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Chapter 7Translation of ForeignCurrency FinancialStatementsTranslation of Foreign CurrencyFinancial StatementsChapter Topics Conceptual issues of foreign currency financialstatements translation. Balance sheet vs. transaction exposure. Methods of financial statement translation. Temporal and cur...

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Chapter 7 Translation of Foreign Currency Financial Statements

Translation of Foreign Currency Financial Statements Chapter Topics      

Conceptual issues of foreign currency financial statements translation. Balance sheet vs. transaction exposure. Methods of financial statement translation. Temporal and current rate methods illustrated. U.S. GAAP, IFRSs, and other standards related to translation. Hedging balance sheet exposure. 7-2

Translating Foreign Currency Financial Statements -- Conceptual Issues    

Foreign country operations usually prepare financial statements using local currency as the monetary unit. These financial statements must be translated into home country currency. These operations also typically use local GAAP. Financial statements must be translated into home country GAAP.

7-3

Translating Foreign Currency Financial Statements -- Conceptual Issues Primary conceptual issues    

Each financial statement item must be translated using the appropriate exchange rate. Choices include the current exchange rate, average exchange rate, and the historical exchange rate. Current exchange rate is as of the balance sheet date, historical exchange rate is as of date of transaction. The resulting translation adjustment can be recognized in current income or included in an equity account on the balance sheet. 7-4

Translating Foreign Currency Financial Statements -- Conceptual Issues Ex: Parentco, a U.S.-based company, establishes a wholly owned subsidiary, Foreignco, in foreign country on Jan. 1, by investing $300, when the exchange rate between the U.S.$ and the foreign currency (FC) is FC1 = $ 0.50. The equity investment of $300 is physically converted into FC600, in addition, Foreignco borrows FC400 from local banks on Jan. 2. Foreign purchases inventory that costs FC900 and maintains FC100 in cash. ForeignCo Opening Balance Sheet in FC Cash

FC 100

Inventory Total

900 FC 1,000 7-5

Liabilities Common Stock Total

FC 400 600 FC 1,000

Translating Foreign Currency Financial Statements -- Conceptual Issues Translated financial statement on Jan. 1 ForeignCo Opening Balance Sheet in $ Cash

$ 50

Liabilities

Inventory

450

Common Stock

Total

$ 500

Total

$ 200 300 $ 500

Note that the amount of common stock is equal to the “Investment in Subsidiary” account in the parent company, so a consolidation statement can be done 7-6

Translating Foreign Currency Financial Statements -- Conceptual Issues During the period Jan.1 to Mar. 31, Foreignco engages in no transactions. However, during that period the FC appreciates in value against the US$ such that the exchange rate at Mar. 31 is FC1 = $0.60 In preparing the Mar. 31 interim financial statement, Parentco now must choose between: - The current exchange rate of US, 1FC = $0.60 - Historical exchange rate of US, 1FC = $0.50 Foreignco’s stockholder’s equity must be translated at the historical rate of US$ 0.50, So that the Parentco’s Investment account can be eliminated against subsidiary’s common stock in the consolidation worksheet 7-7

Translating Foreign Currency Financial Statements -- Conceptual Issues Two approaches exist: First approach: All assets and liabilities are translated at the current exchange rate (the common stock translated at historical exchange rate)

7-8

ForeignCo Opening Balance Sheet in FC Cash

FC 100

Inventory Total

900 FC 1,000

Liabilities

FC 400

Common Stock Total

600 FC 1,000

current exchange rate of US$ 0.60 ForeignCo Interim Balance Sheet on Mar. 31 (Translated in US$) Cash

$ 60

Liabilities

Inventory

540

Common Stock Translation adjustment

Total

$ 600

Total

$ 240 300 60 $ 600 9

Translating Foreign Currency Financial Statements -- Conceptual Issues -The translation adjustment reflects the change in the dollar value of the net investment in Foreignco if the subsidiary were to be sold. Investment in FC = 600 x 0.6 = $360 Change in investment value in $ = 360 – 300 = $60 Equal to translation adjustment -A Positive translation adjustment signals that the appreciation of foreign currency will result in an increase in the US value of future FC dividends 7-10

Translating Foreign Currency Financial Statements -- Conceptual Issues Second Approach: Some assets and liabilities are translated at the current exchange rate, and other assets and liabilities are translated at historical exchange rates when the assets and liabilities were acquired. (the common stock translated at historical exchange rate)

7-11

Translating Foreign Currency Financial Statements -- Conceptual Issues Monetary assets (cash & receivables) and liabilities (most liabilities) are translated at the current exchange rate

Nonmonetary assets (Inventory, fixed assets) translated at historical exchange rate when they acquired, and common stock translated at historical exchange rate when it invested.

