Chapter Ten: Translation of Foreign Currency Financial Statements
Indicators for Determining Functional Currency Indicators:
-Cashflow -Sales Price -Sales Market -Expenses -Financing -Intra-entity transactions
Hedging Balance Sheet Exposure Translation adjustments and remeasurement gains or losses are functions of two factors:
-Changes in the exchange rate. -Balance sheet exposure.
Worldwide Consolidated Financial Statements To prepare worldwide consolidated financial statements, a U.S. parent company must:
-Convert the foreign GAAP financial statements of its foreign operations into U.S. GAAP. -Translate the financial statements from the foreign currency into U.S. dollars.
Calculation of Cost of Goods Sold Under the current rate method
-Cost of Goods Sold (COGS) in foreign currency (FC) is translated using the average-for-the-period exchange rate (ER): COGS in FC × Average ER = COGS in $
Translation Methods Two types of exchange rates are used to apply them:
-Historical exchange rate -Current exchange rate
Indicator: Cashflow Foreign Currency: Parent's Currency:
-Primarily in FC and does not affect parent's cash flows -Directly impacts parent's cash flows on a current basis
Historical exchange rate
the exchange rate that existed when a transaction occurred.
Current exchange rate
the exchange rate that exists at the balance sheet date.
Gain or Loss on the Sale of an Asset The current rate method
translates the gain on sale of land at the exchange rate in effect at the date of sale.
Indicator: Sales Market Foreign Currency: Parent's Currency:
-Active local sales market -Sales market mostly in parent's country or sales denominated in parent's currency
Temporal Method This rule is consistent with the temporal method's underlying objective:
-Assets and liabilities carried on the foreign operation's balance sheet at historical cost are translated at historical exchange rates to yield an equivalent historical cost in U.S. dollars. -Assets and liabilities carried at a current or future value are translated at the current exchange rate to yield an equivalent current value in U.S. dollars.
Disclosures Related to Translation
-Current standards require firms to present an analysis of the change in the cumulative translation adjustment account in the financial statements or notes thereto. -Many companies comply with this requirement directly in their statement of comprehensive income. Other companies provide separate disclosure in the notes. -Although not specifically required to do so, many companies describe their translation procedures in their "summary of significant accounting policies" in the notes to the financial statements.
Hedging Balance Sheet Exposure
-If the U.S. dollar is the functional currency or a foreign operation is located in a highly inflationary economy, remeasurement gains and losses are reported in the consolidated income statement. -If the foreign currency is the functional currency, negative translation adjustments have an adverse impact on the debt-to-equity ratio. -Translation adjustments and remeasurement gains or losses are functions of two factors:
Indicator: Intra-entity transactions Foreign Currency: Parent's Currency:
-Low volume of intra-entity transactions, not extensive interrelationship with parent's operations -High volume of intra-entity transactions and extensive interrelationship with parent's operations
Indicator: Financing Foreign Currency: Parent's Currency:
-Primarily denominated in foreign currency and FC cash flows adequate to service obligations -Primarily from parent or denominated in parent currency of FC cash flows not adequate to service obligations
Indicator: Expenses Foreign Currency: Parent's Currency:
-Primarily local costs -Primarily costs for components obtained from parent's country
Functional Currency Terminology
-Reporting currency -Remeasurment -Translation adjustment
Translation Adjustment Methods:
-Translation Gain or Loss -Cumulative Translation Adjustment
Translation Methods
-Two methods are used in the United States and most other countries to translate foreign currency financial statements into the parent company's reporting currency. -Two types of exchange rates are used to apply them: -Translation methods differ as to which balance sheet and income statement accounts are translated at historical exchange rates and at current exchange rates.
Gain or Loss on the Sale of an Asset The temporal method
-cannot translate the gain on the sale of land directly. The cash received and the cost of the land sold must be translated into U.S. dollars separately, the difference is the U.S. dollar value of the gain. This method translates the Cash account at the exchange rate on the date of sale, and the Land account is translated at the historical rate.
