CHAPTER 16
MULTINATIONAL OPERATIONS
Presenter’s name
Presenter’s title
dd Month yyyy
PRESENTATION CURRENCY AND
FUNCTIONAL CURRENCY
• Presentation currency: The
currency in which the company
presents (reports) its financial
statements.
• Functional currency: The
currency in which the company
conducts its primary activity.
• Local currency: The currency
used within the country in which
the company operates.
• Often, presentation currency =
functional currency = local
currency.
• Often, functional currency of
subsidiary ≠ functional and
presentation currency of parent.
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FOREIGN CURRENCY TRANSACTION
EXPOSURE
Payment Currency?
Goods
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FOREIGN CURRENCY TRANSACTION
EXPOSURE
?
Goods
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FOREIGN CURRENCY TRANSACTION
EXPOSURE
?
Goods
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FOREIGN CURRENCY TRANSACTION
EXPOSURE
• IMPORTER makes purchase
denominated in foreign currency
with timing difference between
purchase date and payment date.
• EXPORTER makes sale
denominated in foreign currency
with timing difference between sale
date and payment receipt date.
• Example: Finnish importer FinnCo
makes credit purchase from MexCo.
• Example: Mexican exporter MexCo
makes credit sale to FinnCo.
• If the purchase is denominated in
Mexican pesos, FinnCo has
foreign currency transaction
exposure.
• If the sale is denominated in
euros, MexCo has foreign currency
transaction exposure.
• Downside risk to FinnCo: If value of
peso increases relative to the euro
during the time between the
purchase date and payment date,
FinnCo must spend more euros to
settle its account payable in pesos.
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• Downside risk to MexCo: If value of
peso increases relative to euro
during the time between the sale
date and receipt of payment, MexCo
can buy fewer pesos with the euros
it receives.
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CHANGES IN EXCHANGE RATES
IMPACT ON SALES: EXAMPLE 1
• FinnCo sells goods to a customer in the United Kingdom
for £10,000 with payment to be received in British pounds.
Credit terms allow 45 days for receipt of payment. FinnCo’s
functional and presentation currency is the euro.
• Exchange rate on the date of the transaction: £1 = €1.460
• Exchange rate on the date of payment:
£1 = €1.475
• Question: What is FinnCo’s foreign exchange gain or loss?
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CHANGES IN EXCHANGE RATES
IMPACT ON SALES: EXAMPLE 1
£
FX Rate
€
Euro value of FinnCo’s receivable on
transaction date
10,000
1.460
14,600
Euro value of FinnCo’s receivable on
receipt date
10,000
1.475
14,750
FinnCo’s foreign exchange gain
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CHANGES IN EXCHANGE RATES
IMPACT ON SALES: EXAMPLE 2
• FinnCo sells goods to a customer in the United Kingdom for
£10,000 with payment to be received in British pounds. Credit
terms allow 45 days for receipt of payment.
• Exchange rate on the date of the transaction:
£1 = €1.460
• Exchange rate on the date of payment:
£1 = €1.475
• Assume that the transaction date was in November Year 1, the
payment date was in January Year 2, and the company has a 31
December year-end.
• Exchange rate on 31 December, Year 1:
£1 = €1.480
• Question: What is FinnCo’s foreign exchange gain or loss for
Year 1? And for Year 2?
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CHANGES IN EXCHANGE RATES
IMPACT ON SALES: EXAMPLE 2
Transaction date
Balance sheet date
Payment receipt date
Exchange rate:
£1 = €1.460
Exchange rate:
£1 = €1.480
Exchange rate:
£1 = €1.475
Value of receivable:
€14,600
Value of receivable:
€14,800
Value of receivable:
€14,750
Gain of
€200
Loss of €50
Overall actual realized foreign
currency gain = €150
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CHANGES IN EXCHANGE RATES
IMPACT ON SALES AND PURCHASES
Transaction
Type of Exposure
Foreign Currency
Strengthens Weakens
Export sale
Asset (account receivable)
Gain
Loss
Import
purchase
Liability (account payable)
Loss
Gain
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CHANGES IN EXCHANGE RATES
IMPACT ON SALES: EXAMPLE 2
Where will FinnCo report the foreign currency transaction gain in Year 1?
