Translation of Foreign Currency

Financial Statements
TRANSLATION OF FOREIGN CURRENCY
FINANCIAL STATEMENTS

 Conceptual issues of foreign currency financial

statements translation.
 Balance sheet vs. transaction exposure.
 Methods of financial statement translation.
 Temporal and current rate methods illustrated.
 U.S. GAAP, IFRSs, and other standards related
to translation.
 Hedging balance sheet exposure.
TRANSLATING FOREIGN CURRENCY FINANCIAL
STATEMENTS -- CONCEPTUAL ISSUES

 Foreign country operations of a MNC usually prepare

financial statements using local currency as the monetary
unit.

 These operations also typically use local GAAP.

 When these operations are consolidated by the MNC, the

foreign operation’s financial statements must be
translated into the currency and GAAP of the MNC.
 TRANSLATING FOREIGN CURRENCY FINANCIAL
STATEMENTS -- CONCEPTUAL ISSUES

Primary conceptual issues

 Each financial statement item must be translated using
some, hopefully relevant, exchange rate.
 What rate should be used?
 the current exchange rate?
 The average exchange rate?
 the historical exchange rate?

 Given that any adjustment is, at the point of translation,

unrealized, how should the resulting adjustment be
recognized?
 in current income?
 in an equity account on the balance sheet?
 BALANCE SHEET EXPOSURE

 Assets and liabilities translated at the current

exchange rate are exposed to risk of a translation
adjustment.
 When foreign currency appreciates, a net asset
exposure results in a positive translation
adjustment.
 When foreign currency appreciates, a net
liability exposure results in a negative translation
adjustment.
 Assets and liabilities translated at the historical
exchange rate are not exposed to a translation
adjustment.
A SIMPLE EXAMPLE
 Let’s say XYZ has a 1000 euro current note
receivable on its books. The euro/$ direct rate is
$ 1 on 1/1. On 12/31, it is $.9091.
 Should we record:
 No change?
 An decrease in value of $90.90?

And if we do report a change, where should the offsetting

gain 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 $ .
9091.
 Should we record:
 No change?
 An decrease in value of $90,900?

And if we do report a change, where should the

offsetting gain be reported?
THE QUESTION:
 How do we account for these effects?

 The matter is complex because the economic impact will

vary depending on what type of asset is held and what is
driving FX movements.

 There is also an interaction with accounting

imperfections and constraints.
THE CURRENT RATE METHOD:
 The receivable would be translated using the current
rate.
 The land would be translated at the current rate.
 TRANSLATION METHODS

Current Rate Method

 Presumes that the parent’s entire investment in a
foreign subsidiary is exposed to exchange risk.
 All assets and liabilities are translated at the
current exchange rate.
 Stockholders’ equity accounts are translated at
historical exchange rates.
 Income statement items are translated at the
exchange rate in effect at the time of the
transaction.
CURRENT RATE METHOD
 Advantages
Simple to do
Ratios are not distorted
BUT WHAT IF:
 Inflation differences caused the decline in the value of
the euro?
 If the inflation differential was 10%, then:
 Before, 1,000,000E=1,000,000$
 Now, 1,100,000E=1,000,000$;
 Thus the direct exchange rate would be .9091
(1,000,000/1,100,000).
 Thus the current value of the land, in euros, is now
1,100,000E. The valuation should be 1100000*.9091 =
1,000,000$, i.e., no change.
THE CURRENT RATE METHOD
 Disadvantages
Can produce disparate results that are not
consistent with the economics that are really
going on.
What does the FC adjustment mean?
Possibility of disappearing assets in
inflationary economies.
THE PROBLEM:
 The receivable is a monetary asset.
 The land is a non-monetary asset.
 TRANSLATION METHODS

