CHAPTER 16

TRANSLATING FOREIGN

STATEMENTS: THE TEMPORAL

METHOD & THE FUNCTIONAL

CURRENCY CONCEPT

FOCUS OF CHAPTER 16

• The Temporal Method of Translation• The Objectives of Translation under

FAS 52• The Functional Currency Concept• U.S. Taxation of Foreign Subsidiary

Earnings

The Temporal Method: The Definition of Temporal

• The dictionary defines temporal as “of or near the temples (of the head).”

Not much help there!

• Furthermore, the term temporal is not specifically used in FAS 52.

The Temporal Method: Temporal—The Defining Moment

• The term “temporal” first appeared as an accounting term in AICPA Research Study No. 12 (1972).– Defined: Expressing foreign currency

amounts in dollars without changing their attributes.

– Attribute: The manner of valuing an item (such as “cost,” “LCM,” “NRV,” “FMV”).

The Temporal Method: “Don’t Make Any Changes”

• Use exchange rates for assets and liabilities that result in preserving the VALUATION BASIS. – Assets carried at value-based prices

are expressed in dollars using the spot rate.

– Assets carried at historical cost are expressed in dollars using historical rates.

WSJ 12/31/06.... $1.44

The Temporal Method: Identifying The Driver

• SUMMARY: The valuation basis is the “driver”—that is, the determinant of the exchange rate to use to translate an asset or liability. Thus the driver must be identified.

The Temporal Method: What’s Relevant and What’s NOT

• What is relevant?– How it is valued (cost, LCM, NRV, FMV).

• What’s not relevant?– Whether it is current or noncurrent (in

the balance sheet).– Maintaining the account item

relationships that exist in the foreign currency statements.

The Temporal Method: What Winds Up Being the Focus?

• The result of applying the temporal method generally enables one to view the method as a focus on the net monetary position: – Monetary Assets > Monetary Liabilities =

A net monetary asset position.

– Monetary Assets < Monetary Liabilities =

A net monetary liability position.

The Temporal Method: Is It Monetary or Is It Nonmonetary?

• Monetary Items:– Cash and accounts obligated to be

settled in cash (includes investments in BONDS [they have a “due date”]).

• Nonmonetary Items:– Accounts that are not monetary items

(includes investments in STOCKS).

The Temporal Method: The Income Statement—Which Rates?

• Items Not Having Passed Through the B/S:– Use spot rate at date when the item was

recognized in the income statement.

• Items Having Passed Through the B/S:– Use historical spot rate—the rate at the

date the item entered the balance sheet.

WSJ 4/15/06.... $1.61

The Temporal Method: Just Passing Through to P/L

• Items That Pass Through the B/S on Their Way to the Income Statement:– Inventory– Depreciable fixed assets– Intangible assets– Prepaid expenses– Deferred charges– Unearned income

The Temporal Method: Compared With the Current Rate Method—P/L

Current Rate Temporal Method MethodRates to be used for : Items not having passed through the B/S...................... CR CR Items having passed through the B/S...................... CR HR Type of rate for items having passed through the B/S......... EXIT ENTRY

The Temporal Method: What and Where Time!

• WHAT are the effects of exchange rate changes called?– “Remeasurement Gains and Losses”

• WHERE are the effects of exchange rate changes reported?”– In earnings.

The Temporal Method: Again, The FASB Is NOT Consistent

• FASB says:– Whether the effects of exchange rate

changes as a result of using the temporal method are unrealized is not relevant—MUST REPORT CURRENTLY IN EARNINGS.

– Whether the effects of exchange rate changes as a result of using the current rate method are unrealized is relevant—CANNOT REPORT CURRENTLY IN EARNINGS .

The Temporal Method Method: Achieves Inflation Adjusted Reporting

Assumptions: Foreign unit buys land on 1/1/06 when thedirect exchange rate is $1.00. Foreign country has 25% inflation in 2006. Exchange rate at 12/31/06 is $.80—the$.20 decrease is due entirely to the foreign inflation.

