Chapter 14

Foreign Currency
Financial
Statements

Foreign Currency Financial

Statements: Objectives
1. Identify the factors that should be considered
when determining an entitys functional
currency.
2. Understand how functional currency
assignment determines the way the foreign
entitys financial statements are converted.
3. Understand how a foreign subsidiarys
economy is determined to be highly
inflationary and how this affects the
conversion of its financial statements.

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Foreign Currency Financial

Statements: Objectives (Cont.)
4. Understand how the investment in a foreign
subsidiary is accounted for at acquisition.
5. Understand which rates are used to
translate balance sheet and income
statement accounts under the current rate
method and the temporal method on a
translation/ remeasurement worksheet.
6. Know how a parent accounts for its
investment in a subsidiary using the equity
method depending on the subsidiarys
functional currency determination.
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Foreign Currency Financial

Statements: Objectives (Cont.)
7. Know how the translation gain or loss,
or remeasurement gain or loss, is
reported under the current rate and
temporal methods.
8. Understand consolidation under the
temporal and current rate methods.
9. Understand how a hedge of the net
investment in a subsidiary is
accounted for under the current rate
and temporal methods.
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Foreign Currency Financial Statements

1: FUNCTIONAL CURRENCY

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Functional Currency
Definition: Currency of the primary economic
environment in which the entity operates.
Primarily, this means the currency received
from customers and used to pay liabilities.
Other factors include the currency:

Used in setting sales prices

Dominant in the sales market
Used to pay operating expenses
Financing the company
Used in intercompany transactions

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Foreign Currency Financial Statements

2: FUNCTIONAL CURRENCY
DETERMINES CONVERSION
METHOD

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Restatement Method Selection

If the functional currency is the U.S. dollar, use the
Temporal method.
If the functional currency is the local currency, use
the Current Rate method.
Examples:
1. A Mexican subsidiary of a U.S. firm has the peso
as its functional currency.
2. A Japanese subsidiary of a U.S. firm has the U.S.
dollar as its functional currency.
3. An Australian subsidiary of a U.S. firm, keeping
its own records in Australian dollars, determines
its functional currency is the euro.

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Selecting the Method

Ex 1

Local currency

Functional currency

Reporting currency

Peso

Peso

U.S.$

Translate (current rate method) from Peso to US$

Ex 2

Yen

U.S.$

U.S.$

Remeasure (temporal method) from Yen to US$

Ex 3

Aus$

Euro

U.S.$

Remeasure from Aus$ to Euros,

then Translate from Euros to U.S.$

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Exchange Rates
Translation (the Current Rate method) will convert
financial statements using
Current (FYE): assets, liabilities
Historical: equity, dividends (retained earnings is
not translated)
Current (average): revenues, expenses
Remeasurement (the Temporal Method) will convert
financial statements using
Current (FYE): monetary assets, liabilities
Historical: other assets, liabilities
Historical: equity, dividends (retained earnings is
not remeasured)
Current (average) and Historical: revenues,
expenses
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Foreign Currency Financial Statements

3: HIGHLY INFLATIONARY
ECONOMIES

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Inflation and Functional

Currency
For subsidiaries of U.S. firms in highly inflationary
economies, assume that the functional currency is the
U.S. dollar.
Remeasure the statements
using the Temporal method.
Highly inflationary = cumulative inflation of 100% or
more over 3 years.

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Foreign Currency Financial Statements

4: BUSINESS
COMBINATIONS

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Translation at Acquisition
Foreign assets and liabilities are
translated using the current rate at the
date of acquisition.
If functional currency = local currency

Translation is appropriate
Analysis of fair value/book value
differentials is performed in local
currency
Results are translated at current rates

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Remeasurement at Acquisition
Foreign assets and liabilities are translated using
the current rate at the date of acquisition.
If functional currency = US$ or reporting currency
Remeasurement is appropriate
Analysis of fair value/book value differentials
is performed in U.S.$
The 'earliest' historical rate generally used in
remeasurement is the date of the acquisition.

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Noncontrolling Interest
For both, remeasurement and translation,
the consolidation process is applied to the
financial statements as restated in U.S.$.
Measures of noncontrolling interest,
noncontrolling interest share, and controlling
interest share are computed in U.S.$.

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Foreign Currency Financial Statements

5: CURRENT RATE METHOD

AND TEMPORAL METHOD

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Assets

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Liabilities and Equity

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Revenues and Expenses

Note that "current" rate, as used for income

statement items, is usually the average rate for
the year. Firms with seasonal business
fluctuations would use a weighted average rate.

