Chapter 12
Translation of Foreign
Currency
Financial
Statements
McGraw-Hill/Irwin
©The McGraw-Hill Companies, Inc. 2006
Scope of Chapter
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2
Translation of the amounts in the financial
statements of the foreign entities from it’s
functional currency to the reporting currency.
Remeasurement of financial records to
functional currency from the local currency.
Functional Currency
The FASB defined functional currency of a foreign
entity as follows:
An entity’s functional currency is the currency of the
primary economic environment in which the entity
operates; normally, that is the currency of the environment
in which an entity primarily generates and expends cash….
Notes:
1.
2.
3
For an entity with operations that are relatively self contained and
integrated within a particular country, the functional currency would be
the currency of that country.
A foreign entity’s functional currency might not be the currency of the
country in which it is located.
Functional Currency: Guidelines by
FASB
Economic factors set forth below and possibly others
should be considered both individually and collectively
when determining the functional currency:
 Cash flow indicators.
 Sales price indicators.
 Sales market indicators.
 Expense indicators.
 Financing indicators.
 Intercompany
transactions
and
arrangements
indicators.
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Cash Flow Indicators
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Foreign Currency: Cash Flows related to the foreign
entity’s individual assets and liabilities are primarily in
the foreign currency and do not directly impact the
parent company’s cash flows.
Parent’s Currency: Cash Flows related to the foreign
entity’s individual assets and liabilities directly impact
the parent’s cash flows on a current basis and are
readily available for remittance to the parent company.
Sales Price Indicators
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Foreign Currency: Sales prices for the foreign entity’s
products are not primarily responsive on a short-term
basis to changes in exchange rates but are determined
more by local competition or local government
regulation.
Parent’s Currency:Sales prices for the foreign entity’s
products are primarily responsive on a short-term basis
to changes in exchange rates; for example,sales prices
are determined more by worldwide competition or by
international prices.
Sales Market Indicators
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Foreign Currency: There is an active local
sales market for the foreign entity’s products,
although there also might be significant
amounts of exports.
Parent’s Currency: The sales market is
mostly in the parent’s country or sales
contracts are denominated in the parent;s
currency.
Expense indicators
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Foreign Currency: Labor, materials, and other costs
for the foreign entity’s product or services are primarily
local costs, even though there also might be imports
from some other countries.
Parent’s Currency: Labor, materials, and other costs
for the foreign entity’s product or services, on a
continuing basis, are primarily costs for components
obtained from the country in which the parent company
is located.
Financing Indicators
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
Foreign Currency: Financing is primarily denominated in
foreign currency, and funds generated by the foreign entity’s
operations are sufficient to service existing and normally
expected debt obligations.
Parent’s Currency:
–
–
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Financing is primarily from the parent or other dollar
denominated obligations, or funds generated by the foreign
entity’s operations are not sufficient to service existing and
normally expected debt obligations without infusion of
additional funds from the parent company.
Infusion of additional funds from the parent company for
expansion is not a factor, provided funds generated by the
foreign entity’s expanded operations are expected to be
sufficient to service that additional financing.
Intercompany Transactions and
Arrangements Indicators

Foreign Currency:
1.
2.

Parent’s Currency:
1.
2.
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There is a low volume of intercompany transactions and there is not
an extensive interrelationship between the operations of the foreign
entity and the parent company.
However, the foreign entity’s operations my rely on the parent’s or
affiliate’s competitive advantages, such as patents and trademarks.
There is a high volume of intercompany transactions and there is an
extensive interrelationship between the operations of the foreign
entity and the parent company.
The parent’s currency generally would be the functional currency if
the foreign entity is a device or shell corporation for holding
investments, obligations, intangible assets, etc., that could readily be
carried on the parent’s or an affiliate’s books.
Alternative Methods for Translating
Foreign Entities’ Financial Statements
The methods for foreign currency translation may
be grouped into the following basic classes:
 Current/Noncurrent Method
 Monetary/Nonmonetary Method
 Current Rate Method
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Rates Used for Translation
Different rates used for translation are as follows:

Current Rate: The exchange rate in effect on the balance sheet
date of the foreign entity.

Historical Rate: The exchange rate in effect at the time the
assets, liabilities, and equities were first recognized in the
foreign entity’s accounting records.

Average Rate: Average exchange rate for the accounting
period.

Question: Which exchange rate/s should be used to translate
the foreign entity’s financial statements?

Answer: According to the FASB statement# 52 ”Foreign
Currency Translation”, several methods have been categorized
into above three basic classes.
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Current/Noncurrent Method
Rates used for translation:
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Current Rate: Current Assets and current liabilities.
Historical Rate: All other assets, liabilities and
owners’ equity in the balance sheet and depreciation
and amortization expense applicable to related assets
in the income statement.
Average Rate: All other revenues and expenses.
Note: Today this method is objectionable with respect to inventories
since inventories are translated at current rate, it represents a
departure from historical cost.
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Monetary/Nonmonetary Method
Rates used for translation:

Current Rate: Monetary assets and liabilities .

Historical Rate: All other assets, liabilities and owners’ equity in
the balance sheet and cost of goods sold and depreciation and
amortization expense applicable to related assets and in the
income statement.