Monetary/Nonmonetary Method
 Monetary assets and liabilities are translated at the
current exchange rate.
 Nonmonetary assets and liabilities and stockholders’
equity accounts are translated at historical exchange
rates.
 The translation adjustment measures the net foreign
exchange gain or loss on current assets and liabilities as
if these items were carried on the parent’s books.
IN OUR EXAMPLE:
 The receivable would be translated using the current
rate.
 The land would be translated at the historical rate.
MONETARY/NON-MONETARY
 Advantages
Easy to understand. Makes intuitive sense.
Usually not difficult to classify assets and
liabilities.
BUT WHAT IF:
 A monetary asset/liability is booked at historical cost
(e.g. long term bonds)
 A nonmonetary asset/liability is booked at current cost
(e.g., revalued property, plant and equipment)
MONETARY/NON-MONETARY METHOD
 Disadvantages
Valuation basis in accounting doesn’t always
line up right with classification, producing
potentially meaningless values.
Thus some assets can disappear in the
presence of inflation while others are over or
under-reported.
 TRANSLATION METHODS

Current/Noncurrent Method
 Current assets and liabilities are translated at the current
exchange rate.
 Noncurrent assets and liabilities and stockholders’ equity
accounts are translated at historical exchange rates.
IN OUR EXAMPLE:
 The receivable would be classified as current and
translated using the current rate.
 The land would be classified as noncurrent and
translated at the historical rate.
CURENT/NONCURRENT
 Advantages?
 Simplistic. Requires no more characterization of
assets/liabilities than is already provided by the financial
statements
 Seems to solve the monetary/non-monetary problem while
remaining more consistent with underlying accounting basis
being used.
CURRENT/NON-CURRENT METHOD
 Disadvantages
 Can still misspecify monetary assets/liabilities. Example:
inventories, noncurrent marketable equity securities.
 Does not explicitly address the accounting problem. For
example, some current assets use historical cost basis. Some
noncurrent assets are booked at current value.
 Thus some assets can still disappear in the presence of severe
inflation. Others can be severely over or undervalued.
 TRANSLATION METHODS

Temporal Method
 Objective is to translate financial statements as if the
subsidiary had been using the parent’s currency.
 Items carried on subsidiary’s books at historical cost,
including all stockholders’ equity items are translated at
historical exchange rates.
 Items carried on subsidiary’s books at current value are
translated at current exchange rates.
 Income statement items are translated at the exchange
rate in effect at the time of the transaction.
IN OUR EXAMPLE:
 The receivable translated using the current rate.
 If reported at historical cost, the land would be translated
at the historical rate.
 If reported at fair value, the land would be translated at
the current rate.
TEMPORAL METHOD
 Advantages
 Lines up with valuation basis used in accounting. Thus the
numbers have most consistent internal meaning.
 They will still be misspecified, however, but only to the
extent the underlying accounting numbers already are.
TEMPORAL METHOD
 Disadvantages
 Lotsof volatility in financial statements.
 Mixing of valuations: does the sum make any sense?
 For our purposes, because they are both called for in
current accounting standards on FX translation, we will
focus on:
 Current
rate method
 Temporal Method
-29

TRANSLATION METHODS
CURRENT RATE METHOD
 Use

Usecurrent
currentexchange
exchangerates
ratesto
to
translate
translateall
allassets
assetsand
andliabilities.
liabilities.
Parent
 Use

Usehistorical
historical(or
(oraverage)
average)
exchange
exchangerates
ratesto
totranslate
translateequity
equity
accounts.
accounts.
 Use

Usehistorical
historical(or
(oraverage)
average)
exchange
exchangerates
ratesto
totranslate
translate
income
incomestatement
statementaccounts.
accounts.
 Assumes

Assumes“net“netinvestment”
investment”in inaa
foreign
foreignoperation
operationisisexposed
exposedtoto
foreign
foreignexchange
exchangerisk
risk

