Post on 05-Feb-2018
7/21/2019 Foreign Currency Translation Presentation
1/49
Chapter 7
Translation of ForeignCurrency Financial
Statements
7/21/2019 Foreign Currency Translation Presentation
2/49
Translation of Foreign Currency Financial
Statements
Conceptual issues of foreign currency financialstatements translation.
Balance sheet vs. transaction exposure.
Methods of financial statement translation.
Temporal and current rate methods illustrated.
U.S. G!" #F$Ss" and other standards relatedto translation.
%edging &alance sheet exposure.
7/21/2019 Foreign Currency Translation Presentation
3/49
Translating Foreign Currency Financial
Statements -- Conceptual Issues
Foreign country operations usually prepare financialstatements using local currency as the monetary unit.
These financial statements must &e translated into homecountry currency.
These operations also typically use local G!.
Financial statements must &e translated into homecountry G!.
Learning Objective 1
7/21/2019 Foreign Currency Translation Presentation
4/49
Translating Foreign Currency Financial
Statements -- Conceptual Issues
Primary conceptual issues'ach financial statement item must &e translated using
some" hopefully relevant" exchange rate.(hat rate should &e used) the current exchange rate)The average exchange rate) the historical exchange rate)
Given that any ad*ustment is" at the point of translation"unreali+ed" ho, should the resulting ad*ustment &erecogni+ed) in current income) in an e-uity account on the &alance sheet)
Learning Objective 1
7/21/2019 Foreign Currency Translation Presentation
5/49
Balance Seet !"posure
ssets and lia&ilities translated at the currentexchange rate are exposed to ris of atranslation ad*ustment.
(hen foreign currency appreciates" a net assetexposure results in a positive translationad*ustment.
(hen foreign currency appreciates" a net lia&ilityexposure results in a negative translation
ad*ustment.ssets and lia&ilities translated at the historical
exchange rate are not exposed to a translationad*ustment.
Learning Objective #
7/21/2019 Foreign Currency Translation Presentation
6/49
simple example
/et0s say 123 has a 4555 euro current notereceiva&le on its &oos. The euro6 direct rate is 4 on 464. 8n 496:4" it is 4.95.
Should ,e record;
7/21/2019 Foreign Currency Translation Presentation
7/49
nother simple example;
/et0s say 123 has land on its &oos that is held&y a su&sidiary located in the 'U. The land ,aspurchased on 464 for 4"555"555 euros ,hen theeuro6 direct rate ,as 4. 8n 496:4" it is .
=5=4.Should ,e record;?5)
nd if ,e do report a change" ,here should the offsettinggain &e reported)
7/21/2019 Foreign Currency Translation Presentation
8/49
(hat if;
#nflation differences caused the decline inthe value of the euro)#f the inflation differential ,as 45@" then;Before" 4"555"555'A4"555"555
7/21/2019 Foreign Currency Translation Presentation
9/49
The difference &et,een these t,oexamples
The receiva&le is a monetary asset.
The land is a nonmonetary asset.
7/21/2019 Foreign Currency Translation Presentation
10/49
#f inflation drives foreign exchange rate movements"and monetary6nonmonetary assets are affecteddifferently" ho, should FC effects &e accounted for)
Suppose" in the first case" the land is reportedat current cost instead of historical cost)
7/21/2019 Foreign Currency Translation Presentation
11/49
Methods devised to sort all this out
Current6noncurrent
Monetary6nonmonetary
Temporal
Current rate
7/21/2019 Foreign Currency Translation Presentation
12/49
Translation $eto%s
Current/Noncurrent MethodCurrent assets and lia&ilities are translated at the current
exchange rate.
7/21/2019 Foreign Currency Translation Presentation
13/49
#n our example;
The receiva&le ,ould &e classified ascurrent and translated using the currentrate.
The land ,ould &e classified asnoncurrent and translated at the historicalrate.
7/21/2019 Foreign Currency Translation Presentation
14/49
Curent6
7/21/2019 Foreign Currency Translation Presentation
15/49
Translation $eto%s
Monetary/Nonmonetary Method
Monetary assets and lia&ilities are translated at thecurrent exchange rate.
