McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7 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  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

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.  The resulting translation adjustment can be recognized in current income or included in an equity account on the balance sheet. Learning Objective 1

7-7 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

7-8 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

7-9 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 parent’s books. Learning Objective 3

7-10 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. Learning Objective 3

7-11 Translation Methods Current Rate Method  Objective is to reflect that the parent’s 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

7-12 Temporal and Current Rate Methods Translation methods illustrated  U.S. Inc. owns Juarez, SA, a subsidiary in Mexico which was established January 1,  Juarez’s balance sheet items as of 12/31/05, in pesos. Cash 1,000Accounts payable2,000 Accounts rec. 2,000Long-term debt6,000 Inventory 2,500Capital stock3,000 Fixed assets 8,000Retained earnings1,500 Accum. depr. 1,000 Learning Objective 4

7-13 Temporal and Current Rate Methods Translation methods illustrated  Juarez’s income statement items for 2005, in pesos. Sales 20,000Depr. exp 1,000 COGS 14,000Interest exp. 500 S,G,&A exp. 2,500Income tax exp. 500 Learning Objective 4

7-14 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  Purchases were made evenly throughout year.  Fixed assets were acquired on January 1,  Capital stock was sold on January 1, Learning Objective 4

7-15 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 4 th quarter 2005$0.09 December 31, 2005$0.08 Learning Objective 4

7-16 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

7-17 Temporal and Current Rate Methods Current Rate Method – Balance Sheet Balance Sheet – December 31, 2005 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 Learning Objective 4

7-18 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 assets1,165 Total liab. & S.E. 1,165 Learning Objective 4

7-19 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 100 Interest expense 48 Income tax expense 47 Remeasurement gain 101 Net income 225 Learning Objective 4

7-20 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

7-21 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

7-22 U.S. GAAP and IFRS Requirements U.S. GAAP  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. Learning Objective 5

7-23 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 standard’s requirements pertaining to hyperinflationary economies are substantially different from SFAS 52. Learning Objective 5

7-24 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

7-25 U.S. GAAP and IFRS Requirements Hyperinflationary Economies -- IFRSs  IAS 21 and 29 use the term hyperinflationary economies.  IAS 21 is not a specific in defining hyperinflationary economies as is 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

7-26 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

7-27 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

7-28 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