Subsidiary
-30

TRANSLATION METHODS
TEMPORAL METHOD
 Use historical exchange rates to translate
Use historical exchange rates to translate
assets Parent
assetsand
andliabilities
liabilitiescarried
carriedatathistorical
historicalcost.
cost.
 Use current exchange rates to translate assets
Use current exchange rates to translate assets
and
andliabilities
liabilitiescarried
carriedatatcurrent
currentcost
costor orfuture
future
value.
value.
 Use historical (or average) exchange rates to
Use historical (or average) exchange rates to
translate
translateequity,
equity,revenue,
revenue,andandexpense
expense
accounts.
accounts.
 Objective is to produce a set of U.S. dollar
Objective is to produce a set of U.S. dollar
translated
translatedfinancial
financialstatements
statementsas asififthe
the
foreign
foreignsubsidiary
subsidiaryhadhadactually
actuallyused
usedU.S.
U.S.
dollars
dollars
Subsidiary
-31
tt
rr
aa
nn
TRANSLATION OF RETAINED EARNINGS
ss
aa
cc
tt At
At the
the end
end of
of the
the first
first year
year of
of
ii operations:
operations:
oo
nn
ss
,,
tt
rr
aa
nn
ss
ll
aa Ending
Ending R/E
R/E from
from year
year 1,
1, becomes
becomes
tt
ii Beginning
Beginning R/E
R/E in
in Year
Year 2.
2.
nn
gg
-32

CALCULATION OF COST OF GOODS

SOLD
Current
Current Rate
Rate Method
Method -- translate
translate using
using the
the
weighted
weighted average
average rate
rate for
for the
the current
current
period.
period.
Temporal
Temporal Method
Method -- decompose
decompose COGS COGS into
into
its
its component
component parts
parts and
and translate
translate each
each
part
part using
using the
the appropriate
appropriate rate rate

Apply
Apply Lower-of-Cost-or-Market
Lower-of-Cost-or-Market using
using the
the
foreign
foreign exchanges
exchanges rates.
rates.
-33

FIXED ASSETS AND ACCUMULATED

DEPRECIATION
Current
CurrentRate
RateMethod
Method-- translate
translate fixed
fixed
assets
assetsand
andaccumulated
accumulated
depreciation
depreciationusing
usingthe
thespot
spot rate
rateas
as
of
of the
thebalance
balancesheet
sheetdate.
date.

Temporal
Temporal Method
Method -- fixed
fixed
assets
assets acquired
acquired atat different
different
times
times will
will be
be translated
translated using
using
their
their respective
respective historical
historical
translation
translation rates.
rates. Accumulated
Accumulated
depreciation
depreciation usesuses the
the same
same
historical
historical rates
rates as
as the
the related
related
-34

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

Temporal
Temporal Method
Method -- translate
translate
depreciation
depreciation expense
expense using
using
the
the various
various historical
historical rates
rates
related
related to
to the
the underlying
underlying
assets.
assets.
-35

GAIN OR LOSS ON THE SALE OF AN

ASSET
Current
Current Rate
Rate Method
Method -- translate
translate thethe gain
gain
or
or loss
loss using
using the
the historical
historical rate
rate in
in effect
effect
on
on the
the date
date of
of sale
sale
Temporal
Temporal Method
Method -- the
thegain
gainmust
mustbe be
computed
computedindirectly,
indirectly, using
usingdifferent
different rates.
rates.
-36

DISPOSITION OF TRANSLATION
ADJUSTMENT
Current

CurrentMethod
Method
Translation Adjustment

Translation Adjustmentisis
reported
reportedon
onthe
theBalance
Balance
Sheet.
Sheet.
Temporal

TemporalMethod
Method
Adjustment is reported
Adjustment is reportedon
on
the
theIncome
IncomeStatement
Statementasasaa
Translation
TranslationGain
Gainoror(Loss)
(Loss)
-37

