CHAPTER 7

TRANSLATION OF FOREIGN CURRENCY

FINANCIAL STATEMENT

LEARNING OBJECTIVES

After reading this chapter, you should be able to

1. Describe the conceptual issues involved in translating foreign currency

financial statements.

2. Explain balance sheet exposure and how it differs from transaction exposure.

3. Describe the concepts underlying the current rate and temporal rate methods

of translation.
 CONT…

4.Apply the current rate and temporal methods of translation and compare

the results of the two methods.

5. Describe the requirements of applicable International Financial

Reporting

Standards (IFRSs) and U.S. generally accepted accounting principles

(GAAP).

6. Discuss hedging of balance sheet exposure.

7. Highlight translation procedures used internationally.

 INTRODUCTION

• In today’s global business environment, many companies have operations in

foreign countries.

• Many operations located in foreign countries keep their accounting records and

prepare financial statements in the local currency using local accounting

principles. To prepare consolidated financial statements, parent companies

must restate their foreign subsidiaries’ financial statements in terms of the

parent company’s reporting generally accepted accounting principles (GAAP)

and then translate the statement into the parent companies company’s reporting

currency .
 Cont…

This chapter focuses on the translation of foreign currency financial statements for

the purpose of preparing consolidated financial statements.

TWO CONCEPTUAL ISSUES

In translating foreign currency financial statements into the parent company’s

reporting currency, two questions must be addressed:

What is the appropriate exchange rate to be used in translating each financial

statement items?

How should the translation adjustment that inherently arises from translation

process be reflected in the consolidated financial statement ?

 Example:

Parentco, a US-based company, establishes a wholly owned subsidiary,

foreignco, in foreign country on January 1 by investing US$600 when the

exchange rate between the U.S. dollar and foreign currency (FC) is

FC1=US$1.00 the equity investment of US$600 is physically converted into

FC600. In addition foreignco borrows FC400 from the local bank on January2.

Foreignco purchases inventory that costs FC900 and maintains FC100 in cash

Foreignco’s operating balance sheet appears as follows:

 Cont…

Foreignco

Opening Balance Sheet

Cash--------------------------------- FC 100 Liabilities---------------------------- FC 400

Inventory---------------------------- 900 Common Stock--------------------- 600

Total--------------------------------- FC 1000 Total---------------------------------- FC 1000

 Cont…

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

balances on Foriegnco’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:

Consolidation worksheet at date of Acquisition for parentco and its subsidiary foreignco

Consolidated

parento Balance sheet

Foreignco______________________Elimination_____________ US$

US$ FC Exchange Rate US$ Dr Cr

Inventory 600 ------ (1)600* 0

Cash (600) 100 $1.00 100 (500)

Inventory Xx 900 $1.00 900 900

Total xxx 1,000 1,000 400

Liabilities Xx 400 $1.00 400 400

Common Xx 600 $1.00 600 (1)600 0_

Stock

Total xxx 1,000 1,000 400__

*the elimination entry eliminates parentco’s investment in subsidiary account against Foreignco’s common stock
account.
 Three months later

• During the period January1to March31, foreignco 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.

• In preparing March 31 interim consolidated financial statements, parentco now

must choose between the current exchange rate of US1.2 0 and the past

(historical) exchange rate of US$1 to translate foreignco’s balance sheet into

US$ . foreignco’s stockholders’ equity must be translated at the historical rate

of US$1
 Cont…

so parentco’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.

• All assets and liabilities are translated at the current exchange rate (the

spot exchange rate on the balance sheet date).

• Some assets and liabilities are translated at the current exchange rate and

other assets and liabilities are translated at historical exchange rate .

