CHAPTER 13

Translation of Financial Statements of Foreign Affiliates

BRIEF OUTLINE
13.1 Accounting for Operations in Foreign Countries
13.2 Translating Financial Statements of
Foreign Affiliates
13.3 Objectives of Translation – SFAS No. 52
13.4 Translation Methods
13.5 Identifying the Functional Currency
13.6 Translation of Foreign Currency Financial Statements
13.7 Translation of Foreign Financial Statements Illustrated
13.8 Financial Statement Disclosure
13.9 Historical Developments of Accounting Standards
Appendix: Accounting for a Foreign Affiliate and Preparation
of Consolidated Statement Workpaper Illustrated
(Available online at www.wiley.com/collete/jeter)

INTRODUCTION

In the last chapter we discussed individual transactions with foreign businesses. In this chapter we will
discuss how to consolidate a foreign subsidiary. There are a number of problems in this, most especially
what exchange rate must be used to translate the numbers in the trial balances. Again, there are many new
terms with specific definitions of which you should take special note.

CHAPTER OUTLINE

13.1 Accounting for Operations in Foreign Countries

A. General rules
1. If a company owns a foreign subsidiary, it must be consolidated unless
a. Control is temporary
b. Control doesn’t rest with P – usually there are foreign government restrictions
limiting a foreign company’s control
2. If a company has a foreign investee (20 – 50%), the equity method should be used unless
there are too many restrictions
B. The rules can be difficult to follow
1. There can be many differences in accounting principles between P’s country and S’s
country
2. Financial statement structure might not be comparable from one country to another
13.2 Translating Financial Statements of Foreign Affiliates
A. The foreign affiliate will generally use the local currency – the currency in its own country
1. The local currency must be converted to US$ – translation
2. Translation can be defined in two ways
a. Any restatement of foreign currency (FC) into P’s currency
b. A specific method of restatement as defined by FASB – we’ll study this more later
3. The process of translation means that all S’s financial information in FC is changed to
reporting currency (US$) so it can be combined with P’s records
B. Another concern in translation is how to determine which exchange rate to use
1. Current exchange rate – the spot rate
2. Historical exchange rate – the spot rate on the date the original transaction occurred
C. Translation adjustment or translation gain or loss
1. If different exchange rates are used to translate amounts on a set of financial statements,
those statements won’t balance any more
2. The amount needed to restore balance is the translation adjustment
3. The translation adjustment can be
a. Included as a part of income
Study Guide to accompany Jeter and Chaney’s Advanced Accounting

b. Included as a part of equity

13.3 Objectives of Translation
A. Functional currency concept
1. Provide information that is compatible with the exposed economic effects of the
exchange rate
a. This means that the translation should reflect the economic reality and the exchange
rate
b. If the exchange rate is favorable it should affect the financial statements favorably,
and vice versa
2. Reflect in the consolidated statements the results of the affiliates’ transactions
a. The affiliated group is a multi-enterprise
b. The foreign entity operates in a different environment from the U.S. corporations
c. The functional currency best reflects economic reality
13.4 Translation methods
A. Current rate method
1. All assets and liabilities are translated using the current rate
2. Revenues and expenses are translated using an average rate for the current accounting
period – a reasonable estimation of the current exchange rate for each transaction!
B. Temporal method
1. Monetary assets (cash and receivables) and liabilities (payables) are translated at the
current rate
2. Assets and liabilities carried at historical cost are translated at the historical exchange rate
3. Assets and liabilities carried at current value (inventory and marketable securities) are
translated at current value
4. Revenues and expenses are translated at average, except those expenses that connect with
historical cost assets (depreciation), which are translated at historical cost
13.5 Identifying the Functional Currency
A. Functional currency may be
1. Local currency (where the business is domiciled)
2. The US$ (the reporting currency)
3. Currency of a third country
B. How to identify which is the functional currency
1. If a foreign affiliate is independent, it uses the local currency as its functional currency
2. If the foreign affiliate is actually managed by its U.S. parent, the functional currency is
the US$
3. If the foreign affiliate is managed by a company in a third country, its functional currency
might be the currency of the third country
4. Illustration 13-1 gives some indicators for identifying the functional currency – it’s not
always easy to do
13.6 Translation of Foreign Currency Financial Statements
A. Use the flow chart in Illustration 13-2 to sort out how to handle the translation gain or loss
B. Two terms are used to define what we must do
1. Remeasurement (Temporal Method) happens when we have to change local currency
statements into the functional currency. In this case the functional currency is the parent’s
currency, or that of a third country (in which case the local currency is first remeasured
into the functional currency and then translated into the US$).
2. Translation (Current Method) should be used when the functional currency is the local
currency.
3. The term “translate” is often also used simply to refer to any conversion between
currencies.
C. Foreign entity operates in a highly inflationary economy

