McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4 Translation of Foreign Currency Financial Statements

7-2 Translation of Foreign Currency Financial Statements Chapter Topics  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.

7-3 Translation of Foreign Currency Financial Statements Learning 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 rate methods of translation. 4.Apply the current rate and temporal methods of translation and compare the results of the two methods.

7-4 Translation of Foreign Currency Financial Statements Learning Objectives 5.Describe the requirements of applicable International Financial Reporting Standards (IFRSs) and U.S. generally accepted accounting principles (GAAP). 6.Discuss hedging of balance sheet exposure. 7. Highlight translation procedures used internationally.

7-5 Translating Foreign Currency Financial Statements -- Conceptual Issues Primary 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 (adjusted) into home country GAAP.  The international efforts to harmonize accounting principles are slowly eliminating the need for such adjustments. Learning Objective 1

7-6 Translating Foreign Currency Financial Statements -- Conceptual Issues Primary conceptual issues  Each financial statement item must be translated using the appropriate exchange rate.  Choices include the current exchange rate, average exchange rate, and the historical exchange rate.  Current exchange rate is as of the balance sheet date  Historical exchange rate is as of date of transaction. Learning Objective 1

7-7 Balance Sheet Exposure  As exchange rate change:  Assets and liabilities translated at current exchange rate change in value from balance sheet to balance sheet in terms of parent company’s reporting currency.  These items are exposed to translation adjustment  Assets and liabilities translated at historical exchange rate do not change in value from balance sheet to balance sheet in terms of parent company’s reporting currency.  These items are not exposed to translation adjustment Exposure to translation adjustment is referred to as Balance Sheet Exposure or Accounting Exposure or Translation Exposure

7-8 Balance Sheet Exposure  The difference resulting from translating some accounts using the current exchange rate and others using the historical exchange rate or average exchange rate refers as to translation adjustment.  The resulting translation adjustment can be recognized in current income or included in an equity account on the balance sheet.

7-9 Illustrate Example  Parentco, a US-based company, established wholly owned subsidiary, Foreignco in foreign country on January 1 by investing US$600 when the exchange rate between the US$ and the foreign currency (FC) was FC1= US$ 1.00 and convert the US$600 to Foreignco. 1.Foreignco borrows 400 FC from local bank on January 2 then Foreignco purchases inventory that cost 900 FC and maintain 100 FC in cash.

7-10 Illustrate Example Foreignco opening Balance sheet FC Cash 100 Inventory 900 Total 1000 Liabilities 400 Common stock 600 Total 1000 During the period January 1 to March 31 Foreignco engage in no transaction but the exchange rate was changed, the FC =$US1.2 (FC appreciate) Three Month Later

7-11 Illustrate Example Foreignco Translated Balance sheet From FC to $US Cash 100 Inventory 900 Total 1000 Liabilities 400 Common stock 600 Total 1000 Foreignco have three approaches to translate it’s Balance sheet to $US: 1- Translate All items Using Historical Exchange rate Three Months Later

7-12 Illustrate Example Foreignco Translated Balance sheet From FC to $US on March 31 FC/$US ItemFCEx.R$USFCEx.R$US Cash Inventory Total Liabilities Common stock Total Adjustment (gain) Translate All Assets and Liabilities Using Spot (Current) Exchange rate Three Months Later

7-13 Illustrate Example Foreignco Translated Balance sheet From FC to $US on March 31 FC/$US ItemFCEx.R$USFCEx.R$US Cash Inventory Total Adjustment (loss) Liabilities Common stock Total Translate some Assets and Liabilities using Current Exchange rate and the other using Historical Exchange rate.

7-14 Balance Sheet Exposure  As We saw  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

7-15 Review Question 1. In accounting exposure, if exposed assets are greater than exposed liabilities, foreign currency depreciations will produce exchange _____. A.appreciation B.losses C.depreciation D.gains E.A and B

7-16 Translation Methods Four major methods of translation foreign currency financial statements have been used world wide: 1.Current/Noncurrent Method 2. Monetary/Nonmonetary Method 3.Temporal Method 4.Current Rate Method Learning Objective 3

7-17 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 since 1975 and never been allowed by IFRSs. Learning Objective 3

7-18 Under IAS1  Current assets  it expects to realize the asset, or intends to sell or consume it, in its normal operating cycle.  it holds the asset primarily for the purpose of trading;  it expects to realize the asset within twelve months after the reporting period; or  the asset is cash or a cash equivalent unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period.  An entity shall classify all other assets as non- current.

7-19 Under IAS1  current liability  it expects to settle the liability in its normal operating cycle;  it holds the liability primarily for the purpose of trading;  the liability is due to be settled within twelve months after the reporting period; or  the entity does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period.  An entity shall classify all other liabilities as non-current.

7-20 Current/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, non-current liabilities were being translated at historical rates of exchange

7-21 Translation Methods  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.  Cash + receivables > payables Net asset exposure  Payables > Cash + receivables Net liability exposure Learning Objective 3

7-22 Translation Methods Monetary/Nonmonetary Method  To remedy the lake of theoretical basis for the Current/Noncurrent method Hepworth developed the Monetary/Nonmonetary method in  This approach is significantly more logical, as the choice of rate is based on an underlying conceptual difference in the nature of the item, rather than its term to maturity  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. Learning Objective 3

7-23 Translation Methods Monetary/Nonmonetary Method  Monetary assets are those assets whose value doesn't fluctuate over time (cash and receivables).  Nonmonetary assets are those assets whose monetary value can fluctuate. They consist of marketable securities, inventory, prepaid expenses, investments, fixed assets and intangible assets (all assets other than cash and receivables ).  Monetary liabilities are those liabilities whose value doesn't fluctuate over time like payables (In general, almost all liabilities are monetary). Learning Objective 3

7-24 Monetary/Non-monetary  Advantages  Easy to understand. Makes intuitive sense.  Usually not difficult to classify assets and liabilities.  Disadvantages  Valuation basis in accounting doesn’t always line up right with classification, producing meaningless values. Examples: long term liabilities such as bonds.