 All Assets and Liabilities Are Translated at the
Current Exchange Rate

• If the first approach is adopted, in which all assets and liabilities are

translated at current exchange rate, the consolidation worksheet on

March31 would appear as follows:

Consolidation worksheet three months after date of acquisition for parentco and its subsidiary foreignco

Change in Eliminations consolidated

Foreignco________________ US$

Parentco FC Exchange US$ Value since Dr Cr Balance sheet

US$ Rate January 1 US$

Inventory 600 --- 600 0

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

Inventory Xx 900 $1.20 1,080 +180 1080

Total xxx 1,000 1,200 +200 600

Liabilities Xx 400 $1.20 480 +80 480

Common xx 600 $1.00 600 ___0 600 ___0_

Stock

Total xxx 1,000 1,080 +80 480

Translation 120 +120 120

adjustments

Total 1,200 +200 600

 Cont…

• $20 gain on cash + $180 gain on inventory - $80 loss on liabilities = $120 net

gain

• The net foreign exchange gain(positive translation adjustment) is unrealized,

that is, it does not result in a cash inflow of US$ 120 for parentco. However,

the gain can be realized by selling foreignco at the book value of its net assets

( FC600) and converting the proceeds in to US dollars at current exchange

rate (FC 600*$1.200=US$720). In that case parentco would realize again

from the sale of its investment in foreingco that would be due solely to mthe

appreciation in value of the foreign currency:

 Cont…

Proceeds from the sale ------------------------------------------------- $720

Original investment ---------------------------------------------------- 600

Realized gain ----------------------------------------------------------- $120

 Monetary assets and liabilities are translated

• Now assume that only monetary assets (cash and receivables) and

monetary liabilities (most liabilities) are translated at the current exchange

rate. The worksheet to translate foreignco’s financial statements into U.S.

dollars on March 31 appears as follows:

Consolidation worksheet three months after date of acquisition for parentco and its subsidiary
foreignco
Change in Eliminations consolidated
Foreignco______________ US$ Value
Parentco FC Exchange US$ since Dr Cr Balance sheet
US$ Rate January 1 US$

Inventory 600 --- 600 0

Cash (600) 100 $1.20 120 +20 (480)
Inventory Xx 900 $1.00 900 0 900
Total xxx 1,000 1,020 +20 420
Liabilities Xx 400 $1.20 480 +80 480
Common xx 600 $1.00 600 ___0 600 ___0_
Stock
Total xxx 1,000 1,080 +80 480
Translation (60) -60 (60)
adjustments

Total 1,020 +20 420

 Cont…

• The translation adjustment is analogous to the net foreign exchange gain or

loss caused by a change in the exchange rate:

$20 gain on cash - $80 loss on liabilities = $60 net loss

• This net foreign exchange loss (negative translation adjustment) also is

unrealized. However, the loss can be realized through the following

process:
 Cont…

 The subsidiary uses its cash (FC100) to pay its liabilities to the extent

possible.

 The parent sends enough U.S. dollars to the subsidiary to pay its remaining

liabilities (FC300). At January 1, the parent would have sent US$300 to

pay FC300 of liabilities (at the $1.00/FC1exchange rate). At March31, the

parent must send US$360 to pay FC300 of liabilities (at the $1.20/FC1

exchange rate). A foreign exchange loss (negative translation adjustment)

of US$60(US$360-US$300) arises on the net monetary liability position

because the foreign currency has appreciated from January 1to March31.
 Balance sheet Exposure

Foreign currency (FC)__________

Balance sheet exposure Appreciates Depreciates

Net assets Positive translation adjustment Negative translation adjustment

Net liabilities Negative translation adjustment Positive translation adjustment

 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

4. The current rate ( or closing rate ) method.

 Current / noncurrent method

The rules for the current / noncurrent method are as follows:

• Current assets and liabilities are translated at the current exchange rate.

• Noncurrent assets and liabilities and stockholders’ equity accounts are

translated at historical exchange rates.

• There is no theoretical basis for this method.

• Method is seldom used in any countries and is not allowed by U.S. GAAP

or IFRS.
 Monetary / nonmonetary

• Monetary assets and liabilities are translated at the current exchange rate.

