Chapter 12

Multinational
Accounting:
Translation of
Foreign Entity
Statements

McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
 Multinational Accounting

• When a U.S. multinational company prepares

its financial statements for reporting to its
stockholder, it must include its foreign operations
measured in U.S. dollars and reported using
U.S. GAAP.

• These foreign operations may be subsidiaries,

branches, or investments of the U.S. company.

12-2
Multinational Accounting

• This chapter presents the translation of the

financial statements of a foreign business
entity into U.S. dollars, a restatement that is
necessary before the statements can be
combined or consolidated with the U.S.
company’s statements, which are already
reported in dollars.

12-3
 Multinational Accounting

• Accountants preparing financial statements must

consider both the differences in accounting
principles and the differences in currencies used
to measure the foreign entity’s operations.

• For example, a British subsidiary of a U.S.

company provides the parent with statements
measured in British pounds sterling, using the
British system of accounting, which is different
from U.S. accounting methods and measures.

12-4
 Multinational Accounting

• The U.S. parent company must typically perform

the following steps in the translation and
consolidation of the British subsidiary (see next
slide):

12-5
 Multinational Accounting
• Receive British subsidiary’s financial statements,
which are reported in pounds sterling.
• Restate the statements to conform to U.S.
generally accepted accounting principles.
• Translate the statements measured in pounds
sterling into their equivalent U.S. dollar amounts.
• Consolidate the translated subsidiary’s
accounts, which are now measured in dollars,
with the parent company’s accounts.

12-6
Differences in Accounting Principles

• Some countries develop their accounting

principles based on the information needs
of the taxing authorities.

• Other countries have accounting principles

designed to meet the needs of the central
government economic planners.

12-7
Differences in Accounting Principles
• The U.S. model focuses on the information
needs of the common stockholder or the
credit grantor through the application of
generally accepted accounting principles.
• The other major accounting standards to U.S
GAAP, the International Accounting Standards
(IAS), are developed by the International
Accounting Standards Board (IASB).
• The IASB’s website may be found at
http://www.iasb.org.uk
12-8
 Differences in Accounting Principles

• The FASB website lists a publication entitled

“The IASC-US Comparison Project: A Report
on the Similarities and Differences between
IASC standards and U.S. GAAP, that provides a
standard-by-standard comparison of each IASC
issued to that date with the body of U.S. GAAP.

12-9
 Differences in Accounting Principles
• It is felt by some accountants that the U.S.
accounting standards are more “rules-based”
while the IASB’s accounting standards are
more “principles-based.”
• What this means is that the principles-based do
not prescribe precisely every standard for every
situation, but provide more general guidance
that accountants use in their professional
judgments. The U.S.’s rules-based standards
are much more detailed and describe the
accounting treatments for many more
circumstances and cases.
12-10
 Differences in Accounting Principles

• One area of concern is that U.S. GAAP has

more disclosure requirements than the IASs.

• This is a major reason that the U.S. Securities

and Exchange Commission (SEC) has
supported global standards but it still does not
accept IAS financial statements without an
additional reconciliation statement to U.S. GAAP.

12-11
 Differences in Accounting Principles

• A number of international firms gain access to

U.S. securities markets via American Depository
Receipts (ADR) which are essentially derivative
instruments representing shares of a non-U.S.
company.

• ADRs are traded on the NYSE and other U.S.

exchanges. About fifteen percent of the total
companies listed on the NYSE are foreign
companies.

12-12
 Differences in Accounting Principles
• The ADRs are issued by a depository bank, such
as J.P. Morgan or Citibank, that holds the actual
shares of the foreign company’s stock. Thus,
the ADRs are a security that represents the
shares of a non-US company.

• Foreign companies with ADRs traded on U.S.

exchanges must be registered with the SEC and
must annually file a Form 20-F statement that
presents the company’s financial statements
with reconciliation to U.S. GAAP.
12-13
 Differences in Accounting Principles
• If convergence efforts are successful, it is
anticipated that there will be a uniform set of
international financial reporting standards that
“harmonizes” the best from U.S. GAAP and
from the IASB’s IASs.

• In turn, it is anticipated that there will eventually

be one set of International Financial Reporting
Standards that will be used by companies listed
on any of the major stock exchanges of the
world.
12-14
 Determining the Functional Currency

• FASB 52 provides specific guidelines for

translating foreign currency financial statements.
The translation process begins with a
determination of whether each foreign affiliate’s
functional currency is also its reporting currency.

