Chapter 7

Translation of Foreign
Currency Financial
Statements

Translation of Foreign Currency Financial

Statements

Conceptual issues of foreign currency financial

statements translation.
Balance sheet vs. transaction exposure.
Methods of financial statement translation.
Temporal and current rate methods illustrated.
U.S. GAAP, IFRSs, and other standards related
to translation.
Hedging balance sheet exposure.

Translating Foreign Currency Financial

Statements -- Conceptual Issues
Foreign country operations usually prepare financial
statements using local currency as the monetary unit.
These financial statements must be translated into home
country currency.
These operations also typically use local GAAP.
Financial statements must be translated into home
country GAAP.

Learning Objective 1

Translating Foreign Currency Financial

Statements -- Conceptual Issues
Primary conceptual issues
Each financial statement item must be translated using
some, hopefully relevant, exchange rate.
What rate should be used?
the current exchange rate?
The average exchange rate?
the historical exchange rate?

Given that any adjustment is, at the point of translation,

unrealized, how should the resulting adjustment be
recognized?
in current income?
in an equity account on the balance sheet?
Learning Objective 1

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.
Learning Objective 2

A simple example
Lets say XYZ has a 1000 euro current note
receivable on its books. The euro/$ direct rate is
$ 1 on 1/1. On 12/31, it is $1.20.
Should we record:
No change?
An increase in value of $200?
An increase in value of $100?
And if we do report a change, where should the offsetting
gain be reported?

Another simple example:

Lets say XYZ has land on its books that is held
by a subsidiary located in the EU. The land was
purchased on 1/1 for 1,000,000 euros when the
euro/$ direct rate was $ 1. On 12/31, it is $ .
9091.
Should we record:
No change?
An decrease in value of $90,901?
An decrease in value of $45,450?
And if we do report a change, where should the offsetting
gain be reported?

What if:
Inflation differences caused the decline in
the value of the euro?
If the inflation differential was 10%, then:
Before, 1,000,000E=1,000,000$
Now, 1,000,000E=1,100,000$;
Thus the direct exchange rate would be .9091
(1,000,000/1,100,000).
Thus the TRUE value of the land, in euros, is
now 1,100,000E. The valuation should be
1100000*.9091 = 1,000,000$, i.e., no change.

The difference between these two

examples
The receivable is a monetary asset.
The land is a non-monetary asset.

 If inflation drives foreign exchange rate movements,

and monetary/non-monetary assets are affected
differently, how should FC effects be accounted for?
Suppose, in the first case, the land is reported
at current cost instead of historical cost?

Methods devised to sort all this out

Current/noncurrent
Monetary/non-monetary
Temporal
Current rate

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 IFRSs.

Learning Objective 3

In our example:
The receivable would be classified as
current and translated using the current
rate.
The land would be classified as
noncurrent and translated at the historical
rate.

Curent/Noncurrent
Advantages?
Simplistic. Requires no more characterization of
assets/liabilities than is already provided by the
financial statements

Disadvantages?
Can mismatch exchange rate with valuation
basis. Example: inventories, noncurrent
marketable equity securities

Translation Methods

Monetary/Nonmonetary Method
Monetary assets and liabilities are translated at the
current exchange rate.
Nonmonetary assets and liabilities and stockholders
equity accounts are 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 parents books.

Learning Objective 3

In our example:
The receivable would be translated using
the current rate.
The land would be translated at the
historical rate, even is it were considered
impaired and thus reported at fair value.

Monetary/Non-monetary
Advantages
Easy to understand. Makes intuitive sense.
Usually not difficult to classify assets and
liabilities.

Disadvantages
Valuation basis in accounting doesnt always
line up right with classification, producing
meaningless values. Examples: impaired
assets, fixed assets revalued upwards, long
term liabilities such as bonds.

Translation Methods

Temporal Method
Objective is to translate financial statements as if the
subsidiary had been using the parents currency.
Items carried on subsidiarys books at historical cost,
including all stockholders equity items are translated at
historical exchange rates.
Items carried on subsidiarys 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.

