Chapter 12 Translation of Foreign Currency Financial Statements
Scope of Chapter • Translation of the amounts in the financial statements of the foreign entities from it’s functional currency to the reporting currency. • Remeasurement of financial records to functional currency from the local currency.
Functional Currency The FASB defined functional currency of a foreign entity as follows: An entity’s functional currency is the currency of the primary economic environment in which the entity operates; normally, that is the currency of the environment in which an entity primarily generates and expends cash…. Notes: • For an entity with operations that are relatively self contained and integrated within a particular country, the functional currency would be the currency of that country. • A foreign entity’s functional currency might not be the currency of the country in which it is located.
Functional Currency: Guidelines by FASB Economic factors set forth below and possibly others should be considered both individually and collectively when determining the functional currency: • Cash flow indicators. • Sales price indicators. • Sales market indicators. • Expense indicators. • Financing indicators. • Intercompany transactions and arrangements indicators.
Cash Flow Indicators • Foreign Currency: Cash Flows related to the foreign entity’s individual assets and liabilities are primarily in the foreign currency and do not directly impact the parent company’s cash flows. • Parent’s Currency: Cash Flows related to the foreign entity’s individual assets and liabilities directly impact the parent’s cash flows on a current basis and are readily available for remittance to the parent company.
Sales Price Indicators • Foreign Currency: Sales prices for the foreign entity’s products are not primarily responsive on a short-term basis to changes in exchange rates but are determined more by local competition or local government regulation. • Parent’s Currency:Sales prices for the foreign entity’s products are primarily responsive on a short-term basis to changes in exchange rates; for example,sales prices are determined more by worldwide competition or by international prices.
Sales Market Indicators • Foreign Currency: There is an active local sales market for the foreign entity’s products, although there also might be significant amounts of exports. • Parent’s Currency:The sales market is mostly in the parent’s country or sales contracts are denominated in the parent;s currency.
Expense indicators • Foreign Currency: Labor, materials, and other costs for the foreign entity’s product or services are primarily local costs, even though there also might be imports from some other countries. • Parent’s Currency:Labor, materials, and other costs for the foreign entity’s product or services, on a continuing basis, are primarily costs for components obtained from the country in which the parent company is located.
Financing Indicators • Foreign Currency: Financing is primarily denominated in foreign currency, and funds generated by the foreign entity’s operations are sufficient to service existing and normally expected debt obligations. • Parent’s Currency: • Financing is primarily from the parent or other dollar denominated obligations, or funds generated by the foreign entity’s operations are not sufficient to service existing and normally expected debt obligations without infusion of additional funds from the parent company. • Infusion of additional funds from the parent company for expansion is not a factor, provided funds generated by the foreign entity’s expanded operations are expected to be sufficient to service that additional financing.
Intercompany Transactions and Arrangements Indicators • Foreign Currency: • There is a low volume of intercompany transactions and there is not an extensive interrelationship between the operations of the foreign entity and the parent company. • However, the foreign entity’s operations my rely on the parent’s or affiliate’s competitive advantages, such as patents and trademarks. • Parent’s Currency: • There is a high volume of intercompany transactions and there is an extensive interrelationship between the operations of the foreign entity and the parent company. • The parent’s currency generally would be the functional currency if the foreign entity is a device or shell corporation for holding investments, obligations, intangible assets, etc., that could readily be carried on the parent’s or an affiliate’s books.
Alternative Methods for Translating Foreign Entities’ Financial Statements The methods for foreign currency translation may be grouped into the following basic classes: • Current/Noncurrent Method • Monetary/Nonmonetary Method • Current Rate Method
Rates Used for Translation Different rates used for translation are as follows: • Current Rate: The exchange rate in effect on the balance sheet date of the foreign entity. • Historical Rate: The exchange rate in effect at the time the assets, liabilities, and equities were first recognized in the foreign entity’s accounting records. • Average Rate: Average exchange rate for the accounting period. • Question: Which exchange rate/s should be used to translate the foreign entity’s financial statements? • Answer: According to the FASB statement# 52 ”Foreign Currency Translation”, several methods have been categorized into above three basic classes.
Current/Noncurrent Method Rates used for translation: • Current Rate: Current Assets and current liabilities. • Historical Rate:All other assets, liabilities and owners’ equity in the balance sheet and depreciation and amortization expense applicable to related assets in the income statement. • Average Rate: All other revenues and expenses. Note: Today this method is objectionable with respect to inventories since inventories are translated at current rate, it represents a departure from historical cost.
Monetary/Nonmonetary Method Rates used for translation: • Current Rate: Monetary assets and liabilities . • Historical Rate: All other assets, liabilities and owners’ equity in the balance sheet and cost of goods sold and depreciation and amortization expense applicable to related assets and in the income statement. • Average Rate: All other revenues and expenses. Notes: • Monetary assets and liabilities are those representing claims or obligations expressed in a fixed monetary amount. • This method focuses on the characteristics of assets and liabilities of the foreign entity, rather than on their balance sheet classifications and misstates the actual financial position and operating results of the foreign entity.
