Chapter Ten
Translation of
Foreign
Currency
Financial
Statements
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Worldwide Consolidated
Financial Statements
To prepare worldwide consolidated financial
statements a U. S. parent must:
(1) convert the foreign GAAP financial statements
of its foreign operations into U.S. GAAP and
(2) translate the financial statements from the
foreign currency into U.S. dollars.
10-2
Worldwide Consolidated
Financial Statements
This conversion and translation process is required
whether the foreign operation is a branch, joint
venture, majority-owned subsidiary, or affiliate
accounted for under the equity method.
Two major related theoretical issues are:
(1) which translation method should be used and
(2) where the resulting translation adjustment
should be reported in the consolidated financial
statements.
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Learning Objective 10-1
Explain the theoretical underpinnings
and the limitations of the current rate
and temporal methods.
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Translation Methods:
Temporal and Current Rate
Two major translation methods are currently used:
(1) the current rate (or closing rate) method and
(2) the temporal method.
Each method is presented from the perspective of a
U.S.–based multinational company translating
foreign currency financial statements into U.S.
dollars.
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Comparison of the Two Translation
Methods
10-6
Treatments for Translation Adjustment
Two issues arise related to the translation of foreign currency
financial statements:
(1) selecting the appropriate method.
(2) deciding where to report the resulting translation adjustment
in the consolidated financial statements.
The two major translation methods and the two possible
treatments for the translation adjustment give rise to four possible
combinations:
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Learning Objective 10-2
Describe guidelines as to when foreign currency
financial statements are to be translated using
the current rate method and when they are to
be translated using the temporal method.
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Two Translation Combinations
Some subs are so closely tied to their U.S. parents. They
use a U.S. dollar perspective to translation, so most of
their transactions are recorded in U.S. dollars using the
temporal method.
Other subs use the local currency perspective; they
operate relatively independent of their U.S. parents and
use the current rate method for translation.
Translation adjustment appears in the equity section.
FASB does not express preference for either of the two
theoretical views
10-9
Functional Currency
To determine whether a subsidiary is integrated with
the parent or operates independently, we look at the
functional currency.
A company’s functional currency is the primary
currency of the foreign entity’s operating environment.
10-10
Determining Subsidiary’s
Functional Currency
10-11
Functional Currency Terminology
Reporting currency – the currency in which the entity
prepares its financial statements. U.S. based corporations use
the U.S. dollar.
Remeasurment – If a foreign operation’s functional currency
is the U.S. dollar, the currency balances must be remeasured
into U. S. dollars using the temporal method resulting in
remeasurement gains and losses.
Translation Adjustment – If a foreign currency is the foreign
operation’s functional currency, the currency balances must
be translated using the current rate method and a translation
adjustment is reported on the balance sheet.
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Highly Inflationary Economies
In highly inflationary economies, the Temporal Method
for translation is required.
A country has a highly inflationary economy when its
cumulative three year inflation exceeds 100 percent. With
compounding, it equates to an average of approximately
26 percent per year for three years in a row.
A country may or may not be classified as highly
inflationary, depending on its most recent three-year
experience with inflation.
10-13
Learning Objective 10-3
Translate a foreign subsidiary’s financial
statements into its parent’s reporting currency
using the current rate method and calculate the
related translation adjustment.
10-14
Current Rate Method
The first step in translating foreign currency financial
statements is to determine the functional currency.
Under the current rate method, all revenues and
expenses are translated at the exchange rate in effect
at the date of accounting recognition.
The weighted average exchange rate is used when
revenues and expenses have been recognized evenly
throughout the year.
10-15
Current Rate Method
However, when an income account, such as a gain or
loss, occurs at a specific point in time, the exchange
rate as of that date is applied.
Depreciation and amortization expenses also are
translated at the average rate for the year. These
expenses accrue evenly throughout the year even
though the journal entry could be delayed until yearend for convenience.
10-16
Learning Objective 10-4
Remeasure a foreign subsidiary’s financial
statements using the temporal method and
calculate the associated remeasurement
gain or loss.
10-17
Temporal Method
If the sub’s functional currency is the US
dollar, then any balances denominated in the
local currency, must be remeasured.
Remeasurement requires the application of
the temporal method.
The remeasurement gain or loss appears on
the income statement.
10-18
Temporal Method
The temporal method remeasures cash, receivables,
and liabilities into U.S. dollars using the current
exchange rate.
Inventory, property and equipment, patents, and
contributed capital accounts are remeasured at
historical rates resulting in differences in total assets
and liabilities plus equity which must be reconciled
resulting in a remeasurement gain or loss.
