International Chapter 8 questions
what factors create a BS exposure to foreign exchange risk?
Balance sheet exposure arises when a foreign currency balance is translated *at the current exchange rate*. By translating at the current exchange rate, the foreign currency item in essence is being revalued in U.S. dollar terms on the consolidated financial statements. There will be either a net asset balance sheet exposure or net liability balance sheet exposure depending upon whether assets translated at the current rate are greater or less than liabilities translated at the current rate.
how does BS exposure differ under these two methods (current rate vs. temporal)
Balance sheet exposure under the temporal method is analogous to the net transaction exposure that exists from having both receivables and payables in a particular foreign currency.
what does functional currency mean?
The functional currency is the currency of the subsidiary's primary economic environment. It is usually identified as the currency in which the company generates and expends cash.
which of the following items is normally translated the same way under both the current rate and temporal methods of translation?
sales revenue
how does balance sheet exposure compare with transaction exposure?
Balance sheet exposure generates a translation adjustment, which does not result in an inflow or outflow of cash. Transaction exposure, which results from the receipt or payment of foreign currency, generates foreign exchange gains and losses that are realized in cash.
which method of translation maintains, in the translated FS, the underlying valuation methods used in the foreign currency FS?
temporal method --> by translating items carried at historical cost by the historical exchange rate, the temporal method maintains the underlying valuation method used by the foreign sub
which of the following best explains how a translation loss arises when the temporal method of translation is used to translate the foreign currency FS of a foreign subsidiary?
the foreign sub has more monetary assets than monetary liabilities, and the foreign currency depreciates in value
the functional currency of xxx inc, a japanese sub is the japanese yen. xxx borrowed japanese yen as a partial hedge of its investment in the sub. how should the transaction gain on the foreign currency borrowing be reported in xxx consolidated FS?
the transaction gain is offset against the negative translation adjustment related to the Japanese sub in the SH's equity section of the BS
in translating the FS of a foreign subsidiary into the parent's reporting currency under the current rate method, which is true?
the translation adjustment is a function of the foreign subsidiary's net assets
which translation method does US GAAP require for operations in highly inflationary countries?
temporal method Use of the current rate method without first restating for inflation results in a "disappearing plant" problem in which fixed assets shrink in terms of their translated carrying amount. By using the same historical rate for translation of fixed assets from one period to the next, the temporal method avoids this problem.
in accordance with US GAAP, which translation combination would be appropriate for a foreign operation whose functional currency is US dollar?
temporal method --> gain or loss in income statement
what are the major procedural differences in applying the current rate and temporal methods of translation?
The major differences relate to non-monetary assets carried at historical cost and related expenses, i.e., inventory and cost of goods sold; property, plant, and equipment and depreciation expense; and intangible assets and amortization expense. Under the temporal method, these items are all translated at historical* exchange rates. Under the current rate method, the assets are translated at the *current exchange rate* and the related expenses are translated at the *average exchange rate* for the current period.
what is the paradox associated with hedging BS exposure?
The paradox in hedging balance sheet exposure is that, by agreeing to receive or deliver foreign currency in the future under a forward contract, a transaction exposure is created. This transaction exposure is speculative in nature, given that there is no underlying inflow or outflow of foreign currency that can be used to satisfy the forward contract. By hedging balance sheet exposure, a company might incur a realized foreign exchange loss to avoid an unrealized negative translation adjustment or unrealized remeasurement loss.
what is the rationale for mandating use of the temporal method in highly inflationary countries?
In developing the current U.S. GAAP guidance on foreign currency translation, the FASB was unwilling to require firms to restate foreign operation financial statements for foreign inflation because of the lack of reliable inflation indices in many countries.
what are the major differences between IFRS and US GAAP in the translation of foreign currency FS?
For foreign entities that report in the currency of a hyperinflationary economy, IAS 21 requires the parent first to restate the foreign financial statements for inflation using IAS 29 rules and then translate the statements into parent company currency using the *current rate method.* U.S. GAAP requires financial statements of such foreign entities to be translated using the *temporal method.* U.S. GAAP specifically defines hyperinflation as cumulative three-year inflation greater than 100%. IAS 29 provides no specific definition for hyperinflation, but suggests that a cumulative three-year inflation rate approaching or exceeding 100% is evidence that an economy is hyperinflationary.
how does a parent company determine the appropriate method for translating the FS of a foreign subsidiary?