7/21/2019 Foreign Currency Translation Presentation
16/49
#n our example;
The receiva&le ,ould &e translated usingthe current rate.
The land ,ould &e translated at thehistorical rate" even is it ,ere consideredimpaired and thus reported at fair value.
7/21/2019 Foreign Currency Translation Presentation
17/49
Monetary6
7/21/2019 Foreign Currency Translation Presentation
18/49
Translation $eto%s
Temporal Method8&*ective is to translate financial statements as if the
su&sidiary had &een using the parent0s currency. #tems carried on su&sidiary0s &oos at historical cost"
including all stocholders0 e-uity items are translated athistorical exchange rates.
#tems carried on su&sidiary0s &oos at current value aretranslated at current exchange rates.
#ncome statement items are translated at the exchangerate in effect at the time of the transaction.
Learning Objective &
7/21/2019 Foreign Currency Translation Presentation
19/49
#n our example;
The receiva&le translated using thecurrent rate.
#f reported at historical cost" the land,ould &e translated at the historical rate.
#f reported at fair value" the land ,ould &etranslated at the current rate.
7/21/2019 Foreign Currency Translation Presentation
20/49
Temporal Method
dvantages/ines up ,ith valuation &asis used in
accounting. Thus the num&ers have most
meaning.isadvantages/ots of volatility in financial statements
!ossi&ility of disappearing assets in inflationaryeconomies.
7/21/2019 Foreign Currency Translation Presentation
21/49
Translation $eto%s
Current Rate Method8&*ective is to reflect that the parent0s entire
investment in a foreign su&sidiary is expose to
exchange ris.ll assets and lia&ilities are translated at thecurrent exchange rate.
Stocholders0 e-uity accounts are translated athistorical exchange rates.
#ncome statement items are translated at theexchange rate in effect at the time of thetransaction.
Learning Objective &
7/21/2019 Foreign Currency Translation Presentation
22/49
Current $ate Method
dvantagesSimple to do
$atios are not distorted
isadvantagesCan produce disparate results that are not
consistent ,ith the economics that are reallygoing on.
(hat does the FC ad*ustment)
7/21/2019 Foreign Currency Translation Presentation
23/49
#n our example;
The receiva&le ,ould &e translated usingthe current rate.
The land ,ould &e translated at thecurrent rate.
7/21/2019 Foreign Currency Translation Presentation
24/49
Temporal an% Current 'ate $eto%s
Translation meto%s illustrate%U.S. #nc. o,ns Iuare+" S" a su&sidiary in Mexico ,hich,as esta&lished Ianuary 4" 955?.Iuare+0s &alance sheet items as of 496:465?" in pesos.
Cash 4"555 ccounts paya&le 9"555
ccounts rec. 9"555 /ongterm de&t J"555
#nventory 9"?55 Capital stoc :"555
Fixed assets K"555 $etained earnings 4"?55
ccum. depr. 4"555
Learning Objective (
7/21/2019 Foreign Currency Translation Presentation
25/49
Temporal an% Current 'ate $eto%s
Translation meto%s illustrate%
Iuare+0s income statement items for 955?" in pesos.
Sales 95"555 epr. exp 4"555
C8GS 4>"555 #nterest exp. ?55S"G"L exp. 9"?55 #ncome tax exp. ?55
Learning Objective (
7/21/2019 Foreign Currency Translation Presentation
26/49
Temporal an% Current 'ate $eto%s
Translation meto%s illustrate%
There ,as no &eginning inventory.
#nventory" ,hich is carried at cost" ,as ac-uired evenly
during the last -uarter of 955?.!urchases ,ere made evenly throughout year.
Fixed assets ,ere ac-uired on Ianuary 4" 955?.
Capital stoc ,as sold on Ianuary 4" 955?.
Learning Objective (
7/21/2019 Foreign Currency Translation Presentation
27/49
Temporal an% Current 'ate $eto%s
Translation meto%s illustrate%
$elevant exchange rates U.S. dollar per Mexican pesoD
Ianuary 4" 955? 5.45
verage for 955? 5.5=?verage for >th-uarter 955? 5.5=
ecem&er :4" 955? 5.5K
Learning Objective (
7/21/2019 Foreign Currency Translation Presentation
28/49
Temporal an% Current 'ate $eto%s
Current 'ate $eto% ) Income Statement
Income Statement ) #**+
Sales 4"=55
C8GS 4"::5Gross profit ?75
S"G"L 9:K
epreciation expense =?
