Chapter 10-Translation of Foreign Currency Financial Statements
Two methods used to translate foreign currency financial statements into the parent company's reporting currency
1. Historical exchange rate 2. Current exchange rate
Highly Inflationary Economy
A country is defined as having a highly inflationary economy when its cumulative three-year inflation exceeds 100 percent.
The temporal method translates assets carried at
at historical cost and stockholders' equity at historical exchange rates.
Under the temporal method cash, marketable securities, receivables, and most liabilities are
carried at current or future value and translated at the current exchange rate
The temporal method translates assets
carried at current value (cash, marketable securities, receivables) and liabilities at the current exchange rate.
Reporting Currency
is the currency in which the entity prepares its financial statements. For U.S.-based corporations, this is the U.S. dollar.
By translating assets carried at historical cost at historical exchange rates, the temporal method
maintains the underlying valuation method used by the foreign operation but distorts relationships in the foreign currency financial statements.
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
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. In other words, 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.
Two major translation methods are currently used
the current rate method the temporal method
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
Current U.S. accounting procedures require
two separate procedures for translating foreign currency financial statements into the parent's reporting currency.
Translation methods differ on the basis of
which accounts are translated at the current exchange rate and which are translated at historical rates. Accounts translated at the current exchange rate are exposed to translation adjustment. Different translation methods give rise to different concepts of balance sheet exposure and translation adjustments of differing signs and magnitude.
The two major issues related to the translation process are
(a) which method to use and (b) where to report the resulting translation adjustment in the consolidated financial statements.
IAS 29 characteristics that indicate hyperinflation
(1) the general population prefers to keep its wealth in a relatively stable foreign currency; (2) interest rates, wages, and other prices are linked to a price index; and (3) the cumulative rate of inflation over three years is approaching, or exceeds, 100 percent.
Does IFRS does provide a bright-line threshold to identify a hyperinflationary economy?
No IFRS does not. IAS 29 provides a list of characteristics that indicate hyperinflation GAAP does
Cumulative translation adjustment in other comprehensive income
The alternative to reporting the translation adjustment as a gain or loss in net income is to include it in other comprehensive income.
Functional Currency
The functional currency is defined as the currency of the foreign entity's primary economic operating environment. It can be either the parent's currency (U.S. dollar for a U.S.-based company) or a foreign currency (generally the local currency).
Translation gain or loss
This treatment considers the translation adjustment to be a gain or loss analogous to the gains and losses arising from foreign currency transactions and reports it in net income in the period in which the fluctuation in the exchange rate occurs.
The temporal method generates either
a net asset or a net liability balance sheet exposure, depending on whether cash plus marketable securities plus receivables are more than or less than liabilities
The current rate method translates
all assets and liabilities at the current exchange rate, giving rise to a net asset balance sheet exposure.
The current rate method requires translation of
all income statement items at the exchange rate in effect at the date of accounting recognition.
Under IAS 21, the financial statements of a foreign subsidiary located in a hyperinflationary economy
are translated into the parent's currency using a two-step process. First, the financial statements are restated for local inflation Second, each financial statement line item, which has now been restated for local inflation, is translated using the current exchange rate.