TRANSLATION
U.S. ACCOUNTING RULES
SFAS

SFASNo.
No.88(1975)
(1975)--
Accounting
Accountingfor
forTranslation
Translationof
of
Foreign
ForeignCurrency
CurrencyTransactions
Transactions
and
andForeign
ForeignCurrency
Currency
Financial
FinancialStatements.
Statements.
SFAS

SFASNo.
No.52
52(1981)
(1981)--Foreign
Foreign
Currency
CurrencyTranslation.
Translation.
SFAS

SFASNo.
No.130
130(1998)
(1998)
-38

SFAS NO. 52
Recognized two
types of subs: Temporal
Temporalmethod
methodstill
stillapplies.
applies.
 Subs that do most
of their
transactions in
U.S. $ Applies
Appliesthe
the“local
“localcurrency
currency
 Subs that operate perspective”.
perspective”.
relatively Uses
Usescurrent
currentrate
ratemethod.
method.
independently of Translation
Translationadjustment
adjustment
appears
appearsin
inthe
theequity
equitysection.
their U.S. section.
parents.
-39

FUNCTIONAL CURRENCY
To
Todetermine
determinewhether
whetheraasubsidiary
subsidiaryis
isintegrated
integratedwith
withthe
theparent
parent
or
oroperates
operatesindependently,
independently,SFAS
SFAS52 52introduced
introducedthe
theconcept
concept
of
offunctional
functionalcurrency.
currency
currency.
currency

AAcompany’s
company’sfunctional
functionalcurrency
currencyisisthe
the
primary
primarycurrency
currencyof
ofthe
theforeign
foreignentity’s
entity’s
operating
operatingenvironment.
environment.
-40

DETERMINING A SUBSIDIARY’S
FUNCTIONAL CURRENCY
Indications that the
Functional Currency is the
Indicator
Foreign Currency
Cash Flows Primarily in FC and do
not affect parent’s
cash flows

Sales Price Not affected on short-

term basis by changes
in exchange rate

Sales Market Active local sales

market
-41

DETERMINING A SUBSIDIARY’S
FUNCTIONAL CURRENCY
Indications that the
Functional Currency is the
Indicator
Foreign Currency
Expenses Primarily local costs

Financing Primarily denominated in

FC and FC cash flows
adequate to service
obligations
inter-company transactions Low volume of inter-
company transactions, not
extensive
interrelationships with
parent’s operations
-42

DETERMINING A SUBSIDIARY’S
FUNCTIONAL CURRENCY
Indications that the
Functional Currency is the
Indicator
Parent’s Currency
Cash Flows Directly impact
parent’s cash flows on
a current basis

Sales Price Affected on a short-

term basis by changes
in exchange rate

Sales Market Sales market mostly in

parent’s country or
sales denominated in
parent’s currency
-43

DETERMINING A SUBSIDIARY’S
FUNCTIONAL CURRENCY
Indications that the
Functional Currency is the
Indicator Parent’s Currency
Expenses Primarily costs for
components obtained from
parent’s country

Financing Primarily from parent or

denominated in parent’s
currency or FC cash flows
not adequate to service
obligations
inter-company transactions High volume of inter-
company transactions and
extensive
interrelationships with
parent’s operations
-44

HIGHLY INFLATIONARY ECONOMIES

In
Inhighly
highlyinflationary
inflationaryeconomies,
economies,SFAS
SFAS52
mandates
mandatesthetheuse
useofofthe
theTemporal
52
TemporalMethod
Method
Why?
for translation.
for translation.