Alternative 1
Alternative 2
Report transaction gain as part of
Report transaction gain as part of
“other operating expenses, net.”
“nonoperating expenses, net.”
• Gross profit margin: no impact
• Gross profit margin: no impact
• Operating profit margin: higher
• Operating profit margin: lower
• Net profit margin: no impact
• Net profit margin: no impact
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IMPACT OF CHANGES IN EXCHANGE RATES:
EXAMPLE DISCLOSURE
“Our exposure to foreign currency transaction gains and losses is the result of
assets and liabilities, (including inter-company transactions) that are
denominated in currencies other than the relevant entity’s functional currency....
Transaction gains and losses on these foreign exchange contracts are recognized
each period in other income, net included on the consolidated statements of
income. During the years ended December 31, 2011, 2010, and 2009, we
recorded net realized and unrealized foreign currency transaction gains of $9
million and $13 million, and a transaction loss of $1 million, respectively.”
Yahoo! Inc., Annual Report (2011)
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TRANSLATING SUBSIDIARIES’ SALES INTO THE
PARENT COMPANY’S PRESENTATION CURRENCY
• In most cases, a foreign subsidiary will operate primarily in the currency of the
country where it is located, which will differ from the currency in which the
parent company presents its financial statements.
• To prepare worldwide consolidated financial statements, the parent company
must translate the foreign currency financial statements of their foreign
subsidiaries into the parent company’s presentation currency.
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TRANSLATING SUBSIDIARIES’ SALES INTO THE
PARENT COMPANY’S PRESENTATION CURRENCY
For example, assume the US subsidiary of a German company keeps its books
in US dollars, and the South African subsidiary of the German company keeps its
books in South African rands. The German parent company must prepare
consolidated financial statements in euros.
• Revenues are translated at the exchange rate that existed when the
transactions took place. For practical reasons, a rate that approximates the
exchange rates at the dates of the transactions, such as an average exchange
rate, may be used.
• If the US dollar and South African rand appreciate against the euro over the
course of a given year, the amount of sales translated into euro will be greater
than if the subsidiaries’ currencies weaken against the euro.
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TRANSLATING FOREIGN CURRENCY FINANCIAL
STATEMENTS INTO THE PARENT COMPANY’S
PRESENTATION CURRENCY
In consolidated financial statements, the assets, liabilities, revenues, and
expenses of both domestic and foreign subsidiaries are added to those
of the parent company.
Overall, two questions must be addressed:
1. What exchange rate should be used for each line item?
2. Where should the translation adjustment be reported?
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WHAT EXCHANGE RATE SHOULD BE USED
FOR EACH LINE ITEM?
• Current rate method: Use spot exchange rate on balance sheet date
for all assets and liabilities.
• Temporal method:
– Use spot exchange rate on balance sheet date for all monetary
assets and liabilities (and for all non-monetary assets and liabilities
that are measured at their current value).
– Use historical exchange rate for non-monetary assets and liabilities
that are measured at historical cost.
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WHAT EXCHANGE RATE SHOULD BE USED
FOR EACH LINE ITEM?
When the subsidiary’s functional
currency is different from the parent’s
functional currency:
When the subsidiary’s functional
currency is the same as the parent’s
functional currency:
• All assets and liabilities: Translate at
current exchange rate (current rate
method)
• Monetary assets and liabilities:
Translate at current exchange rate
• Non-monetary assets and liabilities:
- Historical cost at historical
exchange rates
- Current value at valuation date
exchange rate
• Equity accounts: Translate at
historical exchange rates
• Revenues and expenses:
- Not related to non-monetary assets,
translate at average exchange rate
- Related to non-monetary assets,
use historical exchange rate.