7-12

ForeignCo Opening Balance Sheet in FC Cash Inventory Total

FC 100 900 FC 1,000

Liabilities Common Stock Total

FC 400 600 FC 1,000

Historical exchange rate 1FC = $0.50 current exchange rate 1 FC = $0.60 ForeignCo Interim Balance Sheet on Mar. 31 (Translated in US$) Cash

$ 60

Liabilities

Inventory

450

Common Stock

300

Translation adjustment

(30)

Total

$ 510

Total

$ 240

$ 510 13

Balance Sheet Exposure   

Assets and liabilities translated at the current exchange rate are exposed to risk of a translation adjustment. When foreign currency appreciates, a net asset exposure results in a positive translation adjustment. When foreign currency appreciates, a net liability exposure results in a negative translation adjustment. Net assets and liabilities translated at current exchange rate: = Cash – Liabilities = 100 – 400 = FC(300) Change in Value in US$ = (300) x [0.60-0.50] = $(30) Equal to translation adjustment



Assets and liabilities translated at the historical exchange rate are not exposed to a translation adjustment. 7-14

Translation Methods Current/Noncurrent Method    

Current assets and liabilities are translated at the current exchange rate. Noncurrent assets and liabilities and stockholders’ equity accounts are translated at historical exchange rates. There is no theoretical basis for this method. Method is seldom used in any countries and is not allowed by U.S. GAAP or IFRSs.

7-15

Translation Methods Monetary/Nonmonetary Method  



Monetary assets and liabilities are translated at the current exchange rate. Nonmonetary assets and liabilities and stockholders’ equity accounts are translated at historical exchange rates. The translation adjustment measures the net foreign exchange gain or loss on Monetary assets and liabilities as if these items were carried on the parent’s books.

7-16

Translation Methods Temporal Method  

 

Objective is to translate financial statements as if the subsidiary had been using the parent’s currency. Items carried on subsidiary’s books at historical cost, including all stockholders’ equity items are translated at historical exchange rates. Items carried on subsidiary’s books at current value are translated at current exchange rates. Income statement items are translated at the exchange rate in effect at the time of the transaction.

7-17

Translation Methods Current Rate Method    

Objective is to reflect that the parent’s entire investment in a foreign subsidiary is expose to exchange risk. All assets and liabilities are translated at the current exchange rate. Stockholders’ equity accounts are translated at historical exchange rates. Income statement items are translated at the exchange rate in effect at the time of the transaction.

7-18

Current Rate Method Translation methods illustrated U.S.

Inc. owns Juarez, SA, a subsidiary in Mexico which was established January 1, 2005. Juarez’s balance sheet items as of 31/12/05, in pesos. Cash 1,000 Accounts payable 2,000 Accounts rec. 2,000 Long-term debt 6,000 Inventory 2,500 Capital stock 3,000 Fixed assets 8,000 Retained earnings 1,500 Accum. Depr. (1,000) Juarez’s

income statement items for 2005, in pesos. Sales 20,000 Depr. exp 1,000 COGS 14,000 Interest exp. 500 S,G,&A exp. 2,500 Income tax exp. 500 7-19

Current Rate Method Translation methods illustrated There

was no beginning inventory. Inventory, which is carried at cost, was acquired evenly during the last quarter of 2005. Purchases were made evenly throughout year. Fixed assets were acquired on January 1, 2005. Capital stock was sold on January 1, 2005.

