FOREI GN CURRENCY

TRANSLATI ON
L E A R N I N G O B J E C T I V E
Develop the necessary understanding and skills to translate the financial statements of a foreign
entity into U.S. dollars using the all-current and the monetary-nonmonetary translation methods.
Business rms desiring to sell goods or services in countries other than their home country must make at least
two important decisions:
1. Location of Product Creation. Should the firm create the good or service in its home country and then
export (sell) abroad? Alternatively, should the firm both create and sell the good or service abroad
through some foreign entity (for example, a branch office or subsidiary)?
2. Currency for Denominating Transactions. Should the firm structure transactions so that all cash flows
occur in the currency of the home country? Alternatively, should the firm use the currency of the for-
eign country to denominate all cash ows?
The manner in which a rm structures its foreign operations affects its exposure to exchange-rate changes.
A brief overview of exchange rates will enhance an understanding of the effect of exchange-rate changes on
a rm.
NAT UR E OF E XC HANGE R AT E S
An exchange rate is the price of one countrys currency in terms of another countrys currency. For exam-
ple, the British pound might be worth U.S. $2.00 at a given time. The exchange rate would be stated as one
British pound is worth two dollars, or one dollar is worth .50 (= 1/$2) British pound.
Exchange rates, like the price of any good or service, reect the forces of demand and supply. Economic
and political conditions, as well as prospects within a country relative to those in other countries, affect the
level of exchange rates. New, unanticipated information about a countrys economic and political condi-
tions and prospects causes exchange rates to change.
For example, the exchange rate between the U.S. dollar and the British pound might change as follows:
U.S. Dollars British Pounds
Date per British Pound per U.S. Dollar
January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2.00:1 50:$1
Average during Year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2.10:1 48:$1
December 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2.20:1 45:$1
In this case, the British pound increased in value relative to the U.S. dollar during the year. A purchaser
of British pounds needs $2.20 to purchase one British pound on December 31 but needed only $2.00 on
January 1. Alternatively, a purchaser of U.S. dollars needs only .45 to purchase one U.S. dollar on December
31 but needed .50 on January 1.
E F F E C T OF E XC HANGE - R AT E C HANGE S
Consider now how the structure of a rms foreign operations and the currency in which it denominates trans-
actions affect its exposure to exchange-rate changes.
Example 1 Americo, Inc., a U.S. corporation, desires to expand geographically by selling its products
in the United Kingdom (U.K.). It can manufacture the products in the United States and export the goods to
the U.K. Americo will invest in new plant facilities in the United States to provide the necessary production
capacity. It will purchase all raw materials and labor services in the United States. Americo will set selling
prices for its products in U.S. dollars and will require its U.K. customers to pay in U.S. dollars. Assume that
the exchange rate between the U.S. dollar and the British pound changed during the rst year of operations
as shown above (that is, the British pound increased in value relative to the U.S. dollar).
In this case, Americos British customers enjoy the benefits and bear the risk of exchange-rate changes
between the time of sale, when Americo and its customers agree to a selling price in U.S. dollars, and the time
of cash collection/payment, when the customer pays the agreed amount in U.S. dollars. Because Americo
incurs costs and generates revenues in U.S. dollars, exchange-rate changes do not directly affect it. Exchange-
rate changes may, however, affect the willingness of U.K. customers to purchase products from Americo ver-
sus another competitor. The increased value of the British pound relative to the U.S. dollar makes Americos
products less expensive for U.K. customers. Americos competitors may reduce their prices to avoid losing
their customers to Americo.
Example 2 Refer to Example 1. Suppose again that Americo locates its manufacturing operations in
the United States and then exports finished products. Assume now, however, that Americo sets selling
prices in British pounds instead of U.S. dollars. In this case, Americo enjoys the benets and bears the risk
of exchange-rate changes between the time of sale and the time of cash collection. The asset at risk is
Americos accounts receivable denominated in British pounds.
To understand this example, assume that Americo sells goods for 120 million at a time when the
exchange rate is $2.1:1. This account receivable has the U.S. dollar-equivalent value at the time of sale of
$252 (= $2.10 120) million. The exchange rate on December 31 is $2.2:1. If this account receivable
remains uncollected at year-end, it has the U.S. dollar-equivalent value of $264 (= $2.2 120) million.
Americo prots by $12 (= $264 $252) million from the change in the exchange rate.
Example 3 Refer to Example 1. Suppose now that Americo establishes a wholly-owned subsidiary
in the U.K. to carry out all manufacturing and selling activities in that country. Americo will invest the nec-
essary funds to build the plant facilities. The subsidiary will purchase raw materials and labor services in the
U.K. and denominate sales to U.K. customers in British pounds. To nance future growth, the U.K. subsidiary
will retain within the U.K. the net assets generated by earnings.
In this case, Americo has exposed its investment in the net assets of the subsidiary (= assets liabilities,
or shareholders equity) to the risk of exchange-rate changes. Investing capital in this subsidiary, both initially
and through retained earnings, will result in Americos later receiving cash (from dividends and from the
sale of the subsidiary) in amounts that vary as a result of changes in the value of the British pound.
To understand this example, assume that Americo invested $200 million in a newly created U.K. sub-
sidiary on January 1 in return for all of the subsidiarys stock. The exchange rate on January 1 was $2:1.
Thus, the U.K. equivalent amount for this investment is 100 (= $200/$2) million. During the first year of
operations, the subsidiary generated earnings of 80 million and paid no dividends to Americo. The average
exchange rate during the year was $2.1:1, and the exchange rate on December 31 was $2.2:1. The increas-
ing value of the British pound relative to the U.S. dollar alone increases the dollar valuation of Americos
investment in the net assets of the subsidiary by $28 million, derived as follows:
British Exchange U.S.
Pounds Rate Dollars
Initial Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 $2.0:1 $200
Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 $2.1:1 168
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180 $368
$2.2:1 396
Foreign Exchange Gain . . . . . . . . . . . . . . . . . . . . . . . . $ 28
The net assets derived from Americos initial investment and the retention of earnings total 180 million
on December 31. At the exchange rate of $2.2:1 on this date, the dollar-equivalent amount of these net assets
F o r e i g n Cu r r e n c y T r a n s l a t i o n 2
is $396 million. If Americo had kept the $200 million in its U.S. bank account instead of investing it in the
U.K. subsidiary and had required the subsidiary to remit dividends equal to earnings throughout the year,
Americo would show only $368 million in its U.S. bank account on December 31. Americo proted by $28
million from investing funds in a country whose currency increased in value relative to the U.S. dollar.
