Doupnik 5e Chap007 PDF

Chapter 7:
Translation of
Foreign
Currency
Financial
Statements
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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 methods of translation
4. Apply the current rate and temporal methods of
translation and compare the results
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
7-2
Two Conceptual Issues
 Appropriate exchange rate to be used in translating each
financial statement item
 How should the translation adjustment that inherently
arises from the translation process be reflected in the
consolidated financial statements?
 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
7-3
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
7-4
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
7-5
Translation Methods (2)
 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
7-6
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
7-7
Complicating Aspects of the Temporal Method
 Keeping track of the historical rates for inventory, prepaid

expenses, fixed assets, and intangible assets is necessary
under temporal method and not under 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)
 Application of the Lower of Cost or Market Rule
 Fixed Assets, Depreciation, Accumulated Depreciation
7-8
Translation Methods (3)
 Monetary/Nonmonetary Method
 Concerns with monetary assets and liabilities
 Translated at the current exchange rate
 Concerns with nonmonetary assets and liabilities and
stockholders’ equity accounts
 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
7-9
Disposition of Translation Adjustment
 Translation gain or loss in net income
 Translation adjustment is considered to be a gain or loss
analogous to the gains and losses arise from foreign currency
transaction
 Should be reported in income in the period in which the
fluctuation in exchange rate occurs
 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
7-10
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 functional currency is U.S. Dollar, temporal method
is required
 When functional currency is foreign currency, current rate
method is required
7-11
U.S. GAAP Requirements
 Highly Inflationary Economies – U.S. GAAP
 U.S. GAAP defines such economies as those with cumulative
100% inflation over a period of three years (with
compounding—average of 26% per year for three years in
a row)
 Temporal method required—translation gains/losses
reported in income
7-12
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 U.S. GAAP
7-13
Temporal and Current Rate Methods
Translation methods illustrated
 Multico (U.S. 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 600,00 Euros
 Italco balance sheet items as of 12/31/0, in Euros:
Cash 400,000 Capital stock 1,000,000
Inventory 600,000
7-14
Translation Process Illustrated
 Translation methods illustrated

 Italco’s income statement items for Year 1, in Euros:
Sales 8,000,000
COGS 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 b4 Income Tax 1,100,000
Income Tax 275,000
_______________
Net Income 825,000
7-15
Translation Process Illustrated (2)
 Statement of Retained Earnings 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
7-16
 Balance Sheet December 31 Y1
 Assets Liabilities
 Cash 550,000 accounts pay 330,000
 Accts receivable 600,000 Lt debt 2,000,000
 Inventory (fifo) 800,000 Capital stk 1,000,000
 PPE 2,000,000 R/E 500,000
 a/d PPE (200,000)
 Patents 80,000
 Total: 3,830,000 3,830,000
7-17
 Relevant exchange rates

 January 1 Year 1 $1.35 = 1 euro
 Rate when PPE and LT debt incurred $1.33 = 1euro
 Rate when Patent acquired $1.32 = 1 euro
 Average exchange rate Year 1 $1.30 = 1 euro
 Rate 12/1/Y1 when dividends declared $1.27 = 1euro
 Average exchange rate December Y1 $1.26= 1euro
 December 31 Y1 $1.25 = 1 euro
7-18
Translation of Financial Statements: Current Rate
Method
 Income Statement Year 1 (in thousands)
 € Translation rate $
 Sales 8000 1.30(a) 10,400
 Cogs 6000 1.30(a) 7,800
 -------- --------
 Gross profit 2000 2600
 Sell Adm exp 500 1.30(a) 650
 Dep exp 200 1.30(a) 260
 Amort exp 20 1.30(a) 26
 Interest exp 180 1.30(a) 234
 ------- ------
 Inc. b4 tax 1100 1,430
 Inc tax 275 1.30(a) 357.5
-------- -------
Income 825 1072.5
7-19
Method (2)