10-19
Temporal Method
In remeasuring the statement of cash flows, the U.S.
dollar value for net income is taken from the remeasured
income statement. Depreciation and amortization are
remeasured at the rates used in the income statement,
and the remeasurement loss, a noncash item, is added
back to net income.
Increases in accounts receivable and accounts payable,
related to sales and purchases, are remeasured at the
average rate. The increase in inventory is determined by
the remeasurement of cost of goods sold.
10-20
Nonlocal Currency Balances
If any accounts of the foreign subsidiary are
denominated in a currency other than the local
currency, they would first have to be restated into
the local currency.
Both the foreign currency balance and any related
foreign exchange gain or loss would then be
translated (or remeasured) into US dollars.
10-21
Comparison of Results from
Applying the Two Methods
The determination of the foreign subsidiary’s
functional currency (and the use of different
translation methods) can have a significant
impact on consolidated financial statements.
The current rate method does not always result
in higher net income and a higher amount of
equity than the temporal method and a higher
amount of equity than the temporal method.
10-22
Comparison of Results from
Applying the Two Methods
For example, a company with Swiss francs as the local
currency reports the values for selected financial ratios
calculated from the original foreign currency financial
statements and from the U.S. dollar–translated
statements using the two different translation methods.
10-23
Comparison of Results from
Applying the Two Methods
The temporal method distorts all of the ratios
measured in the foreign currency. The subsidiary
appears to be less liquid, more highly leveraged, and
more profitable than it does in Swiss franc terms.
The current rate method maintains the first three
ratios but distorts return on equity because income
was translated at the average-for-the-period exchange
rate, but total equity was translated at the current
exchange rate.
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Learning Objective 10-5
Understand the rationale for hedging a net
investment in a foreign operation and describe
the treatment of gains and losses on hedges
used for this purpose.
10-25
Hedging Balance Sheet Exposure
When the U.S. dollar is the functional currency or
when a foreign operation is located in a highly
inflationary economy, remeasurement gains and
losses are reported in the consolidated income
statement.
Translation adjustments and remeasurement gains or
losses are functions of two factors:
(1) changes in the exchange rate and
(2) balance sheet exposure.
10-26
Hedging Balance Sheet Exposure
A company can do little to influence exchange rates, but
parent companies can use several techniques to hedge
the balance sheet exposures of their foreign operations.
Balance sheet exposure can be hedged through
derivatives (forward contracts or foreign currency
options) or through nonderivative instruments (foreign
currency borrowings).
Ironically, in seeking to avoid unrealized translation
adjustments, realized foreign exchange gains and losses
can occur!
10-27
Hedging Balance Sheet Exposure
A hedge of a net investment in a foreign operation
eliminates the possibility of reporting a negative
translation adjustment in Accumulated Other
Comprehensive Income, but gains and losses realized in
cash can result.
Current standards provide that the gain or loss on a
hedging instrument designated and effective as a hedge
of the net investment in a foreign operation should be
reported in the same manner as the translation
adjustment being hedged.
10-28
Hedging Balance Sheet Exposure
Current standards also require firms to present
an analysis of the change in the cumulative
translation adjustment account in the financial
statements or notes thereto.
Many companies comply with this requirement
directly in their statement of comprehensive
income. Other companies provide separate
disclosure in the notes
10-29
Learning Objective 10-6
Prepare a consolidation worksheet for a
parent and its foreign subsidiary.
10-30
Consolidation of a Foreign Subsidiary
On January 1, 2014, Altman, Inc., a U.S.-based manufacturing firm, acquired 100
percent of Bradford Ltd. in Great Britain. Altman paid 25 million british pounds
(£25,000,000), which was equal to Bradford’s fair value. Bradford’s balance sheet
on January 1, 2014, was as follows:
Cash . . . . . . . .. . . . . . . . . . £ 925,000 Accounts payable .. . £ 675,000
Accounts receivable . . . . . 1,400,000 Long-term debt . . . . .4,000,000
Inventory . . . . . . . . . . . . . 6,050,000 Common stock. . . . .20,000,000
Plant & equipment (net) 19,000,000 Retained earnings . . 2,700,000
Total . . . . . . . . . . . . . . . . £27,375,000 Total . . . . . . . . . . . . £27,375,000
The £2,300,000 excess fair value over book value results
from undervalued land (part of plant and equipment)
and is not subject to amortization. Altman uses the
equity method to account for its investment in Bradford.
