

TRANSLATION OF FOREIGN CURRENCY
FINANCIAL STATEMENTS

Chapter 7

McGraw-Hill/Irwin

Copyright © 2009 by The McGraw-Hill Companies, Inc. All



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, IFRS, and other standards related to
translation
 Hedging balance sheet exposure
7-2

2. 4. Describe the concepts underlying the current rate and temporal rate methods of translation. Translation of Foreign Currency Financial Statements Learning Objectives 1. 3. Explain balance sheet exposure and how it differs from transaction exposure. Describe the conceptual issues involved in translating foreign currency financial statements. Apply the current rate and temporal methods of translation and compare the results of the two methods. 7-3 .

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

 Translating Foreign Currency Statements -.  Financial statements must be translated into home country GAAP.  These operations also typically use local GAAP.  These financial statements must be translated into home country currency. Learning Objective 1 7-5 .Conceptual Financial Foreign country operations usually prepare financial statements Issues using local currency as the monetary unit.

 The resulting translation adjustment can be recognized in current income or included in an equity account on the balance sheet.Conceptual Primary conceptual issues Issues Each financial statement item must be translated using the appropriate exchange rate. Translating Foreign Currency Financial Statements -. average exchange rate.  Choices include the current exchange rate. while historical exchange rate is as of the date of the transaction. Learning Objective 1 7-6 . and the historical exchange rate.  Current exchange rate is as of the balance sheet date.

 Assets and liabilities translated at the historical exchange rate are not exposed to a translation adjustment.  When foreign currency appreciates.  When foreign currency appreciates. a net asset exposure results in a positive translation adjustment. Learning Objective 2 7-7 . a net liability exposure results in a negative translation adjustment. Balance Sheet Exposure  Assets and liabilities translated at the current exchange rate are exposed to risk of a translation adjustment.

GAAP or IFRS. Learning Objective 3 7-8 . Translation Methods Current/Noncurrent Method  Current assets and liabilities are translated at the current exchange rate.S.  Method is seldom used in any countries and is not allowed by U.  There is no theoretical basis for this method.  Noncurrent assets and liabilities and stockholders’ equity accounts are translated at historical exchange rates.

 Translation Methods Monetary/Nonmonetary Method  Monetary assets and liabilities are translated at the current exchange rate. Learning Objective 3 7-9 .  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.  Nonmonetary assets and liabilities and stockholders’ equity accounts are translated at historical exchange rates.

 Items carried on subsidiary’s books at current value are translated at current exchange rates. Translation Methods Temporal Method  Objective is to translate financial statements as if the subsidiary had been using the parent’s currency. are translated at historical exchange rates. Learning Objective 3 7-10 . including all stockholders’ equity items.  Income statement items are translated at the exchange rate in effect at the time of the transaction.  Items carried on subsidiary’s books at historical cost.

 Stockholders’ equity accounts are translated at historical exchange rates. Translation Methods Current Rate Method  Objective is to reflect that the parent’s entire investment in a foreign subsidiary is exposed to exchange risk. Learning Objective 3 7-11 .  Income statement items are translated at the exchange rate in effect at the time of the transaction.  All assets and liabilities are translated at the current exchange rate.

owns Juarez.000 Inventory 2.000 Fixed assets 8. Cash 1.500 Capital stock 3.000 Learning Objective 4 7-12 . Inc.000 Accounts payable 2. Temporal and Current Rate Methods Translation methods illustrated U. SA. a subsidiary in Mexico which was established January 1.500 Accum. 2. depr.000 Accounts rec. 1. Juarez’s balance sheet items as of 12/31/05. 2005.000 Retained earnings 1. in pesos.S.000 Long-term debt 6.

1. Income tax exp. Temporal and Current Rate Methods Translation methods illustrated Juarez’s income statement items for 2005.&A exp.G.000 2. Learning Objective 4 20.000 14.500 Depr. Sales COGS S. exp Interest exp. in pesos.000 500 500 7-13 .

2005. Learning Objective 4 7-14 . Temporal and Current Rate Methods Translation methods illustrated There was no beginning inventory. Purchases were made evenly throughout year. which is carried at cost. Capital stock was sold on January 1. 2005. was acquired evenly during the last quarter of 2005. Inventory. Fixed assets were acquired on January 1.

