TRANSLATION OF FOREIGN CURRENCY

FINANCIAL STATEMENTS

Chapter 7

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All

Translation of Foreign Currency

Financial Statements
Chapter Topics
Conceptual issues of foreign currency financial
statements translation
Balance sheet vs. transaction exposure
Methods of financial statement translation
Temporal and current rate methods illustrated
U.S. GAAP, IFRS, and other standards related to
translation
Hedging balance sheet exposure
7-2

Translation of Foreign Currency

Financial Statements
Learning Objectives
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.
4. Apply the current rate and temporal methods of translation and
compare the results of the two methods.

7-3

Translation of Foreign Currency

Financial Statements

Learning Objectives

5. Describe the requirements of applicable International Financial

Reporting Standards (IFRS) and U.S. generally accepted
accounting principles (GAAP).
6. Discuss hedging of balance sheet exposure.

7-4

Translating Foreign Currency

Statements -- Conceptual
Financial
Foreign country operations usually prepare financial statements
Issues
using local currency as the monetary unit.
These financial statements must be translated into home country
currency.
These operations also typically use local GAAP.
Financial statements must be translated into home country GAAP.

Learning Objective 1

7-5

Translating Foreign Currency

Financial
Statements -- Conceptual
Primary conceptual issues
Issues
Each financial statement item must be translated using the
appropriate exchange rate.
Choices include the current exchange rate, average exchange rate,
and the historical exchange rate.
Current exchange rate is as of the balance sheet date, while
historical exchange rate is as of the date of the transaction.
The resulting translation adjustment can be recognized in current
income or included in an equity account on the balance sheet.

Learning Objective 1

7-6

Balance Sheet Exposure

Assets and liabilities translated at the current exchange rate are
exposed to 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.

Learning Objective 2

7-7

Translation Methods
Current/Noncurrent Method
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.

Learning Objective 3

7-8

Translation Methods
Monetary/Nonmonetary Method
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 parents books.

Learning Objective 3

7-9

Translation Methods
Temporal Method
Objective is to translate financial statements as if the subsidiary
had been using the parents currency.
Items carried on subsidiarys books at historical cost, including all
stockholders equity items, are translated at historical exchange
rates.
Items carried on subsidiarys 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.
Learning Objective 3

7-10

Translation Methods
Current Rate Method
Objective is to reflect that the parents entire investment in a foreign
subsidiary is exposed to exchange risk.
All assets and liabilities are translated at the current exchange rate.
Stockholders equity accounts are translated at historical exchange
rates.
Income statement items are translated at the exchange rate in
effect at the time of the transaction.

Learning Objective 3

7-11

Temporal and Current Rate

Methods

Translation methods illustrated

U.S. Inc. owns Juarez, SA, a subsidiary in Mexico which was
established January 1, 2005.
Juarezs balance sheet items as of 12/31/05, in pesos.
Cash
1,000 Accounts payable
2,000
Accounts rec.
2,000 Long-term debt
6,000
Inventory
2,500 Capital stock
3,000
Fixed assets
8,000 Retained earnings
1,500
Accum. depr.
1,000

Learning Objective 4

7-12

Temporal and Current Rate

Methods

Translation methods illustrated

Juarezs income statement items for 2005, in pesos.
Sales
COGS
S,G,&A exp.

Learning Objective 4

20,000
14,000
2,500

Depr. exp
Interest exp.
Income tax exp.

1,000
500
500

7-13

Temporal and Current Rate

Methods

Translation methods illustrated

There was no beginning inventory.
Inventory, which is carried at cost, was acquired evenly during the
last quarter of 2005.
Purchases were made evenly throughout year.
Fixed assets were acquired on January 1, 2005.
Capital stock was sold on January 1, 2005.