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 CHAPTER 13 – Translation of Financial Statements for Foreign Affiliates

1. If our foreign affiliate is in a country that’s experiencing high inflation, that affiliate’s
translated financial statements will look worse because of the change in exchange rates.
The current rate method makes the affiliate’s assets look smaller (as if they are
evaporating) even if they aren’t less useful
2. Because of this, the temporal method is used so that the functional currency becomes the
US$, since the FC has lost its utility as a store of value
D. Foreign entity operates in an economy that is not highly inflationary
1. If the local currency is the functional currency, we translate to US$ – current rate
2. If the US$ is the functional currency, we remeasure to the US$ and then don’t need to
translate – temporal method
3. If a third currency is the functional currency, we remeasure from the local currency to the
functional currency (temporal), then translate to the US$ (current rate)
13.7 Translation of Foreign Financial Statements Illustrated
A. Functional currency is the local currency – current rate method
1. Translation rules
a. All assets and liabilities translate at the current exchange rate
b. Paid-in capital accounts are translated at the historical rate – date of acquisition
c. Components of retained earnings
i. Beginning retained earnings – carry forward from last year
ii. Dividends – exchange rate on the date declared
iii. Net income – carried forward from the income statement, as translated
iv. There’s a plug (balancing) amount called cumulative translation adjustment
that’s included in equity
d. Revenues and expenses, and gains and losses are translated at the average rate for the
accounting period
2. An example of the workpaper is below
Workpaper to Translate Account Balances of Foreign Subsidiary
Current Rate Method Adjusted Translation Adjusted
Trial Balance Rate Trial
FC Balance
$
Consolidated Statement of Income and RE
Sales A
Cost of goods sold ( ) A ( )
Depreciation expense ( ) A ( )
Other expenses ( ) A ( )
Income tax expense ( ) A ( )
Net income A
1/1 Retained earnings 1/1

Less: dividends declared ( ) Dec ( )

l
12/31 Retained earnings

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Balance Sheet C
Cash C
Accounts receivable (net) C
Inventories (FIFO) C
Land C
Buildings (net) C
Equipment (net) C
Total
Accounts payable C
Short-term notes payable C
Bonds payable C
Common stock Acq
Additional paid-in capital Acq
Retained earnings (from above)
Total
Cumulative translation adjustment Plug
Total

3. An analysis of the translation adjustment

a. The translation adjustment balances the balance sheet
b. It reflects exchange rate risk
c. Verification of translation adjustment
Verification of the Translation Adjustment
Current Rate Method
Translation
FC Rate US$
1/1 Exposed asset position (net assets)
Adjustments –
Net income
(dividends) ( ) ( )
Net asset position translated using rate in effect at
date of each transaction
12/31 Exposed asset position
Change in cumulative translation adjustment
1/1 Cumulative translation adjustment (last year’s)
12/31 Cumulative translation adjustment
4. This method maintains the relationships between amounts in the FC and the US$ - the
ratios are the same
B. Statements of comprehensive income and statement of shareholders’ equity
1. The Statement of Shareholders’ Equity includes the currency translation adjustment as
another category of equity
2. Comprehensive income includes the currency translation adjustment as an increase or
decrease to comprehensive income
C. Functional currency is the U.S. dollar – temporal method
1. Remeasurement rules
a. Monetary assets and liabilities (cash, receivables and most liabilities) are translated at
the current rate

