evaluating the validity of the appendix 16b functional ...purchasing power parity theory ... does...

Appendix 16B

Evaluating the

Validity of the

Functional

Currency

Concept

1

In this appendix, we show the third possible approach to translating foreign currency financialstatements that was mentioned in Chapter 15: the current-value approach using purchasing

power parity theory (hereafter the PPP current-value approach). We then use this approach to re-veal the characteristics (strengths and weaknesses) of the current rate and temporal methods oftranslation. Next, we address the environment and thinking that gave rise to the functional cur-rency concept and whether it is a valid concept. Last, we discuss how to evaluate and manage for-eign operations when the reporting results of FAS 52 are so unrealistic that the translated state-ments cannot be relied upon.

I. THE CURRENT-VALUE APPROACH USINGPURCHASING POWER PARITY THEORY

In Chapter 13, we discussed that long-term exchange rate changes are best explained by purchas-ing power parity theory, which states the following: The differential rate of inflation between twocountries can be expected to result over the long term in an equal but opposite change in the ex-change rate between the two currencies. Recall further that foreign inflation drives the direct ex-change rate down and that domestic inflation has the opposite result.

The RationaleThe premise of the PPP current-value approach is that it makes little sense to apply an exchangerate that has been impacted downward for foreign inflation to amounts that likewise have not beenadjusted upward for the same inflation. To do so is to deal with only half of accounting for the ex-change rate change problem. Accordingly, under this approach, nonmonetary assets that have in-creased in value because of foreign inflation are adjusted for the foreign inflation and then trans-lated at the current rate. This approach largely achieves current-value accounting.1 All remainingassets and liabilities are also translated at the current rate. All income statement accounts are trans-lated using exchange rates in effect when the items were recognized in earnings (the current rate).

Managerially, a foreign currency unit of measure is achieved only if local management inter-nally uses the inflation-adjusted foreign currency statements to manage the subsidiary.

The Focus: The Net Asset PositionThis approach assumes that all of the foreign unit’s assets and liabilities are exposed to the risk ofexchange rate changes. Thus the exposure pertains to the net asset position (which equals the par-ent’s net investment)—the same focus used for the foreign currency unit of measure approach dis-cussed in Chapter 15. Because a single exchange rate is used in translating all assets and liabilities,

2 APPENDIX 16B EVALUATING THE VALIDITY OF THE FUNCTIONAL CURRENCY CONCEPT

1 The modifier largely is used because no general price-level index can exactly achieve current values on a company-by-companybasis. Also, the base to which the general price index is applied could be unreliable inasmuch as the depreciable life used and/or thedepreciation method used could be inappropriate.

the relationships that exist in the inflation-adjusted foreign balance sheet are maintained in trans-lation (as under the foreign currency unit of measure approach shown in Chapter 15).

Key Observations Regarding the PPP Current-Value ApproachThis approach eliminates the “disappearing plant” problem that can occur in the foreign currencyunit of measure approach (current rate method). To fully understand the reporting results of thePPP current-value approach, it is necessary to analyze the exchange rate change for the periodusing PPP. We will do this shortly.

To illustrate translation under this approach, we will use the same set of assumptions used inillustrating the other two approaches in Chapters 15 and 16. For convenience, we list those as-sumptions again here.

Assumed Factual Data for Illustrations of the Three Possible Translation ApproachesAssume that in late 2004, a U.S. company created a 100%-owned subsidiary in Mexico when thedirect exchange rate was $.50, making a $1,000,000 cash equity investment at that time. For sim-plicity, assume that this direct exchange rate did not fluctuate through December 31, 2004. Thesubsidiary’s first sales were on January 1, 2005. The subsidiary’s balance sheets at the end of 2004and 2005 and the subsidiary’s 2005 income statement are shown in Illustration 16B-1.

Additional assumptions are that (1) no dividends were declared or paid in 2005; (2) fixed assetadditions of Mex$ 200,000 (equal to 2005 depreciation expense) occurred on January 3, 2005,when the exchange rate was $.50; (3) Mexico had 25% inflation for 2005; (4) the United Stateshad 10% inflation for 2005; and (5) the direct exchange rates were $.50 at December 31, 2004,$.44 at December 31, 2005, and $.47 for 2005 as an average.

APPENDIX 16B EVALUATING THE VALIDITY OF THE FUNCTIONAL CURRENCY CONCEPT 3

ILLUSTRATION 16B-1 FOREIGN CURRENCY FINANCIAL STATEMENTS

Pesos

12/31/04 12/31/05

Balance SheetsMonetary assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,200,000 2,500,000Inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 1,250,000Fixed assets, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,800,000 4,800,000a

Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000,000 8,550,000

Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000,000 6,250,000Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000,000b 2,000,000Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . –0– 300,000

Total Liabilities and Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000,000 8,550,000

Income Statements (2005)Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,300,000Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (4,300,000) Depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (200,000) Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (500,000)

Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000

a Because of the 25% inflation in Mexico during 2005, these assets are undervalued 25%.b This amount is the peso equivalent of the $1,000,000 cash investment made by the parent when it formed the subsidiary in late 2004 ($1,000,000/$.50 =Mex$ 2,000,000).


Because Mexico had 25% inflation in 2005, the 2005 inflation adjustment on the fixed assetsis Mex$ 1,200,000 (historical cost of Mex$ 4,800,000 � 25%). The translation worksheet usingthe inflation-adjusted values and the current exchange rate is shown in Illustration 16B-2.

To explain the $399,000 economic gain reported under the PPP current-value approach asshown in Illustration 16B-2, it is necessary to analyze the change in the exchange rate using PPP.This analysis is shown in Illustration 16B-3.

The inflation effects shown in Illustration 16B-3 are used in Illustration 16B-4 to explain the$399,000 economic gain reported in Illustration 16B-2.

ILLUSTRATION 16B-2 THE CURRENT-VALUE APPROACH USING PPP

Inflation Adjusted

ExchangeU.S.

(Pesos) Code Rate Dollars

Income Statement (2005)Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,300,000 A $.47 $ 2,491,000Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (4,300,000) A $.47 (2,021,000) Depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (200,000) A $.47 (94,000) Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (500,000) A $.47 (235,000)

Net Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 $ 141,000

Balance Sheet (as of 12/31/05)Monetary assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500,000 C $.44 $ 1,100,000Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,250,000 C $.44 550,000Fixed assets, net. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000,000(1) C $.44 2,640,000

Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,750,000 $ 4,290,000

Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,250,000 C $.44 $ 2,750,000

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000,000 H $.50 $ 1,000,000Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 (Per above) 141,000Revaluation capital . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200,000 n/aEconomic gain from exchange rate change . . . . . . . . . . . (forced) 399,000(2)

Total Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500,000 $ 1,540,000

Total Liabilities and Equity . . . . . . . . . . . . . . . . . . . 9,750,000 $ 4,290,000

(1) Includes a Mex$ 1,200,000 inflation adjustment (the historical cost at 1/1/05 of Mex$ 4,800,000 x 25%).

(2) This amount can be forced out or calculated. The calculation is shown later in Illustration 16B-5.

Key Review Points:1. Note how ratios and relationships are maintained after translation:

Pesos U.S. Dollars

Debt-to-equity ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.78:1 1.78:1 Gross profit margin ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19% 19% Net income to sales ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6% 6% Fixed assets to total assets ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62% 62% Undervaluation of fixed assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0% 0%

2. Note the increase in the stockholders’ equity (which we later compare to the change under the other two approaches):

Ending stockholders’ equity (per above). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,540,000 Less—Beginning stockholders’ equity (parent’s initial capital investment per Illustration 16B-1) . . . . . . . . . . . 1,000,000

Increase in stockholders’ equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 540,000

Code: A = Average rate; C = Current rate; H = Historical rate.


ILLUSTRATION 16B-3 ANALYZING THE CHANGE IN THE EXCHANGE RATE

Direct Exchange Rate

Actual rate, 1/1/05 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ .50Plus: Increase expected because of U.S. 10% inflation ($.50 � 10%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .05

Subtotal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ .55Less: Decrease expected because of 25% Mexican inflation ($.55/125% = $.44; $.55 – $.44 = $.11) . . . . . . . . (.11)

Expected end-of-year rate under PPP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ .44Plus or minus: Noninflationary factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .00a

Actual rate, 12/31/05 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ .44

a For simplicity, it is assumed that there are no noninflationary factors. Later, noninflationary factors are addressed.