7-20

Current Rate Method

Translation methods illustrated Relevant exchange rates (U.S. dollar per Mexican peso) January 1, 2005 $0.10 Average for 2005 $0.095 Average for 4th quarter 2005 $0.09 December 31, 2005 $0.08

7-21

Current rate Method Translation methods illustrated – Summary Current Rate Method  Income statement translated at average exchange rate  All assets and liabilities translated at current rate.  Capital stock translated at historical exchange rate  Dividend translated at historical exchange rate when the dividend paid  Retained earning from the statement of retained earning  Translating adjustments equal the amount to balance the Balance Sheet, and included in equity

7-22

Current rate Method In the current rate method we use the following translation rate: Date

Translation Rate

Use

1/1/2005 Average 2005

0.100 0.095

Capital stock Revenue & expense

31/12/2005

0.080

Assets & Liabilities

7-23

Current rate Method Income Statement Pesos Sales Cost of good sold Gross profit

20,000 (14,000) 6,000

Selling & Administrative expenses Deprecation expense

(2,500) (1,000)

Interest expense

(500)

Income before Income taxes Income taxes

2,000 (500)

Net Income

1,500 7-24

Current rate Method Income Statement Pesos Translation Rate Sales Cost of good sold

20,000 (14,000)

0.095 (A) 0.095 (A)

Gross profit Selling & Administrative expenses

6,000 (2,500)

0.095 (A)

Deprecation expense

(1,000)

0.095 (A)

Interest expense Income before Income taxes

(500) 2,000

0.095 (A)

Income taxes Net Income

(500) 1,500

0.095 (A)

7-25

Current rate Method Income Statement Pesos Translation Rate Sales Cost of good sold

20,000 (14,000)

$

0.095 (A) 0.095 (A)

1,900.0 (1,330.0)

Gross profit Selling & Administrative expenses

6,000 (2,500)

0.095 (A)

570.0 (237.5)

Deprecation expense

(1,000)

0.095 (A)

(95.0)

Interest expense Income before Income taxes

(500) 2,000

0.095 (A)

(47.5) 190.0

Income taxes Net Income

(500) 1,500

0.095 (A)

(47.5) 142.5

7-26

Current rate Method Statement of Retained Earning Pesos Translation Rate Retained Earnings, 1/1 Net Income

0 1,500

From Income statement

0

(H)

Less: Dividend Retained Earnings, 31/12

1,500

7-27

$ 0 142.5 0 142.5

Current rate Method Balance Sheet Pesos Assets Cash Account Receivable

1,000 2,000

Inventory

2,500

Total current assets Fixed assets

5,500 8,000

Less: Acc, Depreciation

(1,000)

Total Assets

12,500

7-28

Current rate Method Balance Sheet Pesos Liabilities & Owner’s Equity Account payables Total current liabilities

2,000 2,000

Long-Term debt

6,000

Total liabilities Capital stock

8,000 3,000

Retained Earnings

1,500

Total Equity Total Liabilities & O.E.

4,500 12,500 7-29

Current rate Method

Assets

Balance Sheet Pesos Translation Rate

Cash Account Receivable

1,000 2,000

0.08 (C) 0.08 (C)

Inventory

2,500

0.08 (C)

Total current assets Fixed assets

5,500 8,000

0.08 (C)

Less: Acc, Depreciation

(1,000)

0.08 (C)

Total Assets

12,500

7-30

Current rate Method Balance Sheet Pesos Liabilities & Owner’s Equity

Translation Rate

Account payables Total current liabilities

2,000 2,000

0.08 (C)

Long-Term debt

6,000

0.08 (C)

Total liabilities Capital stock

8,000 3,000

0.10 (H)

Retained Earnings

1,500

Total Equity Total Liabilities & O.E.

4,500 12,500 7-31

Current rate Method

Assets

Balance Sheet Pesos Translation Rate

$

Cash Account Receivable

1,000 2,000

0.08 (C) 0.08 (C)

80 160

Inventory

2,500

0.08 (C)

200

Total current assets Fixed assets

5,500

440

8,000

0.08 (C)

640

Less: Acc, Depreciation

(1,000)

0.08 (C)

(80)

Total Assets

12,500

7-32

1,000

Current rate Method Balance Sheet Pesos Liabilities & Owner’s Equity

Translation Rate

$

Account payables Total current liabilities

2,000 2,000

0.08 (C)

160.0 160.0

Long-Term debt

6,000

0.08 (C)

480.0

Total liabilities Capital stock

8,000 3,000

0.10 (H)

640.0 300.0

Retained Earnings Translation Adjustment

1,500

142.5 (82.5)

4,500

360

12,500

1,000

Total Equity Total Liabilities & O.E.

