Chapter 7. Translation of Foreign Currency Financial Statement

INTERNATIONAL SCHOOL
Ha Noi National University

http://is.vnu.edu.vn/
CHAPTER 7:
TRANSLATION OF FOREIGN
CURRENCY FINANCIAL
STATEMENTS
Hanoi, 2020
U.EDU.VN - HTTP://IS.VNU.EDU.VN - HTTP://IS.VNU.EDU.VN
CHAPTER TOPICS
• Conceptual issues of foreign currency financial

statements translation
• Difference between balance sheet exposure and
transaction exposure
• Methods of financial statement translation
• Temporal and current rate methods illustrated
• U.S. GAAP, IFRS, and other standards related to
translation
• Hedging of balance sheet exposure
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 of the two methods
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
TWO CONCEPTUAL ISSUES
1. Appropriate exchange rate to be used in translating each

financial statement item
2. How should the translation adjustment that inherently

arises from the translation process be reflected in the
consolidated financial statements
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
TRANSLATION METHODS
Four major methods of translating foreign currency financial

statements have been used worldwide:
(1) the current/noncurrent method,
(2) the monetary/nonmonetary method,
(3) the temporal method,
and (4) the current rate (or closing rate) method.
TRANSLATION METHODS
I. 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
TRANSLATION METHODS
II. 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.
TRANSLATION METHODS
III. 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
TRANSLATION METHODS
IV. 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 Average
rate
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
Exchange Rates Used under the Current Rate
Method and the Temporal Method for Selected
Financial Statement Items
Exchange Rates Used under the Current Rate
Method and the Temporal Method for Selected
Financial Statement Items
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)
 Fixed Assets, Depreciation, Accumulated
Depreciation
TEMPORAL METHOD
• Calculation of Cost of Goods Sold (COGS)
- Under Current rate method:
COGS in FC x Average ER = COGS in PC
- Under temporal method:
COGS in PC = Beginning in inventory in PC (1) + Purchases
in PC (2) – Ending in inventory in PC (3)
(1) Beginning inventory in FC x Historical ER (e.g. 1 st
QuarterYear 1) = Beginning in inventory in PC
(2) Purchases in FC x Average ER, Year 2 = Purchases in PC
(3) Ending in inventory in PC = Ending in inventory in FC x
Historical ER (e.g. 4th Quarter Year 2)
Example
In FC
• Jan 1, 2010. Inventory : 600,000
• Purchase in 2010: 6,200,000
• Dec 31, 2010. Inventory: 800,000
• Rate:
Jan 1, 2010 : r=$1.00
Average of 2010: r = 0.95
Average of December, 2010: r = 0.91
Dec 31, 2010: 0.90
Calculation COGs 2010 in PC under:

1. Current Rate method
2. Temporal Method
TEMPORAL METHOD
Fixed Assets, Depreciation, Accumulated Depreciation
• Under the temporal method
The fixed assets, accumulated depreciation acquired at
different times must be translated at different (historical)
exchange rates.
• Under current rate method
The fixed assets, accumulated depreciation acquired at
different times must be translated at current exchange rate.
Example?
EXAMPLE
• Jan 1, Year 1. Purchase FC1,000 with rate $1.00 per FC

• Jan 1, Year 2. Purchase FC4,000 with rate $1.20 per FC
• Both equipment have a five-years useful life.
• Dec 31, Year 2. Exchange rate is $1.50 per FC
• Average Exchange rate is $1.40 per FC
I. Under temporal method
II. Under current rate method
1. Assets value in Dec 31, year 2 in PC ($)
2. Depreciation Expense Year 2 in PC ($)
3. Accumulated depreciation at Dec 31, Year 2
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
Translation Process Illustrated
• Translation of financial Statements: Current Rate Method

• Example:
• Translation of financial Statements: Temporal Method

• Example:
Comparison of the results from applying the
two different methods
• The use of different translation methods can have a
significant impact on consolidated financial Statements
Items Translation Method