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Consolidation of a Foreign Subsidiary
On December 31, 2015, two years after the acquisition date,
Bradford submitted the following trial balance for
consolidation (credit balances are in parentheses):
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . £ 600,000
Accounts Receivable . . . . . . . . . . . . . . . . . . . . 2,700,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000,000
Plant and Equipment (net) . . . . . . . . . . . . . 17,200,000
Accounts Payable. . . . . . . . . . . . . . . . . . . . . . . (500,000)
Long-Term Debt. . . . . . . . . . . . . . . . . . . . . . .(2,000,000)
Common Stock . . . . . . . . . . . . . . . . . . . . . . (20,000,000)
Retained Earnings, 1/1/15 . . . . . . . . . . . . . . (3,800,000)
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (13,900,000)
Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . 8,100,000
Depreciation Expense. . . . . . . . . . . . . . . . . . . . . 900,000
Other Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 950,000
Dividends Declared, 6/30/15 . . . . . . . . . . . . . . . 750,000
£
-010-32
Consolidation of a Foreign Subsidiary
Although Bradford generated net income of £1,100,000 in 2014,
it declared or paid no dividends that year. Other than the
payment of dividends in 2015, no intra-entity transactions
occurred between the two affiliates. Altman has determined the
British pound to be Bradford’s functional currency.
Relevant exchange rates for the British pound were:
January 1 June 30 December 31 Average
2014 $1.51
–0–
$1.56
$1.54
2015
1.56
$1.58
1.53
1.55
10-33
Consolidation of a Foreign Subsidiary
The initial step in consolidating the foreign subsidiary is
to translate its trial balance from British pounds into U.S.
dollars.
Because the British pound is the functional currency, the
translation uses the current rate method.
The historical exchange rate for translating Bradford’s
common stock and January 1, 2014, retained earnings is
the exchange rate that existed at the acquisition date—
$1.51.
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Consolidation of a Foreign Subsidiary
Translation of Foreign Subsidiary Trial Balance
10-35
Consolidation of a Foreign Subsidiary
A positive (credit balance) cumulative translation adjustment of
$401,500 is required in 2014 to make the trial balance actually
balance because the British pound appreciated against the U.S.
dollar. The translation adjustment in 2015 is negative because
the British pound depreciated against the U.S. dollar that year.
10-36
Determination of Balance in Investment
As a result of these two journal entries, Altman has a Cumulative
Translation Adjustment of $401,500 on its separate balance sheet.
10-37
Investment in Foreign Subsidiary Account
The carrying value of the investment account in U.S. dollar
terms at December 31, 2015, is $44,783,000. In addition, Altman
reports equity income on its December 31, 2015, trial balance in
the amount of $6,122,500.
10-38
Consolidation Worksheet
with Foreign Subsidiary
10-39
Translation Adjustment
with Foreign Subsidiary
When the foreign currency is the functional currency, the
excess is translated at the current exchange rate with a
resulting translation adjustment. Neither the parent nor the
subsidiary has recorded the translation adjustment related to
the excess, and it also must be entered in the consolidation
worksheet.
10-40
IFRS and Translations
IFRS and US GAAP are consistent on most points.
Significant differences between IFRS and U.S.
GAAP relate to:
(a) the hierarchy of factors used to determine the
functional currency and
(b) the method used to translate the foreign currency
statements of a subsidiary located in a
hyperinflationary country.
10-41
IFRS and Translations
IAS 21 indicates that the primary factors to be
considered in determining the functional currency of
a foreign subsidiary are:
1. The currency that mainly influences sales price.
2. The currency of the country whose competitive
forces and regulations mainly determine
sales price.
3. The currency that mainly influences labor,
material, and other costs of providing goods and
services.
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IFRS and Translations
Other factors to be considered are:
1. The currency in which funds from financing
activities are generated.
2. The currency in which receipts from operating
activities are retained.
3. Whether the foreign operation carries out its
activities as an extension of the parent or with a
significant degree of autonomy.
10-43
IFRS and Translations
Other factors to be considered (continued):
4. The volume of transactions with the parent.
5. Whether cash flows generated by the foreign
operation directly affect the cash flows of the
parent.
6. Whether cash flows generated by the foreign
operation are sufficient to service its debt.
10-44
IFRS and Translations
IAS 21 states that when the above indicators are mixed
and the functional currency is not obvious, the parent
must give priority to the primary indicators in
determining the foreign entity’s functional currency.
U.S. GAAP is silent with respect to weights to be assigned
to various indicators to determine the functional
currency and no hierarchy is provided.
It is possible that a foreign subsidiary could be
determined to have a different functional currency
under IFRS than under U.S. GAAP.
10-45
IFRS and Translations
Under IAS 21, financial statements of a foreign subsidiary
located in a hyperinflationary economy are translated
into the parent’s currency using a two-step process.
Neither the temporal method nor the current rate method
is used.
(1) the financial statements are restated for local inflation
in accordance with IAS 29, “Financial Reporting in
Hyperinflationary Economies.”
(2) each financial statement line item, which has been
restated for local inflation, is translated using the current
exchange rate.
10-46