Week Seven

Translation of Foreign
Currency Financial
Statements

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
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, IFRSs, 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 (IFRSs) and U.S. generally
accepted accounting principles (GAAP).
6. Discuss hedging of balance sheet exposure.
7. Highlight translation procedures used internationally.

7-4
 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.

Learning Objective 1 7-5

 Translating Foreign Currency Financial
Statements -- Conceptual Issues
Primary conceptual 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,
historical exchange rate is as of date of 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 IFRSs.

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 parent’s books.

Learning Objective 3 7-9

 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.

Learning Objective 3 7-10

 Translation Methods

Current Rate Method

 Objective is to reflect that the parent’s entire investment in a
foreign subsidiary is expose 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.
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

Learning Objective 4 7-12

 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

Learning Objective 4 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 160
Accounts Rec. 160 Long-term debt 480
Inventory 200 Capital stock 300
Fixed Assets, net 545 Retained earnings 142
Total assets 985 Cumulative 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 – Balance Sheet

Income Statement – 2005
Sales 1,900
COGS 1,343
Gross profit 557
S,G,&A 238
Depreciation expense 100
Interest expense 48
Income tax expense 47
Remeasurement gain 101
Net income 225
Learning Objective 4 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 asset exposure.
 Net liability exposure and devaluing foreign currency results
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
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.

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 standard’s 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 -- IFRSs

 IAS 21 and 29 use the term hyperinflationary economies.
 IAS 21 is not a 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 rate method of
translation on the restated financial statements.
 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

 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.

Learning Objective 7 7-28