Chapter Eight

Translation of
Foreign
Currency
Financial
Statements
McGraw-Hill/I rwin Copyright 2011 by The McGraw-Hill Companies, I nc. 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.
At the end of the first year of operations:






Ending R/E from year 1, becomes Beginning
R/E in Year 2.
Net Income
in FC
=
Net Income
in US $
-
Dividends in
FC
x
historical exchange
rate when declared
=
Dividends in
US $
Ending R/E
in FC
Ending R/E
in US $
from the translated
income statement
8-8
Calculation of Cost of Goods Sold
Current Rate Method - translate using the weighted
average rate for the current period.
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.
Beginning Inventory Historical Rate
+ Purchases Average Rate
- Ending Inventory Historical Rate
= COGS
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
Temporal Method - the gain must be computed
indirectly, using different rates.
Cash
Received

Current
Rate
= US $ Cash
- Asset Cost
Historical
Rate
=
US $ Asset
Cost
=
Gain
(Loss)
Difference is
the Gain or
(Loss)
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 companys functional
currency is the primary
currency of the foreign
entitys operating
environment.
8-14
Highly Inflationary Economies
In highly inflationary
economies, the Temporal
Method for translation is
required.
Disappearing Plant Problem
If 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 subs 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