Chapter Ten

Translation of Foreign

Currency Financial

Statements

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Worldwide Consolidated Financial Statements

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To prepare worldwide consolidated financial statements a U. S. parent must:

(1) convert the foreign GAAP financial statements of its foreign operations into U.S. GAAP and

(2) translate the financial statements from the foreign currency into U.S. dollars.

Worldwide Consolidated Financial Statements

This conversion and translation process is required whether the foreign operation is a branch, joint venture, majority-owned subsidiary, or affiliate accounted for under the equity method.

Two major related theoretical issues are:

(1)which translation method should be used and

(2)where the resulting translation adjustment should be reported in the consolidated financial statements.

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Learning Objective 10-1

Explain the theoretical underpinnings and the limitations of the current rate and temporal methods.

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Translation Methods: Temporal and Current Rate

Two major translation methods are currently used: (1) the current rate (or closing rate) method and (2) the temporal method.

Each method is presented from the perspective of aU.S.–based multinational company translating foreign currency financial statements into U.S. dollars.

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Comparison of the Two Translation Methods

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Treatments for Translation Adjustment

The two major translation methods and the two possible treatments for the translation adjustment give rise to four possible combinations:

Two issues arise related to the translation of foreign currency financial statements: (1) selecting the appropriate method. (2) deciding where to report the resulting translation adjustment in the consolidated financial statements.

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Learning Objective 10-2

Describe guidelines as to when foreign currency financial statements are to be translated using the current rate method and when they are to be translated using the temporal method.

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Two Translation Combinations

Some subs are so closely tied to their U.S. parents. They use a U.S. dollar perspective to translation, so most of their transactions are recorded in U.S. dollars using the temporal method.

Other subs use the local currency perspective; they operate relatively independent of their U.S. parents and use the current rate method for translation.

Translation adjustment appears in the equity section.

FASB does not express preference for either of the two theoretical views

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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.

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Determining Subsidiary’s Functional Currency

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Functional Currency Terminology

Reporting currency – the currency in which the entity prepares its financial statements. U.S. based corporations use the U.S. dollar.

Remeasurment – If a foreign operation’s functional currency is the U.S. dollar, the currency balances must be remeasured into U. S. dollars using the temporal method resulting in remeasurement gains and losses.

Translation Adjustment – If a foreign currency is the foreign operation’s functional currency, the currency balances must be translated using the current rate method and a translation adjustment is reported on the balance sheet.

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Highly Inflationary Economies

In highly inflationary economies, the Temporal Method for translation is required.

A country has a highly inflationary economy when its cumulative three year inflation exceeds 100 percent. With compounding, it equates to an average of approximately 26 percent per year for three years in a row.

A country may or may not be classified as highly inflationary, depending on its most recent three-year experience with inflation.

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Learning Objective 10-3

Translate a foreign subsidiary’s financial statements into its parent’s reporting currencyusing the current rate method and calculate the related translation adjustment.

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Current Rate Method

The first step in translating foreign currency financial statements is to determine the functional currency.

Under the current rate method, all revenues and expenses are translated at the exchange rate in effect at the date of accounting recognition.

The weighted average exchange rate is used when revenues and expenses have been recognized evenly throughout the year.

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Current Rate Method

However, when an income account, such as a gain or loss, occurs at a specific point in time, the exchange rate as of that date is applied.

Depreciation and amortization expenses also are translated at the average rate for the year. These expenses accrue evenly throughout the year even though the journal entry could be delayed until year-end for convenience.

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Learning Objective 10-4

Remeasure a foreign subsidiary’s financial statements using the temporal method andcalculate the associated remeasurementgain or loss.

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Temporal Method

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

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Temporal Method

The temporal method remeasures cash, receivables, and liabilities into U.S. dollars using the current exchange rate.

Inventory, property and equipment, patents, and contributed capital accounts are remeasured at historical rates resulting in differences in total assets and liabilities plus equity which must be reconciled resulting in a remeasurement gain or loss.

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Temporal Method

In remeasuring the statement of cash flows, the U.S. dollar value for net income is taken from the remeasured income statement. Depreciation and amortization are remeasured at the rates used in the income statement, and the remeasurement loss, a noncash item, is added back to net income.

Increases in accounts receivable and accounts payable, related to sales and purchases, are remeasured at the average rate. The increase in inventory is determined by the remeasurement of cost of goods sold.

