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.
Translating Foreign Currency Financial Statements -- Conceptual Issues • Foreign country operations usually prepare financial statements using local currency as the monetary unit. • These financial statements must be translated into home country currency. • These operations also typically use local GAAP. • Financial statements must be translated into home country GAAP.
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?
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.
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 $90.90? And if we do report a change, where should the offsetting gain be reported?
Another simple example: • Let’s say XYZ has land on its books that is held by a subsidiary located in the EU. The land was purchased on 1/1 for 1,000,000 euros when the euro/$ direct rate was $ 1. On 12/31, it is $ .9091. • Should we record: • No change? • An decrease in value of $90,900? And if we do report a change, where should the offsetting gain be reported?
The Question: • How do we account for these effects?
The Current Rate Method: • The receivable would be translated using the current rate. • The land would be translated at the current rate.
Translation Methods Current Rate Method • Presumes that the parent’s entire investment in a foreign subsidiary is exposed to exchange risk. • All assets and liabilities are translated at the current exchange rate. • Stockholders’ equity accounts are translated at historical exchange rates. • Income statement items are translated at the exchange rate in effect at the time of the transaction.
Current Rate Method • Advantages • Simple to do • Ratios are not distorted
But what if: • Inflation differences caused the decline in the value of the euro? • If the inflation differential was 10%, then: • Before, 1,000,000E=1,000,000$ • Now, 1,000,000E=1,100,000$; • Thus the direct exchange rate would be .9091 (1,000,000/1,100,000). • Thus the current value of the land, in euros, is now 1,100,000E. The valuation should be 1100000*.9091 = 1,000,000$, i.e., no change.
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.
The Problem: • The receivable is a monetary asset. • The land is a non-monetary asset.
If inflation drives foreign exchange rate movements, and monetary/non-monetary assets are affected differently, how should FC effects be accounted for?
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.
In our example: • The receivable would be translated using the current rate. • The land would be translated at the historical rate.
Monetary/Non-monetary • Advantages • Easy to understand. Makes intuitive sense. • Usually not difficult to classify assets and liabilities.
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)
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.
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.
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.
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.
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.
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.
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.
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.
Temporal Method • Disadvantages • Lots of volatility in financial statements. • Mixing of valuations: does the sum make any sense?
Temporal and Current Rate Methods Translation methods illustrated • U.S. Inc. owns Juarez, SA, a subsidiary in Mexico which was established January 1, 2005. • Juarez’s balance sheet items as of 12/31/05, in pesos. Cash 1,000 Accounts payable 2,000 Accounts rec. 2,000 Long-term debt 6,000 Inventory 2,500 Capital stock 3,000 Fixed assets 8,000 Retained earnings 1,500 Accum. depr. 1,000
Temporal and Current Rate Methods Translation methods illustrated • Juarez’s income statement items for 2005, in pesos. Sales 20,000 Depr. exp 1,000 COGS 14,000 Interest exp. 500 S,G,&A exp. 2,500 Income tax exp. 500
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 2005. • Purchases were made evenly throughout year. • Fixed assets were acquired on January 1, 2005. • Capital stock was sold on January 1, 2005.
