financial
statements or notes thereto.
• Many companies comply with this requirement
directly in their statement of comprehensive
income.
– Other companies provide separate disclosure in the
notes.
• Although not specifically required to do so, many
companies describe their translation procedures in
their “summary of significant accounting
policies” in the notes to the financial statements.
 Disclosures Related to
Translation
•• An
An analysis
analysis of
of the
the change
change in
in the
the
cumulative
cumulative translation
translation adjustment.
adjustment.
––May
May appear
appear asas other
other comprehensive
comprehensive
income
income in
in the
the Statement
Statement ofof
Shareholders’
Shareholders’ Equity
Equity or
or as
as aa separate
separate
disclosure
disclosure in
in the
the Notes
Notes
•• Many
Many companies
companies alsoalso include
include aa
description
description of
of the
the translation
translation
procedures
procedures inin Note
Note 1.1.
 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.