Americo earned this $28 million in addition to the operating profits that the U.K. subsidiary earned on its
sales. In contrast, if the British pound had decreased in value relative to the U.S. dollar, Americo would
have been worse off converting its dollars into British pounds at the beginning of the year and allowing the
U.K. subsidiary to retain the net assets generated by earnings during the year.
OVE R VI E W OF F OR E I GN C UR R E NC Y T R ANS L AT I ON
Business firms conduct operations in countries other than their home country through branch offices, sub-
sidiaries, affiliates, joint ventures, and other entities. Domestic rms account for their foreign investments fol-
lowing the same accounting principles that they use for domestic investments:
1. The market value method when the ownership percentage does not convey significant influence, usu-
ally less than 20 percent
2. The equity method when the ownership percentage does convey signicant inuence, usually between
20 percent and 50 percent
3. The consolidation method for majority-owned investments (unless government restrictions severely con-
strain a parent companys ability to exercise control of the foreign subsidiary)
The foreign entities keep their accounting records in their local currencies. To apply the appropriate
accounting method for these investments, the domestic (say, U.S.) firm must translate the foreign (say,
U.K.) entitys nancial statements from the foreign currency (pound sterling, ) into the domestic currency
(dollar, $), a process known as foreign currency translation.
Translating the nancial statements of foreign entities requires responses to two questions:
1. Which exchange rate should a rm use to translate each account in a foreign entitys nancial statements?
2. How should the rm treat any adjustment, analogous to gain or loss, that arises from translation?
Exchange Rate Used i n Transl ati on Accounting distinguishes between the historical
exchange rate and the current exchange rate. The historical exchange rate refers to the exchange rate in effect
when the rm rst recorded a particular transaction. The historical exchange rate for inventories, property,
plant, and equipment means the exchange rate at the time the firm acquired these items. The historical
exchange rate for bonds payable and common stock means the exchange rate at the time the firm issued
these securities. The current exchange rate refers to the exchange rate at the date of the balance sheet for
balance sheet items and refers to the average exchange rate during the current period for income statement
items. Firms could conceivably use the historical exchange rate for each financial statement item, the cur-
rent exchange rate for each item, or some combination of the two.
Treatment of Changes in Amounts that Result from Translation Firms may
have to change the U.S. dollar amount for their foreign account amounts depending on the exchange rate they
use in translation.
I When rms translate foreign currency amounts into their U.S. dollar-equivalent amounts using the his-
torical exchange rate, changes in exchange rates do not affect the U.S. dollar valuation because, by
denition, those items appear in U.S. dollars at their acquisition cost translated at the exchange rate on
the date of acquisition, for assets (or on the date of issue, for equities).
I When firms translate foreign currency amounts into their U.S. dollar-equivalent amounts using the
current exchange rate, changes in exchange rates do affect the U.S. dollar valuation because those
items have dollar valuations different from those at the date of acquisition, for assets (or at the date of
issue, for equities).
F o r e i g n Cu r r e n c y T r a n s l a t i o n 3
When the reported amount of these items varies as a result of a change in the exchange rate, accountants
refer to the variance as a foreign exchange adjustment. Firms might conceivably treat the foreign exchange
adjustment in one of two ways:
1. Include the amount as a foreign exchange gain or loss in the computation of net income for the period,
which rms then close out to retained earnings.
2. Include the amount as a foreign exchange adjustment in other comprehensive income, a separate com-
ponent of the shareholders equity account, bypassing the income statement. This treatment resembles
that for unrealized holding gains and losses on marketable equity securities classied as available for sale,
described in Chapters 11.
These two treatments result in identical total shareholders equity. They differ with respect to the effects
that the foreign exchange adjustment has on net income and on particular shareholders equity accounts.
Generally accepted accounting principles (GAAP) sometimes require the historical exchange rate and some-
times the current exchange rate. The choice depends both on whether the rm uses foreign or U.S. currency
as the primary currency and, if the rm uses the U.S. dollar, on whether the translation applies to a nancial
statement account that is monetary or nonmonetary. The next section explains these principles.
GAAP F OR F OR E I GN C UR R E NC Y T R ANS L AT I ON
GAAP in the United States require rms to identify the functional currency of each foreign unit.
1
The func-
tional currency refers to the currency in which the foreign unit conducts most of its activities. The func-
tional currency depends on the operating characteristics of the foreign unit. Statement of Financial Accounting
Standards (SFAS) No. 52 requires rms to classify each foreign unit into one of two categories:
1. Self-contained: foreign operations are contained within a particular foreign country. (That is, the firm
obtains capital, acquires inventories and labor services, sells to customers, and retains earnings all within
the foreign country. Example 3 illustrates a self-contained foreign operation.) The Financial Accounting
Standards Board (FASB) requires that the currency of the foreign unit be the functional currency for self-
contained foreign operations.
2. Extension of U.S. operations: foreign operations are primarily an extension of the parents operations in
the United States. (That is, the foreign unit obtains capital from the U.S. parent company or borrows in
U.S. dollars, acquires inventories from the U.S. parent, and remits earnings back to the parent. Example
2 illustrates foreign operations that extend the operations of the U.S. parent.) The FASB requires that
the U.S. dollar be the functional currency for foreign operations that extend U.S. operations.
The facts need not clearly signal a unique classication: a particular foreign operation can combine aspects
of the self-contained entity while still being integrated with the parent. For example, a foreign unit may
acquire raw materials from the U.S. parent and remit 50 percent of its earnings back to the parent but may
obtain funds within the foreign country and sell primarily to local customers. Management must weigh all
of the evidence to decide which characterization better describes the foreign operation.
Note on Current Practice. The FASB issued SFAS No. 52, the reporting standard for foreign currency
translation, before the emergence of the global rm that sources capital and raw materials in many countries
and sells to customers in many countries. In this case, the foreign operations are neither self-contained nor
integrally related to the parent, so identifying the functional currency involves some arbitrariness.
SFAS No. 52 requires the all-current translation method for self-contained foreign operations (functional
currency = foreign currency) and the monetary-nonmonetary translation method for foreign operations inte-
grated with those of the U.S. parent (functional currency = U.S. dollar). Foreign operations located in hyper-
inationary countries must also use the monetary-nonmonetary translation method. The FASB considers the
foreign currency to be too unstable in hyperinationary countries to serve as a measuring unit. Firms must use
the U.S. dollar as the functional currency in these cases. We discuss these two translation methods below.
F o r e i g n Cu r r e n c y T r a n s l a t i o n 4
1
Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 52, Foreign Currency Translation, 1981.
Rationale. GAAP attempt to report on the two kinds of foreign operations as if they result from two
different types of U.S. management control patterns.
