Translation Methods

‡ ‡ ‡ ‡ Current/Noncurrent Method Monetary/Nonmonetary Method Temporal Method Current Rate Method

Current/Noncurrent Method
‡ The underlying principal is that assets and liabilities should be translated based on their maturity.
± Current assets translated at the spot rate. ± Noncurrent assets translated at the historical rate in effect when the item was first recorded on the books.

‡ This method of foreign currency translation was generally accepted in the United States from the 1930s until 1975, at which time FASB 8 became effective.

800 . e.100 DM $1.000 6. DM2=$1 ± Noncurrent assets translated at the historical rate in effect when the item was first recorded on the books.Current/Noncurrent Method ± Current assets translated at the spot rate.g.600 DM $2.800 DM $600 2.700 DM $900 900 DM $700 --------------6.050 1.g.600 DM $2.500 DM $750 3.000 DM $1.800 1.200 DM $600 1. e. DM3=$1 Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Current/ Currency Noncurrent 2.

marketable securities. accounts receivable. ‡ All monetary balance sheet accounts (cash.Monetary/Nonmonetary Method ‡ The underlying principal is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes. etc. ‡ All other (nonmonetary) balance sheet accounts (owners¶ equity.) of a foreign subsidiary are translated at the current exchange rate. . land) are translated at the historical exchange rate in effect when the account was first recorded.

000 DM $1.600 DM $2. e.200 DM $600 1.400 .Monetary/Nonmonetary Method ‡ All monetary balance sheet accounts are translated at the current exchange rate.800 DM $900 2.550 1.100 DM $1.600 DM $2.000 6.500 DM $500 3.g. DM2=$1 ‡ All other balance sheet accounts are translated at the historical exchange rate in effect when the account was first recorded. e.050 1.DM3=$1 Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Monetary/ Currency Nonmonetary 2.700 DM $900 900 DM $0 --------------6.g.

.Temporal Method ‡ The underlying principal is that assets and liabilities should be translated based on how they are carried on the firm¶s books. ‡ Balance sheet account are translated at the current spot exchange rate if they are carried on the books at their current value. ‡ Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books.

500 DM 3.000 $2.200 DM 1. DM2=$1 ‡ Items that are carried on the books at historical costs are translated at the historical exchange rates. e.800 DM 2.050 $900 $1.g. e.Temporal Method ‡ Items carried on the books at their current value are translated at the spot exchange rate.400 .700 DM 900 DM -------6.100 DM 1.000 DM 6.600 DM 1.g. DM3=$1 Balance ee Cash Inventory et f e assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity cal Currency 2.600 DM e p ral $1.950 $600 $900 $900 $0 -------$2.

‡ A ³plug´ equity account named cumulative translation adjustment is used to make the balance sheet balance. ‡ Very simple method in application.Current Rate Method ‡ All balance sheet items (except for stockholder¶s equity) are translated at the current exchange rate. .

DM1. 00 DM900 DM6.300 $600 $900 $900 $360 $540 $3. $3.300 .600 Current ate .Current Rate Method ‡ All balance sheet items (except for stockholder¶s equity) are translated at the current exchange rate.200 DM1. DM6. 00 DM2. DM3.600 DM1. 1. ‡ A ³plug´ equity account named cumulative translation adjustment is used to make the balance sheet balance Balance eet Cash Inventory Net ed assets Total ssets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities uity and L cal ency DM2.

How Various Translation Methods Deal with a Change from DM3 to DM2 = $1 Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings earnings CTA Total Liabilities and Equity Local Current/ Monetary/ Currency Noncurrent Nonmonetary 2 1 DM $1 $1 1 DM $ $ 3 DM $1 $1 $2 $2 6 6 DM 1 2 DM $6 $6 1 2 DM $6 $ $ -------$2 $ $ $1 -------$2 Temporal $1 $ $1 $2 $6 $ $ $ -------$2 Current Rate $1 $ $1 $3 3 $6 $ $ $36 $ 4 $3 3 DM DM -------6 6 DM Spot exchange rate .

Equity Balance Sheet .How Various Translation Methods Deal with a Change from DM3 to DM2 = $1 Local Current/ Monetary/ Temporal Current Currency Noncurrent Nonmonetary Rate Cash 2 1 DM $1 $1 $1 $1 Inventory 1 DM $ $ $ $ Net fixed assets 3 DM $1 $1 $1 $1 $2 $2 $2 $3 3 6 6 DM Total Assets Book Current 1 2 DM $6 $6 $6 $6 value of liabilities inventory 1 DM $6 historic $ $ $ Long-Term debt rate Common stock 2 DM $ $ $ $ DM $ $1 $ $36 Retained earnings earnings CTA ----------------------------$ 4 Total 6 6 DM $2 $2 $2 $3 3 Book value of inventory Current value of inventory Liabilities and at spot exchange rate at spot exchange rate.