ILLUSTRATION 16B-4 USING THE EXCHANGE RATE ANALYSIS IN ILLUSTRATION 16B-3 TO EXPLAIN THE INCREASE IN THE SUBSIDIARY’S EQUITY IN ILLUSTRATION 16B-2

(1) Unrealized Nominala Inflationary Holding Gain Resulting from U.S. Inflation (calculated on parent’s beginning net investment position):

Pesos Dollars

Subsidiary’s equity at 1/1/05 (per Illustration 16B-1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000,000Effect of domestic inflation on the exchange rate ($.55 – $.50) . . . . . . . . . . . . . . . . . . . . . . $.05 $ 100,000

(2) Unrealized Inflationary Holding Gain Resulting from Mexico’s Inflation (calculated on nonindexed local (foreign)

debt financing of fixed assets):bFixed assets at 1/1/05 (per Illustration 16B-1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,800,000Less—Equity financing at 1/1/05. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,000,000)

Net Debt Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,800,000Effect of Mexico’s inflation on the exchange rate ($.55 – $.44). . . . . . . . . . . . . . . . . . . . . . . $.11 $ 308,000

(3) Exchange Rate Change Effect on 2005 Earnings: Reported earnings (per Illustration 16B-2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000Difference between the average rate and the year-end rate ($.47 – $.44) . . . . . . . . . . . . . . . . $.03 $ (9,000)

Total Effect of Exchange Rate Changes (a net gain). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 399,000

(4) Subsidiary’s net income (per Illustration 16B-2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141,000

Reported Number of U.S. Dollars the Parent Is Ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 540,000

Calculation of Parent’s Increase in Purchasing PowerReported (nominal) number of U.S. dollars ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 540,000Less—Loss of purchasing power on beginning investment ($1,000,000 � 10%) . . . . . . . . . . . . . . . . . . . . . . . . (100,000)

Real Increase in Purchasing Power. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 440,000

a A “nominal” gain in the parlance of economics means a gain “in name only” as contrasted to a “real” gain. In this case, the $100,000 unrealized gaindoes not result in any increased purchasing power to the parent. In a real gain, the parent would have increased purchasing power. In this chapter, a gain isassumed to be a real gain unless it is labeled a nominal gain.b Nonindexed means that the debt principal is not adjusted upward for any inflation in the foreign country.

II. WHICH OF THE THREE TRANSLATIONAPPROACHES REFLECTS ECONOMIC REALITY?

One of the objectives in foreign currency translation is to properly reflect the economic impact ofexchange rate changes. Each of the three approaches shown produces significantly different results,as summarized:

Economic Gain or Increase in (Loss) from Exchange Subsidiary’s

Rate Change Equity

1. Current rate method, per Illustration 15-5 (page 510). . . . . . . . . $(129,000) $ 12,000 2. Temporal method, per Illustration 16-3 (page 545) . . . . . . . . . . . 232,500 310,000 3. PPP current-value approach, per Illustration 16B-2 (page 4) . . . . 399,000 540,000

They all cannot reflect economic reality because there can be only one economic reality. Onlythe PPP current-value approach reflects the economic effect of the exchange rate change. The onlysensible way to manage the foreign subsidiary and evaluate its results—both at the local level andthe parent level—is to use the inflation-adjusted financial statements shown under the PPP current-value approach.

Because both the current rate method and the temporal method are permitted by FAS 52 (spe-cific conditions determining when to use one or the other), it is necessary to fully understand them.We now compare the current rate method and the temporal method to the PPP current-value ap-proach to isolate the reasons that the reporting differences occur and thus gain insight into thestrengths and weaknesses of each method. Interwoven in this analysis is the issue of adjusting forinflation foreign fixed assets but not domestic fixed assets.

III. THE CHARACTERISTICS OF THECURRENT RATE METHOD

A comparison of the reporting results of the current rate method and the PPP current-value ap-proach is shown in Illustration 16B-5.

The Current Rate Method Properly Reports the Economic Effect of Domestic InflationIllustration 16B-5 shows that the current rate method properly reports the $100,000 economic ef-fect of the upward inflationary effect of $.05 caused by the 10% U.S. inflation—an unrealizednominal inflationary holding gain. If noninflationary factors were present, their economic effectwould also be properly reported because they are dealt with as is the U.S. inflation effect.

The Current Rate Method Does Not Properly Report the Economic Effect of Foreign InflationIllustration 16B-5 also shows that the current rate method does not properly report the $308,000economic effect of Mexico’s 25% inflation—an unrealized inflationary holding gain. Under thecurrent rate method, translating the fixed assets at the $.44 current rate means that both the up-ward inflationary effect of $.05 (Illustration 16B-3) and the downward inflationary effect of $.11(Illustration 16B-3) were considered in the translation process. This approach’s shortcoming—inrelation to the PPP current-value approach—is that the downward inflationary effect of $.11 (forMexico’s 25% inflation) should not have been considered in the translation of the fixed assets. Theresult is $528,000 of suppressed valuation of fixed assets (Mex$ 4,800,000 � $.11).



Applying an exchange rate that has decreased because of Mexico’s inflation to historical costamounts in pesos that have not likewise been adjusted upward for the same inflation is illogicalfrom an economic perspective and produces an amount that is difficult to interpret. The resultingdollar amount of $2,112,000 (Illustration 15-5, page 510) is not the $2,400,000 U.S. dollar equiv-alent needed to acquire the fixed assets when they were acquired (4,800,000 pesos at 1/1/05 asshown in Illustration 16B-1 � the $.50 exchange rate existing when the assets were acquired inlate 2004). Nor is this the current value of the fixed assets—that amount being $2,640,000 (Illus-tration 16B-2). The amount can be described only as historical cost that has been adjusted for theexchange rate change. This difficult-to-interpret problem is not unique to fixed assets. The trans-lated amount for a note receivable or payable having a fixed interest rate different from the cur-rent market rate is also neither the initial dollar equivalent nor a current value amount.

Applying current exchange rates to historical costs does result in fixed assets being maintainedat the same percentage of total assets that existed in the foreign currency statements (the preserva-tion of the functional currency relationship). Accordingly, the dollar amounts are no less meaning-ful or unclear than the foreign currency amounts from which they were derived. Stated differently,if the foreign fixed assets are undervalued by 25% because of inflation, both sets of financial state-ments reflect this undervaluation.

FAS 52 acknowledges the inability of the current rate method to deal properly with the effectsof foreign inflation in dealing with highly inflationary economies. The FASB’s solution to this prob-lem was to have companies (1) disregard all of the so-called economic factors that are prescribed(in FAS 52) to determine the functional currency and (2) instead always use the U.S. dollar as thefunctional currency. This by itself should raise serious questions as to the validity and conceptualmerits of the functional currency concept.

The foreign inflation problem exists for all economies, however, not just highly inflationaryones. For instance, Great Britain had approximately 5.7% annual inflation for the 15 years ended1995, a cumulative change of 128% for 15 years. Under PPP, the exchange rate would decrease56% for this period. U.S. inflation during this period averaged 3.9%, a cumulative change of 76%.

ILLUSTRATION 16B-5 COMPARISON OF THE CURRENT RATE METHOD TO THE CURRENT-VALUE APPROACH USING PPP

CURRENT RATE CURRENT-VALUE METHOD APPROACH REPORTING

(PER ILLUSTRATION 15-5) (PER ILLUSTRATION 16B-2) DIFFERENCE

Earnings (excluding effects of exchange rate changes) . . . . . . . . . . . . . . . $ 141,000 $141,000 $ –0–

Economic gain (loss) from exchange rate changes. . . . . . . . . . . . . . . . (129,000) 399,000 528,000

Parent’s Reported Economic Gain . . . . . . . . . . . $ 12,000 $540,000 $528,000

Comparison of Reported Effects of Exchange Rate Changes

CURRENT-VALUE CURRENT RATE APPROACH REPORTING

METHOD (PER ILLUSTRATION 16B-4) DIFFERENCE

Effect of U.S. inflationBeginning investment of 2,000,000 Mex$ �

$.05 upward inflationary effect . . . . . . . . . . . . $ 100,000 $100,000 $ –0–

Effect of Mexican InflationBeginning investment of 2,000,000 Mex$ �

$.11 downward inflationary effect. . . . . . . . . . . (220,000) 220,000 Debt financing of fixed assets of

Mex$ 2,800,000 � $.11 downwardinflationary effect . . . . . . . . . . . . . . . . . . . . . 308,000 308,000

Effect of exchange rate change on net income. . . . . (9,000) (9,000) –0–

Total Effect of Exchange Rate Change . . . . . . . . $(129,000) $399,000 $528,000

Explanation of $528,000 Reporting DifferenceSuppressed Valuation of Fixed Assets (Mex$ 4,800,000 � $.11). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $528,000


Accordingly, the expected decrease in the exchange rate was only 23% instead of 56%. As shownin Illustration 16B-6, the suppressed valuation of British fixed assets acquired in 1981 is substan-tial for this relatively low inflationary economy even when one considers the countereffect of U.S.inflation during this period.