Calculation of Cost of Goods Sold Under the temporal method
-no single exchange rate can be used to directly translate COGS in FC into COGS in dollars. -COGS must be decomposed into beginning inventory, purchases, and ending inventory, and each component must then be translated at its appropriate historical rate. -When purchases can be assumed to have been made evenly throughout 2017, the average 2017 exchange rate is used to translate purchases:
Hedging Balance Sheet Exposure Translation adjustments and remeasurement gains or losses are functions of two factors: Changes in the exchange rate.
A company has little influence on exchange rates
Translation adjustment
If a foreign currency is the foreign operation's functional currency, the currency balances are translated using the current rate method and a translation adjustment is reported on the balance sheet.
Temporal Method Translation Adjustment
The major difference between a translation adjustment resulting from the use of the temporal method and a foreign exchange gain or loss is the translation adjustment is not necessarily realized through inflows or outflows of cash.
Conversion and Translation Process
This conversion and translation process is required whether the foreign operation is a branch, joint venture, majority-owned subsidiary, or affiliate accounted for under the equity method.
Translation Adjustments and Exposure Liabilities translated at the current exchange rate when the foreign currency has appreciated generate
a negative (debit) translation adjustment.
Translation Adjustments and Exposure Assets translated at the current exchange rate when the foreign currency has appreciated generate
a positive (credit) translation adjustment.
Reporting currency
currency in which an entity prepares its financial statements. U.S.-based companies use the U.S. dollar.
Translation Adjustments and Exposure Transaction exposure gives rise to foreign exchange gains and losses that are ultimately realized in cash;
translation adjustments arising from balance sheet exposure do not directly result in cash inflows or outflows.
Translation Adjustment Two issues related to the translation of foreign currency:
-The appropriate method for the translation of foreign currency financial statements must be selected. -Where to report the resulting translation adjustment in the
Temporal Method
-The basic objective underlying the temporal method of translation is to produce a set of U.S. dollar-translated financial statements as if the foreign subsidiary had actually used U.S. dollars in conducting its operations.
Current Rate Method—Translation Adjustment
-If the foreign currency increases in value, an increase in the U.S. dollar value of the net asset occurs and will be reflected through a positive (credit balance) translation adjustment. -To measure the net investment's exposure to foreign exchange risk, all assets and all liabilities of the foreign operation are translated at the current exchange rate. -Stockholders' equity items are translated at historical rates. -The balance sheet exposure under the current rate method is equal to the foreign operation's net asset (total assets minus total liabilities) position.
Highly Inflationary Economies
-In highly inflationary economies, the temporal method for translation is required with remeasurement gains or losses reported in net income. -A country has a highly inflationary economy when its cumulative three year inflation exceeds 100 percent. With compounding, it equates to an average of approximately 26 percent per year for three years in a row. -A country may or may not be classified as highly inflationary, depending on its most recent three-year experience with inflation.
Indicator: Sales Price Foreign Currency: Parent's Currency:
-Not affected on short-term basis by changes in exchange rate -Affected on short-term basis by changes in exchange rate
Current Rate Method
-The basic assumption underlying the current rate method is that a company's net investment in a foreign operation is exposed to foreign exchange risk. -A foreign operation represents a foreign currency net asset and if the foreign currency decreases in value against the U.S. dollar, a decrease in the U.S. dollar value of the foreign currency net asset occurs. -It will be reflected by reporting a negative (debit balance) translation adjustment in the consolidated financial statements.
Property, Plant, and Equipment, Depreciation, and Accumulated Depreciation
-The temporal method requires translating property, plant, and equipment acquired at different times at different (historical) exchange rates. -The same is true for depreciation of property, plant, and equipment and accumulated depreciation related to property, plant, and equipment. -In comparison with the current rate method, the temporal method can require substantial additional work for subsidiaries that own hundreds and thousands of items of property, plant, and equipment.