How Various Translation Methods Deal with a Change from DM3 to DM2 = $1 Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings earnings CTA Total Liabilities and Equity Local Current/ Monetary/ Currency Noncurrent Nonmonetary 2 1 DM $1 $1 1 DM $ $ 3 DM $1 $1 $2 $2 6 6 DM 1 2 DM $6 $6 1 2 DM $6 $ $ -------$2 historic rate $ Temporal $1 $ $1 $2 $6 $ Current Rate $1 $ $1 $3 3 $6 $ DM DM -------6 6 DM $ $ $ $1 $ $36 --------------$ 4 $2 $2 $3 3 spot exchange rate. .

How Various Translation Methods Deal with a Change from DM3 to DM2 = $1 Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings earnings CTA Total Liabilities and Equity Local Current/ Monetary/ Currency Noncurrent Nonmonetary 2 1 DM $1 $1 1 DM $ $ 3 DM $1 $1 $2 $2 6 6 DM 1 2 DM $6 $6 1 2 DM $6 $ $ -------$2 spot rate $ $ $1 -------$2 Temporal $1 $ $1 $2 $6 $ $ $ -------$2 Current Rate $1 $ $1 $3 3 $6 $ $ $36 $ 4 $3 3 DM DM -------6 6 DM .

How Various Translation Methods Deal with a Change from DM3 to DM2 = $1 Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings earnings CTA Total Liabilities and Equity Local Current/ Monetary/ Currency Noncurrent Nonmonetary 2 1 DM $1 $1 1 DM $ $ 3 DM $1 $1 $2 $2 6 6 DM 1 2 DM $6 $6 1 2 DM $6 $ $ -------$2 $ $ $1 -------$2 spot rate Temporal $1 $ $1 $2 $6 $ $ $ -------$2 Current Rate $1 $ $1 $3 3 $6 $ $ $36 $ 4 $3 3 DM DM -------6 6 DM historical rate .

How Various Translation Methods Deal with a Change from DM3 to DM2 = $1 Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings earnings CTA Total Liabilities and Equity Local Current/ Monetary/ Currency Noncurrent Nonmonetary 2 1 DM $1 $1 1 DM $ $ 3 DM $1 $1 $2 $2 6 6 DM 1 2 DM $6 $6 1 2 DM $6 $ $ -------$2 $ $ $1 -------$2 Temporal $1 $ $1 $2 $6 $ $ $ -------$2 Current Rate $1 $ $1 $3 3 $6 $ $ $36 $ 4 $3 3 DM DM -------6 6 DM historical rate .

Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings earnings CTA Total Liabilities and Equity How Various Translation Methods Deal with a ChangeMonetary/ DM3 to from Temporal Current Balance Sheet Local Current/ Currency DM2 = $1 Noncurrent Nonmonetary Rate 21 1 3 66 12 1 2 DM DM DM DM DM DM $1 $ $1 $2 $6 $6 $ $ -------$2 $1 $ $1 $2 $6 $ $ $1 -------$2 $1 $ $1 $2 $6 $ $ $ -------$2 $1 $ $1 $3 3 $6 $ $ $36 $ 4 $3 3 DM DM -------6 6 DM From income statement .

How Various Translation Methods Deal with a Change from DM3 to DM2 = $1 Balance Sheet Local Current/ Monetary/ Currency Noncurrent Nonmonetary 2 1 DM $1 $1 1 DM $ $ 3 DM $1 $1 $2 $2 6 6 DM 1 2 DM $6 $6 Temporal Current Rate $1 $ $1 $3 3 $6 Cash $1 Inventory $ Net fixed assets $1 $2 Total Assets Current $6 liabilities 1 DM $6 $ $ $ Long-Term debt Common stock 2 DM $ $ $ $ DM $ $1 $ $36 Retained earnings earnings CTA ----------------------------$ 4 Total 6 6 DM $2 $2 $2 $3 3 Under the current rate method a ³plug´ equity account named Liabilities and Equity cumulative translation adjustment makes the balance sheet balance. .

DM $ . DM2. DM $ $1.1 .1 $ $ Income tax (40%) DM $2 $ $2 $2 Profit after tax DM $ $ $ $3 Foreign exchange gain (loss) $3 -$ $1 Net income DM $ $1 $ $3 Dividends DM $ $ $ $ Addition to Retained Earnings DM $ $1 $ $3 Sales translate at average exchange rate over the period. Depreciation Net operating income 1. $ . $ .How Various Translation Methods Deal with a Change from DM3 to DM2 = $1 Local C ent/ Monetary/ Temporal Current Income Statement C ency Noncurrent Nonmonetary Rate Sales 1 . $3. see Exhibit 1 . . DM $3. $2.50 = $1 For notes. COGS DM $333 $333 $333 $ 1. $3. $ .