Accordingly, the “disappearing plant” problem discussed in Chapter 15 can also occur in rel-atively low inflationary economies. Thus, given a choice between valuing foreign fixed assets atcurrent values versus values based on preserving foreign currency relationships that can have thedisappearing plant problem, users will likely choose current values every time.

IV. THE CHARACTERISTICS OFTHE TEMPORAL METHOD

A comparison of the reporting results of the temporal method and the PPP current-value approachis shown in Illustration 16B-7.

The Temporal Method Properly Reports the Economic Effect of Foreign InflationIllustration 16B-7 shows that the temporal method properly reports the $308,000 economic effectof Mexico’s 25% inflation—an unrealized inflationary holding gain. This occurs because the same

ILLUSTRATION 16B-6 THE EFFECTS OF INFLATION IN A LOW INFLATIONARY ECONOMY: GREAT BRITAIN (1981–1995)

Direct Exchange

Rate

Actual rate for the British Pound, 1/1/81 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2.40Less: Decrease expected because of 128% British cumulative inflation for 1981–1995

($2.40/228% = $1.05; $2.40 – $1.05 = $1.35). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1.35)

Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1.05Plus: Increase expected because of 76% U.S. cumulative inflation for 1981–1995 ($1.05 � 76% = $.80) . . . . . . . . . 0.80

Expected Rate at 12/31/95 under PPP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1.85Less: Noninflationary factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (.31)

Actual Rate for the British Pound, 12/31/95 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1.54

Valuations at 12/31/95 for Land Costing U.S.£1,000,000 Acquired on 1/1/81 Pounds Rate Dollars

Temporal method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 � $2.40 = $2,400,000

Current rate method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 � $1.54 = $1,540,000a

PPP current-value approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,280,000d � $1.54 = $3,511,000

Current rate method—assuming that no U.S. inflation had occurred . . . . . . . . . 1,000,000 � $ .74b = $ 740,000c

PPP current-value approach—assuming that no U.S inflation had occurred . . . . 2,280,000d � $1.05 = $2,394,0002,280,000d � $(.31) = (707,000)

2,280,000d � $ .74 = $1,687,000

a The disappearing plant problem occurs here to the extent of $550,000 (£1,000,000 � the $.55 decrease ($2.40 – $1.85) in the exchange rate becauseof higher foreign inflation than domestic inflation).b The expected rate of $1.05 – $.31 for the noninflationary factors.c Note how severe the disappearing plant problem would have been had no offsetting inflation occurred in the United States.d Includes a 128% inflation adjustment of £1,280,000.

$2,400,000 fixed asset amount in U.S. dollars is obtained under the temporal method whether ornot the subsidiary adjusts its fixed assets for inflation as shown:

December 31, 2005

Exchange U.S.Pesos Rate Dollars

Fixed assets, net (as shown in Illustration 16B-1) . . . . . . . . . . 4,800,000 � $ .50 = $2,400,000 Inflation adjustment @ 25%. . . . . . . . . . . . . . . . . . . . . . . . . 1,200,000 (.10)a

Fixed assets, as adjusted . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000,000 � $ .40 = $2,400,000

a ($.50/125% = $.40; $50 – $.40 = $.10)

The $.40 rate is the exchange rate that would have existed if U.S. inflation had been zero.


ILLUSTRATION 16B-7 COMPARISON OF THE TEMPORAL METHOD TO THE PPP CURRENT-VALUE APPROACH

TEMPORAL CURRENT-VALUE METHOD APPROACH REPORTING

(PER ILLUSTRATION 16-3) (PER ILLUSTRATION 16B-2) DIFFERENCE

Earnings (excluding effects ofexchange rate changes) . . . . . . . . . . . . . . . $ 77,500 $141,000 $ 63,500

Economic gain from exchange rate change . . . . . . . . . . . . . . . . . . . . . . . 232,500 399,000 166,500

Parent’s Reported Economic Gain . . . . . . . . . . . $310,000 $540,000 $230,000

Comparison of Reported Effects of Exchange Rate Changes

CURRENT-VALUE TEMPORAL APPROACH REPORTING METHOD (PER ILLUSTRATION 16B-4) DIFFERENCE

Effect of U.S. inflationBeginning investment of Mex$ 2,000,000

� $.05 upward inflationary effect . . . . . . . . . . $100,000 $ 100,000 Debt financing of fixed assets (Mex$ 2,800,000a

� $.05 upward inflationary effect) . . . . . . . . . . $(140,000) 140,000

$ 240,000Debt financing of inventory of Mex $ 1,075,000a

� $.05 upward inflationary effect . . . . . . . . . . (53,750) 53,750

Effect of Mexico’s InflationDebt financing of fixed assets of Mex$ 2,800,000a

� $.11 downward inflationary effect. . . . . . . . . 308,000 308,000 –0–Debt financing of inventory of Mex$ 1,075,000

� $.11 downward inflationary effect. . . . . . . . . 118,250 (118,250) Effect of exchange rate change on net income. . . . . (9,000) (9,000)

Reported effect of exchange rate change . . . . . . . . $ 232,500 $399,000 $ 166,500Difference in reported amounts for

depreciation and cost of sales . . . . . . . . . . . . . (63,500)b 63,500

Corrected Reported Effect of Exchange Rate Change . . . . . . . . . . . . . . . . $ 169,000 $399,000 $ 230,000

Explanation of $230,000 Reporting DifferenceSuppressed valuation of fixed assets (Mex$ 4,800,000 � $.05) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 240,000Overvaluation of inventory ($560,000 – $550,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (10,000)

Net Overvaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 230,000

a The average net monetary liability position for 2005 was Mex$ 3,875,000, which is separated here between fixed assets and inventory.b These additional income statement charges under the temporal method largely offset the $64,500 net inflationary holding gain reported for the debt financ-ing of the inventory ($118,250 – $53,750). Because the inventory turned over in 2005, there is no real inflationary holding gain. The inventory effectivelyis a monetary item.

The Temporal Method Achieves Inflationary Accounting Reporting Results for Foreign InflationAs shown in Illustration 16B-7, the temporal method always reports inflationary holding gainswhen local inflation has caused the direct exchange rate to decrease. Management cannot concludeotherwise than the subsidiary had an inflationary holding gain. Thus, the temporal methodachieves a form of inflationary accounting. Under FAS 52, such inflationary holding gains are re-ported as “foreign currency transaction gains.”

In dealing with highly inflationary economies, the FASB stated in its basis for conclusions thatthe mandatory use of the U.S. dollar as the functional currency in these situations did not intro-duce a form of inflation accounting.2 Quite to the contrary, inflation adjustment accounting is ef-fectively being used in these situations because inflationary holding gains are always reportedunder the temporal method when local inflation has caused the direct exchange rate to decrease.Ironically, this is one aspect of FAS 52 that is sound because the reporting of inflationary holdinggains reflects the underlying economics of these situations.3

Thus, whenever foreign inflation occurs and nonindexed local debt finances fixed assets, FAS52 is inconsistent in a major respect because (1) inflationary holding gains are reported currentlyin the income statement if the U.S. dollar is the functional currency and (2) inflationary holdinggains are not reported currently (neither in the income statement nor as a direct adjustment to eq-uity) if a foreign currency is the functional currency (an erroneous zero net effect is reported).

