Chapter Eight

Translation of Foreign Currency Financial

Statements
INTRODUCTION
This chapter focuses on the translation of foreign currency financial
statements for the purpose of preparing consolidated financial statements.
▪ We begin by examining the conceptual issues related to translation.
▪ describe the manner in which these issues have been addressed by the
International Accounting Standards Board (IASB) and by the Financial
Accounting Standards Board (FASB) in the United States.
▪ illustrate application of the two methods prescribed by those standard-
setters and compare the results from applying the two different methods.
▪ discuss hedging the net investment in foreign operations to avoid the
adverse impact the translation of foreign currency financial statements can
have on the consolidated accounts.
Two conceptual issues
reporting currency, two questions must be addressed:
1. What is the appropriate exchange rate to be used in translating each
financial statement item?
2. How should the translation adjustment that inherently arises from the
translation process be reflected in the consolidated financial statements?
Example: AAA, a U.S.-based company, establishes a wholly owned
subsidiary, BBB, in Foreign Country on January 1 by investing US$600
when the exchange rate between the U.S. dollar and the foreign currency
(FC) is FC1 = US$1.00. The equity investment of US$600 is physically
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 converted into FC600. In addition, BBB borrows FC400 from local banks on
January 2. BBB purchases inventory that costs FC900 and maintains FC100
in cash. BBB’s opening balance sheet appears as follows:
BBB
Opening Balance Sheet
Cash FC 100 Liabilities FC 400
Inventory 900 Common stock 600
Total FC 1,000 Total FC 1,000

To prepare a consolidated balance sheet at the date of acquisition, all FC

balances on BBB’s balance sheet are translated at the exchange rate of
US$1.00 per FC. There is no other exchange rate that possibly could be used
on that date. A partial consolidation worksheet at the date of acquisition
would appear as follows:
AAA’s balance sheet

AAA(BV) BBB(BV) Adjustme consolidat

nts ed
US$ FC Exchange US$
Rate
Cash (600) 100 $1.00 100 (500)

Inventory ××× 900 $1.00 900 900

Investment in BBB 600 600 0

Total ××××× 1,00 1,00

400
0 0
liabilities ××× 400 $1.00 400 400

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 Common stock ××× 600 $1.00 600 600 0

Total ××××× 1,00 1,00

400
0 0

Three Months Later

During the period January 1 to March 31, BBB engages in no transactions.
However, during that period the FC appreciates in value against the US$
such that the exchange rate at March 31 is US$1.20 per FC.
- BBB’s stockholders’ equity must be translated at the historical rate of
US$1.00 so that AAA’s Investment account can be eliminated against the
subsidiary’s common stock in the consolidation worksheet.
- Two approaches exist for translating the subsidiary’s assets and
liabilities:
1. All assets and liabilities are translated at the current exchange rate (the
spot exchange rate on the balance sheet date).
2. Some assets and liabilities are translated at the current exchange rate, and
other assets and liabilities are translated at historical exchange rates (the
exchange rates that existed when the assets and liabilities were acquired).
All assets and liabilities are translated at the current exchange rate
AAA’s balance sheet

AAA(BV) BBB(BV) Change in Adjustme consolidat

US$ nts ed
Value
US$ FC Exchange US Since 1-1
Rate $
Cash (600) 100 $1.20 120 +20 (480)

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Inventory 900 $1.20 1,0 +180 1,080
×××
80

Investment in BBB 600 600 0

Total ××××× 1,0 1,2 +200 600

00 00

liabilities ××× 400 $1.20 480 +80 480

Common stock ××× 600 $1.00 600 600 0

Subtotal ××× 1,0 +80

80

Translation adjustment 120 +120 120

Total ××××× 1,0 1,2 +200 600

00 00

Monetary Assets and Liabilities Are Translated at the Current

Exchange Rates
Now assume that only monetary assets (cash and receivables) and monetary
liabilities (most liabilities) are translated at the current exchange rate.
AAA’s balance sheet

AAA(BV) BBB(BV) Change in Adjustme

US$ nts consolidat
Value ed
US$ FC Exchange US Since 1-1 Dr Cr
Rate $

Cash (600) 100 $1.20 120 +20 (480)

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Inventory ××× 900 $1.00 900 900
Investment in BBB 600 600 0
Total ××××× 1,0 1,0 +20 420
00 20
liabilities ××× 400 $1.20 480 +80 480
Common stock ××× 600 $1.00 600 600 0
Subtotal ××× 1,0 +80 480
80
Translation adjustment (60) -60 (60)
Total ××××× 1,0 1,0 +20 420
00 20