• Equity accounts: Translate at
historical exchange rates
• Revenues and expenses: Translate
at average exchange rate, which
approximates exchange rate on
transaction date
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WHERE SHOULD THE TRANSLATION
ADJUSTMENT BE REPORTED?
When the subsidiary’s functional
currency is different from the
parent’s functional currency:
When the subsidiary’s functional
currency is the same as the
parent’s functional currency:
• Unrealized translation gain/loss
is accumulated as a separate
component of the parent’s equity.
• Translation adjustment is
reported as a gain or loss in the
parent’s net income.
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FACTORS CONSIDERED IN DETERMINING THE
FUNCTIONAL CURRENCY
The functional currency is
• the currency that influences sales prices for goods and services.
• the currency of the country whose competitive forces and regulations
mainly determine the sales price of the entity’s goods and services.
• the currency that mainly influences labor, material, and other costs of
providing goods and services.
• the currency in which funds from financing activities are generated.
• the currency in which receipts from operating activities are usually
retained.
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TRANSLATING FOREIGN CURRENCY
FINANCIAL STATEMENTS: EXAMPLE
Translation worksheet for Amerco (US subsidiary), 31 December 20X1
Exchange rate is €1.00 = US$1.00
Balance Sheet Item
Cash
Inventory
Total
USD
$3,000
12,000
$15,000
Exchange Rate (€)
1.00
1.00
EUR
€3,000
12,000
€15,000
Notes payable
Common stock
Total
$5,000
10,000
$15,000
1.00
1.00
€5,000
10,000
€15,000
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TRANSLATING FOREIGN CURRENCY
FINANCIAL STATEMENTS: EXAMPLE
Translation worksheet for Amerco (US subsidiary), 31 March 20X2
No transactions. Current exchange rate is €0.80 = US$1.00.
Balance Sheet Item
Cash
Inventory
Total
USD
Exchange Rate (€)
$ 3,000
?
12,000
?
$15,000
Notes payable
Common stock
Total
$5,000
10,000
$15,000
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?
1.00
EUR
€?
?
€?
?
10,000
€?
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TRANSLATING FOREIGN CURRENCY
FINANCIAL STATEMENTS: EXAMPLE
Translation worksheet for Amerco (US subsidiary), 31 March 20X2
No transactions. Current exchange rate is €0.80 = US$1.00.
Cash
Inventory
Total
Notes payable
Common stock
Subtotal
Translation
adjustment
Total
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Exchange
US Dollar Rate (€)
$3,000
0.80 C
12,000
0.80 C
$15,000
$5,000
10,000
$15,000
0.80 C
1.00 H
Euro
€2,400
9,600
€12,000
Change in Euro Value
since 31 Dec 20X1
–€ 600
–2,400
–€3,000
€4,000
10,000
€14,000
–€1,000
0
–€1,000
–2,000
€12,000
–2,000
–€3,000
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TRANSLATING FOREIGN CURRENCY
FINANCIAL STATEMENTS: EXAMPLE
Translation worksheet for Amerco (US subsidiary), 31 March 20X2
No transactions. Current exchange rate is €0.80 = US$1.00.
Cash
Inventory
Total
Notes payable
Common stock
Subtotal
Translation adjustment
Total
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Exchange
US Dollar
Rate (€)
$ 3,000
0.80 C
12,000
1.00 H
$15,000
$5,000
10,000
$15,000
0.80 C
1.00 H
Change in Euro
Value since 31
Euro
Dec 20X1
€ 2,400
–€600
12,000
0
€14,400
–€600
€4,000
10,000
€14,000
400
€14,400
–€1,000
0
–€1,000
400
–€600
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CHANGES IN EXCHANGE RATES
IMPACT ON TRANSLATION ADJUSTMENT
Foreign Currency (FC)
Balance Sheet Exposure
Strengthens
Weakens
Net asset
Positive translation
adjustment
Negative translation
adjustment
Net liability
Negative translation
adjustment
Positive translation
adjustment
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EFFECTS OF TRANSLATION METHOD
ON FINANCIAL RATIOS
• Receivables turnover (sales/receivables) is the same under both
current and temporal methods.