The Temporal Method Does Not Properly Report the Economic Effect of Domestic InflationIllustration 16B-7 shows that the temporal method does not properly report the $100,000 eco-nomic effect of the upward inflationary effect of $.05 caused by the 10% U.S. inflation—an unre-alized nominal inflationary holding gain. Clearly, the use of the $.50 historical exchange rate totranslate fixed assets means that the upward factor of $.05 was not considered in determining thefixed asset amount in U.S. dollars. Consequently, $240,000 of suppressed fixed asset valuation ex-ists Mex$ (4,800,000 � $.05) in comparison to the PPP current-value approach. If noninflation-ary factors were present, their economic effect also would not be properly reported because theyare dealt with in the same manner as the U.S. inflation effect.

The inability of the temporal method to produce realistic translation results for the effects ofdomestic inflation on exchange rates is not addressed in FAS 52 (as was the inability of the currentrate method to produce realistic translation results for highly inflationary economies). An interest-ing situation arises when (1) domestic inflation consistently exceeds foreign inflation and (2) theeconomic factors set forth in FAS 52 point to the U.S. dollar as the functional currency. In this sit-uation, high domestic inflation causes the U.S. dollar to weaken against foreign currencies, pushesthe direct exchange rate up, and results in the reporting of large exchange rate change losses underthe temporal method.4 Economically, such reported losses would be nonexistent.

These unusual reporting results have not occurred under FAS 52 only because (1) the annualdomestic inflation rates after 1981 (the year FAS 52 was issued) have not been high relative to theannual inflation rates of the majority of foreign countries5 and (2) FAS 52’s requirements are suchthat the current rate method is used for most foreign operations. If domestic inflation were againto reach the high levels of 1978–1981 and a fair number of companies changed their manner ofdoing business resulting in their having to use the temporal method instead of the current rate


2 FAS 52, paragraph 107.3 If the liabilities of a foreign operation in a highly inflationary economy are indexed for inflation, the indexing adjustment results ina charge to the income statement. In U.S. dollars, the effect of that charge is to partially or fully negate the inflationary holding gainthat otherwise would be reported.4 This reporting result occurs in the typical situation in which the foreign unit has long-term debt. If fixed assets are financed solelyby the parent’s equity investment, it does not occur.5 For the period 1978—1981, the United States did experience a much higher inflation rate than many foreign countries (averaging12.5%), and the U.S. dollar weakened considerably against virtually all of these currencies during this period.

method, however, FAS 52 would produce the same misleading results as the severely criticized FAS8, and the business community again would be clamoring, and justifiably so, for a reexaminationof the foreign currency rules, as it did with FAS 8.

To be consistent with its approach in dealing with a high foreign inflation problem, the FASB’slikely solution to high domestic inflation would be to amend FAS 52 so that companies operatingoverseas in low-inflationary economies (relative to the United States) would be required to use thecurrent rate method instead because this would produce more realistic reporting results. Thus theunderlying rationale of the approach in FAS 52 used for determining whether to use the currentrate method versus the temporal method again would have to be disregarded.

Thus the temporal method is no more able to produce realistic results when high domestic in-flation is the dominant exchange rate change factor than the current rate method is able to pro-duce reliable results when high overseas inflation is the dominant exchange rate change factor. Sothe state of affairs is that the functional currency concept is so theoretically lacking that it must becast aside when the reporting results do not make sense. Furthermore, the temporal method is un-able to produce realistic results when the exchange rate has changed because of noninflationaryfactors.

V. THE FUNCTIONAL CURRENCYCONCEPT: IS IT VALID?

The functional currency concept must be able to withstand the test of both (1) being sound theo-retically and (2) being able to produce results that reflect the economic effects of changes in ex-change rates.

The Theoretical Soundness TestWithout question, the true economics revolve around causes of exchange rate changes. Accord-ingly, the development of translation methodologies based on any other economic factors must bemisguided. Only one true set of economic factors can exist. Consequently, the “economic factors”set forth in Appendix A of FAS 52 (indicators of cash flow, sales price, sales market, expense, fi-nancing, and intercompany transactions and arrangements) must be illusory and irrelevant bothindividually and collectively.

The Results-Produced TestBecause the reporting results under both the current rate method and the temporal method can re-flect the true economic effect of changes to the exchange rate only by coincidence, their reportingresults must be artificial. Thus the functional currency concept cannot be valid. After all, the con-cept calls for the use of these translation methods. Therefore, which particular currency a foreignunit uses to conduct its day-to-day operations is irrelevant—especially in a world in which curren-cies are readily convertible into each other.

Improper LinkageAny linkage between the manner of conducting operations and methods of valuing fixed assets istenuous at best. Nobody would suggest that the fixed assets of an autonomous subsidiary in Texasshould be valued differently from the fixed assets of a nonautonomous subsidiary in New York orthat the economic exposure of the two operations should be measured differently. This is what thefunctional currency concept requires be done, however, for autonomous versus nonautonomousforeign operations. (The true economic exposure is competition, which exists for all operations—whether or not they are autonomous.)

The rationale set forth for making this assumption is that the economic exposure is differentfor each type of operation, an assertion that was soundly rejected in FAS 8 (by a 6-to-1 vote) but


barely accepted in FAS 52 (by a 4-to-3 vote).6 Because two FASB board members voting on FAS 8were also board members when FAS 52 was issued, 12 different individuals served as board mem-bers and voted on the autonomous versus nonautonomous argument. Of these 12 individuals, 7rejected the autonomous versus nonautonomous argument, 4 voted for it, and 1 person votedagainst it in FAS 8 but for it in FAS 52.

In our opinion, the focus should be on selecting the translation method that most realisticallyvalues fixed assets—not on which particular perspective (foreign currency versus U.S. dollars)should be used.

Unjustifiable Reporting Results of This Improper LinkageIBM has “determined” that all of its foreign operations have local currencies as their functionalcurrencies. Hewlett-Packard has “determined” that all of its foreign operations have the U.S. dol-lar as their functional currency. Both companies have extensive operations in western Europe.From a commonsense perspective, it is illogical for these competing companies to be translatingtheir European fixed assets so differently. This problem may be largely the result of the substantiallatitude managements have in deciding between the two allowable translation methods—a prob-lem in implementing the concept. Thus inconsistencies in applying this ill-conceived concept canexacerbate the inherent reporting problems resulting from the concept itself.

Inability to Meaningfully Deal with the Simplest of SituationsThe weakness of the functional currency concept is evident in even the simplest of situations. Forexample, if a U.S. company purchased a parcel of land in a foreign city as a long-term investment,there would be no true functional currency because there would be no day-to-day operations. Anarbitrary selection between the local currency and the U.S. dollar would have to be made. Anotherexample would be the acquisition of land in a foreign country that has natural resources, with theextraction to take place in the future. Again, an arbitrary selection would be necessary. It shouldnot be necessary to make a completely arbitrary decision between two alternatives that in realityare totally artificial in terms of determining the translated valuation of such assets.

VI. HOW THE FUNCTIONAL CURRENCYCONCEPT CAME INTO EXISTENCE

FAS 52 was issued in 1981 as a solution to the perceived deficiencies of FAS 8, “Accounting forthe Translation of Foreign Currency Transactions and Foreign Currency Financial Statements,”which was issued in 1975. The main criticism of FAS 8 was that the reporting results did not re-flect the underlying economic events. This problem was attributed to using only a single unit ofmeasure (the U.S. dollar), which allegedly could not deal well with significantly different economicfacts. (FAS 8 required the use of the temporal method to achieve a U.S. dollar unit of measure.)

Specifically, the complaints focused on (1) the reporting of exchange gains or losses when theevents indicated that either no economic gain or loss had occurred or vice versa and (2) the require-ment to report such exchange gains or losses currently in the income statement, which greatly in-creased the volatility of reported earnings. Prior to FAS 8, exchange gains and losses could be de-ferred and then amortized to income, a practice followed by most firms.

These complaints were loud and many. In a nutshell, industry was furious with the reportingresults of FAS 8. In response, in 1978 the FASB formed the largest task force ever assembled to


6 In 1992, we showed our analysis of the characteristics of the current rate and temporal methods and our conclusions regarding thefunctional currency concept presented in this chapter to Ralph Walters, one of the four FASB members who voted in favor of FAS 52.Walters stated that at the time he was not aware of the strengths and weaknesses of these two translation methods and that he stronglydoubted that the other six board members were aware either. Furthermore, Walters stated that he agreed with our conclusions thatthe functional currency concept was not valid, and he suggested that we send the analysis and the conclusions to the FASB for thepurpose of having it possibly reexamine FAS 52.

reexamine what had proved to be the most complex of all accounting issues. Clearly, the FASB wasunder enormous pressure to find a politically acceptable improvement to FAS 8.

