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Translation of Foreign Currency Financial Statements. Translation of Foreign Currency Financial Statements. Conceptual issues of foreign currency financial statements translation. Balance sheet vs. transaction exposure. Methods of financial statement translation.

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translation of foreign currency financial statements2
Translation of Foreign Currency Financial Statements
  • 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, IFRSs, and other standards related to translation.
  • Hedging balance sheet exposure.
translating foreign currency financial statements conceptual issues
Translating Foreign Currency Financial Statements -- Conceptual Issues
  • Foreign country operations usually prepare financial statements 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.
translating foreign currency financial statements conceptual issues4
Translating Foreign Currency Financial Statements -- Conceptual Issues

Primary conceptual issues

  • Each financial statement item must be translated using some, hopefully relevant, exchange rate.
  • What rate should be used?
    • the current exchange rate?
    • The average exchange rate?
    • the historical exchange rate?
  • Given that any adjustment is, at the point of translation, unrealized, how should the resulting adjustment be recognized?
    • in current income?
    • in an equity account on the balance sheet?
balance sheet exposure
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.
a simple example
A simple example
  • Let’s say XYZ has a 1000 euro current note receivable on its books. The euro/$ direct rate is $ 1 on 1/1. On 12/31, it is $.9091.
  • Should we record:
    • No change?
    • An decrease in value of $90.90?

And if we do report a change, where should the offsetting gain be reported?

another simple example
Another simple example:
  • Let’s say XYZ has land on its books that is held by a subsidiary located in the EU. The land was purchased on 1/1 for 1,000,000 euros when the euro/$ direct rate was $ 1. On 12/31, it is $ .9091.
  • Should we record:
    • No change?
    • An decrease in value of $90,900?

And if we do report a change, where should the offsetting gain be reported?

the question
The Question:
  • How do we account for these effects?
the current rate method
The Current Rate Method:
  • The receivable would be translated using the current rate.
  • The land would be translated at the current rate.
translation methods
Translation Methods

Current Rate Method

  • Presumes 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.
  • 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.
current rate method
Current Rate Method
  • Advantages
    • Simple to do
    • Ratios are not distorted
but what if
But what if:
  • Inflation differences caused the decline in the value of the euro?
  • If the inflation differential was 10%, then:
    • Before, 1,000,000E=1,000,000$
    • Now, 1,000,000E=1,100,000$;
    • Thus the direct exchange rate would be .9091 (1,000,000/1,100,000).
    • Thus the current value of the land, in euros, is now 1,100,000E. The valuation should be 1100000*.9091 = 1,000,000$, i.e., no change.
the current rate method13
The Current Rate Method
  • Disadvantages
    • Can produce disparate results that are not consistent with the economics that are really going on.
    • What does the FC adjustment mean?
    • Possibility of disappearing assets in inflationary economies.
the problem
The Problem:
  • The receivable is a monetary asset.
  • The land is a non-monetary asset.
slide15
If inflation drives foreign exchange rate movements, and monetary/non-monetary assets are affected differently, how should FC effects be accounted for?
translation methods16
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 parent’s books.
in our example
In our example:
  • The receivable would be translated using the current rate.
  • The land would be translated at the historical rate.
monetary non monetary
Monetary/Non-monetary
  • Advantages
    • Easy to understand. Makes intuitive sense.
    • Usually not difficult to classify assets and liabilities.
but what if19
But what if:
  • A monetary asset/liability is booked at historical cost (e.g. long term bonds)
  • A nonmonetary asset/liability is booked at current cost (e.g., revalued property, plant and equipment)
monetary non monetary method
Monetary/Non-monetary method
  • Disadvantages
    • Valuation basis in accounting doesn’t always line up right with classification, producing potentially meaningless values.
    • Thus some assets can disappear in the presence of inflation while others are over or under-reported.
translation methods21
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.
in our example22
In our example:
  • The receivable would be classified as current and translated using the current rate.
  • The land would be classified as noncurrent and translated at the historical rate.
curent noncurrent
Curent/Noncurrent
  • Advantages?
    • Simplistic. Requires no more characterization of assets/liabilities than is already provided by the financial statements
    • Seems to solve the monetary/non-monetary problem while remaining more consistent with underlying accounting basis being used.
current non current method
Current/Non-current method
  • Disadvantages
    • Can still misspecify monetary assets/liabilities. Example: inventories, noncurrent marketable equity securities.
    • Does not explicitly address the accounting problem. For example, some current assets use historical cost basis. Some noncurrent assets are booked at current value.
    • Thus some assets can still disappear in the presence of severe inflation. Others can be severely over or undervalued.
translation methods25
Translation Methods

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.
in our example26
In our example:
  • The receivable translated using the current rate.
  • If reported at historical cost, the land would be translated at the historical rate.
  • If reported at fair value, the land would be translated at the current rate.
temporal method
Temporal Method
  • Advantages
    • Lines up with valuation basis used in accounting. Thus the numbers have most consistent internal meaning.
    • They will still be misspecified, however, but only to the extent the underlying accounting numbers already are.
temporal method28
Temporal Method
  • Disadvantages
    • Lots of volatility in financial statements.
    • Mixing of valuations: does the sum make any sense?
temporal and current rate methods
Temporal and Current Rate Methods

Translation methods illustrated

  • U.S. Inc. owns Juarez, SA, a subsidiary in Mexico which was established January 1, 2005.
  • Juarez’s 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

temporal and current rate methods30
Temporal and Current Rate Methods

Translation methods illustrated

  • Juarez’s income statement items for 2005, in pesos.

