Chapter 7 Translation of Foreign Currency Financial Statements

high inflationary economies

- US GAAP mandates use of the temporal method with translation gain/loss reported in net income - helps avoid a "disappearing plant problem"that exists when the current rate method is used in a country with high inflation

current rate method

- a parent's entire investment in a foreign operation is exposed to foreign exchange risk, and translation of the foreign operation's financial statements should reflect the risk - all assets and liabilities of the foreign operation are translated using the current exchange rate - stockholders' equity accounts are translated at historical exchange rates

balance sheet exposure

- can be hedged through the use of derivative financial instrument such as a forward contract or a foreign currency option, or through the use of a non-derivative hedging instrument such as foreign currency borrowing - paradox of hedging a balance sheet exposure is that in the process of avoiding translation adjustment, realized foreign gain and losses can result

IAS 21

- contains guidance for the translation of foreign currency financial statements - revised in 2003 to adopt the functional currency approach developed more than 20 years ago by the FASB - for foreign subs. whose functional currency is the currency of a hyperinflationary economy, requires the parent to restate the foreign financial statements for inflation using rules in IAS 29 and then translate the statements into parent company currency using the current exchange rate

SFAS 8

- issued by US FASB in 1975 to eliminate noncomparability - mandated the use of temporal method with translation gains/losses reported in income by all companies for all foreign operations - US multinational companies strongly opposed this

Temporal Method

- objective is to produce a set of parent currency translated financial statements as if the foreign subsidiary had actually used the parent currency in conducting its operations - assets and liabilities on the foreign operation's balance sheet at historical cost are translated at historical exchange rates - income statement items are translated at exchange rates that exist when the revenue or the expense is incurred - COGS must be decomposed into its different components

historical exchange rate

- the exchange rates that existed when the assets and liabilities were acquired or incurred - balance sheet items translated do not change in parent currency value from one balance sheet to the next

functional currency

primary currency of the foreign entity's operating environment

current exchange rate

spot exchange rate on the balance sheet date - exposed to translation adjustment

translation gain or loss in net income

the translation adjustment is considered to be a gain or loss analogous to the gains and losses that arise from the foreign currency transactions and should be reported in net income in the period in which the fluctuation in exchange rate occurs

approaches for translating subsidiary's assets and liabilities

1. all assets and liabilities are translated at the current exchange rate 2. some assets and liabilities are translated at the current exchange rate and other assets and liabilities are translated at the historical exchange rate

issues in translating financial statements

1. selection of the appropriate model 2. where the resulting adjustment should be reported in the consolidated financial statements

translation methods

1. temporal method 2. current rate method

issues of translating foreign currency financial statements

1. what is the appropriate exchange rate to be used in translating each financial statement item? 2. how should the translation adjustment that inherently arises from the translation process be reflected in the consolidated financial statements?

Net liability balance sheet exposure

Liabilities translated at current exchange rate are greater than assets translated at current exchange rate

reporting currency

The currency in which an entity prepares its financial statements

Net asset balance sheet exposure

When assets translated at the current exchange rate are greater in amount than liabilities translated at the current exchange rate