The FAS 52 SolutionFAS 52 (1981) made three major changes that were intended to correct the perceived deficienciesof FAS 8.

Major Change 1: Allowing Multiple Units of MeasureThe first major change was to allow multiple units of measure so that different economic factswould be accounted for differently. Accordingly, the foreign currency unit of measure approachwas sanctioned (implemented using the current rate method).7 The U.S. dollar unit of measure ap-proach was retained (implemented using the temporal method).

Major Change 2: Bypassing the Income Statement in Most CasesThe second major change required exchange rate change effects under the current rate method tobe (1) called translation adjustments8 and (2) reported as adjustments to be made directly to stock-holders’ equity—bypassing the income statement. Largely because the current rate method hassince become the most widely used translation method,9 the earnings volatility problem that oc-curred under FAS 8 (as discussed in Chapter 18) has substantially declined. Thus the business com-munity’s acceptance of FAS 52 may rest largely on the reduced income volatility.

Major Change 3: Adding the Functional Currency ConceptThe third major change created the functional currency concept to serve as a framework for deter-mining whether the foreign currency unit of measure (current rate method) or the U.S. dollar unitof measure (temporal method) is to be used for a particular foreign operation.

Linkage between the Functional Currency Concept and Using Multiple Units of MeasureIt is unknown whether (1) the FASB first decided to allow multiple units of measure as a solutionto FAS 8 and then, as an afterthought, created the functional currency concept as a means to deter-mine when the current rate method or the temporal method should be used for a given foreign op-eration or (2) the FASB first created the functional currency concept in the process of trying to iden-tify different economic facts, which, in turn, led to the decision to use multiple units of measure. Inany event, the functional currency concept is not a necessary condition to allow the use of multipleunits of measure; the FASB could have implemented the use of multiple units of measure simply byallowing firms to judgmentally select either the current rate method or the temporal method.

What if Judgmental Selection Had Been Allowed in Choosing between the Current Rate Method and the Temporal Method?If judgmental selection had been allowed, managements would have been free to decide betweenthe two allowable translation methods based on any rationale they deemed appropriate, such as (1)the functional currency used in the foreign operation, (2) the assessment of the causes of exchangerate changes, (3) whether the exchange rate changes are expected to be temporary or permanent,


7 Prior to being sanctioned in FAS 52, the current rate method had never been permitted in a U.S. generally accepted accounting prin-ciple, even though it was used widely in Europe.8 Prior to the issuance of FAS 52, “exchange gains and losses” was the commonly used term (in FAS 8 and elsewhere) to describe theeffect of exchange rate changes. FAS 52 drops this term and uses “translation adjustments” (current rate method) and “foreign cur-rency transaction gain or loss from remeasurement” (temporal method).9 Thomas G. Evans and Timothy Doupnik, Determining the Functional Currency under Statement 52 (Stamford: Financial Account-ing Standards Board, 1986), pp. 34–35.

(4) the method that avoids income statement volatility, (5) the method that most closely producescurrent values for nonmonetary assets, (6) whether local managers are rewarded based on foreigncurrency statement results or U.S. dollar results, or (7) some other rationale (sound or unsound) ofwhich there could be many.

Considering such potential latitude in choosing between the two allowable translation meth-ods, it appears worthwhile that the FASB should prohibit judgmental selection and instead iden-tify the relevant different economic facts so that uniformity is achieved in using one translationmethod or the other.

The Importance of Identifying the Proper Economic FactsWhen two accounting alternatives are allowed, the decision to identify the economic facts for de-ciding between the two alternatives must be done with extreme care—if it is even possible. For in-stance, it may be impossible to determine the economic facts that indicate when to use LIFO ver-sus FIFO.10 If this is possible for foreign currency exchange translation (FAS 52 presumes that itis) and the wrong economic facts are identified, the wrong alternative may be selected, producingnonmeaningful reporting results.

Compounding the problem is the fact that the two allowable alternative practices must be ca-pable of achieving the stated objective. Otherwise, any attempt to decide when to use one methodor the other based on economic facts is senseless. As an analogy, assume that the objective is tovalue a building at its fair market value, which may be above cost. If only the straight-line depre-ciation method and the double declining-balance method can be used, no amount of effort in try-ing to determine the economic facts as to when to use one depreciation method or the other willachieve the objective (although one method will always achieve a closer result than the other). Insummary, achieving meaningful translated reporting results requires both (1) proper identificationof economic facts and (2) the selection of appropriate related translation methods.

Unfortunately, the FASB improperly diagnosed the problem with FAS 8. The problem with FAS8 was not that it did not account differently for different economic facts, as the four members vot-ing in favor of FAS 52 claimed, but that it was not based on addressing the causes of exchange ratechanges. FAS 52 has the same major shortcoming.

VII. WHY THE PPP CURRENT-VALUEAPPROACH WAS NOT CHOSEN

FAS 52 does not allow the use of the PPP current-value approach (nor did FAS 8). Two possibleexplanations for this exist.

The First Possible Explanation: Not Addressing the Proper IssueOne possible explanation is that the FASB did not adequately address the most important issue inforeign currency translation: causes of exchange rate changes. There appears to be substantial sup-port for this explanation. There is no discussion of this issue in FAS 52 or in FAS 8. In the 1974discussion memorandum that preceded FAS 8, a single page (in Appendix C) is devoted to some ofthe fundamental and technical causes of exchange rate changes. However, no methodology basedon causes of exchange rate changes that would fit into the relatively new (at that time) floating ex-change rate system was developed.11


10 In light of the IASC’s 1991 proposal to eliminate LIFO, (later dropped), it would have been interesting to see what economic factsthe FASB could have identified for choosing between LIFO and FIFO.11 The fixed exchange rate system existed from 1944 to August 15, 1971, under the Bretton Woods agreement. An attempt to use asimilar “pegged” exchange rate system began in December 1971; this pegged rate system lasted until February 1973. Thus the float-ing exchange rate system was in its infancy during the time leading to the issuance of FAS 8.

No Revised Discussion MemorandumThe FASB did not prepare a revised discussion memorandum preceding the issuance of FAS 52. Arevised discussion memorandum might have been useful if it had explored the floating exchangerate system, which was then nearly 10 years old. Thus the process that led to FAS 52 (as with FAS8) focused on whether to use (1) a single unit of measure (the U.S. dollar or a foreign currency) or(2) multiple units of measure. Thus this process was a virtual “rounding up of the usual suspects.”

The First Exposure DraftThe first exposure draft (1980) would have required using the current rate method almost exclu-sively—even in highly inflationary economies. This further supports the conclusion that causes ofexchange rate changes were not adequately addressed because the translated financial statementswould quickly become of limited value for such operations. As shown earlier, high foreign infla-tion would drive down the direct exchange rate so severely that the foreign fixed assets quicklywould be reduced to near zero balances in the translated balance sheets (the “disappearing plant”problem shown earlier).

The Second Exposure DraftMany companies operating in highly inflationary economies noted this problem, and in the revisedexposure draft (1981), the FASB proposed that companies in such environments adjust their fixedassets for inflation prior to translation at the current exchange rate. This proposal (later with-drawn) was a clear attempt to address the causes of exchange rate changes. Even so, the consider-ation was narrowly focused on highly inflationary economies.

Erroneous Conclusions Regarding Constructed Exchange RatesAppendix D of the 1974 discussion memorandum contains a three-page discussion of constructedexchange rates based on PPP.12 In the process that led to FAS 8, the use of constructed exchangerates was disregarded as a viable alternative because (1) the basic approach (incorrectly) was as-sumed to be a possibility only under the former fixed exchange rate system and (2) the methodol-ogy that was offered did not allow for the consideration of noninflationary causes of exchange ratechanges.

As shown later, however, the PPP current-value approach can be applied within the frameworkof the floating exchange rate system. Also, the effect of noninflationary causes of exchange ratechanges can be isolated and adjusted for in the translation process. Later we show how to updatefixed assets for a period of several years using the PPP current-value approach when noninflation-ary factors exist.

