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Chapter 7

Translation of Foreign Currency

Financial Statements
Timothy Doupnik | Mark Finn Giorgio Gotti

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill
 Learning Objectives
• Describe the conceptual issues involved in translating
foreign currency financial statements.
• Explain balance sheet exposure and how it differs from
transaction exposure.
• Describe the concepts underlying the current rate and
temporal methods of translation.
• Apply the current rate and temporal methods of translation
and compare the results.
• Describe the requirements of applicable International
Financial Reporting Standards (IFRS) and U.S. generally
accepted accounting principles (GAAP).
• Discuss hedging of balance sheet exposure.
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 Two Conceptual Issues 1

Issues in translating foreign currency financial statements

into the parent company’s reporting currency:
1. What is the appropriate exchange rate to be used in
translating each financial statement item?
2. How should the translation adjustment that inherently
arises from the translation process be reflected in the
consolidated financial statements?

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 Two Conceptual Issues 2

Two approaches exist for translating the subsidiary’s assets

and liabilities:
1. All assets and liabilities translated at the current exchange
rate (the spot exchange rate on the balance sheet date).
2. Some assets and liabilities translated at the current
exchange rate, and other assets and liabilities are
translated at historical exchange rates (the exchange
rates that existed when the assets and liabilities were
acquired or incurred).

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 All Assets and Liabilities Are Translated at the
Current Exchange Rate
If subsidiary currency appreciates against parent currency.
Assets will be written up.
Liabilities will also be written up.
Adjustment needed to equity so balance sheet balances:
• Net asset position: assets > liabilities adjustment.
• Increases parent equity.

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 Monetary Assets and Liabilities Are Translated
at the Current Exchange Rate
If subsidiary currency appreciates against parent currency
and the subsidiary has a net monetary asset position
(monetary assets > monetary liabilities):
• Parent equity increases, but not through the income
statement.

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 Balance Sheet Exposure 1

• Assets and liabilities translated at the current exchange

rate are exposed to the risk of a translation adjustment.
• When foreign currency appreciates, a net asset exposure
results in a positive translation adjustment.
• When foreign currency appreciates, a net liability exposure
results in a negative translation adjustment.
• Assets and liabilities translated at the historical exchange
rate are not exposed to a translation adjustment.

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 Balance Sheet Exposure 2

• Transaction exposure gives rise to foreign exchange gains

and losses that are ultimately realized in cash; translation
adjustments that arise from balance sheet exposure do not
directly result in cash inflows or outflows.
• Net asset balance sheet exposure: assets translated at
current exchange rate exceed liabilities translated at
current exchange rate.

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 Translation Methods: Temporal Method 1

Temporal Method:
• Objective is to translate financial statements.
• As if the foreign subsidiary had been using the parent’s
currency.
• Items carried on the subsidiary’s books at historical cost.
• Including all stockholders’ equity items, and
nonmonetary assets and nonmonetary liabilities.
• Items carried on the 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.

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 Translation Methods: Temporal Method 2

Inventory is shown at lower of cost or market.

• If at cost: historic rate.
• If at market: current exchange rate.

Cost of goods sold: use rate for inventory.

Usually, liabilities exceed monetary assets, so most firms
have net liability balance sheet exposure with temporal
method.

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 Translation Methods: Current Rate Method

Current Rate Method.

• Objective is to reflect that the parent’s entire investment in
a foreign subsidiary is exposed to exchange risk.
• All assets and liabilities are translated at the current
exchange rate.
• Equity accounts are translated at historical exchange rates.
• Revenues and expenses are translated at the exchange
rate in effect at the date of accounting recognition.

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 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.
• Normally, have a net asset position (assets > liabilities).

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 Translation of Retained Earnings: First Year

• Net income FC translated to net income parent currency.

• Dividend FC translated to PC using rate on the dividend
declaration date.
• Gives: the ending retained earnings PC.

