ACC538 Ch 7
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 this risk -all assetes and liabilities are translated at current exchange rate - stockholder's equity accounts are translated at the historical exchange rate
COGS under current rate method
- COGS in foreign currency (FC) is simply translated into the parent currency (PC) using the average-for-the-period exchange rate (ER): COGS in FC* Average ER= COGS in PC
COGS under temporal Method
- COGS must be decomposed into beginning inventory, purchases, and ending inventory, and each component of COGS must then be translated at its appropriate historical rate. (note:Under temporal method, there is no single exchange rate that can be used to directly translate COGS in FC into COGS in PC.)
FASB requires identification of functional currency
- Functional currency is the primary currency of the foreign subsidiary's operating environment. - It can be either the parent's currency (i.e., U.S. $ for U.S.companies) or a foreign currency (generally the local currency)
Translation gain or loss in net income
- Translation adjustment is considered to be a gain or loss analogous to the gains and losses arise from foreign currency transaction (*reported in net income) - Should be reported in income in the period in which the fluctuation in exchange rate occurs
US GAAP
- When functional currency is U.S. Dollar, temporal method is required - When functional currency is foreign currency, current rate method is required
Temporal Method Income statement items
- are translated at the exchange rate in its own unique ways (revenues and most expenses are translated at weighted average rate while COGS, depreciation on PPE, and amortization of intangibles are translated at historical rate
Current Rate method for income statement items
- are translated using the exchange rate in effect at the date of accounting recognition. In most cases an assumption is made that the revenue or expense is incurred evenly throughout the year, and the average-for-the-period (weighted average) is used
1) What is the appropriate exchange rate to be used in translating each financial statement item?
- currency exchange rate --> the spot rate on the balance sheet date - Historical exchange rates --> the exchange rates that existed when assets and liabilities were acquired or incurred - Weighted average exchange rate --> the average exchange rate for a specific time period
Temporal Method Objective
- produce a set of parent currency translated financial statements as if the foreign subsidiary had actually used the parent currency in operations - some assets and liabilities are translated at the current exchange rate, and other assets and liabilities are translated at the historical exchange rate
Current rate method ideal if:
- the subsidiary is mainly independent of the parents companies activities - This can create high amounts of translation risk, as the current exchange rate may change
Advantages of Current Exchange Rate Method
The current rate method differs from the temporal (historical) method in that assets and liabilities are translated at current exchange rates as opposed to historical ones. This can create a high amount of translation risk, as the current exchange rate may change
Advantages of Temporal Method
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
Balance sheet items translated at historical exchange rate do not change in value from balance sheet to the next -->
These items are NOT exposed to translation adjustment
Net asst exposure Current rate method
Total assets > total liabilities
Fixed Assets, Depreciation, Accumulated Depreciation
Under the temporal method, items of PP&E acquired at different times must be translated at different (historical) exchange rates. The same is true for depreciation of PP&E and accumulated depreciation related to PP&E.
Net Asset (Liability) Exposure Temporal Method
cash and recievables + Market securities + inventory carried at net realizable value > (<) Liabilities
Hedging Balance Sheet Exposure
§Companies that have foreign subsidiaries with highly integrated operations use the temporal method §Temporal method requires translation gains and losses to be recognized in income § §Losses negatively affect earnings, and both gains and losses increase earnings volatility §These gains and losses result from the combination of balance sheet exposure and exchange rate fluctuations § §Foreign exchange gains and losses on foreign currency borrowings or foreign currency derivatives employed to hedge translation based exposure (under the current rate method) § §Companies can hedge against gains and losses by using foreign currency forward contracts, options, and borrowings
IFRS similarities with GAAP
§IAS 21, The Effects of Changes in Foreign Exchange Rates is the relevant accounting standard §Uses the functional currency approach developed by the FASB §The standard includes a list, similar to the FASB list, of indicators as guidance for the foreign currency decision
Major Difference between GAAP and IFRS in this setting:
§Unlike U.S. GAAP, IAS 21 provides a hierarchy of primary and secondary factors to be considered in determining the functional currency. (See Exhibit 7.4.) Note: you don't need to know the specific steps or details. § §Different from GAAP, for foreign subsidiaries whose functional currency is the currency of a hyperinflationary economy, IAS 21 requires the parent first 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. §Additionally, all balance sheet accounts, including stockholders' equity, and all income statement accounts are translated at the current exchange rate. § §This approach is substantively different from U.S. GAAP, which requires use of the temporal method for the hyperinflationary economies.
