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Translation of Foreign Currency Financial Statements: Answers To Questions
Translation of Foreign Currency Financial Statements: Answers To Questions
TRANSLATION OF FOREIGN
CURRENCY FINANCIAL STATEMENTS
Answers to Questions
1. The two major issues related to the translation of foreign currency financial statements are:
(a) which method should be used and (b) where should the resulting translation adjustment
be reported in the consolidated financial statements. The first issue relates to determining
the appropriate exchange rate (historical, current, or average for the current period) for the
translation of foreign currency balances. Those items translated at the current exchange
rate are exposed to translation adjustment. The second issue relates to whether the
translation adjustment should be treated as a gain or loss in income, or should be deferred
as a separate component of stockholders’ equity.
2. Balance sheet exposure arises when a foreign currency balance is translated at the current
exchange rate. By translating at the current exchange rate, the foreign currency item in
essence is being revalued in U.S. dollar terms on the consolidated financial statements.
There will be either a net asset balance sheet exposure or net liability balance sheet
exposure depending upon whether assets translated at the current rate are greater or less
than liabilities translated at the current rate. Balance sheet exposure generates a
translation adjustment which does not result in an inflow or outflow of cash. Transaction
exposure, which results from the receipt or payment of foreign currency, generates foreign
exchange gains and losses which are realized in cash.
3. Although balance sheet exposure does not result in cash inflows and outflows, it does
nevertheless affect amounts reported in consolidated financial statements. If the foreign
currency is the functional currency, translation adjustments will be reported in stockholders’
equity. If translation adjustments are negative and therefore reduce total stockholders’
equity, there is an adverse (inflationary) impact on the debt to equity ratio. Companies with
restrictive debt covenants requiring them to stay below a maximum debt to equity ratio,
may find it necessary to hedge their balance sheet exposure so as to avoid negative
translation adjustments being reported. If the U.S. dollar is the functional currency or an
operation is located in a high inflation country, remeasurement gains and losses are
reported in income. Companies might want to hedge their balance sheet exposure in this
situation to avoid the adverse impact remeasurement losses can have on consolidated
income and earnings per share.
The paradox in hedging balance sheet exposure is that, by agreeing to receive or deliver
foreign currency in the future under a forward contract, a transaction exposure is created.
This transaction exposure is speculative in nature, given that there is no underlying inflow
or outflow of foreign currency that can be used to satisfy the forward contract. By hedging
balance sheet exposure, a company might incur a realized foreign exchange loss to avoid
an unrealized negative translation adjustment or unrealized remeasurement loss.
4. The gains and losses arising from financial instruments used to hedge balance sheet
exposure are treated in a similar manner as the item the hedge is intended to cover. If the
foreign currency is the functional currency, gains and losses on hedging instruments will be
taken to other comprehensive income. If the U.S. dollar is the functional currency, gains
and losses on the hedging instruments will be offset against the related remeasurement
gains and losses.
The major concept underlying the current rate method is that the entire foreign investment
is exposed to foreign exchange risk. Therefore all assets and liabilities are translated at
the current exchange rate. Balance sheet exposure under this concept is equal to the net
investment.
7. The major differences relate to non-monetary assets carried at historical cost and related
expenses, i.e., inventory and cost of goods sold; property, plant, and equipment and
depreciation expense; and intangible assets and amortization expense. Under the temporal
method, these items are all translated at historical exchange rates. Under the current rate
method, the assets are translated at the current exchange rate and the related expenses
are translated at the average exchange rate for the current period.
8. The functional currency is the currency of the subsidiary’s primary economic environment.
It is usually identified as the currency in which the company generates and expends cash.
SFAS 52 recommends that several factors such as the location of primary sales markets,
sources of materials and labor, the source of financing, and the amount of intercompany
transactions should be evaluated in identifying an entity’s functional currency. SFAS 52
does not provide any guidance as to how these factors are to be weighted (equally or
otherwise) when identifying an entity’s functional currency.
9. The foreign subsidiary's net asset position in foreign currency at the beginning of the period
is first determined. Changes in net assets are determined to explain the net asset balance
in foreign currency at the end of the period. The beginning net asset position and changes
in net assets are translated at appropriate exchange rates and the ending net asset
position in dollars is determined.
The ending net asset balance in foreign currency is then translated at the current rate and
this result is subtracted from the ending net asset position in dollars (already calculated).
The difference is the translation adjustment. It is positive if the actual dollar net asset
position is less than the net asset position based on the current exchange rate. The
translation adjustment is negative if the actual dollar net asset position is greater than if
translated at the current rate.
