Chapter 8:
Translation of
Foreign
Currency
Financial
Statements
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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
8-2
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
8-3
Two conceptual issues
 Appropriate exchange rate to be used in translating
each financial statement item
 How should the translation adjustment that inherently
arises from the translation process be reflected in the
consolidated financial statements
8-4
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
8-5
Translation Methods
 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
8-6
Translation Methods
 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
8-7
Translation Methods
 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
8-8
Translation Methods
 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 the exchange
rate in effect at the date of accounting recognition
8-9
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
8-10
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)
 Application of the Lower of Cost or Market Rule
 Fixed Assets, Depreciation, Accumulated Depreciation
8-11
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
8-12
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
Accounts rec.
Inventory
Fixed assets
Accum. depr.
1,000
2,000
2,500
8,000
1,000
Accounts payable
Long-term debt
Capital stock
Retained earnings
2,000
6,000
3,000
1,500
8-13
Temporal and Current Rate Methods
 Translation methods illustrated
 Juarez’s income statement items for 2010, in pesos:
Sales
COGS
S,G,&A exp.
20,000
14,000
2,500
Depr. exp.
Interest exp.
Income tax exp.
1,000
500
500
8-14
Temporal and Current Rate Methods
 Translation methods illustrated
 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
8-15
Temporal and Current Rate Methods
 Translation methods illustrated
 Relevant exchange rates (U.S. dollar per Mexican
peso):
January 1, 2010
Average for 2010
Average for 4th quarter 2010
December 31, 2010
$0.10
$0.095
$0.09
$0.08
8-16
Temporal and Current Rate Methods
 Current Rate Method – Income Statement
Income Statement – 2010
Sales
COGS
Gross profit
S,G,&A
Depreciation expense
Interest expense
Income tax expense
Net income
1,900
1,330
570
238
95
48
47
142
8-17
Temporal and Current Rate Methods
 Current Rate Method – Balance Sheet
Balance Sheet – December 31, 2010
Cash
Accounts Rec.
Inventory
Fixed Assets, net
Total assets
80
160
200
545
985
Accounts payable
160
Long-term debt
480
Capital stock
300
Retained earnings
142
Cumulative translation adj. (97)
Total liab. & S.E.
985
8-18
Temporal and Current Rate Methods
 Temporal Method – Income Statement
Income Statement – 2010
Sales
COGS
Gross profit
S,G,&A
Depreciation expense
Interest expense
Income tax expense
Remeasurement gain
Net income
1,900
1,343
557
238
100
48
47
101
225
8-19
Temporal and Current Rate Methods
 Temporal Method – Balance Sheet
Balance Sheet – December 31, 2010
Cash
Accounts Rec.
Inventory
Fixed Assets, net
Total assets
80
160
225
700
1,165
Accounts payable
Long-term debt
Capital stock
Retained earnings
Total liab. & S.E.
160
480
300
225
1,165
8-20
Temporal and Current Rate Methods
 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
8-21
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
8-22
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
8-23
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
8-24
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
8-25
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)
8-26
Hedging Balance Sheet Exposure
 Companies can hedge against gains and losses by
using foreign currency forward contracts, options, and
borrowings
8-27
End of Chapter 8
8-28