Current Rate Temporal Difference
Net income 772.800 806.600 + 4,4%
Total Assets 3.485.300 3.614.100 + 3,7%
Total Equity 1.365.000 1.493.800 + 9,44%
Return on 56,62% 53,99% -4,63%

equity
TEMPORAL AND CURRENT RATE METHODS
Translation methods illustrated

• U.S. Inc. owns Juarez, SA, a subsidiary in Mexico which
was established January 1, 2010
• Juarez’s balance sheet items as of 12/31/10, 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
• Translation methods illustrated

• Juarez’s income statement items for 2010, 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

– There was no beginning inventory
– Inventory, which is carried at cost, was acquired
evenly during the last quarter of 2010
– Purchases were made evenly throughout year
– Fixed assets were acquired on January 1, 2010
– Capital stock was sold on January 1, 2010

• Relevant exchange rates (U.S. dollar per Mexican peso):
January 1, 2010 $0.10
Average for 2010 $0.095
Average for 4th quarter 2010 $0.09
December 31, 2010 $0.08
• Current Rate Method – Income Statement

Income Statement – 2010
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
• Current Rate Method – Balance Sheet
Balance Sheet – December 31, 2010

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
• Temporal Method – Income Statement
Income Statement – 2010

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
• Temporal Method – Balance Sheet

Balance Sheet – December 31, 2010
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
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
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
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
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
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 U.S. GAAP, but does suggest that a
cumulative three-year rate approaching or exceeding 100% is
evidence
– IAS 21 requires restatement of the foreign financial
statements for inflation per IAS 29
– 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 U.S. GAAP
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)
HEDGING BALANCE SHEET EXPOSURE
• Companies can hedge against gains and losses by using

foreign currency forward contracts, options, and
borrowings
End of Chapter 7

Chapter 7. Translation of Foreign Currency Financial Statement

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Chapter 7. Translation of Foreign Currency Financial Statement

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INTERNATIONAL SCHOOL

Ha Noi National University

• Conceptual issues of foreign currency financial

1. Describe the conceptual issues involved in translating

TWO CONCEPTUAL ISSUES

1. Appropriate exchange rate to be used in translating each

2. How should the translation adjustment that inherently

BALANCE SHEET EXPOSURE

• Assets and liabilities translated at the current exchange

Four major methods of translating foreign currency financial

II. Monetary/Nonmonetary Method

III. Temporal Method

IV. Current Rate Method

TRANSLATION OF RETAINED EARNINGS

• Stockholders’ equity items are translated at historical

Calculation COGs 2010 in PC under:

• Jan 1, Year 1. Purchase FC1,000 with rate $1.00 per FC

Translation Process Illustrated

• Translation of financial Statements: Current Rate Method

• Translation of financial Statements: Temporal Method

Items Translation Method

Total Equity 1.365.000 1.493.800 + 9,44%

Return on 56,62% 53,99% -4,63%

TEMPORAL AND CURRENT RATE METHODS

Translation methods illustrated

TEMPORAL AND CURRENT RATE METHODS

• Translation methods illustrated

TEMPORAL AND CURRENT RATE METHODS

• Translation methods illustrated

TEMPORAL AND CURRENT RATE METHODS

• Translation methods illustrated

TEMPORAL AND CURRENT RATE METHODS

• Current Rate Method – Income Statement

TEMPORAL AND CURRENT RATE METHODS

• Current Rate Method – Balance Sheet

Balance Sheet – December 31, 2010

TEMPORAL AND CURRENT RATE METHODS

• Temporal Method – Income Statement

Income Statement – 2010

TEMPORAL AND CURRENT RATE METHODS

• Temporal Method – Balance Sheet

TEMPORAL AND CURRENT RATE METHODS

Translation methods illustrated – Summary

• FASB ASC 830, Foreign Currency Matters( formerly SFAS

U.S. GAAP REQUIREMENTS

• Highly Inflationary Economies – U.S. GAAP

• IAS 21, The Effects of Changes in Foreign Exchange

• Hyperinflationary Economies – IFRS

HEDGING BALANCE SHEET EXPOSURE

• Companies that have foreign subsidiaries with highly

HEDGING BALANCE SHEET EXPOSURE

• Companies can hedge against gains and losses by using

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