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 Translation of Retained Earnings: Subsequent
Years
• Use beginning R/E parent currency (last year’s ending
R/E).
• Add net income translated from FC to PC.
• Subtract dividends using historic rate on the dividend
declaration date.
• Gives: the ending R/E parent currency.

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 Complicating Aspects of the Temporal Method 1

Keeping track of the historical rates for inventory; prepaid

expenses; property, plant, and equipment; and intangible
assets is necessary under the temporal method but not
under the current rate method.
• Translating these assets at historical rates makes
application of the temporal method more complicated than
the current rate method.
Calculation of Cost of Goods Sold (COGS).
• Current rate method:
• COGS in FC × average exchange rate = COGS Parent
Currency.

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 Complicating Aspects of the Temporal Method 2

Calculation of Cost of Goods Sold (COGS).

• Temporal method:
• Beginning inventory parent currency is last year’s ending
inventory parent currency.
• Purchases are converted from foreign currency to parent
currency using the average exchange rate during year.
• Ending inventory converted from foreign currency to
parent currency using the average exchange rate in
Quarter 4.
• Since everything is now in parent currency, simply
determine COGS normally.

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 Complicating Aspects of the Temporal Method 3

Application of the Lower of Cost or Net Realizable Value

Rule.
• Current rate method: use current rate to convert to parent
currency, regardless of whether carried at cost or at a
lower net realizable value.
• Temporal method:
• Calculate value of inventory both methods using foreign
currency.
• Convert to parent currency both methods.
• Use lower value as parent currency amount.

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 Complicating Aspects of the Temporal Method 4

Property, Plant, and Equipment, Depreciation, and

Accumulated Depreciation.
• Use historical cost when asset is acquired so assets will be
converted at different rates.
• Depreciation expense: use historic rate for each asset to
convert expense from foreign to parent currency.
• Accumulated depreciation: use historic rate for each asset
to convert to parent currency.

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 Disposition of Translation Adjustment 1

1. Translation gain or loss in net income.

• Translation adjustment is considered to be a gain or loss
analogous to the gains and losses that arise from foreign
currency transactions.
• Should be reported in income in the period in which the
fluctuation in exchange rate occurs.
• Two conceptual problems:
• Changes in net income when unrealized.
• The gain or loss may not be consistent with economic
reality.
• For example, declining foreign currency is a loss but may make
foreign company more competitive.
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 Disposition of Translation Adjustment 2

2. Cumulative translation adjustment in stockholders’ equity.

• The alternative to reporting the translation adjustment as a
gain or loss in net income is to include it in stockholders’
equity as a component of other comprehensive income.
• This treatment defers the gain or loss in stockholders’
equity until it is realized in some way.

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 U.S. GAAP
FASB ASC 830, Foreign Currency Matters (formerly SFAS
52, Foreign Currency Translation), is the relevant accounting
standard.
Requires identification of functional currency.
• Functional currency is the primary currency of the foreign
subsidiary’s operating environment.
The standard includes a list of indicators as guidance for the
foreign currency decision.
When the functional currency is the U.S. dollar, the temporal
method is required.
When the functional currency is foreign currency, the current
rate method is required.
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 U.S. GAAP Requirements
Highly Inflationary Economies.
• U.S. GAAP defines such economies as those whose
cumulative three–year inflation exceeds 100 percent (with
compounding, this equates to an average of 26% per year
for three years in a row).
• Temporal method is required–translation gains/losses are
reported in income.

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 International Financial Reporting Standards

IAS 21, The Effects of Changes in Foreign Exchange Rates,

is the relevant accounting standard.
Uses the functional currency approach developed by the FA
SB.
The standard includes a list, similar to the FASB list, of
indicators as guidance for the foreign currency decision.
The standard’s requirements pertaining to hyperinflationary
economies are substantially different from U.S. GAAP.
• Restate foreign statements for inflation then convert to
parent currency using current exchange rate.