12. The temporal method must be used to remeasure the financial statements of operations in
highly inflationary countries. One reason for mandating the use of the temporal method is
that it avoids the disappearing plant problem that exists when the current rate method is
used. Under the current rate method, fixed assets are translated at current exchange
rates. With high rates of inflation, the foreign currency will depreciate significantly. When
the historical cost of fixed assets is translated at a significantly lower current exchange rate,
the dollar value of fixed assets “disappears.” This problem is avoided by translating at the
historical exchange rate as is done under the temporal method.
1. C
2. C
3. C
4. B Since the peso is the functional currency, the financial statements must be
translated using the current rate method. Therefore, answers a and d can
be eliminated. Because the subsidiary has a net asset position and the
peso has appreciated from $.16 to $.19, a positive translation adjustment
will result.
9. C Cost of goods sold is translated at the exchange rate in effect at the date
of accounting recognition, which is the date the goods were sold [100,000
x $.18].
16. C Marketable equity securities are carried at market value and therefore
translated at the current exchange rate under the temporal method.
17. B When the U.S. dollar is the functional currency, SFAS 52 requires
remeasurement using the temporal method with remeasurement gains and
losses reported in income.
Notes payable—as a liability, use current rate at the balance sheet date.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
Hoyle, Schaefer, Doupnik, Advanced Accounting, 8/e 10-5
21. (continued)
Cash—as an asset, use the current rate at the balance sheet date.
Translation Remeasurement
Accounts payable $.16 C $.16 C
Accounts receivable $.16 C $.16 C
Accumulated depreciation $.16 C $.26 H
Advertising expense $.19 A $.19 A
Amortization expense $.19 A $.25 H
Buildings $.16 C $.26 H
Cash $.16 C $.16 C
Common stock $.28 H $.28 H
Depreciation expense $.19 A $.26 H
Dividends paid (10/1) $.20 H $.20 H
Notes payable $.16 C $.16 C
Patents (net) $.16 C $.25 H
Salary expense $.19 A $.19 A
Sales $.19 A $.19 A
Translation
Beginning net assets, 12/1 CHF3,700,000 x $.70 = $2,590,000
Ending net assets, 12/31 at
current exchange rate CHF3,700,000 x $.75 = (2,775,000)
Translation adjustment (positive)
$( 185,000)
Remeasurement
Beginning net monetary
liability position, 12/1 CHF(300,000) x $.70 = $(210,000)
Ending net monetary liability
position, 12/31 at current
exchange rate CHF(300,000) x $.75 = (225,000)
Remeasurement loss $ 15,000
25. (30 minutes) (Prepare financial statements for a foreign subsidiary and then
translate them into U.S. dollars)
Fenwicke Company Subsidiary
Income Statement
LCU U.S. Dollars
Rent revenue 60,000 x $1.90 A = $114,000
Interest expense (10,000) x $1.90 A = (19,000)
Depreciation expense (14,000) x $1.90 A = (26,600)
Repair expense (4,000) x $1.85*H = (7,400)
Net income 32,000 $ 61,000
* Repairs is the only expense which is not incurred evenly throughout the
year.
Balance Sheet
LCU U.S. Dollars
Cash 41,000 x $1.80 C = $ 73,800
Accounts receivable 10,000 x $1.80 C = 18,000
Building 140,000 x $1.80 C = 252,000
Accumulated depreciation (14,000) x $1.80 C = (25,200)
Total assets 177,000 $318,600
Interest payable 10,000 x $1.80 C = $ 18,000
Note payable 100,000 x $1.80 C = 180,000
Common stock 40,000 x $2.00 H = 80,000
Retained earnings 27,000 (above) 52,000
Translation adjustment (below) (11,400)
Total liabilities and equities177,000 $318,600
135,000 271,000
Increase in cash 41,000 78,600
Effect of exchange rate change on cash (4,800)
Cash, 1/1 -0- -0-
Cash, 12/31 41,000 x $1.80 C = $ 73,800
* This amount can be verified as ending assets (24,400 KQ) minus ending
liabilities (8,000 KQ) – net assets, 12/31 = 16,400 KQ.
* This amount can be verified as ending assets (17,000 KQ) minus ending
liabilities (8,000 KQ) – net assets, 12/31 = 9,000 KQ.
LIVINGSTON COMPANY
Income Statement
For Year Ending December 31, 2007
** To determine cash proceeds from the sale of the building, changes in the
Accumulated Depreciation and Buildings accounts must be analyzed
along with Depreciation Expense and Gain on Sale of Building.