LCUs Exchange Rate U.S. Dollars 1/1/06.............. 1,000 HC x $1.00 HR = $1,000 HC

Inflation adj.. +250 x (.20) = -0- 12/31/06.......... 1,250 CV x $ .80 CR = $1,000

The Functional Currency Concept:Created By A Mere 4:3 Vote

• SUMMARY OF FUNCTIONAL CURRENCY CONCEPT:– For each foreign unit, identify the

currency it primarily uses to generate and expend cash.

– If a foreign currency, use the current rate method.

– If the U.S. dollar, use the temporal method.

The Functional Currency Concept:Presumed Types of Foreign Operations

• Relatively Autonomous Units:– Expected to have the foreign currency as the

functional currency.• Relatively Nonautonomous Units:

– Expected to have the U.S. dollar as the functional currency.

Observation: In the real world, it’s not that cut and dried.

The Functional Currency Concept:When To Disregard FASB’s Indicators

• When Operating in a Highly Inflationary Economy (approximately 100% cumulative inflation over 3-year period)

– Must use the temporal method.

Currency depreciates in value.

Distinguishing “Translation”from “Remeasurement”

• TRANSLATION (current rate method):

• REMEASUREMENT (temporal method):

Functional Currency(Francs)

Reporting Currency

(U.S. Dollar)

Nonfunctional Currency(Pesos)

Functional (& Reporting)

Currency (U.S. Dollar)

Review Question #1

Under the temporal method, which of the following accounts is translated into dollars using only the current exchange rate? A. Purchases. B. Cost of sales. C. Depreciation expense. D. Gain on equipment disposal. E. Retained earnings (ending balance). F. Injury loss settlement. G. None of the above.

Review Question #1With Answer

Under the temporal method, which of the following accounts is translated into dollars using only the current exchange rate? A. Purchases. B. Cost of sales. [not translated by itself]C. Depreciation expense. D. Gain on equipment disposal. [HR & CR used]E. Retained earnings (ending balance). F. Injury loss settlement. G. None of the above.

Review Question #2

Under the temporal method, which of the following accounts is translated into dollars using the historical exchange rate? A. Inventory (LIFO). B. Income tax expense.C. Patent amortization expense. D. Deferred income taxes payable.E. Deferred charges.F. Bonds Payable (long-term).G. None of the above.

Review Question #2With Answer

Under the temporal method method, which of the following accounts is translated into dollars using the historical exchange rate? A. Inventory (LIFO). B. Income tax expense.C. Patent amortization expense. D. Deferred income taxes payable.E. Deferred charges.F. Bonds Payable (long-term).G. None of the above.

End of Chapter 16 (Appendix 16A follows)

• Time to Clear Things Up—Any Questions?

U.S. Taxation of Foreign Subsidiary Earnings: Overall Perspective

• FOREIGN SUBSIDIARIES:– Cannot file a consolidated tax return

with their U.S. parent.• U.S. PARENTS OF FOREIGN

SUBSIDIARIES:– Cannot use the “dividends received

deduction.”– Can use foreign tax credits.

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U.S. Taxation of Foreign Subsidiary Earnings: FASB’s Rules

• FASB Says:– Record parent-level taxes on foreign

sub’s income in the year the income is earned.• Exception: If sub’s earnings are

expected to be REINVESTED INDEFINITELY, no parent-level taxes need be recorded.

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U.S. Taxation of Foreign Subsidiary Earnings: “We Changed Our Minds”

• Change in Circumstances Concerning Reinvestment of Earnings:– Treat as a change in estimate.– Unrecord taxes already recorded or

record taxes that have not been recorded.

– Do not restate prior periods.

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U.S. Taxation of Foreign Subsidiary Earnings: The Fly in the Ointment

• The Dividend Withholding Tax:– The tax is paid to the foreign

government at the time of the dividend payment.

– The taxes paid are recorded as tax expense on the parent’s bookson the parent’s books—it is a tax to the RECIPIENT.

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