Translation of Foreign Currency Financial Statements

1. Translation of Foreign Currency Financial Statements

2. Translation of Foreign Currency Financial Statements • Conceptual issues of foreign currency financial statements translation. • Balance sheet vs. transaction exposure. • Methods of financial statement translation. • Temporal and current rate methods illustrated. • U.S. GAAP, IFRSs, and other standards related to translation. • Hedging balance sheet exposure.

3. Translating Foreign Currency Financial Statements -- Conceptual Issues • Foreign country operations of a MNC usually prepare financial statements using local currency as the monetary unit. • These operations also typically use local GAAP. • When these operations are consolidated by the MNC, the foreign operation’s financial statements must be translated into the currency and GAAP of the MNC.

4. Translating Foreign Currency Financial Statements -- Conceptual Issues Primary conceptual issues • Each financial statement item must be translated using some, hopefully relevant, exchange rate. • What rate should be used? • the current exchange rate? • The average exchange rate? • the historical exchange rate? • Given that any adjustment is, at the point of translation, unrealized, how should the resulting adjustment be recognized? • in current income? • in an equity account on the balance sheet?

5. 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.

6. A simple example • Let’s say XYZ has a 1000 euro current note receivable on its books. The euro/$ direct rate is $ 1 on 1/1. On 12/31, it is $.9091. • Should we record: • No change? • An decrease in value of $90.90? And if we do report a change, where should the offsetting gain be reported?

7. Another simple example: • Let’s say XYZ has land on its books that is held by a subsidiary located in the EU. The land was purchased on 1/1 for 1,000,000 euros when the euro/$ direct rate was $ 1. On 12/31, it is $ .9091. • Should we record: • No change? • An decrease in value of $90,900? And if we do report a change, where should the offsetting gain be reported?

8. The Question: • How do we account for these effects? • The matter is complex because the economic impact will vary depending on what type of asset is held and what is driving FX movements. • There is also an interaction with accounting imperfections and constraints.

9. The Current Rate Method: • The receivable would be translated using the current rate. • The land would be translated at the current rate.

10. Translation Methods Current Rate Method • Presumes 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. • Stockholders’ equity accounts are translated at historical exchange rates. • Income statement items are translated at the exchange rate in effect at the time of the transaction.

11. Current Rate Method • Advantages • Simple to do • Ratios are not distorted

12. But what if: • Inflation differences caused the decline in the value of the euro? • If the inflation differential was 10%, then: • Before, 1,000,000E=1,000,000$ • Now, 1,100,000E=1,000,000$; • Thus the direct exchange rate would be .9091 (1,000,000/1,100,000). • Thus the current value of the land, in euros, is now 1,100,000E. The valuation should be 1100000*.9091 = 1,000,000$, i.e., no change.

13. The Current Rate Method • Disadvantages • Can produce disparate results that are not consistent with the economics that are really going on. • What does the FC adjustment mean? • Possibility of disappearing assets in inflationary economies.

14. The Problem: • The receivable is a monetary asset. • The land is a non-monetary asset.

15. Translation Methods Monetary/Nonmonetary Method • Monetary assets and liabilities are translated at the current exchange rate. • Nonmonetary assets and liabilities and stockholders’ equity accounts are 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.

16. In our example: • The receivable would be translated using the current rate. • The land would be translated at the historical rate.

17. Monetary/Non-monetary • Advantages • Easy to understand. Makes intuitive sense. • Usually not difficult to classify assets and liabilities.

18. But what if: • A monetary asset/liability is booked at historical cost (e.g. long term bonds) • A nonmonetary asset/liability is booked at current cost (e.g., revalued property, plant and equipment)

19. Monetary/Non-monetary method • Disadvantages • Valuation basis in accounting doesn’t always line up right with classification, producing potentially meaningless values. • Thus some assets can disappear in the presence of inflation while others are over or under-reported.

20. 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.

21. In our example: • The receivable would be classified as current and translated using the current rate. • The land would be classified as noncurrent and translated at the historical rate.

22. Curent/Noncurrent • Advantages? • Simplistic. Requires no more characterization of assets/liabilities than is already provided by the financial statements • Seems to solve the monetary/non-monetary problem while remaining more consistent with underlying accounting basis being used.

23. Current/Non-current method • Disadvantages • Can still misspecify monetary assets/liabilities. Example: inventories, noncurrent marketable equity securities. • Does not explicitly address the accounting problem. For example, some current assets use historical cost basis. Some noncurrent assets are booked at current value. • Thus some assets can still disappear in the presence of severe inflation. Others can be severely over or undervalued.

24. 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.

25. In our example: • The receivable translated using the current rate. • If reported at historical cost, the land would be translated at the historical rate. • If reported at fair value, the land would be translated at the current rate.

26. Temporal Method • Advantages • Lines up with valuation basis used in accounting. Thus the numbers have most consistent internal meaning. • They will still be misspecified, however, but only to the extent the underlying accounting numbers already are.

27. Temporal Method • Disadvantages • Lots of volatility in financial statements. • Mixing of valuations: does the sum make any sense?