08 Learning Objective 4 7-15 . Temporal and Current Rate Methods Translation methods illustrated Relevant exchange rates (U.09 December 31. 2005 $0.10 Average for 2005 $0. dollar per Mexican peso) January 1. 2005 $0.095 Average for 4th quarter 2005 $0.S.

 Temporal and Current Rate Methods Current Rate Method – Income Statement Income Statement – 2005 Sales 1.&A 238 Depreciation expense 95 Interest expense 48 Income tax expense 47 Net income 142 Learning Objective 4 7-16 .G.330 Gross profit 570 S.900 COGS 1.

985 Learning Objective 4 7-17 .E. net 545 Retained earnings Total assets 985 Cumulative 160 480 300 142 translation adj. 160 Long-term debt Inventory 200 Capital stock Fixed Assets. & S. (97) Total liab. Temporal and Current Rate Methods Current Rate Method – Balance Sheet Balance Sheet – December 31. 2005 Cash 80 Accounts payable Accounts Rec.

160 Long-term debt 480 Inventory 225 Capital stock 300 Fixed Assets.165 Learning Objective 4 7-18 .E. 2005 Cash 80 Accounts payable 160 Accounts Rec. 1. & S. Temporal and Current Rate Methods Temporal Method – Balance Sheet Balance Sheet – December 31. net 700 Retained earnings 225 Total assets 1.165 Total liab.

&A Depreciation expense Interest expense Income tax expense Remeasurement gain Net income Learning Objective 4 1. Temporal and Current Rate Methods Temporal Method – Income Statement Income Statement – 2005 Sales COGS Gross profit S.343 557 238 100 48 47 101 225 7-19 .G.900 1.

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.  Net asset exposure and devaluing foreign currency results in translation loss.  Translation adjustment included in equity.  This results in net asset exposure.

 This results in net liability exposure. Learning Objective 4 7-21 .  Translation gain included in current income. Temporal and Current Rate Methods Translation methods illustrated – Summary Temporal Method  Primarily monetary assets and liabilities translated at current rate.  Net liability exposure and devaluing foreign currency result in translation gain.

GAAP and IFRS Requirements U.  The standard includes a list of indicators as guidance for the foreign currency decision.  When functional currency is foreign currency. Dollar. temporal method is required.S. GAAP  SFAS 52. current rate method is required.  Functional currency is the primary currency of the foreign subsidiary’s operating environment.S.  Requires identification of functional currency.S.  When functional currency is U. Learning Objective 5 7-22 . Foreign Currency Translation is the relevant accounting standard. U.

GAAP and IFRS Requirements IFRS  IAS 21.  The standard includes a list.  The standard’s requirements pertaining to hyperinflationary economies are substantially different from SFAS 52.  Uses the functional currency approach developed by the FASB. The Effects of Changes in Foreign Exchange Rates is the relevant accounting standard.S. similar to the FASB list. of indicators as guidance for the foreign currency decision. Learning Objective 5 7-23 . U.

GAAP and IFRS Requirements Highly Inflationary Economies – U.S.S. U.  SFAS 52 requires the use of the temporal method in these cases of significant inflation. Learning Objective 5 7-24 . 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.

Learning Objective 5 7-25 .  IAS 21 requires restatement of the foreign financial statements for inflation per IAS 29. GAAP and IFRS Requirements Hyperinflationary Economies -.  IAS approach is substantially different from SFAS 52.IFRS  IAS 21 and 29 use the term hyperinflationary economies.S.  IAS 21 is not as specific in defining hyperinflationary economies as is SFAS 52.  IAS 21 then requires the use of the current exchange rate to translate the restated financial statements. U. Financial Reporting in Hyperinflationary Economies. including all balance sheet accounts as well as all income statement accounts.

and both gains and losses increase earnings volatility. Learning Objective 6 7-26 .  The temporal method requires translation gains and losses to be recognized in income.  Losses negatively affect earnings. Hedging Balance Sheet Exposure  Companies that have foreign subsidiaries with highly integrated operations use the temporal method.

 Companies can hedge against gains and losses by using foreign currency forward contracts. Hedging Balance Sheet Exposure  These gains and losses result from the combination of balance sheet exposure and exchange rate fluctuations. Learning Objective 6 7-27 .  Companies can also hedge to offset the effects of the translation adjustment to equity under the current rate method. and borrowings. options.