MULTINATIONAL OPERATIONS

LOS 18.a: Distinguish among presentation (reporting) currency,

functional currency, and local currency.

Foreign currency can affect FS in two ways: (1) engaging in FCY transactions (2)
investing in subsidiaries that maintain their books in FCY

The local currency is the currency of local country in which each of the
subsidiaries/parent company is located.

The presentation (reporting) currency is the currency in which the parent

company prepares its financial statements.

The functional currency, determined by management, is the currency of

the primary economic environment in which the entity operates. The
functional currency is usually the currency in which the entity generates
and expends cash (the currency in subsidiary or parent company raises
most of its invoices). Can be LCY or some other CY
Example: Alstoms Subsidiary in China. Local Currency of subsidiary RMB,
presentation currency of Parent EUR, but since most of the invoicing is in USD,
functional currency USD
LOS 18.b: Describe foreign currency transaction exposure, including
accounting for and disclosures about foreign currency transaction
gains and losses.
LOS 18.c: Analyze how changes in exchange rates affect the translated
sales of the subsidiary and parent company.;

LOS 18.d: Compare the current rate method and the temporal method,
evaluate how each affects the parent companys balance sheet and
income statement, and determine which method is appropriate in
various scenarios.

Two methods to remeasure/translate FS of subsidiary to Parent:

Remeasurement/Temporal Method converts Loc. CY into Func. CY

Translation/Current Rate Method converts Func. CY into Rep. CY

Since Functional currency is chosen by management, it may not be completely

objective. According to the IASB, management should consider the following
factors:
 The currency that influences sales prices for goods and services.
Currency of the country whose competitive forces and regulations
mainly determine the sale price of goods and services.
The currency that influences labor, material, and other
costs. The currency from which funds are generated
(financing activities).
The currency in which receipts from operating activities are usually
retained. (If retains = LCY, if remits = parent/reporting)

Applying the Temporal Method/Current Rate Method

Current rate = exchange rate on balance sheet date.

Average rate = average exchange rate over the reporting period.
Historical rate = actual rate that was in effect when the original
transaction occurred.

Temporal Current Rate

Method Method
Balance Sheet
Monetary A/L (Fixed amount e.g. Current/Period- Current/Period-
cash/receivables/payables/ST or LT Debt end end
Non-Monetary A/L (Inventory, Fixed
Current/Period-
Assets, Intangible Assets, Unearned Historical/Actual
end
Revenue Liability)
Common Stock and Dividends Historical/Actual Historical/Actual
Current/Period-
Mixed Rate
Equity (as a whole incl. FX gain/losses) end
Income Statement
Revenue Average Average
Non-Monetary Expenses (COGS,
Historical/Actual Average
Dep/Amortization)
Monetary Expenses (all other) Average Average
Net Income (as a whole including FX
Mixed Average
gain/losses)
Remeasurement/Translation Gain Loss
Equity (BS) -
Income Cum. Translation
FX Gain/Loss
Statement Adjustment
(CTA)

Inventory and COGS Under the Temporal Method

End. Inventory COGS
Exchange Rates used
FIFO Recent Older
COGS Older Recent
Wt. Avg Wt. Avg Wt. Avg

Exposure to Changing Exchange Rates

Current Rate Method:
Parent Company Exposure = Net Asset Position (Assets Liabilities)
Since under Current Rate Method, Assets and Liabilities are both at Current
Rate, only factor exposed to Exchange Rate fluctuation is Equity (or net assets).
Source of Difference highlighted below:

Assets (Current) Liabilities (Current)

Stock (Historical)

Although it is possible for a firm to have a net liability position under the current
rate method, it is unusual. Most firms cant survive very long when their liabilities
exceed their assets.
Assume:
Starting Position If Local Currency Increases by
20%
Assets = 100 Liabilities = 70 Assets = 120 Liabilities = 84
Equity = 30 Equity = 30
CTA = 6
100 100 120 120

Temporal Method:
Parent Company Exposure = Net Monetary Assets (Monetary Assets Monetary
Liabilities)
Since under Temporal Method, all other assets and liabilities except monetary
A/L are at historical rates, only factor exposed to Exchange Rate fluctuation is
net monetary Assets (Source of Difference in Highlighted below).
Monetary Assets(Current) Monetary Liabilities (Current)
Non-Monetary Assets (Historical) Non-Monetary Liabilities (Historical)
Stock (Historical)
Since very few assets are considered to be monetary (mainly cash and
receivables), most firms have net monetary liability exposures
Assume:
Starting Position If Local Currency Increases by
20%
Mon. Assets = Mon. Liab. = 65 Mon. Assets = Mon. Liab. = 78
20 24
NM Assets = 80 NM Liab. = 5 NM Assets = 80 NM Liab. = 5
Equity = 30 Equity = 30
R.E = -9 (thru IS)
100 100 104 104
Under the temporal method, firms can eliminate their exposure to
changing exchange rates by balancing monetary assets and monetary
liabilities. When balanced, no gain or loss is recognized.
Eliminating exposure under the current rate method is more difficult
because balancing assets and liabilities would eliminate shareholders
equity.
Impact of Changing Exchange Rates on Exposure
Local Currency
Exposure
Appreciating Depreciating
Current rate method
Net assets Gain Loss
 Net liabilities Loss Gain
Temporal method
Net monetary assets Gain Loss
Net monetary
Loss Gain
liabilities

LOS 18.e: Calculate the translation effects and evaluate the translation
of a subsidiarys balance sheet and income statement into the parent
companys presentation currency.