Learning Objective 3

In our example:
The receivable translated using the
current rate.
If reported at historical cost, the land
would be translated at the historical rate.
If reported at fair value, the land would be
translated at the current rate.

Temporal Method
Advantages
Lines up with valuation basis used in
accounting. Thus the numbers have most
meaning.

Disadvantages
Lots of volatility in financial statements
Possibility of disappearing assets in inflationary
economies.

Translation Methods

Current Rate Method

Objective is to reflect that the parents entire
investment in a foreign subsidiary is expose to
exchange risk.
All assets and liabilities are translated at the
current exchange rate.
Stockholders equity accounts are translated at
historical exchange rates.
Income statement items are translated at the
exchange rate in effect at the time of the
transaction.
Learning Objective 3

Current Rate Method

Advantages
Simple to do
Ratios are not distorted

Disadvantages
Can produce disparate results that are not
consistent with the economics that are really
going on.
What does the FC adjustment?

In our example:
The receivable would be translated using
the current rate.
The land would be translated at the
current rate.

Temporal and Current Rate Methods

Translation methods illustrated

U.S. Inc. owns Juarez, SA, a subsidiary in Mexico which
was established January 1, 2005.
Juarezs balance sheet items as of 12/31/05, 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

Learning Objective 4

Temporal and Current Rate Methods

Translation methods illustrated

Juarezs income statement items for 2005, in pesos.
Sales
COGS
S,G,&A exp.

Learning Objective 4

20,000
14,000
2,500

Depr. exp
Interest exp.
Income tax exp.

1,000
500
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 2005.
Purchases were made evenly throughout year.
Fixed assets were acquired on January 1, 2005.
Capital stock was sold on January 1, 2005.

Learning Objective 4

Temporal and Current Rate Methods

Translation methods illustrated

Relevant exchange rates (U.S. dollar per Mexican peso)
January 1, 2005
$0.10
Average for 2005
$0.095
Average for 4th quarter 2005
$0.09
December 31, 2005
$0.08

Learning Objective 4

Temporal and Current Rate Methods

Current Rate Method Income Statement

Income Statement 2005
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
Learning Objective 4

Temporal and Current Rate Methods

Current Rate Method Balance Sheet

Balance Sheet December 31, 2005
Cash
80 Accounts payable
Accounts Rec.
160 Long-term debt
480
Inventory
200 Capital stock
Fixed Assets, net 545 Retained earnings
Total assets
985 Cumulative
translation adj.
Total liab. & S.E.
Learning Objective 4

160
300
142
(97)
985

Temporal and Current Rate Methods

Temporal Method Balance Sheet

Balance Sheet December 31, 2005
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

Learning Objective 4

Temporal and Current Rate Methods

Temporal Method Balance Sheet

Income Statement 2005
Sales
1,900
COGS 1,343
Gross profit
557
S,G,&A
238
Depreciation expense
Interest expense
Income tax expense
Remeasurement gain
Net income
225
Learning Objective 4

100
48
47
101

Temporal and Current Rate Methods

Translation methods illustrated Summary

Current Rate Method
All assets and liabilities 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.

Learning Objective 4

Temporal and Current Rate Methods

Translation methods illustrated Summary

Temporal Method
Primarily monetary assets and liabilities translated at
current rate.
This results in net liability asset exposure.
Net liability exposure and devaluing foreign currency
results in translation gain.
Translation gain included in current income.

Learning Objective 4

Other Issues

What is the appropriate current rate?

Translation gains/losses? Deferred or
booked? Shown in income or just equity?

Translation Accounting Around the World

USA
IFRS
Diversity seen in other nations

History of Translation Accounting in USA

Pre-1965: Current/Noncurrent method

applied. Losses recognized into income.
Gains were deferred.
1965-1975: Single Rate method was also
allowed.
1975-1981: FAS 8, which required
temporal method to be used. All gains and
losses taken into income

History of Translation Accounting in USA

1981-today: SFAS 52, which has the following

features:
Functional currency determines accounting.
If functional currency is the local currency- use single
current rate. Gains and losses routed directly to
stockholders equity.
If functional currency is US Dollar, use the temporal
method and fully recognize gains/losses into earnings.
If functional currency is different from local currency or
US Dollar, do both.