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Foreign Currency Financial Statements

6: EQUITY METHOD FOR

FOREIGN INVESTMENTS

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Equity Method Investee

A U.S. firm has a foreign investment it accounts for
under the equity method.
If functional currency is the local currency,
then translation is appropriate
At acquisition
Analyze fair value and book value, compute
goodwill in local/functional currency
Annually
Translate statements into U.S. dollars
Record other comprehensive income for
translation adjustment

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Equity Method Entries

12/31/11 Investment in Star

525,000

Cash

525,000

Acquisition cost
12/1/12 Cash

42,600

Investment in Star

42,600

Dividends received, at current exchange rate

12/31/12 Investment in Star
OCI, translation adjustment

93,200
28,600

Income from Star

121,800

Year-end adjustment for income

The income is from the translated income

statement, with appropriate amortizations
for fair value/book value differences.
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Amortization of Differentials
On 12/31/11, Pat acquired Star. Star had unrecorded
patent of 100,000. The exchange rate was $1.50.
The patent is amortized over 10 years. The average
and year-end exchange rates are $1.45 and $1.40.
12/31/11

Patent

2012

Amortization expense

12/31/12

Patent

100,000

$1.50

$150,000

10,000

$1.45

$14,500

90,000

$1.40

$126,000

OCI translation adjustment for patent is $9,500.

$150,000 14,500 126,000 = $9,500
The adjustment brings the net value of the patent to its translated
year-end amount of $126,000.

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Foreign Currency Financial Statements

7: TRANSLATION
ADJUSTMENTS AND
REMEASUREMENT GAIN/LOSS

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Current Rate Method: Example

Translate the adjusted trial balance:
Assets and Liabilities at the year-end (current)
rate
Equity at the historical rate (from the date of the
related transaction)
Except Retained Earnings which is a composite rate
from each year
Revenues and Expenses will be at the average rate
for the related period
The entry needed to balance the trial balance after
the translation is complete will be an entry to
Accumulated Other Comprehensive Income, and thus
will appear on the balance sheet.
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Current Rate Method: Example

(cont.)

See calculation, next slide

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Current Rate Method: Example

(cont.)

Because all debit and credit balances are not translated using
the same exchange rate, the trial balance will not balance at the
end of the translation. In this example, the debits happen to be
$28,600 less than the credits. This is the debit to accumulated
OCI at the end of the year.
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Temporal Method: Example

Remeasure the adjusted trial balance:
Monetary Assets and Liabilities at the year-end (current) rate
Non-monetary Assets and Liabilities at the rate from the date of
transaction (historical)
Equity at the historical rate (from the date of the related
transaction)
Except Retained Earnings which is a composite rate
Revenues and most Expenses will be at the average rate for the
related period
Cost of Goods Sold, Depreciation and Amortization Expense at
the historical rate of the related asset
The entry needed to balance the trial balance after the translation
is complete will be an Exchange Gain/(Loss), and thus will appear
on the income statement.

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Temporal Method: Example

(cont.)

See calculation, next slide

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Temporal Method: Example

(cont.)

Because all debit and credit balances are not translated using
the same exchange rate, the trial balance will not balance at the
end of the translation. In this example, the debits happen to be
$3,300 less than the credits. This is the exchange loss for the
year.
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Adjustment Summary
Remeasurement results in
Exchange gains or losses on the income statement
Credit to balance = exchange gain
Debit to balance = exchange loss
Include the gain or loss in calculating net income
in U.S. dollars.
Translation results in
Translation adjustment, part of accumulated other
comprehensive income
Include as part of stockholders' equity
- Debit to balance = deduct from equity
- Credit to balance = add to equity

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The Difference in Methodology

The ultimate goal is consolidation.
Use the Temporal method when the U.S. dollar is the
functional currency of the subsidiary, to best reflect the
relationship of the subsidiary as an extension of the
parent, and thus the remeasurement adjustment is part
of the current period income.
Use the Current Rate method when the local currency is
the functional currency of the subsidiary, to best reflect
the subsidiarys status as a free-standing company in
whom the parent is merely invested, thus the translation
adjustment is shown in the equity section of the parents
balance sheet.
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Foreign Currency Financial Statements

8: CONSOLIDATION OF
FOREIGN SUBSIDIARIES

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Consolidating Foreign
Subsidiaries
The parent uses the appropriately translated
or remeasured subsidiary financial statements
in its consolidation worksheet.
Income from the subsidiary and
Investment in subsidiary are eliminated.
Subsidiary equity accounts are eliminated
(including accumulated OCI).
Worksheet procedures are similar to that
for domestic subsidiaries.

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Worksheet Income Statement

Star's balances come from
the translated statements.
Current amortization for
the patent is recorded.

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Worksheet Retained Earnings

Star's beginning retained
earnings and current
dividends are eliminated.

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Worksheet - Assets
The Investment in Star
and intercompany
receivables are
eliminated. Differentials
from acquisition are
recorded the patent and
its current amortization.

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Worksheet Liabilities & Equity

Intercompany payable is eliminated. All
of the subsidiary equity is eliminated,
including Accumulated OCI. Parent's
Accumulated OCI contains impact of
translation adjustments.

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Foreign Currency Financial Statements

9: HEDGE OF NET
INVESTMENT

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Hedge a Foreign Investment

Investee's functional currency = local currency
Effective hedges qualify for hedge
treatment
"Gains or losses" are translation
adjustments which are included in
accumulated OCI
Investee's functional currency = reporting
currency
"Hedging" is treated as speculative
Gains or losses are recognized in income
for the current financial period
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