12-15
 Determining the Functional Currency

• FASB 52 defines an entity’s functional currency

as “the currency of the primary economic
environment in which the entity operates;
normally, that is the currency of the environment
in which an entity primarily generates and
expends cash.”

12-16
Determining the Functional Currency
• FASB 52 indicates that the following six items
must be assessed in order to determine an
entity’s functional currency:
• Cash Flows.
• Sales Prices.
• Sales Markets.
• Expenses.
• Financing.
• Intercompany Transactions.

12-17
 Determining the Functional Currency

• Most foreign affiliates use their local currency as

the functional currency because the majority of
cash transactions of a business generally take
place in the currency of the country in which the
entity operates.

• Also, the foreign affiliate usually has active sales

markets in its own country and obtains financing
from local sources.

12-18
 Determining the Functional Currency

• Some foreign-based entities, however, use a

functional currency different from the local
currency: for example, a U.S. company
subsidiary in Venezuela may conduct virtually
all of its business in Brazil, or a branch or a
subsidiary of a U.S. company operating in
Britain may well use the U.S. dollar as its major
currency although it maintains its accounting
records in British pounds sterling.

12-19
 Determining the Functional Currency

• For example, the following factors would indicate

that the U.S dollar is the functional currency for
the British subsidiary:
– Most of its cash transactions are in U.S.
dollars.
– Its major sales markets are in the U.S.
– Production components are generally
obtained from the U.S.
– The U.S. parent is primarily responsible for
financing the British subsidiary.
12-20
 Determining the Functional Currency

• The functional currency approach requires the

translation of all the foreign entity’s transactions
into the functional currency of the foreign entity.

• If an entity has transactions denominated in

other than its functional currency, the foreign
transactions must be adjusted to their equivalent
functional currency value before the company
may prepare financial statements.

12-21
Functional Currency Designation in Highly
Inflationary Economies

• An exception to the criteria for selecting a

functional currency is specified when the
foreign entity is located in countries such as
Argentina and Peru, which have experienced
severe inflation.

• Severe inflation is defined as inflation

exceeding 100 percent over a three-year
period.

12-22
Highly Inflationary Economies
• The FASB concluded that the volatility of
hyperinflationary currencies distorts the
financial statements if the local currency
is used as the foreign entity’s functional
currency.

• Therefore, in cases of operations located in

highly inflationary economies, the reporting
currency of the U.S. parent—the U.S.
dollar—should be used as the foreign
entity’s functional currency.
12-23
 Highly Inflationary Economies

• Once a foreign affiliate’s functional currency is

chosen, it should be used consistently.

• However, if changes in economic circumstances

necessitate a change in the designation of the
foreign affiliate’s functional currency, the
accounting change should be treated as a
change in estimated: current and prospective
treatment only, no restatement of prior periods.

12-24
Translation versus Remeasurement

• Two different methods are used to restate

foreign entity statements to U.S. dollars:

– Translation
– Remeasurement

12-25
 Translation versus Remeasurement

• Translation is the most common method used

and is applied when the local currency is the
foreign entity’s functional currency.

• This is the normal case in which, for example, a

U.S. company’s Swiss subsidiary uses the Swiss
franc as its recording and functional currency.

• The subsidiary’s statements must be translated

from the Swiss franc into the U.S. dollar.
12-26
 Translation versus Remeasurement

• Remeasurement is the restatement of the

foreign entity’s financial statements from the
local currency measures used by the entity into
the foreign entity’s functional currency.

• Remeasurement is required only when the

functional currency is different from the currency
used to maintain the books and records for the
foreign entity.

12-27
 Translation versus Remeasurement

• After remeasurement, the statements must then

be translated if the functional currency is not the
U.S. dollar. No additional work is needed if the
functional currency is the U.S. dollar.

12-28
 Translation versus Remeasurement

• For example, a relatively self-contained

Canadian sales branch of a U.S. company may
use the U.S. dollar as its functional currency, but
may select the Canadian dollar as its recording
and reporting currency.

12-29
 Translation versus Remeasurement

• Of course, if the Canadian branch used the U.S.

dollar for both its functional and its reporting
currency, no translation or remeasurement is
necessary: its statements are already measured
in U.S. dollars and are ready to be combined
with U.S. home office statements.

12-30
 Translation versus Remeasurement

• The most frequent application of remeasurement

is for affiliates located in countries experiencing
hyperinflation.