I When a domestic parent invests in self-contained foreign operations and does not expect to recapture its
investment for several years, it puts its investment at risk to exchange-rate changes. It delegates to
managers in the foreign country the day-to-day management decisions. Whether those foreign managers
choose highly leveraged or conservative nancing, the U.S. parent considers only its own investment
at risk and has put that investment at risk for several years. The next section illustrates the method
required for self-contained foreign operationsthe all-current translation accounting method. This
method calculates an exchange adjustment based on the parents investment in the shareholders equity
(= assets liabilities) of the foreign unit. Because the parent intends to allow the foreign unit to retain
the net assets represented by its investment for many years, U.S. GAAP require firms to include the
exchange adjustment in a separate shareholders account, not in periodic net income. For the U.S.
investor in a self-contained foreign operation, GAAP attempt to present results as though the U.S.
investor sees only its investment, not the structure of the individual assets and liabilities or the results
of day-to-day operations.
I In contrast, management of a U.S. company extending its operations into a foreign country has day-to-
day control of assets, liabilities, and operations. It intends to require the foreign unit to remit assets
generated by earnings to the United States on an ongoing basis. Remitting assets generated by periodic
earnings will likely require the foreign unit frequently to convert foreign currency into U.S. dollars.
Because the parent intends to have the foreign unit regularly convert the foreign currency into U.S.
dollars and then remit to its U.S. parent the assets generated by foreign earnings, U.S. GAAP require
such rms to include the exchange adjustment in net income each period by using the monetary-non-
monetary translation method. The managers of the parent concern themselves with the affiliates day-
to-day operations. The monetary-nonmonetary measurement basis attempts to reect, in U.S. nancial
statements, this day-to-day control that managers have over their integrated and extended foreign
operations.
The next section describes and illustrates these translation methods using information for Domestic
Company.
Data for Domestic Company Example Domestic Company, a U.S. parent company, estab-
lishes a foreign subsidiary in the U.K. by investing $200 on January 1, Year 1, in return for all of the sub-
sidiarys common stock. The U.S. dollar and the U.K. pound exchange at the rate of $2:1 on this date. The
subsidiary engages in the following transactions during Year 1:
1. Acquires property, plant, and equipment on January 2, Year 1, costing 500. It nances the acquisition
with 450 of long-term debt and 50 of cash.
2. Acquires inventory on account totaling 850. The subsidiary uses a weighted-average cost ow assump-
tion.
3. Sells on account, for 1,000, inventory costing 700.
4. Pays selling and administrative expenses of 80, interest expense of 50, and income tax expense of 40.
5. Collects 880 from customers for sales on account and pays 680 to suppliers for purchases of inven-
tory on account.
6. Recognizes 50 as depreciation expense for Year 1.
7. Pays no dividends to the U.S. parent company.
The average exchange rate during Year 1 was $2.1:1, and the exchange rate on December 31, Year 1, is
$2.2:1. The increase in the number of U.S. dollars required to purchase one U.K. pound means that the
U.S. dollar declined in value relative to the U.K. pound during the year.
Exhibit 1 translates the balance sheet, and Exhibit 2 translates the income statement, both exhibits show-
ing the all-current method and the monetary-nonmonetary method.
F o r e i g n Cu r r e n c y T r a n s l a t i o n 5
AL L - C UR R E NT T R ANS L AT I ON ME T HOD
Self-contained foreign operations (where functional currency = foreign currency) must, to follow GAAP,
use the all-current translation method. The all-current method translates assets and liabilities using the
exchange rate on the date of the balance sheet. It translates revenues, expenses, and net income using the aver-
age exchange rate during the period. The foreign exchange adjustment that results from applying the all-cur-
rent method appears in other comprehensive income, a separate shareholders equity account, and does not
affect net income each period. The rationale for the all-current method for self-contained foreign operations
results from the fact that the U.S. investor views only its investment in (= net assets of) the foreign unit as
being at risk to exchange-rate changes. That is, the U.S. investor has put at risk an amount equal to the
shareholders equity of the foreign unit. A decision to invest in a foreign unit and to permit the foreign unit
to retain, for internal growth, assets generated by earnings means that the parent will not realize the benet
or incur the loss from exchange-rate changes inherent in its net asset position until either the foreign unit
remits a dividend or the parent sells the foreign unit. Because such events will not likely occur for many years,
net income excludes the foreign exchange adjustment each period.
Refer to Exhibits 1 and 2. The all-current method translates assets and liabilities using the exchange rate
on December 31, Year 1, of $2.2:1. The all-current method translates common stock using the exchange rate
of $2.0:1 on January 1, Year 1, the date the domestic parent company established the subsidiary by invest-
ing $200. Retained earnings at the end of Year 1 equal net income for Year 1 because the subsidiary paid no
dividends. The translation of revenues, expenses, and net income uses the average exchange rate during
Year 1 of $2.1:1.
The foreign exchange adjustment is $28, the amount by which the U.S. investors investment, when
translated into dollars from the foreign books, exceeds the dollar amount carried on the U.S. books. Exhibit
3 calculates this $28 amount, a credit because it resembles a gain, although the all-current method will not
report it as a gain.
The net assets of the subsidiary on January 1, Year 1, equal the 100 (or $200) invested by Domestic
Company. The U.K. pound increased in value relative to the U.S. dollar during Year 1. If the subsidiary
F o r e i g n Cu r r e n c y T r a n s l a t i o n 6
EXHI BI T 1
DOMESTIC COMPANY
Translation of Balance Sheet
December 31, Year 1
All-Current Method Monetary-Nonmonetary Method
Exchange Exchange
Pounds Rate Dollars Pounds Rate Dollars
ASSETS
Cash . . . . . . . . . . . . . . . . . . . . . . . . . 80 $2.2:1 $ 176 80 $2.2:1 $ 176
Accounts Receivable. . . . . . . . . . . . . . . 120 $2.2:1 264 120 $2.2:1 264
Inventories. . . . . . . . . . . . . . . . . . . . . . 150 $2.2:1 330 150 $2.1:1 315
Property, Plant, and Equipment . . . . . . . 450 $2.2:1 990 450 $2.0:1 900
Total Assets . . . . . . . . . . . . . . . . . . 800 $1,760 800 $1,655
LIABILITIES AND
SHAREHOLDERS EQUITY
Accounts Payable. . . . . . . . . . . . . . . . . 170 $2.2:1 $ 374 170 $2.2:1 $ 374
Bonds Payable . . . . . . . . . . . . . . . . . . . 450 $2.2:1 990 450 $2.2:1 990
Common Stock . . . . . . . . . . . . . . . . . . 100 $2.0:1 200 100 $2.0:1 200
Foreign Exchange . . . . . . . . . . . . . . . . . See Exh. 3 28
Retained Earnings . . . . . . . . . . . . . . . . 80 See Exh. 2 168 80 See Exh. 2 91
Total Liabilities and
Shareholders Equity . . . . . . . . . . 800 $1,760 800 $1,655
converted net assets of 100 on December 31, Year 1, into U.S. dollars and remitted them to its parent com-
pany, Domestic Company would receive net assets of $220 (= 100 2.2:1). The parent company has
enjoyed an increase in wealth of $20 by the end of Year 1 from placing the $200 in a subsidiary whose cur-
rency increased in value relative to the U.S. dollar. That is, the $220 exceeds by $20 the amount the firm
would have on deposit if it had left the funds in its U.S. bank account.