To determine the appropriate translation method under both IFRS and U.S. GAAP, the functional currency of a foreign subsidiary must be identified. The functional currency is the primary currency of the foreign entity's operating environment. It can be either the parent's reporting currency or a foreign currency (generally the local currency). The functional currency orientation results in the following rule: parents currency --> temporal method --> gain/loss reported in NI foreign currency --> current rate method--> separate component of SH's equity (other comprehensive income)
how is the functional currency determined under IFRS and US GAAP?
1) U.S. GAAP stipulates that several factors such as the location of primary sales markets, sources of materials and labor, the source of financing, and the amount of intercompany transactions should be evaluated in identifying an entity's functional currency. U.S. GAAP does not provide any guidance as to how these factors are to be weighted (equally or otherwise) when identifying an entity's functional currency. 2) IAS 21 also provides factors to be considered in determining the functional currency of a foreign subsidiary. Unlike U.S. GAAP, IAS 21 provides a hierarchy of factors to consider. Two primary factors are first to be considered. If evaluation of these primary factors does not clearly indicate a foreign subsidiary's functional currency, then a group of six secondary factors should be considered.
why might a company want to hedge its BS exposure?
Although balance sheet exposure does not result in cash inflows and outflows, it does nevertheless affect amounts reported in consolidated financial statements. If the foreign currency is the functional currency, translation adjustments will be reported in stockholders' equity. If translation adjustments are negative and therefore reduce total stockholders' equity, there is an adverse (inflationary) impact on the debt to equity ratio. Companies with restrictive debt covenants requiring them to stay below a maximum debt to equity ratio, may find it necessary to hedge their balance sheet exposure so as to avoid negative translation adjustments being reported. If the U.S. dollar is the functional currency or an operation is located in a high inflation country, remeasurement gains and losses are reported in income. Companies might want to hedge their balance sheet exposure in this situation to avoid the adverse impact remeasurement losses can have on consolidated income and earnings per share.
how are gains and losses on foreign currency borrowings used to hedge the net investment in a foreign subsidiary reported in the consolidated FS?
The gains and losses arising from financial instruments used to hedge balance sheet exposure are treated in a similar manner as the item the hedge is intended to cover. If the foreign currency is the functional currency, gains and losses on hedging instruments will be taken to other comprehensive income. If the parent's reporting currency is the functional currency, gains and losses on the hedging instruments will be offset against the related remeasurement gains and losses.
what is the concept underlying the current rate method of translation?
The major concept underlying the current rate method is that the entire foreign investment is exposed to foreign exchange risk. Therefore all assets and liabilities are translated at the current exchange rate. *Balance sheet exposure under this concept is equal to the net investment.*
what is the concept underlying the temporal method of translation?
The major concept underlying the temporal method is that the translation process should result in a set of translated U.S. dollar financial statements as if the foreign subsidiary's transactions had actually been carried out using U.S. dollars. To achieve this objective, assets carried at historical cost and stockholders' equity are translated at historical exchange rates; assets carried at current value and liabilities (carried at current value) are translated at the current exchange rate. Under this concept, the foreign subsidiary's monetary assets and liabilities are considered to be foreign currency cash, receivables, and payables of the parent that are exposed to transaction risk. For example, if the foreign currency appreciates, then the foreign currency receivables increase in U.S. dollar value and a gain is recognized.
what are the two major conceptual issues that must be resolved in translating foreign currency financial statements?
The two major issues related to the translation of foreign currency financial statements are: (a) which method should be used and (b) where should the resulting translation adjustment be reported in the consolidated financial statements. 1) The first issue relates to determining the appropriate exchange rate (historical, current, or average for the current period) for the translation of foreign currency balances. Those items translated at the current exchange rate are exposed to translation adjustment. 2) The second issue relates to whether the translation adjustment should be treated as a gain or loss in income, or should be deferred as a separate component of stockholders' equity.