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b. Nonmonetary assets and liabilities carried at historical cost are translated at the
historical rate when the transaction occurred – the date of acquisition or date of
transaction, whichever is later
c. Nonmonetary assets carried at current or future cost (inventories, marketable
securities) are translated at current rate
d. Paid-in capital is translated at the historical rate at the date of acquisition
e. Retained earnings components
i. Beginning balance is last year’s ending balance
ii. Dividends are translated on the date of declaration
iii. Net income is translated at various rates, as stated below.
f. Revenues and expenses related to assets and liabilities carried at historical cost are
translated at the same historical rate (depreciation, amortization) as the underlying
asset or liability.
g. Other revenues and expenses are translated at the average rate

2. A workpaper is below and continues on the next page

Workpaper to Translate Account Balances of Foreign Subsidiary
Temporal Method Adjusted TB Exchange Adjusted TB
FC Rate $
Balance Sheet
Cash C
Accounts receivable (net) C
Inventories (FIFO) C
Buildings (net) H
Equipment (net) H
Total
Accounts payable C
Short-term notes payable C
Bonds payable C
Common stock acq*
Additional paid-in capital acq*
Retained earnings plug
Total
Consolidated Statement of Income
and RE
Sales A
Cost of goods sold ( ) * ( )
Depreciation expense ( ) H ( )
Other expenses ( ) A ( )
Income tax expense ( ) A ( )
Translation gain or loss __________ plug __________
Net income
1/1 Retained earnings __________ __________
Less: Dividends declared ( ) decl ( )
12/31 Retained earnings (from above)
*stock issued subsequent to acquisition is converted at the historical rate on date of
issue.

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Schedule I – Remeasurement of Cost of Goods Sold

Exchange
FC Rate US$
Beginning inventory (last year’s rate)
Add: Purchases _________ A _________

Less: Ending inventory (this year’s rate) ( ) ( )

Cost of goods sold *

3. An analysis of the translation gain or loss

Remeasurement Gain or Loss
Temporal Method
Exchange
FC Rate US$
1/1 Exposed net monetary liabilities (monetary
liabilities – monetary assets)
Adjustments for changes in net monetary position -
Less: Increases in monetary assets ( ) ( )
Decreases in monetary liabilities ( ) ( )
Add: Decreases in monetary assets
Increases in monetary liabilities
Net monetary liability position
12/31 monetary liability position
Remeasurement gain (loss)

13.8 Financial Statement Disclosure

A. Disclosure requirements
1. Aggregate remeasurement gain or loss included in net income, including gains or losses
from forward contracts
2. An analysis of the cumulative translation adjustment equity account
a. Beginning and ending balances
b. Aggregate adjustment including translation gains or losses and hedging gains or
losses
c. Income taxes for the period allocated to the account
d. Any amounts transferred to income as a result of the sale of an investment in a
foreign company
B. Significant exchange rate changes that occur after balance sheet date effect on unsettled
foreign currency transactions
C. U.S. companies must comply with the provisions of the FCPA (Foreign Corrupt Practices
Act)

13.9 Historical Developments of Accounting Standards

A. FASB’s SFAS No. 8
1. Required uniform accounting standards for the transaction of foreign financial statements
2. Attempted to fill the gap in accounting for foreign transactions
B. It was not well received
1. Reporting translation gains and losses caused net income to fluctuate unnecessarily
2. The method wasn’t necessarily consistent – it caused gains when the economic effects
were negative, or vice versa

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 CHAPTER 13 – Translation of Financial Statements for Foreign Affiliates

3. Certain effective hedges of foreign exchange risk were ignored

C. It was superceded by SFAS No. 52, the one currently in use

Appendix: Accounting for a Foreign Affiliate and Preparation of Consolidated Statement Workpaper
Illustrated (Available online at www.wiley.com/collete/jeter))

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MULTIPLE CHOICE QUESTIONS

Choose the BEST answer for the following questions.