• Nonmonetary assets and liabilities and stockholders’ equity accounts are

translated at historical exchange rates.

• 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.
 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 the

time of the transaction.

 Current rate method

• The fundamental concept underlying the current rate method the

current rate is the that a parent’s entire investment in a foreign

operation is exposure to foreign exchange risk and translation of the

foreign operation’s financial statements should reflect this risk. To

measure the net investment’s exposure to foreign exchange risk:

• All assets and liabilities are translated at the current exchange rate.

• Equity accounts are translated at historical exchange rates.

 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. At the end of the first year of operations, foreign currency

(FC) retained earnings are translated as follows:

Net income in FC Translated per method = + Net income in PC
used to translate income
statement items

-Dividends in FC Historical exchange rate = - Dividends in PC

× when declared

Ending R/E in FC Ending R/E in PC

 EXHIBIT 7.1

Balance sheet
Exchange rate used under the Exchange rate used under the
current rate method temporal method
Assets
Cash and Receivables Current Current
Marketable securities Current Current*
Inventory at market Current Current
Inventory at cost Current Historical
Prepaid expanse Current Historical
Property, plant, and equipment Current Historical
Intangible assets Current Historical
Liabilities
Current liabilities Current Current
Deferred income Current Historical
Long-term debt Current Current
Stockholder’s equity
Capital stock Historical Historical
Additional paid-in capital Historical Historical
Retained earnings Historical Historical
Dividends Historical Historical
*under IAS 39 and SFAS 105, marketable security classified as hold-to-maturity are carried at cost and
therefore are translated at historical exchange rate under temporal method.
 Cont…
Income statements

Exchange rate used Exchange rate used

under the current rate under the temporal
method method

Revenue Average Average

Most expense Average Average

Cost of goods sold Average Historical

Depreciated of property, Average Historical

plant, and equipment

Amortization of Average Historical

intangible
 Cont…

• The ending parent currency retained earnings in year 1 becomes the

beginning parent currency retained earnings for year 2 and the translated

retained earnings in year2( and subsequent years) is then determined as

follows:
Beginning R / E in FC (from last year’s = Beginning R / E in PC
translation)

Net income in FC Translated per method = + Net income in FC

used to translate
income statement
items

-Dividends in FC × Historical exchange = - Dividends in PC

rate when declared

Ending R/E in PC Ending R/E in PC

 Complicating aspects of the temporal method

• Under the temporal method, it is necessary to keeping a record of the

exchange rates that exist when acquiring inventory, prepaid expenses,

fixed assets, and intangible assets because these assets, carried at

historical cost, are translated at historical exchange rates. Keeping track of

the historical rates for these assets is not necessary under the current rate

method. Translating these assets at historical rates makes the application

of the temporal method more complicated than the current rate method.
 Calculation of Cost of Goods Sold

• Under the current rate method, cost of goods sold (COGS) in foreign currency

• (FC) is simply translated using the average-for-the-period exchange rate (ER):

• COGS in FC × Average ER = COGS in PC

• Under the temporal method, COGS must be decomposed into beginning inventory,

purchases, and ending inventory and each component of COGS must then be translated

at its appropriate historical rate. For example, if a company acquires beginning

inventory (FIFO basis) in the year 2011 evenly throughout the fourth quarter of 2010,

then it uses the average exchange rate in the fourth quarter of 2010 to translate

beginning inventory. Likewise, it uses the fourth quarter (4thQ) 2011 exchange rate to
 Cont…

• inventory. When purchases can be assumed to have been made evenly

throughout 2011, the average 2011 exchange rate is used to translate

purchases:

Beginning inventory in FC × Historical ER ( e.g., 4thQ year1) = Beginning inventory in PC

+ Purchases in FC × Average ER, year 2 = + Purchases in PC

- Ending inventory in FC × Historical ER(e.g., 4thQ = -Ending inventory in PC

year2)