7-33

Current rate Method This results is net asset exposure due to foreign currency depreciation Net asset exposure and devaluing foreign currency results in translation loss ($82.5) Translation adjustment included in equity.

7-34

Ex. 14, p.346 In the current rate method we use the following translation rate: Date

Translation Rate

Use

1/1/Y1 Average for Y1

0.84 0.80

Capital stock Retained earning 31/12/Y1

Average for Y2 1/12/Y2

0.72 0.71

Revenue & expense in Y2 Dividend paid in Y2

31/12/Y2

0.70

Assets & liabilities in Y2

7-35

Ex. 14, p.346 Income Statement – Year 2 Cz Sales Cost of good sold Gross profit

540,000 (310,000) 230,000

Operating expenses (108,000) Income before Income taxes 122,000 Income taxes Net Income

(40,000) 82,000

7-36

Ex. 14, p.346 Income Statement – Year 2 Cz Translation Rate Sales Cost of good sold

540,000 (310,000)

0.72 (A) 0.72 (A)

Gross profit Operating expenses

230,000 (108,000)

0.72 (A)

Income before Income taxes

122,000

Income taxes Net Income

(40,000) 82,000

7-37

0.72 (A)

Ex. 14, p.346 Income Statement – Year 2 Cz Translation Rate Sales Cost of good sold

540,000 (310,000)

Gross profit Operating expenses

230,000 (108,000)

Income before Income taxes

122,000

Income taxes Net Income

(40,000) 82,000

7-38

$

0.72 (A) 0.72 (A)

388,800 (223,200)

0.72 (A)

165,600 (77,760) 87,840

0.72 (A)

(28,800) 59,040

Ex. 14, p.346 Statement of Retained Earning – Year 2 Cz Retained Earnings, 1/1/Y2

154,000

Net Income Less: Dividend

82,000 (20,000)

Retained Earnings, 31/12/Y2 216,000

7-39

Ex. 14, p.346 Statement of Retained Earning – Year 2 Cz Translation Rate Retained Earnings, 1/1/Y2 Net Income Less: Dividend

154,000

0.80

82,000

From Income statement

(20,000)

0.71 (H)

Retained Earnings, 31/12/Y2 216,000

7-40

Ex. 14, p.346 Statement of Retained Earning – Year 2 Cz Translation Rate Retained Earnings, 1/1/Y2 Net Income Less: Dividend

154,000

0.80

82,000

From Income statement

(20,000)

0.71 (H)

Retained Earnings, 31/12/Y2 216,000

7-41

$ 123,200 59,040 (14,200) 168,040

Ex. 14, p.346 Balance Sheet – Dec. 31, Year 2 Assets Cash Receivables Inventory

Cz 50,000 100,000 72,000

Plant & Equipment

300,000

Less: Acc. depreciation

(70,000)

Total assets Liabilities

452,000 186,000

Capital Stock Retained Earnings 31/12/Y2 Translation Adjustment Total Liabilities & Stockholder’s Equity

50,000 216,000

452,000 7-42

Ex. 14, p.346 Assets Cash Receivables

Balance Sheet – Dec. 31, Year 2 Translation Cz Rate 50,000 0.70 (C) 100,000 0.70 (C)

Inventory

72,000

0.70 (C)

Plant & Equipment

300,000

0.70 (C)

Less: Acc. depreciation

(70,000)

0.70 (C)

Total assets Liabilities

452,000 186,000

Capital Stock Retained Earnings 31/12/Y2 Translation Adjustment Total Liabilities & Stockholder’s Equity

50,000 216,000

452,000 7-43

0.70 (C) 0.84 (H)

Ex. 14, p.346 Assets Cash Receivables

Balance Sheet – Dec. 31, Year 2 Translation Cz Rate 50,000 0.70 (C) 100,000 0.70 (C)

Inventory

$ 35,000 70,000

72,000

0.70 (C)

50,400

Plant & Equipment

300,000

0.70 (C)

210,000

Less: Acc. depreciation

(70,000)

Total assets Liabilities

452,000 186,000

0.70 (C) (49,000) 316,400 0.70 (C) 130,200

Capital Stock Retained...