Temporal and Current Rate Methods Translation methods illustrated Relevant exchange rates (U.S. dollar per Mexican peso) January 1, 2005 $0.10 Average for 2005 $0.095 Average for 4th quarter 2005 $0.09 December 31, 2005 $0.08
Temporal and Current Rate Methods Current Rate Method – Income Statement Income Statement – 2005 Sales 1,900 COGS 1,330 Gross profit 570 S,G,&A 238 Depreciation expense 95 Interest expense 48 Income tax expense 47 Net income 142
Temporal and Current Rate Methods Current Rate Method – Balance Sheet Balance Sheet – December 31, 2005 Cash 80 Accounts payable 160 Accounts Rec. 160 Long-term debt 480 Inventory 200 Capital stock 300 Fixed Assets, net 560 Retained earnings 142 Total assets 1000 Cumulative translation adj. ( 82) Total liab. & S.E. 1000
Temporal and Current Rate Methods Temporal Method – Balance Sheet Balance Sheet – December 31, 2005 Cash 80 Accounts payable 160 Accounts Rec. 160 Long-term debt 480 Inventory 225 Capital stock 300 Fixed Assets, net 700 Retained earnings 225 Total assets 1,165 Total liab. & S.E. 1,165
Temporal and Current Rate Methods Temporal Method – Balance Sheet Income Statement – 2005 Sales 1,900 COGS 1,295 Gross profit 605 S,G,&A 238 Depreciation expense 100 Interest expense 48 Income tax expense 47 Income before adj 172 Remeasurement gain 53 Net income 225
Temporal and Current Rate Methods Translation methods illustrated – Summary Current Rate Method • All assets and liabilities 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 and Current Rate Methods Translation methods illustrated – Summary Temporal Method • Primarily monetary assets and liabilities translated at current rate. • This results in net liability asset exposure. • Net liability exposure and devaluing foreign currency results in translation gain. • Translation gain included in current income.
Other Issues • What is the appropriate current rate? • Translation gains/losses? Deferred or booked? Shown in income or just equity?
Translation Accounting Around the World • USA • IFRS • Diversity seen in other nations
History of Translation Accounting in USA • Pre-1965: Current/Noncurrent method applied. Losses recognized into income. Gains were deferred. • 1965-1975: Single Rate method was also allowed. • 1975-1981: FAS 8, which required temporal method to be used. All gains and losses taken into income
History of Translation Accounting in USA • 1981-today: SFAS 52, which has the following features: • Functional currency determines accounting. • If functional currency is the local currency- use single current rate. Gains and losses routed directly to stockholder’s equity. • If functional currency is US Dollar, use the temporal method and fully recognize gains/losses into earnings. • If functional currency is different from local currency or US Dollar, do both.
How do you determine the “functional currency”? • What is the “primary” currency of the entity? • See Exhibit 7.2, p. 309 for suggested indicators • Management decides how much weight to give each indicator. • In hyper-inflating environments- use temporal method (so most of the balance sheet will not disappear!)
U.S. GAAP and IFRS Requirements U.S. GAAP under SFAS 52 • 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.
Advantages of SFAS 52 • Allows consideration of context. • In most cases, keeps impact of FC exchange rate movements out of earnings. • Much more accepted by reporting community than FAS 8 was.
Disadvantages of SFAS 52 • From an investor’s viewpoint, is there any economic difference, in substance, between circumstances that distinguish the two methods. If not, why have two different kinds of accounting? • Inconsistent with the notion of consolidation. • Numbers produced by SFAS 52 often lose meaning. • Added risk of earnings management?
U.S. GAAP and IFRS Requirements 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 SFAS 52.
U.S. GAAP and IFRS Requirements Highly Inflationary Economies – U.S. GAAP • SFAS 52 provides guidance on highly inflationary economies. • SFAS 52 defines such economies as those with 100% inflation over a period of three years. • SFAS 52 requires the use of the temporal method in these cases of significant inflation.
U.S. GAAP and IFRS Requirements Hyperinflationary Economies -- IFRSs • IAS 21 and 29 use the term hyperinflationary economies. • IAS 21 is not as specific in defining hyperinflationary economies as SFAS 52. • IAS 21 requires restatement of the foreign financial statements for inflation per IAS 29, Financial Reporting in Hyperinflationary Economies. • IAS 21 then requires the use of the current rate method of translation on the restated financial statements. • IAS approach is substantially different from SFAS 52.
Hedging Balance Sheet Exposure • Companies that have foreign subsidiaries with highly integrated operations use the temporal method. • The temporal method requires translation gains and losses to be recognized in income. • Losses negatively affect earnings, and both gains and losses increase earnings volatility.