1 . Depreciation Net operating income 1.00 = $1 For notes. DM $3.How Various Translation Methods Deal with a Change from DM3 to DM2 = $1 Local Current/ Monetary/ Temporal Current Income Statement Currency Noncurrent Nonmonetary Rate Sales 1 .50 = $1 Translate at new exchange rate. DM $ .1 $ $ Income tax (40%) DM $2 $ $2 $2 Profit after tax DM $ $ $ $3 Foreign exchange gain (loss) $3 -$ $1 Net income DM $ $1 $ $3 Dividends DM $ $ $ $ Addition to Retained Earnings DM $ $1 $ $3 Translate at DM2. COGS DM $333 $333 $333 $ 1. DM2. see Exhibit 1 . $ . DM $ $1. $3. . $ . $ . $3. $2.

DM I c me ( ) DM r fit fter DM F rei e c e i ( ss) Ne i c me DM Divi e s DM A iti Re i e E r i s DM Translate at DM3 = $1 rre / M e ry/ N m e ry c rre $ . DM C 1.1 . $2. DM2. $3. $333 $ $ $ $2 $2 $ $3 $1 $ $3 $ $ $ $3 Translate at average exchange rate. see Exhibit 1 . $ . $3.1 $2 $ $ $ $3 -$ $ $1 $ $ $ $1 em r C rre R te $ . $3. DM De reci ti Ne er i i c me 1. $333 $333 $ $1.5 = $1 For notes.How Various Translation Methods Deal with a Change from DM3 to DM2 = $1 c C C rre cy N I c me eme es 1 . DM . $ .

For notes. $ . DM I c me ( ) DM r fit fter DM F rei e c e i ( ss) Ne i c me DM Divi e s DM A iti Re i e E r i s DM Note the effect on after-tax profit. DM De reci ti Ne er i i c me 1. $333 $ $ $ $2 $2 $ $3 $1 $ $3 $ $ $ $3 .How Various Translation Methods Deal with a Change from DM3 to DM2 = $1 c C C rre cy N I c me eme es 1 .1 rre / M e ry/ N m e ry c rre $ . $3. $333 $333 $ $1. $ . $2. DM C 1.1 $2 $ $ $ $3 -$ $ $1 $ $ $ $1 em r C rre R te $ . $3. $3. see Exhibit 1 . DM .

1 $2 $ $ $ $3 -$ $ $1 $ $ $ $1 em r C rre R te $ .How Various Translation Methods Deal with a Change from DM3 to DM2 = $1 c C C rre cy N I c me eme es 1 . DM C 1. $3. $333 $ $ $ $2 $2 $ $3 $1 $ $3 $ $ $ $3 Note the effect that foreign exchange gains (losses) has on net income. DM I c me ( ) DM r fit fter DM F rei e c e i ( ss) Ne i c me DM Divi e s DM A iti Re i e E r i s DM rre / M e ry/ N m e ry c rre $ . $ . DM .1 . $3. $333 $333 $ $1. $2. $3. DM De reci ti Ne er i i c me 1. see Exhibit 1 . $ . For notes.

. ± Such as translating inventory at historical rates. with some subtleties. ‡ This leads to variability in reported earnings. which is a hassle. ‡ Which leads to irritated corporate executives. ‡ Requires taking foreign exchange gains and losses through the income statement.FASB Statement 8 ‡ Essentially the temporal method.

FASB Statement 52 ‡ The Mechanics of the FASB 52 Translation Process ± Functional Currency ± Reporting Currency .

The Mechanics of FASB Statement 52 ‡ Functional Currency ± The currency that the business is conducted in. . ‡ Reporting Currency ± The currency in which the MNC prepares its consolidated financial statements.

± If the local currency in which the foreign entity keeps its books is not the functional currency. when the foreign entity¶s functional currency is not the same as the parent¶s currency. remeasurement into the functional currency is required. the foreign entity¶s books are translated using the current rate method.The Mechanics of FASB Statement 52 ‡ Two Stage Process ± First. ± Second. . determine in which currency the foreign entity keeps its books.

Should Firms Hedge Translation Exposure? No ‡ The value of the firm is the PV of cash flows ‡ Translation exposure doesn¶t effect cash flows. so ignore it ‡ Yes ‡ Investors don¶t have enough information to estimate cash flows and instead must rely on reported earnings. investors will misvalue the firm. ‡ If reported earnings are distorted by translation issues. .

one should ask whether managers ought to devote time and money to hedging what amounts to cosmetics .Hedging Translation Exposure ‡ We will talk about hedging instruments in some detail in the next two sections (dealing with operating and transactions exposure). Remember. just how the firm is perceived. by definition. ‡ Thus. Much of what will be learned there can be applied here. translation exposure doesn¶t describe what is happening to cash flows. ‡ But the really essential question is whether managers should worry about translation exposure.

the mandated switch «should not change the value of the firm. the actual cash flows of the multinationals would not be affected if managers were not making suboptimal decisions based on accounting rather than economic considerations«In such cases.´ ‡ Which is what was found. ‡ GFF (cited in your book) ³Despite the impact of the change (from 8 to 52) on reported earnings.Final Word: Does Translation Exposure Matter? ‡ Some research has been done investigating whether the change from FASB 8 to FASB 52 made any difference to firm value. .

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