_____ 1. How does a corporation handle a foreign subsidiary?

a. Leave it on the consolidated financial statements as an investment
b. Consolidate its statements with the parent’s
c. Include it as a special equity account
d. Add the assets and liabilities, but not the revenue or expenses

_____ 2. What is translation?

a. Any restatement of FC into P’s currency
b. A specific method of restatement as defined by FASB
c. Changing all the financial statements to the reporting currency so it can be combined with
P’s records
d. All of these

_____ 3. What is the functional currency?

a. Always the local currency
b. Always the parent’s currency
c. Can be the reporting currency or the local currency
d. The currency the statements are in

_____ 4. The functional currency concept is

a. to provide information that is compatible with economic reality
b. to reflect in the consolidated statements the results of the affiliates’ transactions
c. that the financial statements should reflect the shift in exchange rates
d. all of these

_____ 5. How does the current rate method translate capital assets?
a. At the current rate
b. At the historical rate on the date of acquisition
c. At the average exchange rate for the current year
d. At the historical rate on the date the asset was purchased by the subsidiary

_____ 6. What is the basic premise of the temporal method?

a. The accounts should all be translated at the same exchange rate
b. The accounts should be translated at the exchange rate that most closely fits their
economic substance
c. The accounts should all be translated at the historical rate
d. The accounts should all be translated at the current rate

_____ 7. How does high inflation affect a foreign subsidiary’s translation to US$?
a. The level of inflation has no impact on FC translation
b. P has the option of choosing the current method or the temporal method
c. P must use the temporal method
d. P must use the current method

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 CHAPTER 13 – Translation of Financial Statements for Foreign Affiliates

_____ 8. What is remeasurement?

a. Changing the functional currency to the US$
b. Changing the local currency to the functional currency
c. Changing the local currency to the reporting currency
d. Changing the reporting currency into the local currency

_____ 9. What is the cumulative translation adjustment?

a. The equity account which shows the effects of foreign currency translation over the life
of the business combination
b. The difference between net income in FC and net income in US$
c. The asset account used to balance financial statement translation
d. All of these

_____10. How is shareholders’ equity affected by foreign currency translation?

a. In the temporal method, it is not adjusted
b. In the restatement method, it is adjusted for translation gain or loss
c. In the current method, a separate account lists the changes due to translation
d. In the functional concept, it is always a gain

_____11. How are monetary assets translated under the temporal method?
a. Historical exchange rate
b. Current rate
c. Rate at acquisition
d. Average rate for the year

_____12. What is the difference between the current method and the temporal method in translating
expenses?
a. There is no difference, except for depreciation
b. Temporal translates at historical rate, when known (otherwise average), while current
translates all at weighted average
c. Current translates at current rate
d. Both use the current rate

_____13. How would a parent company which owned a Canadian subsidiary which had branches in
Mexico handle statements of the Mexican branch?
a. Translate
b. Restate
c. Restate then translate
d. Translate then restate

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MATCHING

Match the terms in the list to the definitions below. Each term may be used only once.

A. Translation F. Local currency

B. Restatement G. Functional currency
C. Temporal method H. Translation gain or loss
D. Current rate method I. FASB ASC subtopic 830-30
E. Reporting currency J. Cumulative translation adjustment

