AK0048

INTERNATIONAL ACCOUNTING

Translation of Foreign Currency

Financial Statements

ACCOUNTING PROGRAM
Chapter Topics
• Conceptual issues of foreign currency financial statements translation
• Difference between balance sheet exposure and transaction exposure
• Methods of financial statement translation
• Temporal and current rate methods illustrated
• U.S. GAAP, IFRS, and other standards related to translation
• Hedging of balance sheet exposure
Objectives
1. Describe the conceptual issues involved in translating foreign
currency financial statements
2. Explain balance sheet exposure and how it differs from transaction
exposure
3. Describe the concepts underlying the current rate and temporal
methods of translation
4. Apply the current rate and temporal methods of translation and
compare the results of the two methods
5. Describe the requirements of applicable International Financial
Reporting Standards (IFRS) and U.S. generally accepted accounting
principles (GAAP)
6. Discuss hedging of balance sheet exposure
 Two conceptual issues

• Appropriate exchange rate to be used in translating each

financial statement item
• How should the translation adjustment that inherently
arises from the translation process be reflected in the
consolidated financial statements
 Balance Sheet Exposure

• Assets and liabilities translated at the current exchange rate

are exposed to risk of a translation adjustment
• When foreign currency appreciates, a net asset exposure
results in a positive translation adjustment
• When foreign currency appreciates, a net liability exposure
results in a negative translation adjustment
• Assets and liabilities translated at the historical exchange
rate are not exposed to a translation adjustment
 Translation Methods

• Current/Noncurrent Method
• Current assets and liabilities are translated at the current exchange
rate
• Noncurrent assets and liabilities and stockholders’ equity accounts
are translated at historical exchange rates
• There is no theoretical basis for this method
• Method is seldom used in any countries and is not allowed by U.S.
GAAP or IFRS
 Translation Methods

• Monetary/Nonmonetary Method
• Concerns with monetary assets and liabilities
• Translated at the current exchange rate
• Concerns with nonmonetary assets and liabilities and stockholders’
equity accounts
• Translated at historical exchange rates
• The translation adjustment measures the net foreign
exchange gain or loss on current assets and liabilities as if
these items were carried on the parent’s books
 Translation Methods

• Temporal Method
• Objective is to translate financial statements
• As if the subsidiary had been using the parent’s currency
• Items carried on subsidiary’s books at historical cost
• Including all stockholders ’ equity items, are translated at historical
exchange rates
• Items carried on subsidiary’s books at current value are translated
at current exchange rates
• Income statement items are translated at the exchange rate in
effect at the time of the transaction
 Translation Methods

• Current Rate Method

• Objective is to reflect that the parent’s entire investment in a
foreign subsidiary is exposed to exchange risk
• All assets and liabilities are translated at the current exchange rate
• Equity accounts are translated at historical exchange rates
• Revenues and expenses are translated at the exchange rate in effect
at the date of accounting recognition
 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 retained
earnings, which is a composite of many previous transactions:
• Revenues, expenses, gains, losses, and declared dividends occurring over
the life of the company
 Complicating Aspects of the Temporal
Method
• Keeping track of the historical rates for inventory, prepaid expenses,
fixed assets, and intangible assets is necessary under temporal method
and not under current rate method
• Translating these assets at historical rates makes application of the
temporal method more complicated than the current rate method
• Calculation of Cost of Goods Sold (COGS)
• Application of the Lower of Cost or Market Rule
• Fixed Assets, Depreciation, Accumulated Depreciation
 DISPOSITION OF TRANSLATION
ADJUSTMENT
• 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
• Should be reported in income in the period in which the fluctuation
in exchange rate occurs
• Cumulative translation adjustment in stockholders’ equity
• 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
• This treatment defers the gain or loss in stockholders’ equity until it
is realized in some way
 Temporal and Current Rate Methods

Translation methods illustrated

• U.S. Inc. owns Juarez, SA, a subsidiary in Mexico
which was established January 1, 2010
• Juarez’s balance sheet items as of 12/31/10, in
pesos:
Cash 1,000 Accounts payable 2,000
Accounts rec. 2,000 Long-term debt 6,000
Inventory 2,500 Capital stock 3,000
Fixed assets 8,000 Retained earnings 1,500
Accum. depr. 1,000
 Temporal and Current Rate Methods