During Year 1, the net assets of the subsidiary increased by 80 from earnings. Domestic Company per-
mitted net assets equal to this 80 of earnings to remain in the subsidiary when it could have required the sub-
sidiary to remit them to the parent company as a dividend. Had the foreign subsidiary remitted the dividend
in U.K. pounds and had the U.S. parent converted those pounds to dollars on receiving them, the U.S. parent
would have had U.S. dollars of $168 (= 80 $2.1:1). By leaving the assets in the foreign company rather
than taking them out via dividends, the parent had a year-end total of assets denominated in U.K. pounds with
a U.S. dollar equivalent value on December 31, Year 1, of $176 (= 80 $2.2:1). Domestic Company has
increased its wealth by $8 (= $176 $168) from leaving the net assets generated by earnings in the U.K.
subsidiary instead of transferring them back to the United States. The total foreign exchange adjustment for
Year 1 totals $28 [= $20 (on initial investment) + $8 (on earnings retention)].
MONE T AR Y- NONMONE T AR Y T R ANS L AT I ON ME T HOD
The accounting for foreign operations highly integrated with the U.S. parent company must, to follow GAAP,
use the monetary-nonmonetary translation method. The monetary-nonmonetary translation method pro-
vides translated amounts for a foreign unit similar to the amounts that the parent would report if it engaged
F o r e i g n Cu r r e n c y T r a n s l a t i o n 7
EXHI BI T 2
DOMESTIC COMPANY
Translation of Income Statement for Year 1
All-Current Method Monetary-Nonmonetary Method
Exchange Exchange
Pounds Rate Dollars Pounds Rate Dollars
Sales. . . . . . . . . . . . . . . . . . . . . . . . 1,000 $2.1:1 $ 2,100 1,000 $2.1:1 $ 2,100
Cost of Goods Sold. . . . . . . . . . . . . . (700) $2.1:1 (1,470) (700) $2.1:1 (1,470)
Selling and
Administrative . . . . . . . . . . . . . . . (80) $2.1:1 (168) (80) $2.1:1 (168)
Depreciation . . . . . . . . . . . . . . . . . . (50) $2.1:1 (105) (50) $2.0:1 (100)
Interest . . . . . . . . . . . . . . . . . . . . . . (50) $2.1:1 (105) (50) $2.1:1 (105)
Income Taxes. . . . . . . . . . . . . . . . . . (40) $2.1:1 (84) (40) $2.1:1 (84)
Foreign Exchange Loss . . . . . . . . . . . See Exh. 4 (82)
Net Income . . . . . . . . . . . . . . . . . . . 80 $ 168 80 $ 91
EXHI BI T 3
DOMESTIC COMPANY
Calculation of Foreign Exchange Adjustment
All-Current Method for Year 1
Pounds Exchange Rate Dollars
Net Assets Position, January 1, Year 1 . . . . . . . . . . . . . . . . . . . 100 $2.0:1 $200
Increase in Net Assets during Year 1 from Net Income. . . . . . . . 80 $2.1:1 168
Net Asset Position, December 31,
Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180 368
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2.2:1 396
Foreign Exchange Adjustment for Year 2 . . . . . . . . . . . . . . . . . . $ 28
in export transactions to carry out its foreign operations (that is, if it manufactured goods in the United
States and then sold them to customers abroad) instead of operating through a foreign unit. Because the
operations of integrally related foreign units resemble export activities, domestic rms achieve comparable
reported amounts for both types of activities by using the monetary-nonmonetary translation method.
The monetary-nonmonetary method translates monetary assets and liabilities using the current exchange
rate and translates nonmonetary assets and liabilities using the historical exchange rate. Monetary items rep-
resent claims receivable or payable in a fixed number of foreign currency units regardless of changes in
exchange rates. Monetary items include cash, accounts receivable, accounts payable, bonds payable, and most
liabilities other than Advances from Customers. Because firms translate monetary items using the current
exchange rate, a foreign exchange adjustment arises for these items when exchange rates change. The firm
includes the foreign exchange adjustment as an exchange gain or loss in measuring net income each period
under the monetary-nonmonetary method. The rationale results from noting that the foreign unit must regu-
larly convert currency (from dollars to pounds or vice versa) to settle its receivables or payables and will
therefore realize the gain or loss in the near term. This near-term realization contrasts with the longer-term
realizability of the foreign exchange adjustment from self-contained foreign operations translated using the
all-current method.
Nonmonetary items include inventories, prepayments, property, plant and equipment, intangible assets,
advances from customers, and common stock. Unlike monetary items, nonmonetary items do not result in a
xed future cash inow or outow. Translating nonmonetary items using the historical exchange rate results
in reporting them at their U.S. dollar-equivalent amounts regardless of changes in the exchange rate.
Refer to Exhibits 1 and 2. The monetary-nonmonetary method translates monetary items at the exchange
rate of $2.2:1 on December 31. Monetary items include cash, accounts receivable, accounts payable, and
bonds payable. The accountant translates nonmonetary items at the historical exchange rate. The subsidiary
acquired inventory items evenly during Year 1 and uses a weighted-average cost ow assumption. Thus, the
ending inventory translates using the average exchange rate of $2.1:1. A FIFO cost ow assumption requires
the use of an exchange rate later in the year for inventory items. A LIFO cost ow assumption requires the use
of the exchange rate for the year of each LIFO inventory layer. The property, plant, and equipment translate
using the exchange rate at the time of their acquisition of $2.0:1. The common stock translates at the
exchange rate at the time of its issue of $2.0:1. Most revenues and expenses result from transactions recorded
evenly during Year 1 and therefore translate using the average exchange rate of $2.1:1. Cost of goods sold
represents an allocation of a cost initially recorded when the subsidiary purchased the inventory items.