Average Rate: All other revenues and expenses.
Notes:
1.
2.
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Monetary assets and liabilities are those representing claims or
obligations expressed in a fixed monetary amount.
This method focuses on the characteristics of assets and liabilities of
the foreign entity, rather than on their balance sheet classifications
and misstates the actual financial position and operating results of
the foreign entity.
Current Rate Method
Rates used for translation:
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Current Rate: All balance sheet amount other
than owners’ equity and in income statement,
all revenue and expenses, if practical.
Historical Rate: Owners’ equity.
Average Rate: All other revenues and
expenses.
Standards for Translation Established
by the FASB – FASB Statement No. 52
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FASB Statement No. 52 has adopted the current rate
method for translating a foreign entity’s financial statements
from the entity’s functional currency to the reporting
currency of the parent company.
If the foreign entity’s accounting records are maintained in a
currency other than its functional currency, account
balances must be remeasured to the functional currency
before their translation.
Remeasurement is accomplished by the monetaty/nonmonetary method of translation.
If a foreign entity’s functional currency is the U.S. dollar,
remeasurement eliminates the need for translation (as
remeasurement must precede translation).
Remeasurement of a Foreign
Entity’s Accounts – FASB Guidelines

The remeasurement process should produce the same

result as if the entity’s books of record had been initially
recorded in the functional currency.
To accomplish that result it is necessary to use:
1.
2.
3.
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Historical exchange rates between the functional currency
and another currency for certain accounts.
Current rate for all others.
Recognize currently in income, all gains and losses from
remeasurement of monetary assets and liabilities that are not
denominated in the functional currency.
Nonmonetary Balance Sheet Items and
Related Revenu/Expense Items
Remeasured Using Historical Rates
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Marketable Securities carried at cost:
1.
2.
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Equity Securities
Debt securities not intended to be held until maturity.
Inventories carried at cost.
Short-term prepayments such as insurance,
advertising, and rent.
Plant assets and their accumulated depreciation.
Patents, trademarks, licenses, formulas, goodwill,
other intangible assets and their accumulated
amortization.
Deferred charges and credits.
Nonmonetary Balance Sheet Items and
Related Revenu/Expense Items
Remeasured Using Historical Rates
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Deferred revenue.
Common stock.
Preferred stock carried at issuance price.
Examples of revenue and expenses related to
nonmonetary items:
Cost of goods sold.
2.
Depreciation of plant assets.
3.
Amortization of intangible assets.
4.
Amortization of deferred charges or credits.
Note: The appropriate historical or current exchange rate generally is
the rate applicable to conversion of foreign currency for dividend
remittances.
1.
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Other Aspects of Foreign Currency
Translation
The FASB Statement No. 52 also includes the
following topics:
 Transaction gains and losses excluded from
net income.
 Functional currency in highly inflationary
economies.
 Income taxes related to foreign currency
translation.
 Disclosure of foreign currency translation.
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Transaction Gains and Losses
Excluded from Net Income
The FASB requires that gains and losses from the
following foreign currency transactions be accounted
for in the same manner as foreign currency
adjustments:
1.
2.
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Foreign currency transactions that are designated as, and are
effective as, economic hedges of a net investment in a foreign
entity, commencing as of the designation date.
Intercompany foreign currency transactions that are of a longterm investment nature (that is, settlement is not planned or
anticipated in the foreseeable future), when the entities to the
transaction are consolidated, combined, or accounted for by the
equity method.
Functional Currency in Highly
Inflationary Economies
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The FASB requires that the functional currency of a
foreign entity in a highly inflationary economy be
identified as the reporting currency (the U.S. dollar for
a U.S. multinational enterprise).
The FASB defined a highly inflationary economy as on
having cumulative inflation of 100% or more over a
three-year period.
Thus, financial statements of a foreign entity in a
country experiencing severe inflation are remeasured
in U.S. dollars, regardless of the criteria for
determination of the functional currency.
Income Taxes Related to Foreign
Currency Translation
Conventional interperiod and intraperiod income tax allocation
procedures were described by the FASB as follows:
1.
Interperiod tax allocation for temporary differences associated
with foreign currency transaction gains and losses that are
reported in different accounting periods for financial accounting
and income taxes.
2.
Interperiod tax allocation for temporary differences associated
with foreign currency translation adjustments that do not meet
the criteria for nonrecognition of deferred tax liabilities for
undistributed earnings of foreign subsidiaries.
3.
Intraperiod tax allocation for foreign currency translation
adjustments included in the stockholders’ equity section of the
balance sheet.
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Disclosure of Foreign Currency
Translation
The FASB requires disclosure:
 in the income statement or in a note to financial
statements of the aggregate foreign currency
transaction gains or losses or an accounting period.
 of changes in foreign currency translation adjustments
(as well as other components of accumulated other
comprehensive income) during an accounting period.
 for forward contracts or other financial instruments
designated as hedges of the foreign currency
exposure of a net investment in a foreign operation.
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Appraisal of Accounting Standards
for Foreign Currency Translation
Criticisms:
1.
It established an identifiable distinction between
transaction gains and losses arising from
remeasurement and translation adjustments resulting
from translation although both involve comparable
activities. Thus, they should be accounted for in the
same manner.
2.
It abandoned the historical-cost principle by
sanctioning use of the current rate method for
translation of foreign currency financial statements.
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