• For example, an Argentinean subsidiary of a

U.S. parent records and reports its financial
statements in the local currency, the Argentine
peso.

12-31
 Translation versus Remeasurement

• However, because the Argentine economy

experiences inflation exceeding 100 percent
over a three-year period, the U.S. dollar is
specified as the functional currency for reporting
purposes and the subsidiary’s statements must
then be remeasured from Argentine pesos into
U.S. dollars.

12-32
 Translation

• Most business entities transact and record

business activities in the local currency.

• Therefore, the local currency of the foreign entity

is its functional currency.

• The translation of the foreign entity’s statement

into U.S. dollars is a relatively straightforward
process.

12-33
Translation Exchange Rates

ACCOUNTS EXCHANGE RATES_______

Revenue & Expense Generally, weighted-average
exchange rate for period
covered by statement

Assets & Liabilities Current exchange rate on

balance sheet date

Stockholders’ Equity Historical exchange rates

12-34
 Translation Adjustment

• Because a variety of rates are used to translate

the foreign entity’s individual accounts, the trial
balance debits and credits after translation
generally are not equal.

• The balancing item to make the translated trial

balance debits equal the credits is called the
translation adjustment.

12-35
Translation Adjustment

• The translation adjustment resulting from the

translation process is part of the entity’s
comprehensive income for the period.

• FASB 130 requires the reporting of

comprehensive income as part of the primary
financial statements of the entity.

12-36
Remeasurement

• A second method of restating foreign

affiliates’ financial statements in U.S.
dollars is remeasurement.

• Although remeasurement is not as

commonly used as translation, some
situations exist in which the functional
currency of the foreign affiliate is not
local currency.

12-37
 Remeasurement

• Remeasurement is similar to translation in that

its goal is to obtain equivalent U.S. dollar values
for the foreign affiliate’s accounts so they may
be combined or consolidated with the U.S.
company’s statements.

• The exchange rates used for remeasurement,

however, are different from those used for
translation, resulting in different dollar values for
the foreign affiliate’s accounts.

12-38
 Remeasurement

• The remeasurement process divides the

balancesheet into monetary and nonmonetary
accounts. Monetary assets and liabilities, such
as cash, short-term or long-term receivables,
and short-term or long-term payables, have their
amounts fixed in terms of the units of currency.
Nonmonetary assets are accounts such as
inventories, and plant equipment, which are not
fixed in relation to monetary units.

12-39
Remeasurement

• The monetary accounts are remeasured using

the current exchange rate.

• These accounts are subject to gains or losses

from changes in exchange rates.

• The appropriate historical exchange rate is

used to remeasure nonmonetary balance
sheet account balances and related revenue,
expense, gain, and loss account balances.
12-40
Remeasurement Gain or Loss

• Because of the variety of rates used to

remeasure the foreign currency trail
balance, the debits and credits of the
U.S. dollar equivalent trial balance will
probably not be equal.

• In this case, the balancing item is the

remeasurement gain or loss, which is
included in the period’s income statement.

12-41
Remeasurement Gain or Loss

• Any exchange gain or loss arising from the

remeasurement process is included in the
current period’s income statement, usually
under “Other Income.”

• Various account titles are used, such as

Foreign Exchange Gain (Loss), Currency
Gain (Loss), Exchange Gain (Loss), or
Remeasurement Gain (Loss).

12-42
 Hedge of a Net Investment

• FASB 133 states that the gain or loss on the

effective portion of a hedge of a net investment
is taken to other comprehensive income as part
of the translation adjustment.

• However, the amount of offset to comprehensive

income is limited to the translation adjustment
for the net investment.

12-43
 Additional Disclosure Requirements

• FASB 52 requires that the aggregate foreign

transaction gain or loss included in income must
be separately disclosed in the income statement
or in an accompanying note.

• This includes gains or losses recognized from

foreign currency transactions, forward exchange
contracts, and any remeasurement gain or loss.

12-44
Additional Disclosure Requirements

• If not disclosed as a one-line item on the

income statement, this disclosure is usually
a one-sentence footnote summarizing the
company’s foreign operations.

12-45
 You Will Survive This Chapter !!!

• The restatement of a foreign affiliate’s financial

statements in U.S. dollars may be made using
the translation or remeasurement method,
depending on the foreign entity’s functional
currency.

• Most foreign affiliates’ statements are translated

using the current rate method because the local
currency unit is typically the functional currency.

12-46
 Chapter 12

End of Chapter

McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.