Because the subsidiary uses a weighted-average cost flow assumption, cost of goods sold translates at the
average exchange rate of $2.1:1. A FIFO cost flow assumption in this illustration requires the use of an
exchange rate earlier in the year for cost of goods sold. A LIFO cost ow assumption requires the use of an
exchange rate later in the year (unless a rm dips into LIFO layers of earlier years). Depreciation expense like-
wise represents an allocation of a cost initially recorded when the subsidiary purchased the depreciable assets.
Depreciation expense translates at the historical exchange rate of $2.0:1.
The foreign exchange loss for the year, computed in Exhibit 4, is $82. The U.K. subsidiary held a net mon-
etary liability position (that is, its monetary liabilities exceeded its monetary assets) during most of the year
as a result of its long-term borrowing to nance purchases of property, plant, and equipment. The U.S. dollars
needed to repay this net liability position in pounds increased during Year 1 as a result of the decline in the
value of the U.S. dollar. This causes a foreign exchange loss.
Exhibit 4 demonstrates the calculation of the foreign exchange loss. Translating each transaction affecting
the net monetary position at the exchange rate at the time of the transaction results in a net monetary liability
of $842 at the end of the year. The actual net monetary liability position at the end of the year in pounds com-
prises cash (80) plus accounts receivable (120) minus accounts payable (170) minus bonds payable (450),
or a negative 420. The U.S. dollar-equivalent of the net monetary liability at the end of the year is $924.
That is, the U.S. dollar amount needed at year-end to discharge the net monetary liability would be $924. Had
the U.S. rm discharged each net U.K. pound monetary liability with dollars as it arose, the U.S. rm would
have $82 more at year-end than if it discharged the net monetary liability all at year-end. By letting the liabil-
ities accumulate in pounds while the dollar was losing value relative to the pound, the U.S. firm lost $82.
Note that the issuance of bonds, the collection of accounts receivable, and the payment of accounts payable
cause no change in the net monetary position because each of these transactions involves simultaneous
increases (or decreases) in both monetary assets and monetary liabilities. For example, the issuance of bonds
increases the monetary asset Cash while it increases the monetary liability Bonds Payable.
F o r e i g n Cu r r e n c y T r a n s l a t i o n 8
AN I NT E R NAT I ONAL P E R S P E C T I VE
The International Accounting Standards Committee (IASC) recommends foreign currency translation meth-
ods similar to those described and illustrated above.
2
Most countries outside of the United States similarly dis-
tinguish self-contained from integrally related foreign units and require the all-current method for the
self-contained and the monetary-nonmonetary translation method for the integrally related foreign units.
Countries differ as to whether the exchange adjustment under the monetary-nonmonetary method affects net
income or appears in a separate shareholders equity account.
P R OB L E M F OR S E L F - S T UDY
Translating foreign currency financial statements. Refer to the preceding illustra-
tion for Domestic Company and its U.K. subsidiary for Year 1. The following information relates to the
U.K. subsidiary for Year 2. All transactions occur evenly during Year 2.
1. Acquires inventory on account totaling 850.
2. Sells inventory costing 800 on account for 1,200.
3. Pays selling and administrative expenses of 160, interest expense of 50, and income tax expense of
45.
4. Collects 1,160 from customers for sales on account and pays 820 to suppliers for purchases of inven-
tory on account.
5. Pays dividends of 25 evenly during Year 2.
6. Recognizes 50 of depreciation expense.
The exchange rates were as follows:
F o r e i g n Cu r r e n c y T r a n s l a t i o n 9
2
International Accounting Standards Committee, International Accounting Standard No. 21, The Effects of Changes in Foreign
Exchanges Rates, 1993.
EXHI BI T 4
DOMESTIC COMPANY
Calculation of Foreign Exchange Adjustment
Monetary-Nonmonetary Method for Year 1
Pounds Exchange Rate Dollars
Net Monetary Asset (Liability) Position,
January 1, Year 1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 $2.0:1 $ 200
Increases in Net Monetary Assets
Cash or Accounts Receivable from Sales . . . . . . . . . . . . . . . . 1,000 $2.1:1 2,100
Decreases in Net Monetary Assets
Purchase of Property, Plant, and Equipment . . . . . . . . . . . . . . (500) $2.0:1 (1,000)
Purchase of Inventory on Account. . . . . . . . . . . . . . . . . . . . . . (850) $2.1:1 (1,785)
Payment of Selling and Administrative Expenses . . . . . . . . . . . (80) $2.1:1 (168)
Payment of Interest Expenses . . . . . . . . . . . . . . . . . . . . . . . . (50) $2.1:1 (105)
Payment of Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . (40) $2.1:1 (84)
Net Monetary Asset (Liability) Position,
December 31, Year 1. . . . . . . . . . . . . . . . . . . . . . . . . . . . (420) (842)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2.2:1 924
Foreign Exchange Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 82
When Subsidiary Issued Bonds and Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2.0:1
When Subsidiary Acquired Property, Plant, and Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2.0:1
December 31, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2.2:1
Average during Year 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2.0:1
When Subsidiary Acquired Inventory Available for Sale during Year 2 . . . . . . . . . . . . . . . . . . . . . $2.015:1
December 31, Year 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.8:1
a. Prepare a balance sheet for the U.K. subsidiary in U.K. pounds and in U.S. dollars on December 31, Year
2, using (1) the all-current translation method and (2) the monetary-nonmonetary translation method.
Follow U.S. accounting principles by including the foreign exchange adjustment in a separate share-
holders equity account under the all-current method and in net income (and, therefore, retained earnings)
under the monetary-nonmonetary method.
b. Prepare a statement of net income and retained earnings for the U.K. subsidiary for Year 2 in U.K.
pounds and U.S. dollars using (1) the all-current translation method and (2) the monetary-nonmonetary
translation method. This statement should reconcile the change in retained earnings during Year 2 in both
U.K. pounds and U.S. dollars. Note that retained earnings on January 1, Year 2, is $168 under the all-cur-
rent method and $91 under the monetary-nonmonetary method (see Exhibit 1).
c. Prepare analyses that show the calculation of the foreign exchange adjustment for Year 2 under the all-
current method and the monetary-nonmonetary method. Refer to Exhibits 3 and 4 for the formats for
these analyses.
S UGGE S T E D S OL UT I ON T O P R OB L E M F OR S E L F - S T UDY
(Domestic Company; translating foreign currency nancial statements.)
a. Exhibit 5 presents the translated balance sheet.
b. Exhibit 6 presents the translated income statement.
c. Exhibit 7 presents the calculation of the foreign exchange adjustment under the all-current method, and
Exhibit 8 presents the calculation of the foreign exchange gain or loss under the monetary-nonmonetary
method.