Sales 20,000 Depr. exp 1,000

COGS 14,000 Interest exp. 500

S,G,&A exp. 2,500 Income tax exp. 500

temporal and current rate methods31
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.
temporal and current rate methods32
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

temporal and current rate methods33
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

temporal and current rate methods34
Temporal and Current Rate Methods

Current Rate Method – Balance Sheet

Balance Sheet – December 31, 2005

Cash 80 Accounts payable 160

Accounts Rec. 160 Long-term debt 480

Inventory 200 Capital stock 300

Fixed Assets, net 560 Retained earnings 142

Total assets 1000 Cumulative

translation adj. ( 82) Total liab. & S.E. 1000

temporal and current rate methods35
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

temporal and current rate methods36
Temporal and Current Rate Methods

Temporal Method – Balance Sheet

Income Statement – 2005

Sales 1,900

COGS 1,295

Gross profit 605

S,G,&A 238

Depreciation expense 100

Interest expense 48

Income tax expense 47

Income before adj 172

Remeasurement gain 53

Net income 225

temporal and current rate methods37
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.
temporal and current rate methods38
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 asset exposure.
  • Net liability exposure and devaluing foreign currency results in translation gain.
  • Translation gain included in current income.
other issues
Other Issues
  • What is the appropriate current rate?
  • Translation gains/losses? Deferred or booked? Shown in income or just equity?
translation accounting around the world
Translation Accounting Around the World
  • USA
  • IFRS
  • Diversity seen in other nations
history of translation accounting in usa
History of Translation Accounting in USA
  • Pre-1965: Current/Noncurrent method applied. Losses recognized into income. Gains were deferred.
  • 1965-1975: Single Rate method was also allowed.
  • 1975-1981: FAS 8, which required temporal method to be used. All gains and losses taken into income
history of translation accounting in usa42
History of Translation Accounting in USA
  • 1981-today: SFAS 52, which has the following features:
    • Functional currency determines accounting.
    • If functional currency is the local currency- use single current rate. Gains and losses routed directly to stockholder’s equity.
    • If functional currency is US Dollar, use the temporal method and fully recognize gains/losses into earnings.
    • If functional currency is different from local currency or US Dollar, do both.
how do you determine the functional currency
How do you determine the “functional currency”?
  • What is the “primary” currency of the entity?
  • See Exhibit 7.2, p. 309 for suggested indicators
  • Management decides how much weight to give each indicator.
  • In hyper-inflating environments- use temporal method (so most of the balance sheet will not disappear!)
u s gaap and ifrs requirements
U.S. GAAP and IFRS Requirements

U.S. GAAP under SFAS 52

  • 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.
advantages of sfas 52
Advantages of SFAS 52
  • Allows consideration of context.
  • In most cases, keeps impact of FC exchange rate movements out of earnings.
  • Much more accepted by reporting community than FAS 8 was.
disadvantages of sfas 52
Disadvantages of SFAS 52
  • From an investor’s viewpoint, is there any economic difference, in substance, between circumstances that distinguish the two methods. If not, why have two different kinds of accounting?
  • Inconsistent with the notion of consolidation.
  • Numbers produced by SFAS 52 often lose meaning.
  • Added risk of earnings management?
u s gaap and ifrs requirements47
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 standard’s requirements pertaining to hyperinflationary economies are substantially different from SFAS 52.
u s gaap and ifrs requirements48
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.
u s gaap and ifrs requirements49
U.S. GAAP and IFRS Requirements

Hyperinflationary Economies -- IFRSs

  • IAS 21 and 29 use the term hyperinflationary economies.
  • IAS 21 is not as specific in defining hyperinflationary economies as 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 rate method of translation on the restated financial statements.
  • IAS approach is substantially different from SFAS 52.
hedging balance sheet exposure
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.
hedging balance sheet exposure51
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.
translation procedures internationally
Translation Procedures Internationally

Canada – very similar to U.S., however under the temporal method, some translations adjustments can be deferred and amortized.

Mexico – standards are silent, but SFAS 52 is commonly followed. In cases where it is not, practice varies widely.

Brazil – current rate method is used with gains and losses included in income.

Japan – significantly different from U.S. GAAP and IFRSs, with cumulative translation adjustment reported as an asset or liability.

Korea – only the current rate method is used.

one final problem
One final problem
  • How do we interpret reported FC gains and losses, irrespective of where they show up?
  • Example: Company has a large subsidiary in the EU. The subsidiary has a large net asset position. The Euro depreciates more than 40%. Huge losses are reported.
  • The subsidiary’s sales and profits skyrocket, since they now seem more competitive to customers than ever.
thus and strangely
Thus, and strangely:
  • In a world of “floating rate” currency, sometimes a weak currency is good, and a strong currency is bad!
  • This explains why, when markets are in strong decline, or the risk of deflation after a bubble is great, nations have been known to compete with each other in a race to devalue their money the most!
summary
Summary
  • All kinds of problems arise when the value of money changes and is uncertain.
  • The economic impact of these changes vary as a function of the inherent cause of the FC movement and the type of holding (asset/liability; monetary/non-monetary; current/noncurrent).
  • Accounting limitations (e.g., historical cost) mix with this uncertainty, making financial reporting difficult at best.
  • The current paradigm is SFAS 52. This could easily change at any time, as it has several times before.