#nterest expense >K
#ncome tax expense >7
9
Learning Objective (
7/21/2019 Foreign Currency Translation Presentation
29/49
Temporal an% Current 'ate $eto%s
Current 'ate $eto% ) Balance SeetBalance Seet ) ,ecember &1 #**+
Cash K5 ccounts paya&le 4J5
ccounts $ec. 4J5 /ongterm de&t>K5#nventory 955 Capital stoc :55Fixed ssets" net ?>? $etained earnings 4>9
Total assets =K? Cumulativetranslation ad*. =7D
Total lia&. L S.'. =K?
Learning Objective (
7/21/2019 Foreign Currency Translation Presentation
30/49
Temporal an% Current 'ate $eto%s
Temporal $eto% ) Balance Seet
Balance Seet ) ,ecember &1 #**+
Cash K5 ccounts paya&le 4J5
ccounts $ec. 4J5 /ongterm de&t >K5
#nventory 99? Capital stoc :55
Fixed ssets" net 755 $etained earnings 99?
Total assets 4"4J? Total lia&. L S.'. 4"4J?
Learning Objective (
7/21/2019 Foreign Currency Translation Presentation
31/49
Temporal an% Current 'ate $eto%s
Temporal $eto% ) Balance Seet
Income Statement ) #**+
Sales 4"=55
C8GS 4":>:
Gross profit ??7
S"G"L 9:K
epreciation expense 455
#nterest expense >K
#ncome tax expense >7
$emeasurement gain 454
7/21/2019 Foreign Currency Translation Presentation
32/49
Temporal an% Current 'ate $eto%s
Translation meto%s illustrate% ) Summary
Current Rate Method
ll assets and lia&ilities translated at current rate.
This results in net asset exposure.
7/21/2019 Foreign Currency Translation Presentation
33/49
Temporal an% Current 'ate $eto%s
Translation meto%s illustrate% ) Summary
Temporal Method
!rimarily monetary assets and lia&ilities translated at
current rate.This results in net lia&ility asset exposure.
7/21/2019 Foreign Currency Translation Presentation
34/49
8ther #ssues
(hat is the appropriate current rate)
Translation gains6losses) eferred or&ooed) Sho,n in income or *ust e-uity)
7/21/2019 Foreign Currency Translation Presentation
35/49
Translation ccounting round the (orld
US
#F$S
iversity seen in other nations
7/21/2019 Foreign Currency Translation Presentation
36/49
%istory of Translation ccounting in US
!re4=J?; Current6
7/21/2019 Foreign Currency Translation Presentation
37/49
%istory of Translation ccounting in US
4=K4today; SFS ?9" ,hich has the follo,ingfeatures;Functional currency determines accounting.#f functional currency is the local currency use single
current rate. Gains and losses routed directly tostocholder0s e-uity.#f functional currency is US ollar" use the temporal
method and fully recogni+e gains6losses into earnings.#f functional currency is different from local currency or
US ollar" do &oth.
7/21/2019 Foreign Currency Translation Presentation
38/49
./S/ 0P an% IF'S 'e2uirements
./S/ 0P un%er SFS +#$e-uires identification of functional
currency.Functional currency is the primary
currency of the foreign su&sidiary0soperating environment.
The standard includes a list of indicatorsas guidance for the foreign currencydecision.
Learning Objective +
7/21/2019 Foreign Currency Translation Presentation
39/49
dvantages of SFS ?9
llo,s consideration of context.
#n most cases" eeps impact of FCexchange rate movements out ofearnings.
Much more accepted &y reportingcommunity than FS K ,as.
7/21/2019 Foreign Currency Translation Presentation
40/49
isadvantages of SFS ?9
From an investor0s vie,point" is there anyeconomic difference" in su&stance" &et,eencircumstances that distinguish the t,o methods.
#f not" ,hy have t,o different inds ofaccounting)
#nconsistent ,ith the notion of consolidation.