Balance Sheet Exposure

Balance sheet exposure can be contrasted with the transaction exposure
discussed in Chapter 7 that arises when a company has foreign currency
receivables and payables in the following way:
Transaction exposure gives rise to foreign exchange gains and losses that
are ultimately realized in cash; translation adjustments that arise from
balance sheet exposure do not directly result in cash inflows or outflows.
TRANSLATION METHODS
Four major methods of translating foreign currency financial statements
have been used worldwide: (1) the current/noncurrent method, (2) the
monetary/nonmonetary method, (3) the temporal method, and (4) the current
rate (or closing rate) method.
(1) Current/Noncurrent Method
▪ Current assets and liabilities are translated at the current exchange rate
▪ Noncurrent assets and liabilities and stockholders’ equity accounts are
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translated at historical exchange rates
▪ There is no theoretical basis for this method
▪ Method is not allowed by U.S. GAAP or IFRS
(2) monetary/nonmonetary method
▪ monetary assets and liabilities are translated at the current exchange
rates
▪ Monetary assets: are those assets whose value does not fluctuate over
time—primarily cash and receivables.
▪ Monetary liabilities: are those liabilities whose monetary value cannot
fluctuate over time, which is true for most payables.
▪ nonmonetary assets, nonmonetary liabilities, and stockholders’ equity
accounts are translated at historical exchange rates.
▪ Nonmonetary assets: are assets whose monetary value can fluctuate.
They consist of marketable securities, inventory, prepaid expenses,
investments, fixed assets, and intangible assets; that is, all assets other than
cash and receivables.
(3) 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
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the time of the transaction
(4) 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
The current rate method and the temporal method are the two methods
required to be used under IAS 21, and FASB ASC 830.
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
INTERNATIONAL FINANCIAL REPORTING STANDARDS
▪ 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
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 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
Balance Sheet
Exchange Rate Used under
Current Rate Method Temporal Method
Assets
Cash and receivables Current Current
Marketable securities Current Current
Inventory at (market value) Current Current
Inventory at cost Current Historical
Prepaid expenses Current Current
Property, plant, and equipment Current Historical
Intangible assets Current Historical
Liabilities
Current liabilities Current Current
Deferred income Current Current
Long-term debt Current Current
Stockholders’ Equity
Capital stock Historical Historical
Additional paid-in capital Historical Historical
Retained earnings Historical Historical
Dividends Historical Historical
Income Statement
Exchange Rate Used under
Current Rate Method Temporal Method
Revenues Average Average
Most expenses Average Average
Cost of goods sold Average Average
Depreciation of property, plant, and
Average Historical
equipment
Amortization of intangibles Average Historical

Example: assume that AAA (a U.S.-based company) forms a wholly owned

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subsidiary in Italy (Italco) on December 31, Year 0. On that date, AAA
invests $1,000,000 in exchange for all of the subsidiary’s capital stock.
Given the exchange rate of €1.00 = $1.00, the initial capital investment is
€1,000,000, of which €600,000 is immediately invested in inventory and the
remainder is held in cash. Italco’s beginning balance sheet on January 1,
Year 1, is shown in Exhibit (1).
Exhibit (1)
ITALCO’s Balance Sheet, January 1, Year 1
Assets € Liabilities and Equity €
Cash 400,000 Capital stock 1,000,000
Inventory 600,000 1,000,000
1,000,000
Financial statements for Year 1 (in euros) appear in Exhibit (2).
Exhibit (2)
Income Statement, Year 1 €
Sales 8,000,000
Cost of goods sold 6,000,000
Gross profit 2,000,000
Selling and administrative expenses 500,000
Depreciation expenses 200,000
Amortization expense 20,000
Interest expense 180,000
Income before income taxes 1,100,000
Income taxes 275,000
Net income 825,000
Statement of Retained Earnings Year 1
Retained earnings, 1/1/Y1 0
Net income, Y1 825,000
Less: Dividends, 12/1/Y1 (325,000)
Retained earnings, 12/31/Y1 500,000
Balance Sheet, December 31, Year 1
Assets € Liabilities and Equity €
Cash 550,000 Accounts payable 330,000
Accounts receivable 600,000 Total current liabilities 330,000
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 Inventory* 800,000 Long-term debt 2,000,000
Total current assets 1,950,000 Total liabilities 2,330,000
Property and equipment 2,000,000 Capital stock 1,000,000
Less: Accumulated depreciation (200,000) Retained earnings 500,000
Patents, net 80,000 Total 3,830,000
Total assets 3,830,000
* Inventory is carried at first-in, first-out (FIFO) cost; ending inventory was acquired evenly throughout the month of December.