Balance sheet exposure -->
Exposure to translation adjustment - As exchange rates change, those assets and liabilities translated at the current exchange rate change in value from balance sheet to the parent company's reporting currency --> these items are exposed to risk of a translation adjustment
Which method is preferred by US GAAP and IFRS
IFRS = foreign currency statements are first restated for local inflation and then translated using the current exchange rate GAAP = the foreign currency financial statements are translated suing the temporal method, with no restatement for inflation
Translation of Retained Earnings
Stockholders' equity items are translated at historical exchange rates under both the temporal and current rate methods - This creates somewhat of a problem in translating retainedearnings, which is a composite of many previous transactions: - Revenues, expenses, gains, losses, and declared dividends occurring over the life of the company - The same approach is used for translating retained earnings underboth the current rate and the temporal methods. The onlydifference is that translation of the current period's net income isdone differently under the two methods.
Cumulative translation adjustment in stockholders' equity (OCI)
The alternative to reporting the translation adjustment as a gain or loss in net income is to include it in stockholders' equity as a component of other comprehensive income (OCI)
Highly Inflationary Economies - U.S. GAAP
- §U.S. GAAP defines such economies as those with cumulative 100% inflation over a period of three years [usually with most recent three-year period] (with compounding—average of 26% per year for three years in a row) - §Countries that have met this definition in the past include Argentina, Brazil, Israel, Mexico, Turkey, Venezuela, and Zimbabwe. - §For those foreign entities located in a highly inflationary economy, U.S. GAAP mandates use of the temporal method with translation gains/losses reported in net income. - §One reason for this rule is to avoid a "disappearing plant problem" that exists when the current rate method is used in a country with high inflation. (remember under current rate method, all assets (including PP&E) are translated at the current exchange rate.
Temporal Method Specifically
1) Items carried on subsidiaries books at historical cost are translated at historical exchange rates 2) Items carried on subsidiaries books at current value are translated at current exchange rates
Two methods of translating foreign currency financial statements are currently used worldwide:
1) Temporal method 2) Current rate method
Issues with Translation of foreign currency
1) The first issue related to the translation of foreign currency financial statements is selection of the appropriate method. 2) The second issue in financial statement translation relates to where the resulting translation adjustment should be reported in the consolidated financial statements.
Balance sheet exposure can be contrasted with transaction exposure that arises when a company has foreign business transactions:
1) Transaction exposure gives rise to foreign exchange gains and loses that are ultimately realized in cash 2) Transaction adjustments that arise from balance sheet exposure do not directly result in cash inflows or outflows
In translating foreign currency financial statements into the parent company's reporting currency, two questions must be addressed:
1) What is the appropriate exchange rate to be used in translating each financial statement item? 2) How should the translation adjustment that arises from the translation process be reflected in consolidated financial statements?
FASB ASC 830, Foreign Currency Matters( formerly SFAS 52, Foreign Currency Translation) is the relevant accounting standard in this setting to determine whether a specific foreign operation
1) is integrated with its parent 2) self-contained and integrated with the local economy.
Risk of translation adjustment specifically:
1) when foreign currency appreciates, a net asset (liability) exposure results in a positive (negative) translation adjustment 2) The net translation adjustment needed to keep the consolidated balance sheet in balance is based solely on the net assets or net liability exposure