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 IFRS: Factors Considered in Determining the
Functional Currency 1

1. The currency that primarily influences sales prices for

goods/services
2. The currency of the country whose competitive forces and
regulations primarily determine sales prices.
3. The currency that primarily affects the cost of providing
goods/services.
4. The currency in which funds from financing activities
received.

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 IFRS: Factors Considered in Determining the
Functional Currency 2

5. The currency in which receipts from operating activities

areretained.
6. Whether the activities of the foreign entity are carried out
with significant autonomy or are an extension of the
parent company.
7. Whether the transactions with the parent company are a
large or small proportion of the foreign entity’s activities.
8. Whether cash flows of the foreign entity directly affect the
parent company’s cash flows and are available to be
remitted to the parent.
9. Whether foreign cash flows are sufficient to service debt
or if parent funds will be needed.

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 The Translation Process Illustrated 1

• Multico (a U.S. –based company) owns Italco, a subsidiary

in Italy, which was established December 31, Year 0 when
Multico invested $1,350,000 [$1.35 = 1 Euro]. Italco
immediately purchased inventory for 600,000 Euros.
• Italco’s balance sheet items as of 12/31/0, in Euros:

Assets € Liabilities and Equity €

Cash 400,000 Capital stock 1,000,000
Inventory 600,000

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 The Translation Process Illustrated 2

Italco’s Income Statement for Year 1, in Euros:

€
Sales 8,000,000
CO GS 6,000,000
Gross profit 2,000,000
Selling and administrative expenses 500,000
Depreciation expense 200,000
Amortization expense 20,000
Interest expense 180,000
Income before income taxes 1,100,000
Income taxes 275,000
Net Income 825,000

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 The Translation Process Illustrated 3

Italco’s Statement of Retained Earnings for Year 1:

€
Retained earnings, 1/1/Y1 0
Net income, Y1 825,000
Less: Dividends, 12/1/Y1 (325,000)
Retained earnings, 12/31/Y1 500,000

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 The Translation Process Illustrated 4

Italco’s Balance Sheet December 31, Year 1:

Assets € Liabilities and Equity €

Cash 550,000 Accounts payable 330,000
Accounts receivable 600,000 Long–term debt 2,000,000
Inventory (FIFO) 800,000 Capital stock 1,000,000
Property and equipment 2,000,000 Retained earnings 500,000
Less: Accumulated depreciation (200,000) Total 3,830,000
Patents, net 80,000
Total assets: 3,830,000

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 The Translation Process Illustrated 5

Relevant exchange rates:

January 1, Year 1 $1.35 = 1 euro

Rate when property and equipment acquired and $1.33 = 1 euro
long–term debt incurred, January 15, Year 1
Rate when patent acquired, February 1, Year 1 $1.32 = 1 euro
Average Year 1 $1.30 = 1 euro
Rate when dividends declared, 12/1/Y1 $1.27 = 1 euro
Average for the month of December $1.26= 1 euro
December 31, Year 1 $1.25 = 1 euro

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 Translation of Financial Statements: Current
Rate Method 1

• Revenues/Expenses: use weighted average for Year 1.

• Gains/Losses: use rate when event happened.
• Assets/Liabilities: use spot rate on balance sheet date.
• Dividends: use rate on date declared.
• Paid in capital (equity) historic rate.
• R/E (discussed earlier).
• Use foreign currency translation adjust to balance balance
sheet (Part of AOCI).

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 Translation of Financial Statements: Current
Rate Method 2

Income Statement Year 1 (in thousands).