Statement of Retained Earnings
 Year 1
 € Translation Rate $
 Beg bal 0 0
 Income 825,000 from inc. stmt. 1,072,500
 Dividends (325,000) 1.27(H) (412,750)
 ------------ -------------
 Ending 500,000 659,750
7-20
Method (3)
 Balance Sheet
 December 31 Y1(in thousands)
 Assets € Translation Rate $
 Cash 550 1.25 (C) 687.5
 Acct rec. 600 1.25 (C) 750
 Inventory 800 1.25 (C) 1,000
 PPE 2000 1.25 (C) 2,500
 a/d PPE (200) 1.25 (C) (250)
 Patent 80 1.25 (C) 100
 --------- ------------
 Total 3,830 4,787.5
7-21
Method (4)
 Balance Sheet (in thousands)
 Continued
 Lia and equity € Translation Rate $
 Acct pay 330 1.25 (C) 412.5
 LT debt 2,000 1.25 (C) 2,500.0
 -------- ----------
 Total liabilities 2330 2,912.5
 Cap stock 1,000 1.35 (C) 1,350.0
 R/E 500 stmt r/e 659,750
 Trans adj to balance (134,750)
 -------- -----------
 Total 3,830 4,787.5
7-22
Method (5)
 5 Steps to calculate translation adjustment
 1) Net asset balance at beginning of year at exchange rate on that date
 2) TRANSLATION OF FINANCIAL STATEMENTS: CURRENT RATE METHOD
Individual increases and decreases in net asset balance translated at
rates in effect when increases/decreases occur
 3) Translated beginning net asset balance and translated value of the
individual changes are combined to arrive at relative value of net assets
being held prior to impact of any exchange rate fluctuations
 4) The ending net asset balance is then translated at 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 ending translated value a negative (debit) translation
adjustment arises.
7-23
Computation of Translation Adjustment
€ Rate $
Net asset 1/1/Y1 1,000,000 1.35 1,350,000
Change in assets
Income Y1 825,000 1.30 1,072,500
dividends Y1 (325,000) 1.27 (412,750)
Net asset 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 adj (-) 134,750
7-24
Translation Balance Sheet: Temporal Method
 Balance Sheet
 December 31, Y1
 ASSETS € Rate $
 Cash 550,000 1.25 (C) 687,500
 A/R 600,000 1.25 (C) 750,000
 Inventory 800,000 1.26 (H) 1,008,000
 PPE 2,000,000 1.33 (H) 2,660,000
 a/d (200,000) 1.33 (H) (266,000)
 Patents 80,000 1.32 (H) 105,600
 ------------ -----------
 Total 3,830,000 4,945,100
7-25
Translation of Balance Sheet: Temporal Method (2)
 Liabilities & Equity € Rate $

 Accts Pay 330,000 1.25 (C) 412,500
 Lt 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
7-26
Translation of Income Statement and Statement of
Retained Earnings: Temporal Method
 Income Statement
 Year 1
 € Rate $
 Sales 8,000,000 1.30 (A) 10,400,000
 Cogs 6,000,000 see below 7,862,000
 -------------- ----------------
Gross Profit 2,000,000 2,538,000
Sell Adm 500,000 1.30 (A) 650,000
Dep exp 200,000 1.33 (H) 266,000
Amort exp 20,000 1.32 (H) 26,400
Int exp 180,000 1.30 (A) 234,000
Inc b4 tax 1,100,000 1,361,600
Income tax (275,000) 1.30 (A) (357,500)
Adjustment to balance 91,250
Net income 825,000 1,095,350
Beginning 600000 € at 1.35= 810000 purchases 6200000 at €1.3 = 8060000 ending 800000€ at 1.26 =1.26 giving 7862000
7-27
Translation of Statement of Retained Earnings:
Temporal Method
 Statement of Retained Earnings
 Year 1
 € rate $
 R/E 1/1Y1 0 0
 Income Y1 825,000 from i/s 1,095,350
 Dividends (325,000) 1.27 (H) (412,750)
 R/E 12/31 500,000 682,600
7-28
Computation of Remeasurement Gain
 € Rate $
 Net Monetary
 Assets 1/1/Y1 400,000 1.35 540,000
 INCREASE MONETARY ITEMS
 Sales 8,000,000 1.3 10,400,000
 Inv. Purch (6,200,000) 1.3 (8,060,000)
 Selling adm (500,000) 1.3 (650,000)
 interest (180 000) 1.3 (234,000)
 Inc. tax (275,000) 1.3 (357,500)
 Buy PPE 2,000,000 1.33 (2,660,000)
 Buy patent (100,000) 1.32 (132,000)
 Dividend (325,000) 1.27 (412,750)
 ------------- ---------------
 Net monetary
 Liabilities (1,180,000) (1,566,250)
 Net monetary
 Liabilities at
 Current rate (1,180,000) 1.25 (1,475,000)
 Remeasure-
 Ment gain (91,250)
7-29
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
7-30
Comparison of Results from Applying the 2
Different Translation Methods
 Translation Method
 Current Temporal Difference
 Income $1,072,500 $1,095,350 +2.1%
 Assets $4,787,500 $4,945,100 +3.3%
 Equity $1,875,000 $2,032,600 +8.4%
 Return on
 Ending Equity 57.2% 53.9% -5.8%
7-31
Underlying Relationships
 Ratio € Current Temporal
 Current ratio 5.91 5.91 5.93
 Debt/equity 1.55 1.55 1.43
 Gross profit 25% 25% 24.4%
 Return equity 55% 57.2% 53.9%
7-32
Hedging Balance Sheet Exposure
 Companies that have foreign subsidiaries with highly
integrated operations use the temporal method
 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 balance
sheet exposure and exchange rate fluctuations
 Foreign exchange gains and losses on foreign currency
borrowings or foreign currency derivatives employed to
hedge translation based exposure (under the current rate
method)
7-33
Hedging Balance Sheet Exposure (2)
 Companies can hedge against gains and losses by using
foreign currency forward contracts, options, and
borrowings
7-34
End of Chapter 7
7-35
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent o f McGraw-Hill Education.

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Chapter 7:

 Keeping track of the historical rates for inventory, prepaid

 Translation methods illustrated

 Relevant exchange rates

 Liabilities & Equity € Rate $

Capital Stock 1,000,000 1.35 (H) 1,350,000

Total 3,830,000 4,945,100

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