_____ 1. The currency of the country in which the company is domiciled

_____ 2. Changing FC to the currency of the financial statements

_____ 3. The FASB document which outlines the rules for translation

_____ 4. Changing FC to the currency which best reflects financial reality

_____ 5. The result of changing the financial statements from FC to US$

_____ 6. The currency used on the financial statements

_____ 7. A technique to restate the financial records to the functional currency

_____ 8. The currency which provides information most compatible with the economic effects of
exchange rate differences

_____ 9. The translation method which changes the functional currency to the reporting currency

_____10. The equity account which reflects the economic effects of exchange rate differences

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EXERCISES

1. On January 1, 2012, Paisano Company, a U.S. corporation, acquired 100% of the common stock of
Chiara Company, an Italian chocolate company. It was determined that the functional currency of
Chiara was the euro. At the time of the combination, Chiara’s retained earnings were 150,000 euros.
Chiara’s assets has all been purchased at its incorporation, January 2, 2010, and had a book value of
400,000 (70,000 net monetary assets) euros at the beginning of 2010. Relevant exchange rates are
listed below. Chiara uses the FIFO method of inventory valuation and its ending inventory in both
2011 and 2012 was purchased in the last quarter of the year. Chiara declared dividends of $40,000
euros on September 1, 2012.
Date Exchange Rate
January 1, 2010 .8542 A
January 1, 2012 1.0451 B
September 1, 2012 1.1572 C
December 31, 2012 1.1762 D
Average for 2012 1.1106 E
Average for last three months of 2012 1.1667 F
Average for last three months of 2011 1.0223 G
A. Complete the worksheet below, assuming the current rate method
Workpaper to Translate Account Balances of Foreign Subsidiary
Current Rate Method Adjusted Adjusted
Trial Balance Translation Trial Balance
euro Rate US$
Consolidated Statement of Income and RE
Sales 280,000
Cost of goods sold (100,000) ( )
Depreciation expense ( 20,000) ( )
Other expenses ( 80,000) ( )
Income tax expense ( 30,000) ( )
Net income 50,000
1/1 Retained earnings 150,000
200,000
Less: dividends (declared 9/1) ( 40,000) ( )
12/31 Retained earnings 160,000
Balance Sheet
Cash 30,000
Accounts receivable 50,000
Inventories (FIFO) 20,000
Land 100,000
Buildings (net) 200,000
Equipment (net) 180,000
Total 580,000
Accounts payable 30,000
Bonds payable 140,000
Common stock 200,000
Additional paid-in capital 50,000
Retained earnings (from above) 160,000
Total 580,000
Cumulative translation adjustment _______
Total 580,000

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B. Complete the following verification of the translation adjustment

Verification of the Translation Adjustment
Current Rate Method
Translation
Euro Rate US$
1/1 Exposed asset position (net assets)
Adjustments – Net income
(dividends) ( ) ( )
Net asset position translated using rate in effect at date
of each transaction
12/31 Exposed asset position
Change in cumulative translation adjustment
1/1 Cumulative translation adjustment (last year’s)
12/31 Cumulative translation adjustment

2. Using the information from Exercise 1 assume the functional currency is the US$.
A. Complete the attached worksheet, assuming the temporal method
Workpaper to Translate Account Balances of Foreign Subsidiary
Temporal Method Adjusted TB Translation Adjusted TB
FC Rate $
Balance Sheet
Cash 30,000
Accounts receivable 50,000
Inventories (FIFO) 20,000
Land 100,000
Buildings (net) 200,000
Equipment (net) 180,000
Total 580,000
Accounts payable 30,000
Bonds payable 140,000
Common stock 200,000
Additional paid-in capital 50,000
Retained earnings 160,000
Total 580,000
Consolidated Statement of Income and RE
Sales 280,000
Cost of goods sold (100,000)
Depreciation expense ( 20,000)
Other expenses ( 80,000)
Income tax expense ( 30,000)
Translation gain or loss ________
Net income 50,000
1/1 Retained earnings 150,000
200,000
Less: Dividends declared ( 40,000)
12/31 Retained earnings (from above) 160,000
Schedule I – Translation of Cost of Goods Sold
FC Exch. Rate US$
Beginning inventory 15,000
Add: Purchases 105,000
120,000
Less: Ending inventory 20,000
Cost of goods sold * 100,000

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 CHAPTER 13 – Translation of Financial Statements for Foreign Affiliates