KE Y T E R MS AND C ONC E P T S
Foreign currency translation
Historical exchange rate
Current exchange rate
Foreign exchange adjustment
Functional currency
All-current translation method
Monetary-nonmonetary translation method
Monetary items
Nonmonetary items
International Accounting Standards Committee (IASC)
F o r e i g n Cu r r e n c y T r a n s l a t i o n 10
F o r e i g n Cu r r e n c y T r a n s l a t i o n 11
EXHI BI T 5
Translation of Balance Sheet
December 31, Year 2
(Problem for Self-Study)
All-Current Method Monetary-Nonmonetary Method
Exchange Exchange
Pounds Rate Dollars Pounds Rate Dollars
ASSETS
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 140 $1.8:1 $ 252 140 $1.8:1 $ 252
Accounts Receivable. . . . . . . . . . . . . . . 160 $1.8:1 288 160 $1.8:1 288
Inventories. . . . . . . . . . . . . . . . . . . . . . 200 $1.8:1 360 200 $2.015:1 403
Property, Plant, and
Equipment (net) . . . . . . . . . . . . . . . 400 $1.8:1 720 400 $2.0:1 800
Total Assets . . . . . . . . . . . . . . . . . . 900 $1,620 900 $1,743
LIABILITIES AND
SHAREHOLDERS EQUITY
Accounts Payable. . . . . . . . . . . . . . . . . 200 $1.8:1 $ 360 200 $1.8:1 $ 360
Bonds Payable . . . . . . . . . . . . . . . . . . . 450 $1.8:1 810 450 $1.8:1 810
Common Stock . . . . . . . . . . . . . . . . . . 100 $2.0:1 200 100 $2.0:1 200
Foreign Exchange Adjustment . . . . . . . . Exh. 7 (58)
Retained Earnings . . . . . . . . . . . . . . . . 150 Exh. 6 308 150 Exh. 6 373
Total Liabilities and
Shareholders Equity . . . . . . . . . . 900 $1,620 900 $1,743
EXHI BI T 6
Translation of Income Statement and Retained Earnings for Year 2
(Problem for Self-Study)
All-Current Method Monetary-Nonmonetary Method
Exchange Exchange
Pounds Rate Dollars Pounds Rate Dollars
Sales . . . . . . . . . . . . . . . . . . . . . . . . 1,200 $2.0:1 $2,400 1,200 $2.0:1 $ 2,400
Cost of Goods Sold . . . . . . . . . . . . . . (800) $2.0:1 (1,600) (800) $2.015:1 (1,612)
Selling and Administrative . . . . . . . . . (160) $2.0:1 (320) (160) $2.0:1 (320)
Depreciation . . . . . . . . . . . . . . . . . . . (50) $2.0:1 (100) (50) $2.0:1 (100)
Interest . . . . . . . . . . . . . . . . . . . . . . . (50) $2.0:1 (100) (50) $2.0:1 (100)
Income Taxes . . . . . . . . . . . . . . . . . . (45) $2.0:1 (90) (45) $2.0:1 (90)
Exchange Gain or Loss. . . . . . . . . . . . Exh. 8 154
Net Income . . . . . . . . . . . . . . . . . . . . 95 $ 190 95 $ 332
Less Dividends . . . . . . . . . . . . . . . . . (25) $2.0:1 (50) (25) $2.0:1 (50)
Increase in Retained Earnings . . . . . . 70 $ 140 70 $ 282
Retained Earnings, January 1, Year 2 . 80 Exh. 1 168 80 Exh. 1 91
December 31, Year 2 . . . . . . . . . . 150 $ 308 150 $ 373
EXHI BI T 8
Calculation of Foreign Exchange Adjustment
Monetary-Nonmonetary Method for Year 2
(Problem for Self-Study)
Pounds Exchange Rate Dollars
January 1, Year 2. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (420) $2.2:1 $ (924)
Increases in Net Monetary Assets
Cash and Accounts Receivable from Sales . . . . . . . . . . . . 1,200 $2.0:1 2,400
Decreases in Net Monetary Assets
Purchase of Inventory on Account . . . . . . . . . . . . . . . . . . . (850) $2.0:1 (1,700)
Payment of Selling and Administrative Expenses . . . . . . . . (160) $2.0:1 (320)
Payment of Interest Expense . . . . . . . . . . . . . . . . . . . . . . (50) $2.0:1 (100)
Payment of Investments. . . . . . . . . . . . . . . . . . . . . . . . . . (45) $20:1 (90)
Payment of Dividends. . . . . . . . . . . . . . . . . . . . . . . . . . . . (25) $2.0:1 (50)
Net Monetary Asset (Liability) Position,
December 31, Year 2. . . . . . . . . . . . . . . . . . . . . . . . . . . . (350) $ (784)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.8:1 630
Foreign Exchange Gain, Year 2. . . . . . . . . . . . . . . . . . . . . . . . $ 154
F o r e i g n Cu r r e n c y T r a n s l a t i o n 12
EXHI BI T 7
Calculation of Foreign Exchange Adjustment for Year 2
All-Current Method
(Problem for Self-Study)
Pounds Exchange Rate Dollars
Net Assets Position, January 1, Year 2. . . . . . . . . . . . . . . . . . 180 $2.2:1 $396
Net Income for Year 2. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 $2.0:1 190
Dividends. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (25) $2.0:1 (50)
Net Assets, December 31, Year 2 . . . . . . . . . . . . . . . . . . . . . 250 $536
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.8:1 450
Change in Foreign Exchange Adjustment for Year 2 . . . . . . . . . $(86)
Foreign Exchange Adjustment, January 1, Year 2. . . . . . . . . . . 28
Foreign Exchange Adjustment, December 31, Year 2. . . . . . . . $(58)
F o r e i g n Cu r r e n c y T r a n s l a t i o n 13
QUE S T I ONS , E XE R C I S E S , P R OB L E MS , AND C AS E S
QUESTI ONS
FORCUR 1. Review the meaning of the terms and concepts listed above in Key Terms and Concepts.
FORCUR 2.
a. The all-current translation method assumes that exchange-rate changes affect a foreign entitys net assets
position (= assets minus liabilities = shareholders equity). Why are net assets the appropriate base for
measuring exchange rate exposure when a foreign entitys operations are self-contained within the for-
eign country?
b. The monetary-nonmonetary translation method assumes that exchange-rate changes affect a foreign
entitys monetary assets and monetary liabilities. Why are net monetary items the appropriate base for
measuring exchange-rate exposure when a foreign entitys operations are an integrated extension of the
U.S. parent company?