28. For our purposes, because they are both called for in current accounting standards on FX translation, we will focus on: • Current rate method • Temporal Method

29. Parent Subsidiary 8-29 Translation MethodsCurrent Rate Method • Use current exchange rates to translate all assets and liabilities. • Use historical (or average) exchange rates to translate equity accounts. • Use historical (or average) exchange rates to translate income statement accounts. • Assumes “net investment” in a foreign operation is exposed to foreign exchange risk

30. Parent Subsidiary 8-30 Translation MethodsTemporal Method • Use historical exchange rates to translate assets and liabilities carried at historical cost. • Use current exchange rates to translate assets and liabilities carried at current cost or future value. • Use historical (or average) exchange rates to translate equity, revenue, and expense accounts. • Objective is to produce a set of U.S. dollar translated financial statements as if the foreign subsidiary had actually used U.S. dollars

31. At the end of the first year of operations: Ending R/E from year 1, becomes Beginning R/E in Year 2. 8-31 Translation of Retained Earnings Since R/E is a composite of many previous transactions, translating R/E requires special attention.

32. Temporal Method - decompose COGS into its component parts and translate each part using the appropriate rate Apply Lower-of-Cost-or-Market using the foreign exchanges rates. 8-32 Calculation of Cost of Goods Sold Current Rate Method - translate using the weighted average rate for the current period.

33. 8-33 Fixed Assets and Accumulated Depreciation Current Rate Method - translate fixed assets and accumulated depreciation using the spot rate as of the balance sheet date. Temporal Method - fixed assets acquired at different times will be translated using their respective historical translation rates. Accumulated depreciation uses the same historical rates as the related asset.

34. 8-34 Depreciation Expense Current Rate Method - translate depreciation expense using the weighted-average rate for the current period Temporal Method - translate depreciation expense using the various historical rates related to the underlying assets.

35. Temporal Method - the gain must be computed indirectly, using different rates. 8-35 Gain or Loss on the Sale of an Asset Current Rate Method - translate the gain or loss using the historical rate in effect on the date of sale

36. 8-36 Disposition of Translation Adjustment • Current Method • Translation Adjustment is reported on the Balance Sheet. • Temporal Method • Adjustment is reported on the Income Statement as a Translation Gain or (Loss)

37. 8-37 TranslationU.S. Accounting Rules • SFAS No. 8 (1975) - Accounting for Translation of Foreign Currency Transactions and Foreign Currency Financial Statements. • SFAS No. 52 (1981) - Foreign Currency Translation. • SFAS No. 130 (1998)

38. 8-38 SFAS No. 52 Recognized two types of subs: • Subs that do most of their transactions in U.S. $ • Subs that operate relatively independently of their U.S. parents. Temporal method still applies. Applies the “local currency perspective”. Uses current rate method. Translation adjustment appears in the equity section.

39. 8-39 Functional Currency To determine whether a subsidiary is integrated with the parent or operates independently, SFAS 52 introduced the concept of functional currency. A company’s functional currency is the primary currency of the foreign entity’s operating environment.

40. Determining a Subsidiary’s Functional Currency 8-40 Indications that the Functional Currency is the Foreign Currency Indicator

41. Determining a Subsidiary’s Functional Currency 8-41 Indications that the Functional Currency is the Foreign Currency Indicator

42. Determining a Subsidiary’s Functional Currency 8-42 Indications that the Functional Currency is the Parent’s Currency Indicator

43. Determining a Subsidiary’s Functional Currency 8-43 Indications that the Functional Currency is the Parent’s Currency Indicator

44. 8-44 Highly Inflationary Economies In highly inflationary economies, SFAS 52 mandates the use of the Temporal Method for translation. Why? Disappearing Plant Problem If the Current Method were used, the US $ equivalent would be VERY small due to the rapidly increasing exchange rate.

45. 8-45 Defining “Highly Inflationary Economy” • Remember, SFAS 52 mandates use of the temporal method, with re-measurement gains or losses reported in income!!! • A “highly inflationary economy” is one having a cumulative three-year inflation exceeding 100% (With compounding, this is about 26% inflation per year for three straight years)

46. 8-46 Current Rate Method Example • Duzy Co., is a wholly owned foreign sub of Maly Corporation. Duzy Co.’s transactions and financial statements are denominated in the local (functional) currency, the Pater (PT). • Using the following information, translate their statements into US $.

47. 8-47 Current Rate Method Example • Duzy Co.’s common stock was issued in 1992 when the exchange rate was $1.00 = 1.20 PT. • Fixed assets were acquired in 1993 when the exchange rate was $1.00 = 1.10 PT. • As of Jan. 1, 2008, the R/E balance was translated at $350,000. • Inventory was acquired evenly throughout the year.

48. 8-48 Current Rate Method Example • The Dec. 31, 2008 translation adjustment had a debit balance of $69,841. • Dividends were declared on March 15, 2008, and equipment was sold on October 1, 2008. • The following direct exchange rates were in effect during the year:

49. Note: The following example uses a division process and indirect rates. This may seem to differ from what is described in your text. But there is no real difference. • For example, if translation of $ 1,000 PT is made using the Oct1st direct rate of $ 1.25, the same translation can be made using the indirect rate, which is the inverse, i.e., 1 $ = .80PT. • To use the direct rate, one multiplies the # of PT by 1.25; 1.25 x 1000 = $ 1,250. • To use the indirect rate, one divides the # of PT by the indirect rate, .80; 1000/.80 = $ 1,250.

50. 8-50 Current Rate Method Example • The following indirect exchange rates were in effect during the year: