Chap010

Chapter Ten: 

Chapter Ten Translation of Foreign Currency Financial Statements McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Translation of Financial Statements: 

If we control our subsidiaries, why don’t they all use the US Dollar as their currency? Our subsidiaries are required by local regulations to use their local currency. Their statements must be translated to US $. Translation of Financial Statements 10- 2 What happens when a US corporation owns a foreign corporation?

Translation of Financial Statements: 

In addition, many countries have different accounting rules that we must consider before translating the sub’s financial statements. Translation of Financial Statements 10- 3

Exchange Rates Used in Translation: 

To translate a foreign subsidiary’s financial statements into U.S. $, we must use both: Historical Exchange Rates and Current Exchange Rates. Exchange Rates Used in Translation 10- 4

Exchange Rates: 

Exchange Rates Historical Exchange Rates – those which existed at the time a transaction occurred Current Exchange Rate – the exchange rate which exists at the balance sheet date 10- 5

Translation Adjustments: 

Translation Adjustments The use of different exchange rates during translation means the resulting financial statements will not balance! To force the statements to balance, an account called “ Translation Adjustment ” is debited or credited. 10- 6

Translation Adjustments: 

Translation Adjustments Exposure to translation adjustments is called “ balance sheet ,” “ translation ,” or “ accounting ” exposure. Assets translated at the current exchange rate when the foreign currency is appreciating (increasing in value relative to the US$) generate positive translation adjustments (a credit entry) Liabilities translated at the current exchange rate when the foreign currency is appreciating generate negative translation adjustments (a debit entry) 10- 7

Balance Sheet Exposure: 

Balance Sheet Exposure Balance sheet items translated at current exchange rates change in value from one balance sheet to the next and are exposed to translation adjustments . Balance sheet items translated at historical exchange rates do not change in value from one balance sheet to the next and are NOT subject to balance sheet exposure. 10- 8

Balance Sheet Exposure: 

Balance Sheet Exposure Net Asset Balance Sheet Exposure When assets translated at current rates > liabilities translated at current rates. Net Liability Balance Sheet Exposure When liabilities translated at current rates > assets translated at current rates. 10- 9

Translation Methods - CURRENT RATE METHOD: 

Parent Subsidiary Translation Methods - CURRENT RATE METHOD Use current exchange rates to translate all assets and liabilities . Use historical (or average) exchange rates to translate equity accounts. Use historical (or average) exchange rates to translate income statement accounts. Assumes “net investment” in a foreign operation is exposed to foreign exchange risk . 10- 10

Translation Methods - TEMPORAL METHOD: 

Parent Subsidiary Translation Methods - TEMPORAL METHOD Use historical exchange rates to translate assets and liabilities carried at historical cost . Use current exchange rates to translate those carried at current cost or future value. Use historical (or average) exchange rates to translate equity , revenue , and expense accounts. Objective is to produce a set of financial statements as if the foreign subsidiary had actually used U.S. dollars 10- 11

Translation of Retained Earnings: 

Translation of Retained Earnings Translating R/E requires special attention, because it is the composite of many prior transactions . At the end of the first year of operations: Ending R/E from year 1, becomes Beginning R/E in Year 2. 10- 12

Calculation of Cost of Goods Sold: 

Calculatio n of Cost of Goods Sold 10- 13 Current Rate Method - translate using the weighted average rate for the current period. Temporal Method - decompose COGS into its component parts and translate each part using the appropriate rate Apply Lower-of-Cost-or-Market using the foreign exchanges rates.

Fixed Assets and Accumulated Depreciation: 

Fixed Assets and Accumulated Depreciation Current Rate Method - translate fixed assets and accumulated depreciation using the spot rate as of the balance sheet date. Temporal Method - fixed assets acquired at different times will be translated using their respective historical translation rates . Accumulated depreciation uses the same historical rates as the related asset. 10- 14

Depreciation Expense: 

Depreciation Expense Current Rate Method - translate depreciation expense using the weighted-average rate for the current period Temporal Method - translate depreciation expense using the various historical rates related to the underlying assets. 10- 15

Gain or Loss on the Sale of an Asset: 

Gain or Loss on the Sale of an Asset Current Rate Method - translate the gain or loss using the historical rate in effect on the date of sale Temporal Method - the gain must be computed indirectly, using different rates . 10- 16

Disposition of Translation Adjustment: 

Disposition of Translation Adjustment Current Method Translation Adjustment is reported on the Balance Sheet . Temporal Method Adjustment is reported on the Income Statement as a Translation Gain or (Loss) 10- 17

Two Translation Combinations: 

Applies the “local currency perspective” with the current rate method. Translation adjustment appears in the equity section. Two Translation Combinations There are two types of subs: Subs that do most of their transactions in U.S. $ Subs that operate relatively independent of their U.S. parents. Temporal method still applies. 10- 18

Functional Currency: 

Functional Currency To determine whether a subsidiary is integrated with the parent or operates independently, we look at the functional currency . A company’s functional currency is the primary currency of the foreign entity’s operating environment . 10- 19

Determining a Subsidiary’s Functional Currency: 

Determining a Subsidiary’s Functional 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 Indications that the Functional Currency is the Foreign Currency Indicator 10- 20

Determining a Subsidiary’s Functional Currency: 

Determining a Subsidiary’s Functional Currency Expenses Primarily local costs Financing Primarily denominated in FC and FC cash flows adequate to service obligations Intercompany transactions Low volume of intercompany transactions, not extensive interrelationships with parent’s operations Indications that the Functional Currency is the Foreign Currency Indicator 10- 21

Determining a Subsidiary’s Functional Currency: 

Determining a Subsidiary’s Functional 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 Indications that the Functional Currency is the Parent’s Currency Indicator 10- 22

Determining a Subsidiary’s Functional Currency: 

Determining a Subsidiary’s Functional 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 settle obligations Intercompany transactions High volume of intercompany transactions and extensive interrelationships with parent’s operations Indications that the Functional Currency is the Parent’s Currency Indicator 10- 23

Highly Inflationary Economies: 

Highly Inflationary Economies In highly inflationary economies, the Temporal Method for translation is required. Disappearing Plant Problem If the Current Method were used, the US $ equivalent would be VERY small due to the rapidly increasing exchange rate. Why? 10- 24

Current Rate Method - Example: 

Current Rate Method - Example 10- 25 Pawn Co., is a wholly owned foreign sub of King Corporation. Pawn Co.’s transactions and financial statements are denominated in the local (functional) currency, the Pater (PT). Using the following information, translate their statements into US $.

Current Rate Method Example: 

Current Rate Method Example 10- 26 Pawn Co.’s common stock was issued in 2002 when the exchange rate was $1.00 = 1.20 PT. Fixed assets were acquired in 2003 when the exchange rate was $1.00 = 1.10 PT. As of Jan. 1, 2012, the R/E balance was translated at $350,000. Inventory was acquired evenly throughout the year.

Current Rate Method Example: 

Current Rate Method Example The Dec. 31, 2012 translation adjustment had a debit balance of $69,841. Dividends were declared on March 15, 2012, and equipment was sold on October 1, 2012. The following exchange rates were in effect during the year: 10- 27

Current Rate Method Example: 

Current Rate Method Example Determine the appropriate exchange rates to use for each account. 10- 28

Current Rate Method Example: 

Current Rate Method Example Weighted average rates are generally used for Sales, COGS, and other recurring expenses. 10- 29

Current Rate Method Example: 

Current Rate Method Example The actual historical rate is used when we can identify it efficiently. 10- 30

Current Rate Method Example: 

Current Rate Method Example 10- 31

Current Rate Method Example: 

Determine the appropriate exchange rates to use for each account. Current Rate Method Example 10- 32

Current Rate Method Example: 

Current Rate Method Example The beginning R/E is carried over from the prior year. 10- 33

Current Rate Method Example: 

Current Rate Method Example The net income is taken from the income statement. 10- 34

Current Rate Method Example: 

Current Rate Method Example Dividends are translated at the historical rate on the date of declaration. 10- 35

Current Rate Method Example: 

Current Rate Method Example 10- 36

Current Rate Method Example: 

Current Rate Method Example 10- 37

Current Rate Method Example: 

Current Rate Method Example All assets and liabilities are translated at the current rate on the balance sheet date. 10- 38

Current Rate Method Example: 

Current Rate Method Example Common Stock is translated at the historical rate at the time the stock was issued. 10- 39

Current Rate Method Example: 

Current Rate Method Example The Ending R/E comes from the statement of retained earnings. 10- 40

Current Rate Method Example: 

Current Rate Method Example The translation adjustment is: The difference between Net Assets at current rates and Net Assets at historical rates added to the translation adjustment balance at the beginning of the year: $41,511 + $69,841 = $111,352 10- 41

Current Rate Method Example: 

Current Rate Method Example 10- 42

Remeasurement of Financial Statements: 

Remeasurement of Financial Statements If the sub’s functional currency is the US $ , then any balances denominated in the local currency, must be remeasured . Remeasurement requires the application of the temporal method . The remeasurement gain or loss appears on the income statement . 10- 43

Nonlocal Currency Balances: 

Nonlocal Currency Balances If any accounts of the foreign subsidiary are denominated in a currency other than the local currency (or the US$), they would first have to be restated into the local currency Both the foreign currency balance and any related foreign exchange gain or loss would then be translated (or remeasured) into US$ 10- 44

Hedging Balance Sheet Exposure: 

Hedging Balance Sheet Exposure Translation adjustments and re-measurement gains / losses arise from: (1) Exchange rate changes and (2) Balance sheet exposure 10- 45 Balance sheet exposure can be hedged, through derivatives (forward contracts or foreign currency options) or through nonderivative instruments (foreign currency borrowings) Ironically, in seeking to avoid unrealized translation adjustments, realized foreign exchange gains and losses can occur!

IFRS and Translations: 

IFRS and Translations IFRS and US GAAP are consistent on most points, however, IFRS has a hierarchy of characteristics for determining the functional currency , and The method used to translate statements from a hyperinflationary country differs. 10- 46 In either case, an analysis of the change in the cumulative translation adjustment must be disclosed .

Summary: 

Summary The translation of foreign currency financial statements is an important accounting challenge in the current global environment. The two primary methods used are the temporal and current rate methods. When the foreign operation’s functional currency is their local currency , use the current rate method. Use the temporal method when the operation’s functional currency is the US$ , or in the case of a highly inflationary economy 10- 47

Possible Criticisms: 

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. 10- 48 WHAT DO YOU THINK????