7/21/2019 Foreign Currency Translation Presentation
41/49
./S/ 0P an% IF'S 'e2uirements
IF'S
#S 94" The Effects of Changes in Foreign ExchangeRates is the relevant accounting standard.
Uses the functional currency approach developed &y theFSB.
The standard includes a list" similar to the FSB list" ofindicators as guidance for the foreign currency decision.
The standard0s re-uirements pertaining tohyperinflationary economies are su&stantially differentfrom SFS ?9.
Learning Objective +
7/21/2019 Foreign Currency Translation Presentation
42/49
./S/ 0P an% IF'S 'e2uirements
3igly Inflationary !conomies ) ./S/ 0P
SFS ?9 provides guidance on highly inflationaryeconomies.
SFS ?9 defines such economies as those ,ith 455@inflation over a period of three years.
SFS ?9 re-uires the use of the temporal method inthese cases of significant inflation.
Learning Objective +
7/21/2019 Foreign Currency Translation Presentation
43/49
./S/ 0P an% IF'S 'e2uirements
3yperinflationary !conomies -- IF'Ss
#S 94 and 9= use the term hyperinflationary economies.
#S 94 is not as specific in defining hyperinflationary
economies as SFS ?9. #S 94 re-uires restatement of the foreign financial
statements for inflation per #S 9=" Financial Reportingin Hyperinflationary Economies.
#S 94 then re-uires the use of the current rate methodof translation on the restated financial statements.
#S approach is su&stantially different from SFS ?9.
Learning Objective +
7/21/2019 Foreign Currency Translation Presentation
44/49
3e%ging Balance Seet !"posure
Companies that have foreign su&sidiaries ,ith highlyintegrated operations use the temporal method.
The temporal method re-uires translation gains andlosses to &e recogni+ed in income.
/osses negatively affect earnings" and &oth gains andlosses increase earnings volatility.
Learning Objective 4
7/21/2019 Foreign Currency Translation Presentation
45/49
3e%ging Balance Seet !"posure
These gains and losses result from the com&ination of&alance sheet exposure and exchange rate fluctuations.
Companies can also hedge to offset the effects of thetranslation ad*ustment to e-uity under the current rate
method.Companies can hedge against gains and losses &y using
foreign currency for,ard contracts" options" and&orro,ings.
Learning Objective 4
7/21/2019 Foreign Currency Translation Presentation
46/49
Translation Proce%ures Internationally
Canada very similar to U.S." ho,ever under thetemporal method" some translations ad*ustmentscan &e deferred and amorti+ed.Mexico standards are silent" &ut SFS ?9 is
commonly follo,ed. #n cases ,here it is not"practice varies ,idely.Brazil current rate method is used ,ith gains andlosses included in income.
Japan significantly different from U.S. G! and#F$Ss" ,ith cumulative translation ad*ustmentreported as an asset or lia&ility.Korea only the current rate method is used.
Learning Objective 5
7/21/2019 Foreign Currency Translation Presentation
47/49
8ne final pro&lem
%o, do ,e interpret reported FC gains andlosses" irrespective of ,here they sho, up)
'xample; Company has a large su&sidiary in the
'U. The su&sidiary has a large net assetposition. The 'uro depreciates more than >5@.%uge losses are reported.
The su&sidiary0s sales and profits syrocet"since they no, seem more competitive tocustomers than ever.
7/21/2019 Foreign Currency Translation Presentation
48/49
Thus" and strangely;
#n a ,orld of Nfloating rateO currency"sometimes a ,ea currency is good" anda strong currency is &adP
This explains ,hy" ,hen marets are tightor declining" nations compete ,ith eachother in a race to devalue their money the
mostP
7/21/2019 Foreign Currency Translation Presentation
49/49
Summary
ll inds of pro&lems arise ,hen the value ofmoney changes and is uncertain.
The economic impact of these changes vary as afunction of the inherent cause of the FC
movement and the type of holding asset6lia&ilitymonetary6nonmonetary current6noncurrentD.
ccounting limitations e.g." historical costD mix,ith this uncertainty" maing financial reporting
difficult at &est.The current paradigm is SFS ?9. This couldeasily change at any time" as it has several times&efore.