Translation Adjustments and Exposure
-Assets translated -Liabilities translated -Transaction exposure
Reporting Translation Adjustments
-Should the translation adjustment be treated as a translation gain or loss reported in net income and then closed to retained earnings? -Should the translation adjustment be treated as a direct adjustment to owners' equity in accumulated AOCI without affecting net income?
Translation of Retained Earnings
-Stockholders' equity items are translated at historical exchange rates under both the current rate and temporal methods. This creates somewhat of a problem in translating retained earnings. -Retained earnings is an accumulation of all of the net income less dividends declared by a company since its inception. -Keeping a record of the acquisition date exchange rates is necessary when translating inventory, prepaid expenses, property, plant and equipment, and intangible assets because these assets, carried at historical cost, are translated at historical exchange rates (not necessary under the current rate method).
Hedging Balance Sheet Exposure Translation adjustments and remeasurement gains or losses are functions of two factors: Balance sheet exposure.
-Parent companies can use several techniques to hedge the balance sheet exposures of their foreign operations. -Balance sheet exposure can be hedged through derivatives (forward contracts or foreign currency options) or through nonderivative instruments (foreign currency borrowings). -A hedge of a net investment in a foreign operation eliminates the possibility of a negative translation adjustment in Accumulated Other Comprehensive Income, but gains and losses realized in cash can result.
Determining the Appropriate Translation Method
-Some subs are so closely tied to their U.S. parents, they use a U.S. dollar perspective to translation. Most of their transactions are recorded in U.S. dollars using the temporal method as if the foreign subsidiary had actually used the dollar in carrying out its activities. Translation gains and losses are reported in net income. -Other subs operate relatively independent of their parents; they use a local currency perspective and use the current rate method for translation. Translation adjustments should be reported as a separate component in accumulated other comprehensive income on the balance sheet.
Translation Adjustment Methods: Cumulative Translation Adjustment
-The alternative to reporting the translation adjustment as a gain or loss in net income is to include it in Other Comprehensive Income. -This treatment defers the gain or loss in stockholders' equity (Accumulated Other Comprehensive Income or AOCI) until it is realized in some way. -As a balance sheet account, the cumulative translation adjustment is not closed at the end of an accounting period and fluctuates in amount over time.
Translation Adjustment Methods: Translation Gain or Loss
-Translation gain or loss considers a translation adjustment to be a gain or loss similar to gains and losses arising from foreign currency transactions. -The translation adjustment is reported in net income in the period in which the fluctuation in the exchange rate occurs. -Problems with treating translation adjustments as gains or losses in income is that the gain or loss is unrealized; no cash inflow or outflow accompanies it. -The gain or loss could be inconsistent with economic reality.
Conversion and Translation Process Two major related theoretical issues are:
-Which translation method should be used. -Where the resulting translation adjustment should be reported in the consolidated financial statements.
Remeasurment
if a foreign operation's functional currency is the U.S. dollar, the currency balances are remeasured into U. S. dollars using the temporal method resulting in remeasurement gains and losses.
Translation Methods: Two major translation methods are currently used:
-The current rate (or closing rate) method. -The temporal method. -Each method is presented from the perspective of a U.S.-based multinational company translating foreign currency financial statements into U.S. dollars.
Temporal Method Translation Adjustment The U.S. dollar translation adjustment is *realized* only if:
-The parent sends U.S. dollars to the foreign subsidiary to pay all of its liabilities. -The subsidiary converts its receivables and marketable securities into cash and then sends this amount plus the amount in its cash account to the U.S. parent, which converts it into U.S. dollars.
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.
Functional Currency: *Foreign currency* Translation Method: Translation Adjustment:
Translation Method: *Current Rate Method* Translation Adjustment: *Separate component of Other Comprehensive Income (Stockholder's Equity)*
Functional Currency: *U.S. dollar* Translation Method: Translation Adjustment:
Translation Method: *Temporal Method* Translation Adjustment: *Gain (loss) in Net Income*