Disappearing
DisappearingPlant
PlantProblem
Problem
IfIfthe
theCurrent
CurrentMethod
Methodwere
wereused,
used,the
theUS
US$$
equivalent
equivalentwould
wouldbebeVERY
VERYsmall
smalldue
duetoto
the
therapidly
rapidlyincreasing
increasingexchange
exchangerate.
rate.
-45

DEFINING “HIGHLY INFLATIONARY

ECONOMY”
 Remember, SFAS 52 mandates use of the temporal
method, with re-measurement gains or losses reported in
income!!!
 A “highly inflationary economy” is one having a
cumulative three-year inflation exceeding 100%

(With compounding, this is about 26% inflation per year

for three straight years)
-46

CURRENT RATE METHOD EXAMPLE

Duzy

DuzyCo.,
Co.,isisaawholly
whollyowned
owned
foreign
foreignsub
subofofMaly
MalyCorporation.
Corporation.
Duzy
DuzyCo.’s
Co.’stransactions
transactionsand
and
financial
financialstatements
statementsareare
denominated
denominatedin inthe
thelocal
local
(functional)
(functional)currency,
currency,the
thePater
Pater
(PT).
(PT).
 Using

Usingthe
thefollowing
followinginformation,
information,
translate
translatetheir
theirstatements
statementsinto
intoUS
US
$.
$.
-47

CURRENT RATE METHOD EXAMPLE

 Duzy

DuzyCo.’s
Co.’scommon
commonstock
stockwas
wasissued
issuedin
in
1992
1992when
whenthetheexchange
exchangerate
ratewas
was$1.00
$1.00
==1.20
1.20PT.
PT.
 Fixed

Fixedassets
assetswere
wereacquired
acquiredin
in1993
1993when
when
the
theexchange
exchangerate
ratewas
was$1.00
$1.00==1.10
1.10PT.
PT.
 As

AsofofJan.
Jan.1,
1,2008,
2008,the
theR/E
R/Ebalance
balancewas
was
translated
translatedatat$350,000.
$350,000.
 Inventory

Inventorywas
wasacquired
acquiredevenly
evenly
throughout
throughoutthetheyear.
year.
-48

CURRENT RATE METHOD EXAMPLE

 The Dec. 31, 2008 translation adjustment had a debit
balance of $69,841.
 Dividends were declared on March 15, 2008, and
equipment was sold on October 1, 2008.
 The following direct exchange rates were in effect
during the year:
 Note: The following example uses a division process and
indirect rates. This may seem to differ from what is
described in your text. But there is no real difference.
 For example, if translation of $ 1,000 PT is made using
the Oct1st direct rate of $ 1.25, the same translation can
be made using the indirect rate, which is the inverse, i.e.,
1 $ = .80PT.
 To use the direct rate, one multiplies the # of PT by 1.25;
1.25 x 1000 = $ 1,250.
 To use the indirect rate, one divides the # of PT by the
indirect rate, .80; 1000/.80 = $ 1,250.
-50

CURRENT RATE METHOD EXAMPLE

 The following indirect exchange rates were in effect

during the year:
-51

CURRENT RATE METHOD EXAMPLE

Determine
Determine the
the
appropriate
appropriate
exchange
exchange rates
rates
to
to use
use for
for each
each
account.
account.
-52

CURRENT RATE METHOD EXAMPLE

Weighted
Weighted
average
average rates
rates
are
are generally
generally
used
used for
for
Sales,
Sales, COGS,
COGS,
and
and other
other
recurring
recurring
expenses.
expenses.
-53

CURRENT RATE METHOD EXAMPLE

The
The actual
actual historical
historical
rate
rate is
is used
used when
when we we
can
can identify
identify itit
efficiently.
efficiently.
-54

CURRENT RATE METHOD EXAMPLE

-55

CURRENT RATE METHOD EXAMPLE

Determine
Determine the
the
appropriate
appropriate
exchange
exchange rates
rates
to
to use
use for
for each
each
account.
account.
-56

CURRENT RATE METHOD EXAMPLE

The
The beginning
beginning R/ER/E
is
is carried
carried over
over from
from
the
the prior
prior year.
year.
-57

CURRENT RATE METHOD EXAMPLE

The
The net
net income
income is
is
taken
taken from
from the
the
income
income statement.
statement.
-58

CURRENT RATE METHOD EXAMPLE

Dividends
Dividends are
are
translated
translated at
at
the
the historical
historical
rate
rate on
on the
the date
date
of
of declaration.
declaration.
-59