COGS in FC COGS in PC
 There is no single exchange rate can be used to directly translate COGS in FC
into COGS in PC

Application of the Lower-of-Cost-or-Market Rule

• Under the current rate method, the ending inventory reported on the
foreign currency balance sheet is translated at the current exchange rate
regardless of whether it is carried at cost or a lower market value.
Application of the temporal method requires the inventory’s foreign
currency cost and foreign currency market value to be translated into U.S.
dollars at appropriate exchange rates, and the lower of the dollar cost and
dollar market value is reported on the consolidated balance sheet. As a
result, inventory can be carried at cost on the foreign currency balance
sheet and at market value on the U.S. dollar consolidated balance sheet,
and vice versa.
 Fixed Assets, Depreciation, and Accumulated
Depreciation
• The temporal method requires translating fixed assets acquired at different times at different

(historical) exchange rates. The same is true for depreciation of fixed assets and

accumulated depreciation related to fixed assets.

• For example, assume that a company purchases a piece of equipment on January 1, year1,

for FC 1,000 when the exchange rate is $1.00 per FC1. Another item of equipment is

purchased on January 1, year2, for FC 4,000 when the exchange rate is $1.20 per FC1. Both

pieces of equipment have a five-year useful life. Under the temporal method, the amount at

which equipment would be reported on the consolidated balance sheet on December 31,

year2, when the exchange rate is $1.50 per FC1, as follows:

FC 1,000 × $1.00 = $1,000

FC 4,000 × $1.20 = $4,800

FC5,000 $5,800
Depreciation expense for year2 under the temporal method would be
calculated as shown here:

FC200 × $1.00 = $200

FC800 × $1.20 = $960

FC1,000 $1160
Accumulated depreciation at December 31, year 2, under the temporal method
would be calculated as follows:

FC 400 × $1.00 = $400

FC 800 × $1.20 = $960

FC1,200 $1360
Similar procedures apply for intangible assets as well.

The current rate method, equipment would be reported on

the December 31, year2, balance sheet at FC 5,000 ×

$1.50 = $7500. Depreciation expense would be translated

at the average exchange rate of $1.40, FC 1,000 × $1.40 =

$1,400, and accumulated depreciation is FC 1,200 × $1.50

= $1,800.
 DISPOSITION OF TRANSLATION ADJUSTMENT

• The first issue related to the translation of foreign currency financial statements is

selecting the appropriate method. The second issue in financial statement translation

relates to deciding where to report the resulting translation adjustment in the

consolidated financial statements.

• There are two prevailing schools of thought with regard to this issue:

1. Translation gain or loss: This treatment considers the translation adjustment to be a gain

or loss analogous to the gains and losses arising from foreign currency transactions and

reports it in net income in the period in which the fluctuation in the exchange rate occurs.
 Cont…

• The first of two conceptual problems with treating translation adjustments

as gains or losses in income is that the gain or loss is unrealized; that is,

no cash inflow or outflow accompanies it. The second problem is that the

gain or loss could be inconsistent with economic reality. For example, the

depreciation of a foreign currency can have a positive impact on the

foreign operation’s export sales and income, but the particular translation

method used gives rise to a translation loss.

 Cont…

2. Cumulative translation adjustment in other comprehensive income: The

alternative to reporting the translation adjustment as a gain or loss in net

income is to include it in Other Comprehensive Income. In effect, this

treatment defers the gain or loss in stockholders’ equity until it is realized in

some way. As a balance sheet account, the cumulative translation adjustment

is not closed at the end of an accounting period and fluctuates in amount over

time.
The two major translation methods and the two possible treatments for the translation adjustment give rise to

these four possible combinations:

Combination Translation Method Treatment of

Translation
Adjustment
A Temporal Gain or loss in Net
Income
B Temporal Deferred in Other
Comprehensive Income
C Current rate Gain or loss in Net
Income
D Current rate Deferred in Other
Comprehensive Income
• END