U.S. GAAP and IFRS Requirements

U.S. GAAP under SFAS 52

Requires identification of functional
currency.
Functional currency is the primary
currency of the foreign subsidiarys
operating environment.
The standard includes a list of indicators
as guidance for the foreign currency
decision.
Learning Objective 5

Advantages of SFAS 52

Allows consideration of context.

In most cases, keeps impact of FC
exchange rate movements out of
earnings.
Much more accepted by reporting
community than FAS 8 was.

Disadvantages of SFAS 52

From an investors viewpoint, is there any

economic difference, in substance, between
circumstances that distinguish the two methods.
If not, why have two different kinds of
accounting?
Inconsistent with the notion of consolidation.
Numbers produced by SFAS 52 often lose
meaning.
Added risk of earnings management?

U.S. GAAP and IFRS Requirements

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 standards requirements pertaining to
hyperinflationary economies are substantially different
from SFAS 52.
Learning Objective 5

U.S. GAAP and IFRS Requirements

Highly Inflationary Economies U.S. GAAP

SFAS 52 provides guidance on highly inflationary
economies.
SFAS 52 defines such economies as those with 100%
inflation over a period of three years.
SFAS 52 requires the use of the temporal method in
these cases of significant inflation.

Learning Objective 5

U.S. GAAP and IFRS Requirements

Hyperinflationary Economies -- IFRSs

IAS 21 and 29 use the term hyperinflationary economies.
IAS 21 is not as specific in defining hyperinflationary
economies as SFAS 52.
IAS 21 requires restatement of the foreign financial
statements for inflation per IAS 29, Financial Reporting
in Hyperinflationary Economies.
IAS 21 then requires the use of the current rate method
of translation on the restated financial statements.
IAS approach is substantially different from SFAS 52.
Learning Objective 5

Hedging Balance Sheet Exposure

Companies that have foreign subsidiaries with highly

integrated operations use the temporal method.
The temporal method requires translation gains and
losses to be recognized in income.
Losses negatively affect earnings, and both gains and
losses increase earnings volatility.

Learning Objective 6

Hedging Balance Sheet Exposure

These gains and losses result from the combination of

balance sheet exposure and exchange rate fluctuations.
Companies can also hedge to offset the effects of the
translation adjustment to equity under the current rate
method.
Companies can hedge against gains and losses by using
foreign currency forward contracts, options, and
borrowings.

Learning Objective 6

Translation Procedures Internationally

Canada very similar to U.S., however under the

temporal method, some translations adjustments
can be deferred and amortized.
Mexico standards are silent, but SFAS 52 is
commonly followed. In cases where it is not,
practice varies widely.
Brazil current rate method is used with gains and
losses included in income.
Japan significantly different from U.S. GAAP and
IFRSs, with cumulative translation adjustment
reported as an asset or liability.
Korea only the current rate method is used.
Learning Objective 7

One final problem

How do we interpret reported FC gains and
losses, irrespective of where they show up?
Example: Company has a large subsidiary in the
EU. The subsidiary has a large net asset
position. The Euro depreciates more than 40%.
Huge losses are reported.
The subsidiarys sales and profits skyrocket,
since they now seem more competitive to
customers than ever.

Thus, and strangely:

In a world of floating rate currency,
sometimes a weak currency is good, and
a strong currency is bad!
This explains why, when markets are tight
or declining, nations compete with each
other in a race to devalue their money the
most!

Summary
All kinds of problems arise when the value of
money changes and is uncertain.
The economic impact of these changes vary as a
function of the inherent cause of the FC
movement and the type of holding (asset/liability;
monetary/non-monetary; current/noncurrent).
Accounting limitations (e.g., historical cost) mix
with this uncertainty, making financial reporting
difficult at best.
The current paradigm is SFAS 52. This could
easily change at any time, as it has several times
before.