FORCUR 3. The foreign exchange adjustment using the all-current translation method does not affect net
income each period but appears in other comprehensive income, a separate shareholders equity account. The
foreign exchange adjustment using the monetary-nonmonetary translation method affects net income and
retained earnings each period. Why do these two translation methods treat the exchange adjustment differ-
ently?
FORCUR 4. The foreign currency of a foreign unit may increase or decrease in value relative to the U.S. dol-
lar during a particular year. Which direction of change in the value of the foreign currency relative to the U.S.
dollar will result in a credit change in other comprehensive income under the all-current translation method?
Which direction of change results in a debit change in other comprehensive income? Explain.
FORCUR 5. The foreign currency of a foreign unit may increase or decrease in value relative to the U.S. dol-
lar during a particular period. Under what circumstances will a foreign exchange gain arise from the transla-
tion of a foreign units financial statements into U.S. dollars using the monetary-nonmonetary translation
method? Under what circumstance will a foreign exchange loss arise? Explain.
FORCUR 6.
a. One can convert an income statement based on the all-current translation method into an income state-
ment based on the monetary-nonmonetary translation method simply by including in net income the
change during the period in the foreign exchange adjustment account under the all-current method. Do
you agree? Why or why not?
b. One can convert a balance sheet based on the all-current translation method into a balance sheet based
on the monetary-nonmonetary method simply by reclassifying the exchange adjustment under the all-cur-
rent method from a separate shareholders equity account into the retained earnings account. Do you
agree? Why or why not?
FORCUR 7. Translating the nancial statements of a particular foreign entity into U.S. dollars results in a
debit change in other comprehensive income under the all-current translation method but a foreign exchange
gain under the monetary-nonmonetary translation method for a particular period. Why does the direction of
the foreign exchange adjustment differ for these two translation methods?
EXERCI SES
FORCUR 8. Selecting the exchange rate for foreign currency translation. Firms might translate nan-
cial statement items using the historical exchange rate (H), the average exchange rate during the current
period (CA), or the exchange rate at the end of the current period (CE). Indicate the exchange rate used
for each nancial statement item below under (1) the all-current translation method and (2) the monetary-non-
monetary translation method.
F o r e i g n Cu r r e n c y T r a n s l a t i o n 14
a. Cash
b. Accounts Receivable
c. Inventories
d. Prepaid Rent
e. Investment in Securities (10 percent ownership)
f. Land
g. Building
h. Accumulated Depreciation
i. Patent
j. Goodwill
k. Accounts Payable
l. Bank Loan Payable
m. Bonds Payable
n. Common Stock
o. Sales
p. Cost of Goods Sold
q. Depreciation Expense
r. Interest Expense
s. Income Tax Expense
FORCUR 9. Identifying the foreign currency translation method. Indicate whether each of the statements
below refers to the all-current translation method (C), the monetary-nonmonetary translation method (MN),
to both translation methods (B), or to neither translation method (N).
a. Firms use this translation method when the foreign entity engages in frequent transactions with its U.S.
parent company.
b. Firms use this translation method when the foreign entity acquires and sells goods and services within the
foreign country and pays no dividends to its U.S. parent company.
c. Firms use this translation method when the foreign entity operates in a highly inationary environment.
d. A foreign exchange gain or loss will not likely appear in the income statement each period when rms
use this translation method.
e. Firms use the current exchange rate to translate accounts receivable under this translation method.
f. Firms use the current exchange rate to translate inventories under this translation method.
g. Firms use the historical exchange rate to translate bonds payable under this translation method.
h. Firms include cumulative foreign exchange gains and losses in retained earnings under this translation
method.
i. Firms use the current exchange rate to translate common stock under this translation method.
j. Firms use the average exchange rate during the current period to translate income tax expense under
this translation method.
FORCUR 10. Identifying the nature of a foreign exchange adjustment. A condensed balance sheet for a
foreign subsidiary for Year 6 appears in Exhibit 9.
a. Assume that the foreign currency (FC) increased in value relative to the U.S. dollar during Year 6.
What is the likely sign of the foreign exchange adjustment under the all-current translation method
(adjustment included in other comprehensive income) and under the monetary-nonmonetary translation
method (adjustment included in net income) for Year 6? Explain.
b. Repeat part a, but assume that the foreign currency decreased in value relative to the U.S. dollar.
FORCUR 11. Interpreting translated financial statements. Exhibit 10 presents the translated financial
statements of Foreign Sub for its first year of operations. The first column shows the statements using the
all-current translation method, and the second column shows the statements using the monetary-nonmonetary
translation method.
a. Did the foreign currency increase or decrease in value relative to the U.S. dollar during the year? Explain.
b. Describe the cause of the negative foreign exchange adjustment of $25,200 on the balance sheet.
c. Describe the cause of the foreign exchange gain of $10,000 on the income statement.
F o r e i g n Cu r r e n c y T r a n s l a t i o n 15
EXHI BI T 9
Balance Sheet for Foreign Subsidiary
(Exercise 10)
January 1, December 31,
Year 6 Year 6
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FC 10 FC 15
Accounts Receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 60
Inventories. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 55
Fixed Assets (net). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 110
Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FC 200 FC 240
Current Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FC 80 FC 110
Long-term Debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 50
Shareholders Equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70 80
Total Liabilities and Shareholders Equity . . . . . . . . . . . . . . . . . . . . FC 200 FC 240
EXHI BI T 10
FOREIGN SUB
Translated Financial Statements
(Exercise 11)
All-Current Monetary-Nonmonetary
Translation Method Translation Method
BALANCE SHEET
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,000 $ 12,000
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48,000 48,000
Inventories (FIFO). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,000 40,000
Property, Plant, and Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 100,000
Total Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $176,000 $200,000
Accounts Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,000 $60,000
Long-term Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48,000 48,000
Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 80,000
Foreign Exchange Adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . (25,200)
Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,200 12,000
Total Liabilities and Shareholders Equity . . . . . . . . . . . . . . . . $176,000 $200,000
INCOME STATEMENT
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $152,000 $152,000
Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (72,000) (80,000)
Selling and Administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (36,000) (36,000)
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (12,800) (16,000)
Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (4,000) (4,000)
Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (14,000) (14,000)
Foreign Exchange Gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 13,200 $ 12,000
PROBLEMS
FORCUR 12. Translating foreign currency nancial statements. U.S. Manufacturing, Inc., established a
wholly-owned subsidiary in South America on January 2, Year 4, by contributing $600 for the subsidiarys
common stock. The subsidiary issued long-term bonds for FC200 and acquired plant and equipment costing
F o r e i g n Cu r r e n c y T r a n s l a t i o n 16
FC500 on January 2, Year 4. Exhibit 11 presents a balance sheet on December 31, Year 4, and a statement
of income and retained earnings for Year 4 for this subsidiary. The subsidiary accrued revenues and expenses
evenly during Year 4 and uses a weighted-average cost flow assumption for inventories and cost of goods
sold. The exchange rates on various dates appear below:
Average Year 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.50:FC1
December 31, Year 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.00:FC1
a. Prepare a balance sheet as of December 31, Year 4, and a statement of income and retained earnings for
Year 4 in U.S. dollars using the all-current translation method. Include a separate schedule showing the
calculation of the foreign exchange adjustment included in other comprehensive income for Year 4.