- Sales are translated at the average exchange rate under both.
- Receivables are translated at the current exchange rate under
both.
• Current ratio (current assets/current liabilities) differs.
- Inventory is translated at the current exchange rate under the
current method, but the historical exchange rate under the
temporal method.
- If the subsidiary’s currency appreciates relative to the parent,
the current ratio will be higher under the current method than
the temporal.
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RATIOS UNDER LOCAL CURRENCY VS. RATIOS IN
TRANSLATED CURRENCY: CURRENT METHOD
• Underlying relationships in a subsidiary’s local currency financial
statement are preserved when
- ratios involve only the balance sheet (e.g., current ratio, debt-toassets ratio, debt-to-equity ratio).
- ratios involve only the income statement (e.g., interest coverage ratio,
gross profit margin, operating profit margin, net profit margin).
• Underlying relationships in a subsidiary’s local currency financial
statement are distorted when ratios involve amounts from both the
balance sheet and income statement because
- assets and liabilities are translated using the current exchange rate.
- revenues and expenses are translated using the average exchange
rate.
- equity accounts are translated at historical exchange rates.
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RATIOS UNDER LOCAL CURRENCY VS. RATIOS IN
TRANSLATED CURRENCY: TEMPORAL METHOD
• Underlying relationships in a subsidiary’s local currency financial statement are
preserved when both numerator and denominator use the historical exchange
rate (e.g., Inventory turnover = Cost of goods sold/Inventory).
• Otherwise, underlying relationships in a subsidiary’s local currency financial
statement are distorted because of the following:
- Monetary assets and liabilities are translated at current exchange rate.
- Non-monetary assets and liabilities
- Historical cost translated at historical exchange rates.
- Current value translated at valuation date exchange rate.
- Revenues and expenses
- Not related to non-monetary assets, translated at average exchange rate.
- Related to non-monetary assets, translated at historical rate.
- Equity accounts are translated at historical exchange rates.
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SUBSIDIARIES OPERATING IN
HYPERINFLATIONARY ECONOMIES
• For a subsidiary in a hyperinflationary economy, translating local
foreign currency financial statements into the parent’s presentation
currency requires the following:
• Under IFRS
• First, restate the subsidiary’s local currency financial statements for
local inflation.
• Then, translate the inflation-restated foreign currency financial
statements into the parent’s presentation currency using the
current exchange rate.
• Under US GAAP
• Use the temporal method to translate the subsidiary’s local
currency financial statements.
• Include the resulting translation adjustment as a gain or loss in
determining net income.
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SUBSIDIARIES OPERATING IN
HYPERINFLATIONARY ECONOMIES: EXAMPLE
• Assume a US company established a subsidiary in Turkey on 1
January 2000 (at which time Turkey was highly inflationary).
• The US parent sent the subsidiary US$1,000 on 1 January 2000 to
purchase a piece of land at a cost of TL542,700,000 (TL542,700/US$ ×
US$1,000 = TL542,700,000).
• Assuming no other assets or liabilities, what are the annual and
cumulative translation gains or losses given the following data?
Date
01 Jan 2000
31 Dec 2000
31 Dec 2001
31 Dec 2002
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Exchange Rates
TL542,700 = US$1
TL670,800 = US$1
TL1,474,525 = US$1
TL1,669,000 = US$1
Year
Inflation Rate
(%)
2000
2001
2002
38
69
45
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SUBSIDIARIES OPERATING IN
HYPERINFLATIONARY ECONOMIES: EXAMPLE
• A Turkish subsidiary of a US parent has one asset: A piece of land at
an original cost of TL542,700,000. The US parent sent the subsidiary
US$1,000. What are the annual and cumulative translation gains or
losses under IFRS?