Current Rate Method Rates used for translation: • Current Rate: All balance sheet amount other than owners’ equity and in income statement, all revenue and expenses, if practical. • Historical Rate:Owners’ equity. • Average Rate: All other revenues and expenses.
Standards for Translation Established by the FASB – FASB Statement No. 52 • FASB Statement No. 52 has adopted the current rate method for translating a foreign entity’s financial statements from the entity’s functional currency to the reporting currency of the parent company. • If the foreign entity’s accounting records are maintained in a currency other than its functional currency, account balances must be remeasured to the functional currency before their translation. • Remeasurement is accomplished by the monetaty/non-monetary method of translation. • If a foreign entity’s functional currency is the U.S. dollar, remeasurement eliminates the need for translation (as remeasurement must precede translation).
Remeasurement of a Foreign Entity’s Accounts – FASB Guidelines • The remeasurement process should produce the same result as if the entity’s books of record had been initially recorded in the functional currency. • To accomplish that result it is necessary to use: • Historical exchange rates between the functional currency and another currency for certain accounts. • Current rate for all others. • Recognize currently in income, all gains and losses from remeasurement of monetary assets and liabilities that are not denominated in the functional currency.
Nonmonetary Balance Sheet Items and Related Revenu/Expense Items Remeasured Using Historical Rates • Marketable Securities carried at cost: • Equity Securities • Debt securities not intended to be held until maturity. • Inventories carried at cost. • Short-term prepayments such as insurance, advertising, and rent. • Plant assets and their accumulated depreciation. • Patents, trademarks, licenses, formulas, goodwill, other intangible assets and their accumulated amortization. • Deferred charges and credits.
Nonmonetary Balance Sheet Items and Related Revenu/Expense Items Remeasured Using Historical Rates • Deferred revenue. • Common stock. • Preferred stock carried at issuance price. • Examples of revenue and expenses related to nonmonetary items: • Cost of goods sold. • Depreciation of plant assets. • Amortization of intangible assets. • Amortization of deferred charges or credits. Note: The appropriate historical or current exchange rate generally is the rate applicable to conversion of foreign currency for dividend remittances.
Other Aspects of Foreign Currency Translation The FASB Statement No. 52 also includes the following topics: • Transaction gains and losses excluded from net income. • Functional currency in highly inflationary economies. • Income taxes related to foreign currency translation. • Disclosure of foreign currency translation.
Transaction Gains and Losses Excluded from Net Income The FASB requires that gains and losses from the following foreign currency transactions be accounted for in the same manner as foreign currency adjustments: • Foreign currency transactions that are designated as, and are effective as, economic hedges of a net investment in a foreign entity, commencing as of the designation date. • Intercompany foreign currency transactions that are of a long-term investment nature (that is, settlement is not planned or anticipated in the foreseeable future), when the entities to the transaction are consolidated,combined, or accounted for by the equity method.
Functional Currency in Highly Inflationary Economies • The FASB requires that the functional currency of a foreign entity in a highly inflationary economy be identified as the reporting currency (the U.S. dollar for a U.S. multinational enterprise). • The FASB defined a highly inflationary economy as on having cumulative inflation of 100% or more over a three-year period. • Thus, financial statements of a foreign entity in a country experiencing severe inflation are remeasured in U.S. dollars, regardless of the criteria for determination of the functional currency.
Income Taxes Related to Foreign Currency Translation Conventional interperiod and intraperiod income tax allocation procedures were described by the FASB as follows: • Interperiod tax allocation for temporary differences associated with foreign currency transaction gains and losses that are reported in different accounting periods for financial accounting and income taxes. • Interperiod tax allocation for temporary differences associated with foreign currency translation adjustments that do not meet the criteria for nonrecognition of deferred tax liabilities for undistributed earnings of foreign subsidiaries. • Intraperiod tax allocation for foreign currency translation adjustments included in the stockholders’ equity section of the balance sheet.
Disclosure of Foreign Currency Translation The FASB requires disclosure: • in the income statement or in a note to financial statements of the aggregate foreign currency transaction gains or losses or an accounting period. • of changes in foreign currency translation adjustments (as well as other components of accumulated other comprehensive income) during an accounting period. • for forward contracts or other financial instruments designated as hedges of the foreign currency exposure of a net investment in a foreign operation.
Appraisal of Accounting Standards for Foreign Currency Translation Criticisms: • It established an identifiable distinction between transaction gains and losses arising from remeasurement and translation adjustments resulting from translation although both involve comparable activities. Thus, they should be accounted for in the same manner. • It abandoned the historical-cost principle by sanctioning use of the current rate method for translation of foreign currency financial statements.