• Translation methods illustrated

• Juarez’s income statement items for 2010, in pesos:
Sales 20,000 Depr. exp. 1,000
COGS 14,000 Interest exp. 500
S,G,&A exp. 2,500 Income tax exp. 500
 Temporal and Current Rate Methods

• Translation methods illustrated

• There was no beginning inventory
• Inventory, which is carried at cost, was acquired evenly during the
last quarter of 2010
• Purchases were made evenly throughout year
• Fixed assets were acquired on January 1, 2010
• Capital stock was sold on January 1, 2010
 Temporal and Current Rate Methods

• Translation methods illustrated

• Relevant exchange rates (U.S. dollar per Mexican
peso):
January 1, 2010 $0.10
Average for 2010 $0.095
Average for 4th quarter 2010 $0.09
December 31, 2010 $0.08
 Temporal and Current Rate Methods

• Current Rate Method – Income Statement

Income Statement – 2010
Sales 1,900
COGS 1,330
Gross profit 570
S,G,&A 238
Depreciation expense 95
Interest expense 48
Income tax expense 47
Net income 142
 Temporal and Current Rate Methods
• Current Rate Method – Balance Sheet
Balance Sheet – December 31, 2010
Cash 80 Accounts payable 160
Accounts Rec. 160 Long-term debt 480
Inventory 200 Capital stock 300
Fixed Assets, net 545 Retained earnings 142
Total assets 985 Cumulative translation adj. (97)
Total liab. & S.E. 985
 Temporal and Current Rate Methods
• Temporal Method – Income Statement
Income Statement – 2010
Sales 1,900
COGS 1,343
Gross profit 557
S,G,&A 238
Depreciation expense 100
Interest expense 48
Income tax expense 47
Remeasurement gain 101
Net income 225
 Temporal and Current Rate Methods

• Temporal Method – Balance Sheet

Balance Sheet – December 31, 2010
Cash 80 Accounts payable 160
Accounts Rec. 160 Long-term debt 480
Inventory 225 Capital stock 300
Fixed Assets, net 700 Retained earnings 225
Total assets 1,165 Total liab. & S.E. 1,165
Temporal and Current Rate Methods

• Translation methods illustrated – Summary

• Current Rate Method
• All assets and liabilities are translated at current rate
• This results in net asset exposure
• Net asset exposure and devaluing foreign currency results in translation
loss
• Translation adjustment included in equity
• Temporal Method
• Primarily monetary assets and liabilities are translated at current rate
• This results in net liability exposure
• Net liability exposure and devaluing foreign currency result in
translation gain
• Translation gain included in current income
 U.S. GAAP
• FASB ASC 830, Foreign Currency Matters( formerly SFAS 52, Foreign
Currency Translation) is the relevant accounting standard
• Requires identification of functional currency
• Functional currency is the primary currency of the foreign subsidiary’s
operating environment
• The standard includes a list of indicators as guidance for the foreign
currency decision
• When functional currency is U.S. Dollar, temporal method is required
• When functional currency is foreign currency, current rate method is
required
 U.S. GAAP Requirements

• Highly Inflationary Economies – U.S. GAAP

• U.S. GAAP defines such economies as those with cumulative 100%
inflation over a period of three years (with compounding—average
of 26% per year for three years in a row)
• Temporal method required—translation gains/losses reported in
income
 IFRS

• 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
• The standard’s requirements pertaining to hyperinflationary
economies are substantially different from U.S. GAAP
 IFRS Requirements

• Hyperinflationary Economies – IFRS

• IAS 21 and 29 use the term hyperinflationary economies
• IAS 21 is not as specific in defining hyperinflationary economies as
is U.S. GAAP, but does suggest that a cumulative three-year rate
approaching or exceeding 100% is evidence
• IAS 21 requires restatement of the foreign financial statements for
inflation per IAS 29
• IAS 21 then requires the use of the current exchange rate to
translate the restated financial statements, including all balance
sheet accounts as well as all income statement accounts
• IAS approach is substantially different from U.S. GAAP
 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)
 Hedging Balance Sheet Exposure

• Companies can hedge against gains and losses by using

foreign currency forward contracts, options, and borrowings