€ Translation Rate US$
Sales 8,000 $ 1.30 (A) 10,400
C OGS 6,000 1.30 (A) 7,800
-------- --------
Gross profit 2,000 2,600
Selling and administrative expenses 500 1.30 (A) 650
Depreciation expense 200 1.30 (A) 260
Amortization expense 20 1.30 (A) 26
Interest expense 180 1.30 (A) 234
------- ------
Income before income taxes 1,100 1,430
Income taxes 275 1.30 (A) 357.5
-------- -------
Net income 825 1,072.5

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 Translation of Financial Statements: Current
Rate Method 3

Statement of Retained Earnings Year 1

€ Translation Rate US$
Retained earnings, 1/1,Y1 0 0
Net income, Year 1 825,000 From income statement 1,072,500
Less: Dividends, 12/1/Y1 (325,000) $ 1.27 (H) (412,750)
------------ -------------
Retained earnings, 12/31/Y1 500,000 659,750

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 Translation of Financial Statements: Current
Rate Method 4

Balance Sheet December 31, Y1 (in thousands)

Assets € Translation Rate US$
Cash 550 $ 1.25 (C) 687.5
Accounts receivable 600 1.25 (C) 750
Inventory 800 1.25 (C) 1,000
Property and equipment 2,000 1.25 (C) 2,500
Less: Accumulated depreciation (200) 1.25 (C) (250)
Patents, net 80 1.25 (C) 100
--------- ------------
Total assets 3,830 4,787.5

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 Translation of Financial Statements: Current
Rate Method 5

Balance Sheet (in thousands) (Continued)

Liabilities and Equity € Translation Rate US$

Accounts payable 330 $ 1.25 (C) 412.5

Long-term debt 2,000 1.25 (C) 2,500.0
-------- ----------
Total liabilities 2,330 2,912.5
Capital stock 1,000 1.35 (H) 1,350.0
Retained earnings 500 From statement r/e 659,750
Cumulative translation adjustment To balance (134,750)
-------- -----------
Total 3,830 4,787.5

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 Translation of Financial Statements: Current
Rate Method 6

Five steps to calculate translation adjustment.

1. The net asset balance at the beginning of the year is translated at the
exchange rate on that date.
2. Individual increases and decreases in the net asset balance are translated at
the rates in effect when those increases and decreases occur.
3. The translated beginning net asset balance and translated value of the
individual changes are combined to arrive at the relative value of the net
assets being held prior to the impact of any exchange rate fluctuations.
4. The ending net asset balance is then translated at the current exchange rate
to determine the reported value after all exchange rate changes have
occurred.
5. The translated value of the net assets prior to any rate changes is compared
with the ending translated value. The difference is the result of exchange rate
changes during the period. If net assets prior to any rate changes exceeds
the ending translated value, a negative (debit) translation adjustment arises.

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 Computation of Translation Adjustment

€ Rate US$
Net asset balance, 1/1/Y1 1,000,000 $ 1.35 = 1,350,000
Change in net assets:
Net income, Year 1 825,000 1.30 = 1,072,500
Dividends, 12/1/Y1 (325,000) 1.27 = (412,750)
Net asset balance, 12/31/Y1 1,500,000 2,009,750
Net asset balance,
12/31/Y1, at current rate 1,500,000 1.25 = 1,875,000
Translation adjustment, Year 1
(negative) 134,750

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 Remeasurement of Financial Statements:
Temporal Method 1

Balance Sheet December 31, Y1

Assets € Rate US$

Cash 550,000 $ 1.25 (C) 687,500
Accounts receivable 600,000 1.25 (C) 750,000
Inventory 800,000 1.26 (H) 1,008,000
Property and equipment 2,000,000 1.33 (H) 2,660,000
Less: Accumulated depreciation (200,000) 1.33 (H) (266,000)
Patents, net 80,000 1.32 (H) 105,600
------------ -----------
Total assets 3,830,000 4,945,100

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 Remeasurement of Financial Statements:
Temporal Method 2

Balance Sheet December 31, Y1 (Continued)

Liabilities & Equity € Rate US$

Accounts payable 330,000 $1.25 (C) 412,500
Long-term debt 2,000,000 1.25 (C) 2,500,000
Capital stock 1,000,000 1.35 (H) 1,350,000
Retained earnings 500,000 To balance 682,600
Total 3,830,000 4,945,100

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 Remeasurement of Income Statement 1