Depreciation expense is KR 15,000; KR 5,000 is attributable to equipment
(Accumulated Depreciation—Equipment increases by KR 5,000), KR
10,000 is depreciation of buildings. Accumulated Depreciation—
Buildings increases by only KR 5,000 during 2007, therefore, the
accumulated depreciation related to the building sold during 2007 is KR
5,000. The Buildings account is decreased by KR 21,000, thus the book
value of the building sold must have been KR 16,000 (as given). The
Gain on Sale of Building is KR 6,000; therefore, cash proceeds from the
sale are KR 22,000.
b. Translation Adjustment
Net assets, 1/1/07* 100,000 KR x 2.50 = $250,000
Increases in net assets
Issued Common Stock (4/1/07) 10,000 KR x 2.60 = 26,000
Gain on Sale of Building** (7/1/07) 6,000 KR x 2.80 = 16,800
Sales (2007) 80,000 KR x 2.70 = 216,000
Decreases in net assets
Paid Dividends (10/1/07) (32,000) KR x 2.90 = (92,800)
Depreciation Expense (2007) (15,000) KR x 2.70 = (40,500)
Rent Expense (2007) (14,000) KR x 2.70 = (37,800)
Salary Expense (2007) (20,000) KR x 2.70 = (54,000)
Utilities Expense (2007) ( 5,000) KR x 2.70 = (13,500)
Net assets, 12/31/07 110,000 KR $270,200
Net monetary assets, 12/31/07 at
current exchange rate 110,000 KR x 3.00
330,000
Translation adjustment (positive) $(59,800)
Balance Sheet
December 31, 2007
Step One
Simbel's financial statements are first translated into U.S. dollars after
reclassification of the 10,000 pound expenditure for rent from rent expense
to prepaid rent. Credit balances are in parentheses.
Translation Worksheet
Exchange
Account Pounds Rate Dollars
Sales (800,000) 0.274 (219,200)
Cost of goods sold 420,000 0.274 115,080
Salary expense 74,000 0.274 20,276
Rent expense (adjusted) 36,000 0.274 9,864
Other expenses 59,000 0.274 16,166
Gain on sale of fixed
assets, 10/1/08 (30,000) 0.273 (8,190)
Net income (241,000) (66,004)
Pounds Dollars
Retained earnings, 1/1/07 -0- -0-
Net income, 2007 (163,000) 0.288 (46,944)
Dividends, 6/1/07 30,000 0.290 8,700
Retained earnings, 12/31/07 (133,000) (38,244)
Pounds Dollars
Step Two
Cayce and Simbel's U.S. dollar accounts are then consolidated. Necessary
adjustments and eliminations are made.
Consolidation Worksheet
Adjustments and
Consolidated
Cayce Simbel Eliminations Balances
Account Dollars Dollars Debit Credit Dollars
Sales (200,000) (219,200) (419,200)
Cost of goods sold 93,800 115,080 208,880
Salary expense 19,000 20,276 39,276
Rent expense 7,000 9,864 16,864
Other expenses 21,000 16,166 37,166
Dividend income (13,750) -0- (I) 13,750 -0-
Gain, 10/1/08 -0- (8,190) (8,190)
Net income (72,950) (66,004) (125,204)
Ret earn, 1/1/08 (318,000) (38,244) (S) 38,244 (*C) (38,244) (356,244)
Net income (72,950) (66,004) (125,204)
Dividends paid 24,000 13,750 (I) (13,750) 24,000
Ret earn, 12/31/08 (366,950) (90,498) (457,448)
Entry *C
Investment in Simbel..................................................... 38,244
Retained earnings, 1/1/08........................................ 38,244
To accrue 2007 increase in subsidiary book value (see Schedule 1). Entry is
needed because parent is using the cost method.
Entry S
Common Stock (Simbel) ................ 72,000
Add'l Paid-in-capital (Simbel)............ 45,000
Retained earnings, 1/1/08 (Simbel)... 38,244
Fixed assets (revaluation) ................ 9,000
Investment in Simbel ................ 164,244
To eliminate subsidiary's stockholders' equity accounts and allocate the
excess of purchase price over book value to land (fixed assets).
The excess of cost over book value is calculated as follows:
Purchase price.................................................... $126,000
Book value, 1/1/07...............................................