The Second Possible Explanation: Trying to Stay within the Bounds of Historical CostRegardless of its ability to reflect the economics, the primary objection to using the PPP valuationtechnique is the perceived inappropriateness of mixing foreign fixed assets valued at current val-ues with domestic fixed assets valued at historical costs—a departure from historical cost. Accord-ingly, to stay within the bounds of historical cost, the PPP current-value approach may have beendismissed out of hand. An influencing factor may have been the lack of reliable price indices forsome countries that have highly inflationary economies. For these situations, however, the tempo-ral method could have been mandated as a practical matter, with the PPP current-value approachbeing used for other countries.

As shown earlier, however, the temporal method results achieve inflationary reporting resultsas foreign fixed assets had been adjusted for inflation. Accordingly, its use automatically results in


12 Dealing with disparities in price levels when translating foreign currency financial statements was recommended in NAA ResearchReport 36, “Management Accounting Problems in Foreign Operations” (New York: NAA, 1960). This report recommended the useof constructed exchange rates as an alternative to fixed exchange rates when a wide disparity in relative purchasing powers at the cur-rent exchange rate exists.


mixing different valuation bases; this was either not understood or merely not acknowledged bythe FASB. Furthermore, the use of the current rate method results in adjusting foreign fixed assetsfor the effects of domestic inflation—a different kind of mixing result.

VIII. EVALUATING AND MANAGING AFOREIGN OPERATION USING THEREPORTING RESULTS OF FAS 52

Besides not being designed to reflect the true economic effect of exchange rate changes, FAS 52often does not achieve its stated objective of attaining general compatibility. Recall from Chapter16 that the FASB did not define what it meant by general compatibility. For simplicity, let us as-sume that the term means reporting a positive effect when a positive effect should be reported andreporting a negative effect when a negative effect should be reported—a directional quality ratherthan a materiality quality. Illustration 16B-8 shows various exchange rate change causes and out-lines the situations in which FAS 52 achieves or does not achieve its general compatibility objective.

Accordingly, because the translated amounts produced under FAS 52 are not always reliable,great care must be taken in using such results and operationally trying to manage foreign perform-ance based on such results. For each individual foreign operation, the most that can be hoped forwithin the confines of FAS 52 is that companies use the method that best deals with exchange ratechange causes. Except for highly inflationary economies, this occurs only by coincidence under FAS52. Thus it is necessary to prepare more meaningful translated amounts for nonmonetary assets incertain circumstances (we show how shortly). The importance of this cannot be overemphasized.We now discuss in more detail the specific situations in which FAS 52 does and does not producereliable results.

In terms of the causes of exchange rate changes under the floating exchange rate system, for-eign operations can be grouped into three categories:

1. Highly inflationary economies.2. Nonhighly inflationary economies for which domestic and foreign inflation are consistently ap-

proximately the same.

ILLUSTRATION 16B-8 REPORTING RESULTS UNDER VARIOUS EXCHANGE RATE CHANGE CAUSES

Achieves “General Compatibility” with the Reflects the “True Economic Effect of the Economic Effect” of the Exchange Rate Changea Exchange Rate Change

Assumed Sole Cause of Current Rate Temporal Current Rate Temporal Exchange Rate Change Method Method Method Method

Foreign inflation . . . . . . . . . . . . . . . . . . . . . . . . . . No Yes No Yes Domestic inflation . . . . . . . . . . . . . . . . . . . . . . . . . Yes No Yes No Noninflationary factors . . . . . . . . . . . . . . . . . . . . . . Yes No Yes No Offsetting foreign and domestic inflation

(no net change) . . . . . . . . . . . . . . . . . . . . . . . . Nob Nob No No Domestic inflation > foreign inflation . . . . . . . . . . . . Yes No No No Foreign inflation > domestic inflation . . . . . . . . . . . . No Yes No No

a This means that a favorable result is reported when a favorable result should be reported and an unfavorable result is reported when an unfavorable resultshould be reported. Thus the answer is based only on the direction of the reported effect—not its materiality relative to the true economic effect of the ex-change rate change.b In this situation, a zero effect is reported under FAS 52, whereas economically the effect is favorable.

3. Nonhighly inflationary economies for which domestic and foreign inflation are not consistentlyapproximately the same.

These categories are useful in determining when FAS 52’s results can be relied upon.

Highly Inflationary EconomiesPerhaps the soundest part of FAS 52 is its requirement to use the temporal method when operat-ing in a highly inflationary economy. This is because foreign inflation is by far the dominant ex-change rate change factor. For many of these countries, the annual inflation rate is over 100%,with some countries exceeding 2000% annually. Accordingly, FAS 52 consistently produces sensi-ble reporting results in these situations. However, such operations account for only a small per-centage of foreign operations of U.S. companies.

Nonhighly Inflationary EconomiesFor these economies, the dominant exchange rate change factor involves noninflationary factors,for which the noninflationary factors can cause as much as a 30–40% change in the exchange ratein any given year.

Results under the Current Rate MethodAs shown earlier, only the current rate method can properly deal with the effects of noninflation-ary causes of exchange rate changes. Because the current rate method is the translation method thatis used predominantly in these situations, sensible reporting results usually occur when the currentrate method is used. However, when the foreign inflation rate is consistently slightly higher thanour domestic inflation rate, the disappearing plant problem occurs under the current rate method(although it occurs very gradually in comparison to what would occur if the current rate methodwere used in a highly inflationary economy). This was shown earlier in Illustration 16B-6 in whichthe cumulative inflation of 128% in Great Britain substantially exceeded the cumulative U.S. in-flation of 76% for the 15-year-period 1981–1995. Thus the current rate method does not producesensible reporting results in such situations. To properly evaluate and soundly manage operationsfacing this differential inflation rate problem, it is necessary to use the PPP current-value approachinternally to obtain meaningful translated amounts for fixed assets.

Results under the Temporal MethodUsing the temporal method in non-highly inflationary economies (as do Hewlett-Packard and DuPont, for instance) makes little sense because it produces the bizarre and volatile reporting resultsso heavily criticized in FAS 8. Furthermore, when domestic inflation is consistently slightly higherthan foreign inflation, the disappearing plant problem occurs here as well (although it also occursvery gradually). To properly evaluate and soundly manage operations facing this differential infla-tion rate problem, it is necessary to use the PPP current-value approach internally to obtain mean-ingful translated amounts for fixed assets.

We now show how to update fixed assets for several years using the PPP current-value approach.

IX. UPDATING FIXED ASSET VALUATIONS USINGTHE PPP CURRENT-VALUE APPROACH

The procedures for updating fixed asset valuations using PPP for several years are shown in Illus-tration 16B-9, which continues the earlier example in later years. This example also shows the wayto deal with the effects of noninflationary factors. Note that even when noninflationary factors arepresent, adjustments are made to achieve largely current-value reporting results. Accordingly, the



PPP current-value approach can be applied within the framework of the floating exchange ratesystem.

SUMMARY OF KEY POINTS FOR APPENDIX 16B

1. The only way to correctly determine the true economic effect of exchange rate changes is to usethe PPP current-value approach.

2. Under the PPP current-value approach, nonmonetary assets that have increased in value becauseof foreign inflation are adjusted for inflation and then translated at the current rate.

3. The current rate method (as used in the foreign currency unit of measure approach) cannot re-flect the economic effect of exchange rate decreases caused by foreign inflation—this methodproperly reflects only the effects of domestic inflation and noninflationary effects.

4. The temporal method (used under the U.S. dollar unit of measure approach) cannot reflect theeconomic effect of exchange rate changes caused by domestic inflation or noninflationary ef-fects—this method properly reflects only the effects of foreign inflation.

ILLUSTRATION 16B-9 PROCEDURES FOR VALUING FIXED ASSETS IN U.S. DOLLARS USING PURCHASING POWER PARITY THEORY

Effect of Direct Annual InflationNoninflationary Exchange U.S.

