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.