Exchange
KCS Rate US$
Sales 25,000,000 0.035 875,000
Cost of goods sold (12,000,000) Sched.A (493,500)
Depreciation expense—equipment (2,500,000) Sched.B (118,000)
Depreciation expense—building (1,800,000) Sched.C (85,200)
Research and development expense (1,200,000) 0.035 (42,000)
Other expenses (1,000,000) 0.035 (35,000)
Income before remeasurement gain 6,500,000 101,300
Remeasurement gain, 2008 - 408,000
Net income 6,500,000 509,300
Retained earnings, 1/1/08 500,000 given 353,000
Dividends paid, 12/15/08 (1,500,000) 0.031 (46,500)
Retained earnings, 12/31/08 5,500,000 815,800
KCS ER US$
Beginning inventory 6,000,000 0.043
258,000
Purchases 14,500,000 0.035 507,500
Ending inventory (8,500,000) 0.032 (272,000)
Cost of goods sold 12,000,000 493,500
Schedule B—Equipment
KCS ER US$
Old Equipment—at 1/1/08 20,000,000 0.050 1,000,000
New Equipment—acquired 1/3/08 5,000,000 0.036 180,000
Total 25,000,000 1,180,000
Schedule C—Building
KCS ER US$
Old Building—at 1/1/07 60,000,000 0.050 3,000,000
New Building—acquired 3/5/08 12,000,000 0.034 408,000
Total 72,000,000 3,408,000
Accum. Depr.—Old Building 30,000,000 0.050 1,500,000
Accum. Depr.—New Building 300,000 0.034 10,200
Total 30,300,000 1,510,200
Deprec. expense—Old Building 1,500,000 0.050 75,000
Deprec. expense—New Building 300,000 0.034 10,200
Total 1,800,000 85,200
Part I (c). U.S. dollar is the functional currency—temporal method (no long-
term debt)
Exchange
KCS Rate US$
Sales 25,000,000 0.035 875,000
Cost of goods sold (12,000,000) Sched.A (493,500)
Depreciation expense—equipment (2,500,000) Sched.B (118,000)
Depreciation expense—building (1,800,000) Sched.C (85,200)
Research and development expense (1,200,000) 0.035 (42,000)
Other expenses (1,000,000) 0.035 (35,000)
Income before remeasurement loss 6,500,000 101,300
Remeasurement loss, 2008 - (92,000)
Net income 6,500,000 9,300
Retained earnings, 1/1/08 500,000 given (147,000)
Dividends paid, 12/15/08 (1,500,000) 0.031 (46,500)
Retained earnings, 12/31/08 5,500,000 (184,200)
3. With the FC as functional currency, the U.S. dollar net income reflected in the
consolidated income statement is $315. If the U.S. dollar were the functional
currency, the amount would be twice as much—$630. The amount of total
assets reported on the consolidated balance sheet is 23.4% smaller than if the
U.S. dollar were functional currency [($3,940 – $3,192)/$3,192].
The relations between the current ratio, the debt to equity ratio, and profit
margin calculated from the FC financial statements and from the translated
U.S. dollar financial statements are shown below.
Profit margin
NI 700 630 315
Sales 5,000 2,250 2,250
0.14 0.28 0.14
Return on equity
NI 700 630 315
Average TSE 3,550 1,915 1,541
0.19718 0.32898 0.20441
Inventory turnover
COGS 3,000 1,360 1,350
Average Inventory 1,000 430 380
3 3.16279 3.55263
These results show that the temporal method distorts all ratios as
calculated from the original foreign currency financial statements. The
current rate method maintains all ratios that use numbers in the numerator
and denominator from the balance sheet only (current ratio, debt-to-equity
ratio) or the income statement only (profit margin). For ratios that combine
numbers from the income statement and balance sheet (return on equity,
inventory turnover), even the current rate method creates distortions.
The U.S. dollar amounts reported under the temporal method for inventory
and fixed assets reflect the equivalent U.S. dollar cost of those assets as if
the parent had sent dollars to the subsidiary to purchase the assets. For
example, to purchase FC 6,000 worth of fixed assets when the exchange
rate was $.50/FC, the parent would have had to provide the subsidiary with
$3,000.
The U.S. dollar amounts reported under the current rate method for
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2007
Hoyle, Schaefer, Doupnik, Advanced Accounting, 8/e 10-33
inventory and fixed assets reflect neither the equivalent U.S. dollar cost of
those assets nor their U.S. dollar current value. By multiplying the FC
historical cost by the current exchange rate, these assets are reported at
what they would have cost in U.S. dollars if the current exchange rate had
been in effect when they were purchased. This is a hypothetical number
with little, if any, meaning.