Current Rate 0.5

Average Rate 0.4
Historical/Actual Rate 0.3 Current Rate Temporal
Sub (LCY) Parent (USD) Parent (USD)
Cash 100 50 50
Acc Rec. 650 325 325
Inventory 1,200 600 360
Net Fixed Assets 900 450 270
Total Assets 2,850 1,425 1,005
Acc. Pay. 500 250 250
ST Debt 200 100 100
LT Debt 950 475 475
Common Stock 400 120 120
310 = Beg
Retained Earnings
800 (100*0.3) + NI 60 (Bal. Figure)
(Beg: 100)
(280)
CTA 170 (Bal. Figure)
Total Liabilities and
Equity 2,850 1,425 1,005
Revenue 5,000 2,000 2,000
COGS (3,300) (1,320) (990)
Gross Margin 1,700 680 1,010
Other Expenses (400) (160) (160)
Depreciation (600) (240) (180)
Remeasurement (640)
30 = End Beg
Net Income 700 280 R.E

LOS 18.f: Analyze how the current rate method and the temporal
method affect financial statements and ratios.
Pure balance sheet and pure income statement ratios will be the same.
(because total equity as a whole is also preserved under Current Rate
Method). Pure Ratio means both numerator and denominator are either
from BS or IS.
If the foreign currency is depreciating, translated mixed ratios (with IS
item in Num and Ending BS item in Den) will be larger than the original
ratio.
In comparing the ratio effects of the temporal method and current rate method, it
is necessary to:

Determine whether the local currency is appreciating or depreciating.

 Determine which rate (historical rate, average rate, or current rate) is
used to convert the numerator and denominator under both methods
and analyze the effects on the ratio.
Determine whether the ratio will increase, decrease, or stay the same
based on the direction of change in the numerator and the denominator.

LOS 18.g: Analyze how alternative translation methods for subsidiaries

operating in hyperinflationary economies affect financial statements
and ratios.

During hyperinflation, local currency will rapidly depreciate thus using the
current rate to translate all BS items will result in much lower
assets/Liabilities. The subsidiary will disappear in parents consolidated FS
FASB/GAAP hyperinflation cumulative inflation exceeds 100% over a 3-
year period (~26% pe annum). Functional currency is considered to be
parents reporting currency; thus, the temporal method is used.
IASB/IFRS no specific definition. Subsidiarys FS is restated for inflation
and then translated using the Current Rate Method

Item Index Applied

Non-Monetary Assets End/Beg Index
Monetary Assets N/A
Non-Monetary Liabilities End/Beg Index
Monetary Liabilites N/A
CS End/Beg Index
RE Plug Figure
Income Statement End/Avg Index
Net Purchasing Power G/L Plug Figure
Numerator = Ending Index, Denominator = Beg. Index (BS),
Avg. Index (IS)

Example:
Indices: Beg = 100, Avg = 125, End = 150
2014 2015 Adjusted
Cash 5,000 8,000 = 8,000
*150/100
Supplies 25,000 25,000 = 37,500
T.Assets 30,000 33,000 45,500

A/P 20,000 20,000 = 20,000

*150/100
CS 10,000 10,000 = 15,000
RE - 3,000 Bal. Figure 10,500
30,000 33,000 45,500

*150/125
Revenue 15,000 = 18,000
*150/125
Exp (12,000) = (14,400)
PP Gain/Loss Bal. Figure 6,900
NI 3,000 From RE 10,500

Analyzing Foreign Currency Disclosure

 Multinational firms may have many foreign subsidiaries, so it is difficult for
the analyst to get information about the each subsidiarys currency and
the specific exposure. Very Limited Disclosure. Sometimes, difficult to
whether temporal or current rate method used.
One way of increasing comparability involves adding CTA to the firms net
income. By bringing translation gain or loss into IS, comparisons with
temporal method are improved. (not totally resolves but improves
comparability)
Including gains and losses (in shareholders equity) in Net Income is known
as clean-surplus accounting. Term dirty-surplus is used to describe
gains/losses reported directly in shareholders equity.
LOS 18.h: Describe how multinational operations affect a companys
effective tax rate.
Earnings of multinational companies are subject to multiple tax
jurisdictions (various subsidiaries)
Statutory tax rate often differs from the effective tax rate. Accounting
standards require companies to provide a reconciliation between the
effective tax rate and the statutory tax rate.
Analyst can project future tax cash expense by analyzing the (i) expected
changes in the mix of profits from different countries (ii) changes in tax
rates
LOS 18.i: Explain how changes in the components of sales affect the
sustainability of sales growth.
Changes in currency values affect the value of translated sales. Sales growth
owing to an increase in volumes or prices is considered more sustainable than
sales growth due to appreciation of the foreign currencies in which sales were
made. Organic growth in sales is defined as growth in sales excluding the effects
of acquisitions/divestitures and currency effects.
LOS 18.j: Analyze how currency fluctuations potentially affect financial
results, given a companys countries of operation.
Foreign exchange risks include the impact of changes in currency values on
assets and liabilities of a business, as well as on future sales. Disclosures (in
MD&A) may enable an analyst to evaluate the impact of changes in currency
values on a companys business. Analysts should also inquire about any hedging
tools employed by the company to manage its currency exposures.