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Nonlocal Currency Balances

If any accounts of the foreign subsidiary are denominated in a currency other than the local currency, they would first have to be restated into the local currency.

Both the foreign currency balance and any related foreign exchange gain or loss would then be translated (or remeasured) into US dollars.

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Comparison of Results from Applying the Two Methods

The determination of the foreign subsidiary’s functional currency (and the use of different translation methods) can have a significant impact on consolidated financial statements.

The current rate method does not always result in higher net income and a higher amount of equity than the temporal method and a higher amount of equity than the temporal method.

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Comparison of Results from Applying the Two Methods

For example, a company with Swiss francs as the local currency reports the values for selected financial ratios calculated from the original foreign currency financial statements and from the U.S. dollar–translated statements using the two different translation methods.

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Comparison of Results from Applying the Two Methods

The temporal method distorts all of the ratios measured in the foreign currency. The subsidiary appears to be less liquid, more highly leveraged, and more profitable than it does in Swiss franc terms.

The current rate method maintains the first three ratios but distorts return on equity because income was translated at the average-for-the-period exchange rate, but total equity was translated at the current exchange rate.

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Learning Objective 10-5

Understand the rationale for hedging a net investment in a foreign operation and describethe treatment of gains and losses on hedges used for this purpose.

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Hedging Balance Sheet Exposure

When the U.S. dollar is the functional currency or when a foreign operation is located in a highly inflationary economy, remeasurement gains and losses are reported in the consolidated income statement.

Translation adjustments and remeasurement gains or losses are functions of two factors:

(1) changes in the exchange rate and

(2) balance sheet exposure.

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Hedging Balance Sheet Exposure

Balance sheet exposure can be hedged through derivatives (forward contracts or foreign currency options) or through nonderivative instruments (foreign currency borrowings).

Ironically, in seeking to avoid unrealized translation adjustments, realized foreign exchange gains and losses can occur!

A company can do little to influence exchange rates, but parent companies can use several techniques to hedge the balance sheet exposures of their foreign operations.

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Hedging Balance Sheet Exposure

A hedge of a net investment in a foreign operation eliminates the possibility of reporting a negative translation adjustment in Accumulated Other Comprehensive Income, but gains and losses realized in cash can result.

Current standards provide that the gain or loss on a hedging instrument designated and effective as a hedge of the net investment in a foreign operation should be reported in the same manner as the translation adjustment being hedged.

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Hedging Balance Sheet Exposure

Current standards also require firms to present an analysis of the change in the cumulative translation adjustment account in the financial statements or notes thereto.

Many companies comply with this requirement directly in their statement of comprehensive income. Other companies provide separate disclosure in the notes

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Learning Objective 10-6

Prepare a consolidation worksheet for a parent and its foreign subsidiary.

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Consolidation of a Foreign Subsidiary

On January 1, 2014, Altman, Inc., a U.S.-based manufacturing firm, acquired 100 percent of Bradford Ltd. in Great Britain. Altman paid 25 million british pounds (£25,000,000), which was equal to Bradford’s fair value. Bradford’s balance sheet on January 1, 2014, was as follows:

Cash . . . . . . . .. . . . . . . . . . £ 925,000 Accounts payable .. . £ 675,000

Accounts receivable . . . . . 1,400,000 Long-term debt . . . . .4,000,000

Inventory . . . . . . . . . . . . . 6,050,000 Common stock. . . . .20,000,000

Plant & equipment (net) 19,000,000 Retained earnings . . 2,700,000

Total . . . . . . . . . . . . . . . . £27,375,000 Total . . . . . . . . . . . . £27,375,000

The £2,300,000 excess fair value over book value results from undervalued land (part of plant and equipment) and is not subject to amortization. Altman uses the equity method to account for its investment in Bradford.