b. Repeat part a using the monetary-nonmonetary translation method. Include a separate calculation of the
foreign exchange gain or loss for Year 4.
c. Why is the sign (debit or credit) of the foreign exchange adjustment for Year 4 under the all-current trans-
lation method different from the sign under the monetary-nonmonetary translation method?
d. Compute the ratio of net income to sales (1) in the foreign currency of the subsidiary, (2) in U.S. dollars
using the all-current translation method, and (3) in U.S. dollars using the monetary-nonmonetary
translation method. Why are the ratios under (1) and (2) the same? Why do the ratios under (2) and (3)
differ?
EXHI BI T 11
SOUTH AMERICAN SUBSIDIARY
Financial Statement Data
(Problem 12)
BALANCE SHEET December 31, Year 4
Assets
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FC 100
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
Fixed Assets (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FC 1,000
Liabilities and Shareholders Equity
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FC 400
Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Total Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FC 600
Common Stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FC 300
Retained Earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Total Shareholders Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FC 400
Total Liabilities and Shareholders Equity. . . . . . . . . . . . . . . . . . . . . . . . FC 1,000
STATEMENT OF INCOME AND RETAINED EARNINGS For Year 4
Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FC 2,000
Cost of Goods Sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,200)
Selling and Administrative Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (400)
Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (100)
Interest Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (20)
Income Tax Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (120)
Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FC 160
Dividends (Declared and Paid on December 31, Year 4) . . . . . . . . . . . . . . . (60)
Retained Earnings, December 31, Year 4 . . . . . . . . . . . . . . . . . . . . . . . . . . FC 100
F o r e i g n Cu r r e n c y T r a n s l a t i o n 17
FORCUR 13. Translating foreign currency financial statements using the all-current method. Casey
Corporation, a multinational U.S. corporation, established McGann Corporation, a wholly-owned Irish sub-
sidiary, by contributing $300,000 on January 1, Year 1. Exhibit 12 presents the financial statements of
McGann Corporation for Year 1 and Year 2 measured in Irish pounds. The exchange rates on various dates
appear below:
January 1, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.50:1
Average, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.48:1
December 31, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.45:1
Average, Year 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.49:1
December 31, Year 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.52:1
a. Prepare a balance sheet as of December 31, Year 1, and an income statement and retained earnings
statement for Year 1 in U.S. dollars using the all-current translation method. Include a separate calcula-
tion of the foreign exchange adjustment for Year 1.
b. Repeat part a for Year 2.
c. Explain the reason for the sign (debit versus credit) of the foreign exchange adjustment for Year 1.
d. Explain the reason for the sign (debit versus credit) of the foreign exchange adjustment for Year 2.
e. Compute the ratio of net income to sales revenue for each year using financial data expressed in Irish
pounds and in U.S. dollars. Why is this ratio the same in each year regardless of whether the calculation
uses Irish pounds or U.S. dollars?
EXHI BI T 12
MCGANN CORPORATION
Financial Statement Data
(Problem 13)
December 31, Year 1 December 31, Year 2
BALANCE SHEET
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 75,000
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 110,000
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 200,000
Fixed Assets (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125,000 100,000
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335,000 485,000
Account Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 150,000
Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . - 100,000
Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 200,000
Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 35,000
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335,000 485,000
INCOME STATEMENT
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 600,000
Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (300,000) (360,000)
Depreciation Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (25,000) (25,000)
Other Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (155,000) (185,000)
Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 30,000
RETAINED EARNINGS STATEMENT
Balance, Beginning of Year . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 30,000
Dividends (declared and paid December 31) . . . . . . . . . . . . . . (5,000) (10,000)
Balance, End of Year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 35,000
F o r e i g n Cu r r e n c y T r a n s l a t i o n 18
FORCUR 14. Translating foreign currency financial statements. U.S. Rental Properties, Inc., estab-
lished Canadian Subsidiary on January 2, Year 1, by contributing U.S.$500,000 for all of the subsidiarys
common stock. Canadian Subsidiary invested C$500,000 in a building with an expected useful life of 20 years
and rented it to tenants. Exhibit 13 presents balance sheets and income statements for Canadian Subsidiary for
Year 1 and Year 2. Revenues and expenses accrued evenly over each year. Canadian Subsidiary declared
and paid dividends of $30,000 on December 31, Year 1, and $39,000 on December 31, Year 2. The exchange
rates on various dates appear below:
January 2, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . US$.90:C$1.00
Average, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . US$.85:C$1.00
December 31, Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . US$.80:C$1.00
Average, Year 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . US$.82:C$1.00
a. Prepare a balance sheet as of December 31, Year 1, and an income statement and retained earnings
statement for Year 1 in U.S. dollars using the all-current translation method. Include a separate calcula-
tion of the foreign exchange adjustment for Year 1.
b. Repeat part a using the monetary-nonmonetary translation method. Include a separate calculation of the
foreign exchange gain or loss for Year 1.
c. Repeat part a using the all-current translation method for Year 2.
d. Repeat part a using the monetary-nonmonetary translation method for Year 2.
EXHI BI T 13
CANADIAN SUBSIDIARY
Financial Statement Data
(Problem 14)
December 31
BALANCE SHEET Year 1 Year 2
Assets
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . C$ 77,555 C$ 116,555
Rent Receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000 30,000
Building (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 475,000 450,000
Total Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . C$ 577,555 C$ 596,555
Liabilities and Shareholders Equity
Accounts Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . C$ 6,000 C$ 7,500
Salaries Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 5,500
Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 555,555 555,555
Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 28,000
Total Liabilities and Shareholders Equity . . . . . . . . . . . . . . . . C$ 577,555 C$ 596,555
For the Year Ended
December 31
INCOME STATEMENT Year 1 Year 2
Rent Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . C$ 125,000 C$ 150,000
Operating Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (28,000) (34,000)
Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (25,000) (25,000)
Income Tax Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (30,000) (36,000)
Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . C$ 42,000 C$ 55,000