Date Mexico U.S. Factors Pesosa Rate Dollars

12/31/04. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,800,000 � $ .50 = $2,400,000

10% 4,800,000 � .05 = 240,000

4,800,000 � $ .55 = $2,640,00025% 1,200,000 � (.11) = n/a

12/31/05. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000,000 � $ .44 = $2,640,000

$(.02) 6,000,000 � (.02) = (120,000)b

12/31/06. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000,000 � $ .42 = $2,520,000

6,000,000 � .02 = 120,000c

6,000,000 � $ .44 = $2,640,00010% 600,000 � (.04) = n/a

6,600,000 � $ .40 = $2,640,000

$.05 6,600,000 � .05 = 330,000d

12/31/07. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,600,000 � $ .45 = $2,970,000

Valuation at 12/31/07 under FAS 52Current rate method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,800,000 � $0.45 = $2,160,000

Temporal method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,800,000 � $0.50 = $2,400,000

a For simplicity, fixed asset additions were assumed to be made on January 3 of each year at amounts equal to depreciation expense for the year.b This adjustment reflects a decrease in economic value that results from a $0.02 decrease in the exchange rate attributable to noninflationary factors. If thefixed assets are sold on 12/31/06 for cash of Mex$ 6,000,000 (the inflation-adjusted book value on this date), the realizable amount in U.S. dollars is$2,520,000.c This is a reversal of the 2006 noninflationary factor decrease of $.02 to get back to the $.44 exchange rate expected at 12/31/06 under PPP. The $.44 isthe constructed exchange rate that must be used for dealing with future inflation.d This is the same type of adjustment as that made on 12/31/06, only it goes in the opposite direction.

Note: Significant differences can occur between the expected rate under PPP and the actual year-end rate. For the British pound, the average of the absoluteannual year-end differences between the expected rate under PPP and the actual rate for 1981–1995 was 22%; the cumulative difference at 12/31/95 was17%. Similar differences were found for the French franc, the German mark, and the Japanese yen for these years.

5. The characteristics of the current rate method and temporal method are such that their report-ing results do not always reflect either (a) the true expected economic effects of exchange ratechanges or (b) general compatibility with the expected economic effects of an exchange ratechange.

6. The functional currency concept came into existence because the problem with FAS 8 was im-properly diagnosed. The concept is not valid.

7. To properly evaluate and soundly manage foreign operations, it may be necessary to use fixedasset valuations based on the PPP current-value approach in certain situations.

GLOSSARY OF NEW TERMS FOR APPENDIX 16B

Constructed exchange rates Exchange rates calculated based on the effects of foreign and domes-tic inflation.

Nominal gain An illusory gain when considering purchasing power.Real gain A gain that results in an increase in purchasing power.

SELF-STUDY QUESTIONS FOR APPENDIX 16B

(Answers are at the end of these questions.)

1. The disappearing plant problem can occura. Only under the current rate method.b. Only under the temporal method.c. Under both the current rate and temporal methods.d. Only under the PPP current-value approach.

2. The current rate method properly accounts fora. Only domestic inflation.b. Only foreign inflation.c. Only noninflationary factors.d. Both domestic inflation and noninflationary factors.e. Both foreign inflation and noninflationary factors.

3. The temporal method properly accounts fora. Only domestic inflation.b. Only foreign inflation.c. Only noninflationary factors.d. Both domestic inflation and noninflationary factors.e. Both foreign inflation and noninflationary factors.

4. An inflationary holding gain can occur when fixed assets are financed witha. Nonindexed debt.b. Equity.c. Debt or equity.d. Indexed debt.

5. On 1/1/04, the direct exchange rate is $.24. Management forecasts that the United States willhave 5% inflation during 2004 and that the foreign country will have 20% inflation during2004. Under PPP theory, what is the expected exchange rate at 12/31/04?a. $.20b. $.21c. $.274d. $.208


Answers to Self-Study Questions1. c 2. d 3. b 4. a 5. b

REVIEW QUESTIONS FOR APPENDIX 16B

1. What is an explanation of the current-value approach using purchasing power parity theory?

2. What are the strengths and weaknesses of the current rate method?

3. What are the strengths and weaknesses of the temporal method?

4. If the exchange rate has changed solely because of foreign inflation, what are the true eco-nomic effect and the effect reported under the current rate method?

5. What is the answer to Question 4 using the temporal method?

6. If the exchange rate has changed solely because of domestic inflation, what are the true eco-nomic effect and the effect reported under the current rate method?

7. What is the answer to Question 6 using the temporal method?

8. What are the two situations in which the disappearing plant problem occurs?

9. What is the relationship between conducting a foreign unit’s transactions in a certain currencyand the way to value the foreign unit’s fixed assets?

10. In which situations might it be necessary to evaluate and manage a foreign unit using fixedasset valuations determined by the PPP current-value approach?

EXERCISES FOR APPENDIX 16B

E 16B-1 Foreign Inflation: Determining Reporting Results Following are several assumed asset composi-tion and related financing situations of a foreign subsidiary:

Subsidiary’s Assets

Nature Amount Type of Financinga

1. Monetary assets 100,000 LCUs All equity2. Monetary assets 100,000 LCUs All local debt (nonindexed)3. Monetary assets 100,000 LCUs All local debt (indexed for local inflation)4. Nonmonetary assets 100,000 LCUs All equity5. Nonmonetary assets 100,000 LCUs All local debt (nonindexed)6. Nonmonetary assets 100,000 LCUs All local debt (indexed for local inflation)

a Indexed means the debt is adjusted upward for any inflation in the foreign country.

Required For each situation, determine the dollar effect on the subsidiary’s stockholders’ equity of a $.20 de-crease in the direct exchange rate (from $1.00 to $.80) caused solely by foreign inflation of 25%.For favorable effects, indicate whether the effect is a nominal gain or a real gain. Use the follow-ing answer format:

Reporting Result Under

Correct Economic Reporting Current Temporal Result in Dollars Rate Method Method

1. ____________________________ ____________________________ ____________________________2. ____________________________ ____________________________ ____________________________3. ____________________________ ____________________________ ____________________________4. ____________________________ ____________________________ ____________________________5. ____________________________ ____________________________ ____________________________6. ____________________________ ____________________________ ____________________________


E 16B-2 Domestic Inflation: Determining Reporting Results Following are several assumed asset composi-tion and related financing situations:

Subsidiary’s Assets

Nature Amount Type of Financing

1. Monetary assets 100,000 LCUs All equity2. Monetary assets 100,000 LCUs All local debt (nonindexed)3. Monetary assets 100,000 LCUs All local debt (indexed for local inflation)4. Nonmonetary assets 100,000 LCUs All equity5. Nonmonetary assets 100,000 LCUs All local debt (nonindexed)6. Nonmonetary assets 100,000 LCUs All local debt (indexed for local inflation)

Required For each situation, determine the dollar effect on the subsidiary’s stockholders’ equity of a $.25 in-crease in the direct exchange rate (from $1.00 to $1.25) caused solely by domestic inflation of25%. For favorable effects, indicate whether the effect is a nominal gain or a real gain. Use the fol-lowing answer format:

Reporting Result Under

Correct Economic Reporting Current Temporal Result in Dollars Rate Method Method

1. ____________________________ ____________________________ ____________________________2. ____________________________ ____________________________ ____________________________3. ____________________________ ____________________________ ____________________________4. ____________________________ ____________________________ ____________________________5. ____________________________ ____________________________ ____________________________6. ____________________________ ____________________________ ____________________________

E 16B-3 Determining When Nominal and Real Gains Are Reported Following are four possible scenariosfor the reason that the exchange rate changed:

1. Foreign inflation—current rate method used.

2. Foreign inflation—temporal method used.

3. Domestic inflation—current rate method used.

4. Domestic inflation—temporal method used.

Assume that the foreign operations’ fixed assets are financed with 50% nonindexed debt and 50%equity.

Required For each scenario, indicate the following:1. Is a favorable or unfavorable result reported under FAS 52?2. If a favorable or unfavorable result is reported, is that result a nominal gain, a real gain, a real

loss, or an imaginary loss?

E 16B-4 Translating Fixed Assets Mirage Inc. created a foreign subsidiary on 1/1/06 by making a $920,000cash investment in exchange for 1,000 shares of the subsidiary’s common stock. The subsidiaryused the money to buy land on the same day. During 2006, the foreign country had 15% inflation,and the United States had 5% inflation. Direct exchange rate information follows:

January 1, 2006 . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2.30 December 31, 2006. . . . . . . . . . . . . . . . . . . . . . . . . . $2.05

Required Determine the translated amount at year-end for the fixed assets for (1) the current rate method,(2) the temporal method, and (3) the PPP current-value approach.