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Consolidation of a Foreign Subsidiary

On December 31, 2015, two years after the acquisition date, Bradford submitted the following trial balance for consolidation (credit balances are in parentheses):

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . £ 600,000Accounts Receivable . . . . . . . . . . . . . . . . . . . . 2,700,000Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000,000Plant and Equipment (net) . . . . . . . . . . . . . 17,200,000Accounts Payable. . . . . . . . . . . . . . . . . . . . . . . (500,000)Long-Term Debt. . . . . . . . . . . . . . . . . . . . . . .(2,000,000)Common Stock . . . . . . . . . . . . . . . . . . . . . . (20,000,000)Retained Earnings, 1/1/15 . . . . . . . . . . . . . . (3,800,000)Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (13,900,000)Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . 8,100,000Depreciation Expense. . . . . . . . . . . . . . . . . . . . . 900,000Other Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 950,000Dividends Declared, 6/30/15 . . . . . . . . . . . . . . . 750,000

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Consolidation of a Foreign Subsidiary

Although Bradford generated net income of £1,100,000 in 2014, it declared or paid no dividends that year. Other than the payment of dividends in 2015, no intra-entity transactions occurred between the two affiliates. Altman has determined the British pound to be Bradford’s functional currency.

Relevant exchange rates for the British pound were:

January 1 June 30 December 31 Average2014 $1.51 –0– $1.56 $1.542015 1.56 $1.58 1.53 1.55

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Consolidation of a Foreign Subsidiary

The initial step in consolidating the foreign subsidiary is to translate its trial balance from British pounds into U.S. dollars.

Because the British pound is the functional currency, the translation uses the current rate method.

The historical exchange rate for translating Bradford’s common stock and January 1, 2014, retained earnings is the exchange rate that existed at the acquisition date—$1.51.

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Consolidation of a Foreign Subsidiary

Translation of Foreign Subsidiary Trial Balance

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Consolidation of a Foreign Subsidiary

A positive (credit balance) cumulative translation adjustment of $401,500 is required in 2014 to make the trial balance actually balance because the British pound appreciated against the U.S. dollar. The translation adjustment in 2015 is negative because the British pound depreciated against the U.S. dollar that year.

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Determination of Balance in Investment

As a result of these two journal entries, Altman has a Cumulative Translation Adjustment of $401,500 on its separate balance sheet.

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Investment in Foreign Subsidiary Account

The carrying value of the investment account in U.S. dollar terms at December 31, 2015, is $44,783,000. In addition, Altman reports equity income on its December 31, 2015, trial balance in the amount of $6,122,500.

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Consolidation Worksheet with Foreign Subsidiary

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Translation Adjustment with Foreign Subsidiary

When the foreign currency is the functional currency, theexcess is translated at the current exchange rate with a resulting translation adjustment. Neither the parent nor the subsidiary has recorded the translation adjustment related to the excess, and it also must be entered in the consolidation worksheet.

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IFRS and Translations

IFRS and US GAAP are consistent on most points. Significant differences between IFRS and U.S. GAAP relate to:

(a) the hierarchy of factors used to determine the functional currency and

(b) the method used to translate the foreign currency statements of a subsidiary located in a hyperinflationary country.

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IFRS and Translations

IAS 21 indicates that the primary factors to be considered in determining the functional currency of a foreign subsidiary are:

1. The currency that mainly influences sales price.

2. The currency of the country whose competitive forces and regulations mainly determine

sales price.

3. The currency that mainly influences labor, material, and other costs of providing goods and services.

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IFRS and Translations

Other factors to be considered are:

1. The currency in which funds from financing activities are generated.

2. The currency in which receipts from operating activities are retained.

3. Whether the foreign operation carries out its activities as an extension of the parent or with a significant degree of autonomy.

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IFRS and Translations

Other factors to be considered (continued):

4. The volume of transactions with the parent.

5. Whether cash flows generated by the foreign operation directly affect the cash flows of the parent.

6. Whether cash flows generated by the foreign operation are sufficient to service its debt.

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IFRS and Translations

IAS 21 states that when the above indicators are mixed and the functional currency is not obvious, the parent must give priority to the primary indicators in determining the foreign entity’s functional currency.

U.S. GAAP is silent with respect to weights to be assigned to various indicators to determine the functional currency and no hierarchy is provided.

It is possible that a foreign subsidiary could be determined to have a different functional currency under IFRS than under U.S. GAAP.

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IFRS and Translations

Under IAS 21, financial statements of a foreign subsidiary located in a hyperinflationary economy are translated into the parent’s currency using a two-step process. Neither the temporal method nor the current rate method is used.

(1) the financial statements are restated for local inflation in accordance with IAS 29, “Financial Reporting in Hyperinflationary Economies.”

(2) each financial statement line item, which has been restated for local inflation, is translated using the current exchange rate.

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