Relevant exchange rates are as follows:

January 1, Year 1 $1.35
Rate when property and equipment were acquired and long-term debt was
1.33
incurred, January 15, Year 1
Rate when patent was acquired, February 1, Year 1 1.32
Average Year 1 1.30
Rate when dividends were declared, December 1, Year 1 1.27
Average for the month of December 1.26
December 31, Year 1 1.25

TRANSLATION OF FINANCIAL STATEMENTS:

1- CURRENT RATE METHOD

Income Statement, Year 1
€ Translation Rate US$
Sales 8,000,000 $1.30 10,400,00
0
Cost of goods sold 6,000,000 1.30 7,800,000
Gross profit 2,000,000 2,600,000
Selling and administrative expenses 500,000 1.30 650,000
Depreciation expenses 200,000 1.30 260,000
Amortization expense 20,000 1.30 26,000
Interest expense 180,000 1.30 234,000
Income before income taxes 1,100,000 1,430,000
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 Income taxes 275,000 1.30 357,000
Net income 825,000 *1,072,50
0

Statement of Retained Earnings, Year 1

€ Translation Rate US$
Retained earnings, 1/1/Y1 0 0
Net income, Y1 825,000 *1,072,50
0
Less: Dividends, 12/1/Y1 (325,000) 1.27 (412,750)
Retained earnings, 12/31/Y1 500,000 **659,750

Balance Sheet, December 31, Year 1

Assets € Translation Rate US$
Cash 550,000 1. 25 687,500
Accounts receivable 600,000 1. 25 750,000
Inventory* 800,000 1. 25 1,000,000
Total current assets 1,950,000 2,437,500
Property and equipment 2,000,000 1. 25 2,500,000
Less: Accumulated depreciation (200,000) 1. 25 (250,000)
Patents, net 80,000 1.25 100,000
Total assets 3,830,000 4,787,500
Liabilities and Equity
Accounts payable 330,000 1. 25 412,500
Total current liabilities 330,000 412,500
Long-term debt 2,000,000 1. 25 2,500,000
Total liabilities 2,330,000 2,912,500
Capital stock 1,000,000 1. 35 1,350,000
Retained earnings 500,000 **659,750
Cumulative translation adjustment - ***(134,750
)
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Total equity 1,500,000 1,875,000
Total 3,830,000 4,787,500
***determination of the translation adjustment to be reported for Italco in
this example is calculated as follows:

Net asset balance, 1/1/Y1 1,000,000 1. 35 1,350,000

Change in net assets:
Net income, Year 1 825,000 1.30 1,072,500
Dividends, 12/1/Y1 (325,000) 1.27 (412,750)
2,009,750
Net asset balance, 12/31/Y1, at current exchange rate 1,500,000 1.25 1,875,000
Translation adjustment, Year 1(negative) (134,750)

2- TEMPORAL (REMEASUREMENT) METHOD

Income Statement, Year 1
€ Translation Rate US$
Sales 8,000,000 $1.30 10,400,000
Cost of goods sold 6,000,000 calculation *7,862,000
Gross profit 2,000,000 2,538,000
Selling and administrative expenses 500,000 1.30 650,000
Depreciation expenses 200,000 1.33 266,000
Amortization expense 20,000 1.32 26,400
Interest expense 180,000 1.30 234,000
Income before income taxes 1,100,000 1,361,600
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 Income taxes 275,000 1.30 357,500
Remeasurement gain - 91,250
Net income 825,000 **1,095,35
0
* Cost of goods sold is remeasured at historical exchange rates using the following
Procedure:

€ Translation Rate US$

Beginning inventory 600,000 1.35 810,000
Plus: Purchases 6,200,000 1.30 8,060,000
Less: Ending inventory (800,000) 1.26 (1,008,000)
Cost of goods sold 6,000,000 *7,862,000

Statement of Retained Earnings, Year 1

€ Translation Rate US$
Retained earnings, 1/1/Y1 0 0
Net income, Y1 825,000 **1,095,35
0
Less: Dividends, 12/1/Y1 (325,000) 1.27 (412,750)
Retained earnings, 12/31/Y1 500,000 ***682,600

Balance Sheet, December 31, Year 1

Assets € Translation Rate US$
Cash 550,000 1. 25 687,500
Accounts receivable 600,000 1. 25 750,000
Inventory 800,000 1. 26 1,008,000
Total current assets 1,950,000 2,445,500
Property and equipment 2,000,000 1. 33 2,660,000
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Less: Accumulated depreciation (200,000) 1. 33 (266,000)
Patents, net 80,000 1.32 105,600
Total assets 3,830,000 4,945,100
Liabilities and Equity
Accounts payable 330,000 1. 25 412,500
Total current liabilities 330,000 412,500
Long-term debt 2,000,000 1. 25 2,500,000
Total liabilities 2,330,000 2,912,500
Capital stock 1,000,000 1. 35 1,350,000
Retained earnings 500,000 ***682,600
Total equity 1,500,000 2,032,600
Total 3,830,000 4,945,100

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