E 16B-5 Calculating the Projected Exchange Rate On 1/1/06, the direct exchange rate was 1 local currencyunit equals $.60. For 2006, management expects 5% inflation for the United States and 20% in-flation for the foreign country.

Required Calculate the expected exchange rate at 12/31/06 under PPP theory.


PROBLEMS FOR APPENDIX 16B

P 16B-1 Evaluating Reporting Results: U.S. Dollar Is the Functional Currency Ten years ago, Golli Inc. cre-ated a 100%-owned subsidiary in Mexico and invested $1,000,000 in the subsidiary. The sub-sidiary purchased a farm in Mexico for $500,000 cash and designated the remaining $500,000 tobe used for working capital. The U.S. dollar is the functional currency because employees and ven-dors are paid in dollars and the produce is sold in the United States for dollars. Other assumptionsare as follows:

1. When the farm was purchased, Mex$ 1 equaled $.50.

2. During the past 10 years, the United States had cumulative inflation of 100%, and Mexico hadzero cumulative inflation. As a result, the direct exchange rate is now $1.00. For simplicity, weassume that no noninflationary factors exist that could affect the exchange rate.

3. All earnings are distributed to the parent monthly.

4. The typical balance sheet at year-end is as follows:

Pesos

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000

2,000,000

Common Stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000,000

Required 1. Prepare a translated balance sheet under the temporal method at the end of the 10th year.2. What are the long-term consequences of using the temporal method, assuming a continuation

of each country’s assumed 10-year inflation history?3. If the farm were sold at the end of the 10th year for its book value in pesos, how many dollars

would be available for distribution to the parent?

P 16B-2 Determining Translated Fixed Asset Valuations On 1/1/05, Cola Inc. purchased a parcel of landin a foreign country at a cost of $1,440,000. Exchange rate and inflation information follows:

Direct Exchange Rate

January 1, 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $.60 December 31, 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .65 December 31, 2006 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .57 December 31, 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .52

Inflation Rates

U.S. Foreign

2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10% —2006 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20% 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 10

Required 1. Calculate the inflation-adjusted carrying value of the land in foreign currency at 12/31/07.2. Calculate the translated amount in dollars at 12/31/07 under the PPP current-value approach.3. Calculate the translated amounts in dollars at 12/31/07 under the current rate method and the

temporal method.

P 16B-3 Evaluating Translated Financial Statement Results Assume that on 10/1/05, Pana Inc. created a100%-owned subsidiary, Sonic Inc., in England when the direct exchange rate was $1.10. Panamade a $1,100,000 cash equity investment at that time. For simplicity, assume that this direct ex-change rate did not fluctuate through 12/31/05. Sonic’s first sales were on 1/1/06. Sonic’s balancesheets at the end of 2005 and 2006 and Sonic’s 2006 income statement are shown in Exhibit 1 toProblem 16B-3. Additional assumptions follow:


1. No dividends were declared or paid in 2006.

2. Fixed assets additions of 100,000 pounds (equal to the 2006 depreciation expense) occurred on1/3/06.

3. England had 10% inflation for 2006.

4. The United States had 2% inflation for 2006.

5. The direct exchange rates were as follows:

December 31, 2005 . . . . . . . . . . . . . . . . . . . . . . . $1.10 Average rate for 2006 . . . . . . . . . . . . . . . . . . . . . 1.06 December 31, 2006 . . . . . . . . . . . . . . . . . . . . . . . 1.02

The properly prepared translated financial statements for the subsidiary for 2006 in dollarsunder both functional currency possibilities (using the procedures prescribed in FAS 52) are alsoshown in Exhibit 1 to Problem 16B-3.


Exhibit 1 to Problem 16B-3Pound Financial Statements and FAS 52 Translated Financial Statements

(under both functional currency possibilities)

FUNCTIONAL CURRENCY

POUND U.S. DOLLAR POUNDS(CURRENT RATE) (TEMPORAL)

12/31/05 12/31/06 12/31/06 12/31/06

Balance SheetsMonetary assets . . . . . . . . . . . . . . . . . . . 500,000 900,000 $ 918,000a $ 5,918,000a

Inventory . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 1,100,000 1,122,000a 1,133,000b

Fixed assets, net . . . . . . . . . . . . . . . . . . 3,000,000 3,000,000 3,060,000a 3,300,000b

4,500,000 5,000,000 $ 5,100,000 $ 5,351,000

Liabilities . . . . . . . . . . . . . . . . . . . . . . . 3,500,000 3,600,000 $ 3,672,000a $ 3,672,000a

Common stock . . . . . . . . . . . . . . . . . . . . 1,000,000 1,000,000 1,100,000b 1,100,000b

Retained earnings. . . . . . . . . . . . . . . . . . –0– 400,000 424,000 579,000Cumulative translation adjustment . . . . . . n/a n/a (96,000)c n/a

4,500,000 5,000,000 $ 5,100,000 $ 5,351,000

Income Statements (2006)Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,150,000 $ 5,459,000d $ 5,459,000d

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (4,150,000) (4,399,000)d (4,468,000)b

Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (100,000) (106,000)d (110,000)b

Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (500,000) (530,000)d (530,000)d

Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000 $ 424,000 $ 351,000Remeasurement gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . n/a n/a 228,000e

Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000 $ 424,000 $ 579,000

Parent’s Reported Economic GainSubsidiary’s reported net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 424,000 $ 579,000Less—Translation adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (96,000) n/a

Parent’s Reported Economic Gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 328,000 $ 579,000

a The current (year-end) exchange rate of $1.02 was used.b The historical rate was used ($1.10 for fixed assets, depreciation, and common stock; $1.077 for cost of sales; and $1.03 for inventory).c Net asset position at 1/1/06 of £1,000,000 � $.08 decrease in the direct exchange rate equals . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(80,000)

Net income of £400,000 � $.04 difference between the average rate and the year-end rate ($1.06 – $1.02) equals . . . . . . . . . . . . . . . (16,000)

Total Translation Adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(96,000)

d The average exchange rate of $1.06 was used (it is assumed that sales, expenses, and purchases occurred fairly evenly throughout the year).e Average net monetary liability position of £2,850,000 � $.08 decrease in the exchange rate equals $228,000.

Required 1. Adjust Sonic’s fixed assets at 12/31/06 for 2006 inflation, and then translate the 12/31/06 finan-cial statements using the current rate method.

2. Analyze and explain the economic gain calculated in requirement 1.3. Reconcile the economic gain calculated in requirement 1 to the economic gain shown for the

current rate method under FAS 52. In other words, explain what accounts for the difference.4. Optional—Very Challenging: Repeat requirement 3 but for the temporal method under FAS 52.5. Assume that the United States had 0% inflation in 2006—instead of 2%. How would this

change your answer in requirement 2?

THINKING CRITICALLY

Cases for Appendix 16BC 16B-1 Evaluating the Current Rate Method: Domestic Inflation Assume that the current rate method is

used. If domestic inflation is the sole cause of the exchange rate change, the direct exchange ratewill increase, and a foreign subsidiary’s fixed assets will be valued at a higher amount in transla-tion, resulting in an increase in reported equity. Assume fixed assets are financed with equity.

Required 1. Evaluate the logic of valuing foreign fixed assets higher as a result of domestic inflation and re-porting a corresponding increase in equity under the current rate method.

2. Evaluate the reporting result described in requirement 1 with the manner of accounting for theparent’s domestic fixed assets when domestic inflation occurs.

C 16B-2 Evaluating the Current Rate Method: Foreign Inflation Assume that the current rate method isused. If foreign inflation is the sole cause of the exchange rate change, the direct rate will decrease,and a foreign subsidiary’s fixed assets will be valued at a lower amount in translation, resulting inreporting a decrease in equity. Assume that fixed assets are financed with equity.

Required 1. Should an unfavorable economic event be reported in translation as a result of foreign inflation?2. Evaluate the reporting result described in requirement 1 with the manner of accounting for the

parent’s domestic fixed assets when domestic inflation occurs.


evaluating the validity of the appendix 16b functional ...purchasing power parity theory ... does...

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