Chapter 8: Translation of Foreign Currency Financial Statements

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

Learning Objectives Describe the conceptual issues involved in translating foreign currency financial statements Explain balance sheet exposure and how it differs from transaction exposure Describe the concepts underlying the current rate and temporal methods of translation Apply the current rate and temporal methods of translation and compare the results of the two methods Describe the requirements of applicable International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (GAAP) 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

End of Chapter 8