1. McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Eight Translation of Foreign Currency Financial Statements Copyright © 2012 The McGraw-Hill Companies, All Rights Reserved

2. 8-2 Chapter Topics Conceptual issues of foreign currency financial statements translation. Methods of financial statement translation. Temporal and current rate methods illustrated U.S. GAAP, IFRS, and other standards related to translation Hedging balance sheet exposure.

3. 8-3 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. 5. Describe the requirements of applicable International Financial Reporting Standards (IFRS) and U.S. generally accepted accounted principles (GAAP). 6. Discuss hedging of balance sheet exposure.

4. 8-4 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

5. 8-5 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, while historical exchange rate is as of the date of the transaction. The resulting translation adjustment can be recognized in current income or included in an equity account on the balance sheet. Learning Objective 1

6. 8-6 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. 8-7 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. Learning Objective 3

8. 8-8 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

9. 8-9 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

10. 8-10 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. 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

11. 8-11 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 Learning Objective 4

12. 8-12 Translation methods illustrated Juarez ’ s income statement items for 2010, 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

13. 8-13 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. Learning Objective 4

14. 8-14 Translation methods illustrated Relevant exchange rates (U.S. dollar per Mexican peso): January 1, 2010$0.10 Average for 2010$0.095 Average for 4 th quarter 2010$0.09 December 31, 2010$0.08 Learning Objective 4

15. 8-15 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 Learning Objective 4

16. 8-16 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 Learning Objective 4

17. 8-17 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 Learning Objective 4

18. 8-18 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 assets1,165 Total liab. & S.E. 1,165 Learning Objective 4

19. 8-19 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

20. 8-20 Translation methods illustrated – Summary Temporal Method Primarily monetary assets and liabilities 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. Learning Objective 4

21. 8-21 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. Learning Objective 5

22. 8-22 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. Learning Objective 5

23. 8-23 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 Learning Objective 5

24. 8-24 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, Financial Reporting in Hyperinflationary Economies. 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. Learning Objective 5

25. 8-25 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

26. 8-26 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