Income Statement Year 1

€ Rate US$
Sales 8,000,000 $ 1.30 (A) 10,400,000
COGS 6,000,000 Calculation 7,862,000
-------------- (see below) ----------------
Gross profit 2,000,000 2,538,000
Sell and Adm 500,000 1.30 (A) 650,000
Depreciation expense 200,000 1.33 (H) 266,000
Amortization expense 20,000 1.32 (H) 26,400
Interest expense 180,000 1.30 (A) 234,000
Income before taxes 1,100,000 1,361,600
Income taxes (275,000) 1.30 (A) (357,500)
Remeasurement gain To balance 91,250
Net income 825,000 1,095,350

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 Remeasurement of Income Statement 2

Statement of Retained Earnings Year 1

€ Rate US$
Retained earnings, 1/1/Y1 0 0
Net income, Year 1 825,000 From income
statement 1,095,350
Less: Dividends, 12/1/Y1 (325,000) 1.27 (H) (412,750)
Retained earnings, 12/31/Y1 500,000 682,600

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 Computation of Remeasurement Gain
€ Rate US$
Net monetary assets, 1/1/Y1 400,000 $ 1.35 = 540,000
Increase in monetary items:
Sales, Year 1 8,000,000 1.30 = 10,400,000
Decrease in monetary items:
Purchases of inventory, Year 1 (6,200,000) 1.30 = (8,060,000)
Selling and administrative expenses, Year 1 (500,000) 1.30 = (650,000)
Payment of interest, Year 1 (180 000) 1.30 = (234,000)
Incomes taxes, Year 1 (275,000) 1.30 = (357,500)
Purchase of property and equipment, 1/15/Y1 2,000,000 1.33 = (2,660,000)
Acquisition of patent, 2/1/Y1 (100,000) 1.32 = (132,000)
Dividends, 12/1/Y1 (325,000) 1.27 = (412,750)
------------- ---------------
Net monetary liabilities, 12/31/Y1 (1,180,000) = (1,566,250)
Net monetary liabilities at current rate (1,180,000) 1.25 = (1,475,000)
Remeasurement gain (91,250)

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 Temporal and Current Rate Methods
Translation Methods Illustrated–Summary.
• Current Rate Method:
• All assets and liabilities are translated at current rate.
• This results in net asset exposure.
• Net asset exposure and devaluing foreign currency results in translation
loss.
• Translation adjustment included in equity.
• Temporal Method:
• Primarily monetary assets and liabilities are translated at current rate.
• This results in net liability exposure.
• Net liability exposure and devaluing foreign currency result in translation
gain.
• Translation gain included in current income.

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 Comparison of the Results from Applying the
Two Different Translation Methods

Translation Method
Current Rate Temporal Difference
Net income $1,072,500 $1,095,350 2.1%
Total assets $4,787,500 $4,945,100 3.3%
Total equity $1,875,000 $2,032,600 8.4%
Return on ending equity 57.2% 53.9% 5.8%

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 Underlying Relationships

US$
Ratio € Current Temporal
Current ratio 5.91 5.91 5.93
Debt/equity ratio 1.55 1.55 1.43
Gross profit ratio 25.0% 25.0% 24.4%
Return on equity 55.0% 57.2% 53.9%

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 Hedging Balance Sheet Exposure
Companies that have foreign subsidiaries with highly integrated
operations use the temporal method.
• The temporal method requires translation gains and losses to be
recognized in income.

Losses negatively affect earnings, and both gains and losses

increase earnings volatility.
• These gains and losses result from the combination of
exchange rate fluctuations and balance sheet exposure.
No control over exchange rate but companies can hedge balance
sheet exposure by creating equilibrium of foreign currency assets
and foreign currency liabilities.
Companies can hedge against gains and losses by using foreign
currency forward contracts, options, and borrowings.
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 Disclosures Related to Translation
Under both GAAP and IFRS, companies are required to
provide analysis of change in cumulative translation
adjustment.
• In the U.S., this is done through the statement of
comprehensive income.

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