CURRENT RATE METHOD EXAMPLE

-60

CURRENT RATE METHOD EXAMPLE

-61

CURRENT RATE METHOD EXAMPLE

All
All assets
assets
and
and liabilities
liabilities
are
are translated
translated
at
at the
the current
current
rate
rate onon the
the
balance
balance sheet
sheet
date.
date.
-62

CURRENT RATE METHOD EXAMPLE

Common
Common Stock Stock
is
is translated
translated at at
the
the historical
historical
rate
rate atat the
the time
time
the
the stock
stock was
was
issued.
issued.
-63

CURRENT RATE METHOD EXAMPLE

The
The Ending
Ending R/E
R/E comes
comes
from
from the
the statement
statement of
of
retained
retained earnings.
earnings.
-64

CURRENT RATE METHOD EXAMPLE

The
The translation
translation adjustment
adjustment
is:
is:
The
The difference
difference between
between Net
Net
Assets
Assets atat current
current rates
rates and
and
Net
Net Assets
Assets atat historical
historical
rates
rates added
added toto the
the
translation
translation adjustment
adjustment
balance
balance atat the
the beginning
beginning ofof
the
the year:
year:
$41,511
$41,511 ++ $69,841
$69,841 ==
$111,352
$111,352
-65

CURRENT RATE METHOD EXAMPLE

-66

RE-MEASUREMENT OF FINANCIAL
STATEMENTS
If

Ifthe
thesub’s
sub’sfunctional
functionalcurrency
currencyisisthe
the
U.S.
U.S.$,$,then
thenany
anybalances
balances
denominated
denominatedin inthe
thelocal
localcurrency,
currency,
must
mustbebere-measured.
re-measured.
re-measurement

re-measurementrequires
requiresthe
the
application
applicationof ofthe
thetemporal
temporalmethod.
method.
The

There-measurement
re-measurementgain gainor
orloss
loss
appears
appearson onthe
theincome
incomestatement.
statement.
-67

NONLOCAL CURRENCY BALANCES

 If any accounts of the foreign subsidiary are
denominated in a currency other than the local currency
(or the US$), they would first have to be restated into the
local currency
 Both the foreign currency balance and any related
foreign exchange gain or loss would then be translated
(or re-measured) into US$
-68

HEDGING BALANCE SHEET EXPOSURE

 Translation adjustments and re-measurement gains or
losses arise from:
(1)Exchange rate changes and
(2)Balance sheet exposure

Balance sheet exposure can be hedged, either through

derivatives such as forward contracts or foreign currency
options or through the use of such non-derivative
instruments as foreign currency borrowings

Ironically, in seeking to avoid unrealized translation

adjustments, realized foreign exchange gains and losses
can occur!
-69

SUMMARY
 Because many US firms have significant financial
investments in foreign countries, the translation of
foreign currency financial statements is an important
accounting challenge
 The two primary methods used are the temporal and
current rate methods
 SFAS 52 established translation through the use of the
current rate method when the foreign operation’s
functional currency is a foreign currency
 re-measurement through the temporal method is
appropriate when the operation’s functional currency is
the US$, or in the case of a highly inflationary economy
-70

POSSIBLE CRITICISMS
 Some critics contend that the functional currency
decision can be quite subjective.
 Others argue that having two fundamentally different
approaches to translation creates confusion.
 Reporting unrealized gains and losses as an element of
the balance sheet is controversial.

WHAT DO YOU THINK????

 Thus we see a myriad of measurement problems
arise when the value of money changes and is
uncertain.
 The economic impact of FX changes vary as a
function of the cause of the change and the type
of exposure (asset/liability; monetary/non-
monetary).
 Accounting limitations (e.g., historical cost) mix
with this uncertainty.
 The current standard is SFAS 52. This could
easily change at any time, as it has several times
before.