Learning Objective 4

7-14

Temporal and Current Rate

Methods

Translation methods illustrated

Relevant exchange rates (U.S. dollar per Mexican peso)
January 1, 2005
$0.10
Average for 2005
$0.095
Average for 4th quarter 2005
$0.09
December 31, 2005
$0.08

Learning Objective 4

7-15

Temporal and Current Rate

Methods

Current Rate Method Income Statement

Income Statement 2005
Sales
1,900
COGS
1,330
Gross profit
570
S,G,&A
238
Depreciation expense
95
Interest expense
48
Income tax expense
47
Net income
142
Learning Objective 4

7-16

Temporal and Current Rate

Methods

Current Rate Method Balance Sheet

Balance Sheet December 31, 2005
Cash
80
Accounts payable
Accounts Rec.
160
Long-term debt
Inventory
200
Capital stock
Fixed Assets, net
545
Retained earnings
Total assets
985
Cumulative

160
480
300
142

translation adj. (97)

Total liab. & S.E.
985
Learning Objective 4

7-17

Temporal and Current Rate

Methods

Temporal Method Balance Sheet

Balance Sheet December 31, 2005
Cash
80
Accounts payable
160
Accounts Rec.
160
Long-term debt
480
Inventory
225
Capital stock
300
Fixed Assets, net
700
Retained earnings 225
Total assets
1,165
Total liab. & S.E. 1,165

Learning Objective 4

7-18

Temporal and Current Rate

Methods

Temporal Method Income Statement

Income Statement 2005
Sales
COGS
Gross profit
S,G,&A
Depreciation expense
Interest expense
Income tax expense
Remeasurement gain
Net income

Learning Objective 4

1,900
1,343
557
238
100
48
47
101
225
7-19

Temporal and Current Rate

Methods

Translation methods illustrated Summary

Current Rate Method
All assets and liabilities 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.

Learning Objective 4

7-20

Temporal and Current Rate

Methods

Translation methods illustrated Summary

Temporal Method
Primarily monetary assets and liabilities 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.

Learning Objective 4

7-21

U.S. GAAP and IFRS Requirements

U.S. GAAP
SFAS 52, Foreign Currency Translation is the relevant accounting
standard.
Requires identification of functional currency.
Functional currency is the primary currency of the foreign
subsidiarys operating environment.
The standard includes a list of indicators as guidance for the foreign
currency decision.
When functional currency is U.S. Dollar, temporal method is
required.
When functional currency is foreign currency, current rate method is
required.
Learning Objective 5

7-22

U.S. GAAP and IFRS Requirements

IFRS
IAS 21, The Effects of Changes in Foreign Exchange Rates is the
relevant accounting standard.
Uses the functional currency approach developed by the FASB.
The standard includes a list, similar to the FASB list, of indicators
as guidance for the foreign currency decision.
The standards requirements pertaining to hyperinflationary
economies are substantially different from SFAS 52.

Learning Objective 5

7-23

U.S. GAAP and IFRS Requirements

Highly Inflationary Economies U.S. GAAP
SFAS 52 provides guidance on highly inflationary economies.
SFAS 52 defines such economies as those with 100% inflation over
a period of three years.
SFAS 52 requires the use of the temporal method in these cases of
significant inflation.

Learning Objective 5

7-24

U.S. GAAP and IFRS Requirements

Hyperinflationary Economies -- IFRS
IAS 21 and 29 use the term hyperinflationary economies.
IAS 21 is not as specific in defining hyperinflationary economies as
is SFAS 52.
IAS 21 requires restatement of the foreign financial statements for
inflation per IAS 29, Financial Reporting in Hyperinflationary
Economies.
IAS 21 then requires the use of the current exchange rate to
translate the restated financial statements, including all balance
sheet accounts as well as all income statement accounts.
IAS approach is substantially different from SFAS 52.
Learning Objective 5

7-25

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.

Learning Objective 6

7-26

Hedging Balance Sheet Exposure

These gains and losses result from the combination of balance
sheet exposure and exchange rate fluctuations.
Companies can also hedge to offset the effects of the translation
adjustment to equity under the current rate method.
Companies can hedge against gains and losses by using foreign
currency forward contracts, options, and borrowings.

Learning Objective 6

7-27