SOLUTIONS

MULTIPLE CHOICE

1. B 5. A 8. B 11. B
2. D 6. B 9. A 12. B
3. C 7. C 10. C 13. C
4. D

MATCHING

1. F 4. B 7. C 9. D
2. A 5. H 8. G 10. J.
3. I. 6. E

EXERCISES

1. A.
Workpaper to Translate Account Balances of Foreign Subsidiary
Current Rate Method Adjusted Adjusted
Trial Balance Translation Trial Balance
euro Rate US$
Consolidated Statement of Income and RE
Sales 280,000 A 1.1106 $310,968
Cost of goods sold (100,000) A 1.1106 (111,060)
Depreciation expense (20,000) A 1.1106 (22,212)
Other expenses (80,000) A 1.1106 (88,848)
Income tax expense (30,000) A 1.1106 (33,318)
Net income 50,000 A 1.1106 55,530
1/1 Retained earnings 150,000 1/1 1.0451 156,765
200,000 212,295
Less: dividends (declared 9/1) (40,000) decl 1.1572 (46,288)
12/31 Retained earnings 160,000 166,007
Balance Sheet
Cash 30,000 C 1.1762 35,286
Accounts receivable 50,000 C 1.1762 58,810
Inventories (FIFO) 20,000 C 1.1762 23,524
Land 100,000 C 1.1762 117,620
Buildings (net) 200,000 C 1.1762 235,240
Equipment (net) 180,000 C 1.1762 211,716
Total 580,000 682,196
Accounts payable 30,000 C 1.1762 35,286
Bonds payable 140,000 C 1.1762 164,668
Common stock 200,000 acq 1.0451 209,020
Additional paid-in capital 50,000 acq 1.0451 52,255
Retained earnings (from above) 160,000 166,007
Total 580,000 627,236
Cumulative translation adjustment _______ plug 54,960
Total 580,000 682,196

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B.
Verification of the Translation Adjustment
Current Rate Method
Translation
Euro Rate US$
1/1 Exposed asset position (net assets) 400,000 1.0451 $418,040
Adjustments –
Net income 50,000 1.1106 55,530
(dividends) (40,000) 1.1572 (46,288)
Net asset position translated using rate in effect at date
of each transaction $427,282
12/31 Exposed asset position 410,000 1.1762 482,242
Change in cumulative translation adjustment $ 54,960
1/1 Cumulative translation adjustment (last year’s) 0
12/31 Cumulative translation adjustment $ 54,960

2. A.
Workpaper to Translate Account Balances of Foreign Subsidiary
Temporal Method Adjusted Adjusted
Trial Balance Translation Trial Balance
FC Rate $
Balance Sheet
Cash 30,000 C 1.1762 $ 35,286
Accounts receivable 50,000 C 1.1762 58,810
Inventories (FIFO) (last quarter of 2012) 20,000 C 1.1667 23,334
Land 100,000 H 1.0451 104,510
Buildings (net) 200,000 H 1.0451 209,020
Equipment (net) 180,000 H 1.0451 188,100
Total 580,000 $619,060
Accounts payable 30,000 C 1.1762 $ 35,286
Bonds payable 140,000 C 1.1762 164,668
Common stock 200,000 qcq 1.0451 209,020
Additional paid-in capital 50,000 qcq 1.0451 52,255
Retained earnings 160,000 plug 157,831
Total 580,000 $619,060
Consolidated Statement of Income and RE
Sales 280,000 A 1.1106 $310,968
Cost of goods sold (100,000) * (108,956)
Depreciation expense ( 20,000) H 1.0451 ( 20,902)
Other expenses ( 80,000) A 1.1106 ( 88,848)
Income tax expense ( 30,000) A 1.1106 ( 33,318)
Translation gain or loss ________ plug ( 11,590)
Net income 50,000 $ 47,354
1/1 Retained earnings 150,000 1/1 1.0451 156,765
200,000 $204,119
Less: Dividends declared ( 40,000) decl 1.1572 (46,288)
12/31 Retained earnings (from above) 160,000 $157,831

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Schedule I – Translation of Cost of Goods Sold

Exchange
FC Rate US$
Beginning inventory (date of acquisition) 15,000 1.0451 $ 15,677
Add: Purchases 105,000 A 1.1106 116,613
120,000 $132,290
Less: Ending inventory (this year’s rate) 20,000 1.1667 23,334
Cost of goods sold * 100,000 $108,956

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