Chapter Eight

Translation of Translation of Foreign Foreign

Currency Currency Financial Financial

StatementsStatements

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Exchange Rates

Historical Exchange Rates – those which existed at the time a transaction occurred

Current Exchange Rate – the exchange rate which exists at the balance sheet date

8-2

Translation Adjustments

The use of different exchange rates during translation means the resulting financial statements will not balance!

To force the statements to balance, an account called “Translation Adjustment” is debited or credited.

8-3

Translation Adjustments

Exposure to translation adjustments is called “balance sheet,” “translation,” or “accounting” exposure.

Assets translated at the current exchange rate when the foreign currency is appreciating (increasing in value relative to the US$) generate positive translation adjustments (a credit entry)

Liabilities translated at the current exchange rate when the foreign currency is appreciating generate negative translation adjustments (a debit entry)

8-4

Balance Sheet Exposure

Balance sheet items translated at current exchange rates change in value from one balance sheet to

the next and are exposed to translation adjustments.

Balance sheet items translated at historical exchange rates do not change in value from one balance sheet to the next and

are NOT subject to balance sheet exposure.

8-5

Parent

Subsidiary

Translation Methods - CURRENT 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.

8-6

Parent

Subsidiary

Translation Methods -TEMPORAL METHOD

Use historical exchange rates to translate assets and liabilities carried at historical cost.

Use current exchange rates to translate those 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 financial statements as if the foreign subsidiary had actually used U.S. dollars

8-7

Translation of Retained Earnings

Translating R/E requires special attention, because it is the composite of many prior transactions.

8-8

Calculation of Cost of Goods Sold

Current Rate Method - translate using the weighted average rate for the current period.

8-9

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.

8-10

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.

8-11

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

8-12

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)

8-13

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.

8-14

Highly Inflationary Economies

In highly inflationary economies, the Temporal Method for translation is

required.

Disappearing Plant ProblemIf the Current Method were used, the US $ equivalent

would be VERY small due to the rapidly increasing

exchange rate.

Why?

8-15

Remeasurement of Financial Statements

If the sub’s functional currency is the US $, 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.

8-16