Date
Inflation
Rate
(%)
01/01/00
31/12/00
31/12/01
31/12/02
38
69
45
Restated
Current Translated
Carrying
Exchange Amount in
Value in TL
Rate TL/$
US$
542,700,000
542,700
$1,000
748,926,000
670,800
1,116
1,265,684,940 1,474,525
858
1,835,243,163 1,669,000
1,100
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Annual
Cumulative
Translation Translation
Gain
Gain
(Loss)
(Loss)
N/A
N/A
$116
$116
(258)
(142)
242
100
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SUBSIDIARIES OPERATING IN
HYPERINFLATIONARY ECONOMIES: EXAMPLE
• A Turkish subsidiary of a US parent has one asset: A piece of land at
an original cost of TL542,700,000. The US parent sent the subsidiary
US$1,000. What are the annual and cumulative translation gains or
losses under US GAAP?
Historical
Exchange
Rate
Translated
Amount in
US$
Annual
Translation
Gain (Loss)
Cumulative
Translation
Gain (Loss)
Date
Carrying
Value in TL
01/01/00
542,700,000
542,700
$1,000
N/A
N/A
31/12/00
542,700,000
542,700
1,000
N/A
N/A
31/12/01
542,700,000
542,700
1,000
N/A
N/A
31/12/02
542,700,000
542,700
1,000
N/A
N/A
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MULTINATIONAL OPERATIONS AND EFFECTIVE
TAX RATE
• Effective tax rate: Tax expense divided by pretax accounting profits
• Statutory tax rate: The income tax rate in the company’s home tax jurisdiction.
• Required disclosures include a reconciliation schedule explaining reasons for
the differences between the statutory tax rate and the company’s effective tax
rate.
• When a company earns profits outside its home country and incurs taxes at
foreign tax rates that differ from its home country statutory tax rate, the effect
will be shown in the reconciliation schedule.
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COMPONENTS OF SALES GROWTH AND
SUSTAINABILITY
Excerpt from General Mills 2011 Annual Report
MD&A
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COMPONENTS OF SALES GROWTH AND
SUSTAINABILITY
Excerpt from General Mills 2011 Annual Report
Supplementary Schedule
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COMPONENTS OF SALES GROWTH AND
SUSTAINABILITY
Hypothetical Companies’
Components of International Sales Growth
(percentage points)
Contributions from volume growth
Contributions from price increases
Foreign currency exchange
Net sales growth
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A
8
1
1
10
B
1
8
1
10
C
1
1
8
10
D
6
3
1
10
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CURRENCY FLUCTUATIONS—POTENTIAL
IMPACT ON FINANCIAL RESULTS
• As discussed, a multinational company’s sales denominated in currencies
other than the company’s functional currency give rise to exchange risks.
• Over the medium to long term, a company can create a “natural hedge” by
more closely matching the currency of its expenses with the currency of its
sales—for example,
– by making more of its purchases in the same currencies as the sales, and/or
– by locating its manufacturing facilities in the country of sales.
• Over shorter time frames, a company can hedge currency risks in the financial
markets.
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CURRENCY FLUCTUATIONS—POTENTIAL
IMPACT ON FINANCIAL RESULTS
• For example, BMW AG faces exchange risks arising from sales of vehicles
outside the Eurozone.
• BMW measures currency risk using a “cash-flow-at-risk” model.
– Identify forecasted foreign currency transaction exposure.
– Exposures are compared with all hedges that are in place to determine
unhedged risk positions.
– The potential negative impact on earnings is computed based on exchange
rate volatility and probability distributions.
• BMW discloses the potential negative earnings impact of unfavorable changes
in exchange rates.
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SUMMARY
• Fluctuations in foreign exchange rates cause the translated values of
foreign currency assets and liabilities to change, giving rise to foreign
exchange differences that must be reflected in the financial statements.
• For export sales (or import purchases), any change in the functional
currency value of the foreign currency account receivable (or account
payable) that occurs between the transaction date and the settlement
date is recognized as a foreign currency transaction gain or loss in net
income.
• For translating foreign subsidiaries’ financial statements into the parent
company’s presentation currency, either the current method or the
temporal method is used.
• Companies typically disclose information about the impact of foreign
currency on sales growth and sensitivity of profits to currency
fluctuations.
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