Foreign Currency Translation

Foreign Currency Translation• To consolidate statements, the following must be

consolidated:– Language

– Accounting Concepts (GAAP)

– Currency

• What should be included in consolidated statements?– Narrow View: Consolidated statements should include

the parent firm and all domestic subsidiaries

– Wide View: All subsidiaries, regardless of location, should be consolidated.

Translation MethodsTwo working parts:1 What exchange rate should be used to translate

each line of the foreign financial statements into the domestic currency?

2 How should exchange rate gains and losses be reported in the financial statements?

Three alternatives for the exchange rate:1 Current, or closing rate

2 Historical rate

3 Average Rate for the period

Translation Methods: Example

• Suppose you had 100 British pounds on deposit in a London bank at the end of 1993 when the exchange rate is $1.80. To report the deposit on your 1994 Balance Sheet stated in dollars, you would translate the deposit at the current rate and you would report an asset of $180.

• At the end of 1994, you still have the 100 pounds in the bank, but now the exchange rate is $1.70. To report the deposit on your 1994 Balance Sheet, it would now translate into $170 and you would have an imbalance of $10 to deal with.

Translation Methods: Example

• If you translated at the historical rate, you would still translate into $180 and there would be no imbalance.

• Has the $10 been realized in cash?

• Should realization affect reporting?

Exchange Rates

• Current rate--exchange rate prevailing as of the financial statement date

• Historical rate--exchange rate prevailing when a foreign currency asset was first acquired or a foreign currency liability was first incurred

• Average rate--simple or weighted average of either current or historical exchange rates

Two Major Issues

• Which exchange rate should be used to translate foreign currency balances to domestic currency?

• How should translation gains and losses be accounted for? Should they be included in income?

• Translation methods may employ a single rate or multiple rates.

Translation Models

• 4 Major models:

• Current/Noncurrent

• Monetary/Nonmonetary

• Temporal

• Current Rate

Revenues/Expenses

• In general, all 4 models agree on the translation of sales revenues and other revenues and most operating expenses on the income statement (depreciation expense may be an exception; what historical rate do you use?) .

• Typically, these are translated using the historical rate in effect when the revenue was earned or the expense recognized. That may be an average rate for the period.

Translation Models• Current-Noncurrent Model

– Traditional Accounting Classification for assets and liabilities

– Current items on the balance sheet are translated at the current rate.

– Long-term items on the balance sheet are translated at the historical rate.

– COGS is translated at the current rate (it is based on inventory, a current asset)*

– *Some authorities translate COGS at average rate (historical rate, assuming COGS is incurred evenly over the period)

– Depreciation is translated at the appropriate historical rate based on the date of acquisition of the assets (otherwise there would be an additional imbalance.)

– No theoretical support for this model.– Translation gains and losses are generally

included in Net Income, but treatment is flexible.

Translation Models

• Monetary-Nonmonetary

• Focuses on the financial character of the foreign financial statement elements to determine appropriate rate.

– Foreign currency assets and liabilities expressed as a fixed number of currency units are defined as monetary (receivables and payables). Other items are nonmonetary.

– Monetary items translate at the current rate.– Nonmonetary items translate at the

historical rate.

Monetary/Nonmonetary

• Monetary assets and liabilities

• Representing rights to receive or obligations to pay a fixed number of foreign currency units in the future. Translated at current rate.

Nonmonetary items

• Nonmonetary items include fixed assets, long term investments, and inventories.

• Translated at the historical rate.

Translation Models

Main difference between Current-Noncurrent and Monetary-Nonmonetary:

– Translation rates used for noncurrent receivables and payables, (current rate)

– Translation rates used for inventory, and prepaid items (historical rate)

Issues…

• INVENTORY is a non-monetary item and is translated at the historical rate.

• COGS is also translated at the historical rate. **• DEPRECIATION is translated at the historical

rate.

** While COGS is translated at the historical rate, Sales revenue is still translated at the average rate for the period. This impacts gross margin.

• Also, inventory is translated at the historical rate, but payables (used to finance inventory) are translated at the current rate.

Temporal Method

• The temporal model considers currency translation as a measurement conversion process

• As such, it cannot be used to change the attribute of an item being measured, it can only change the unit of measure.

• There is a time dimension.

• The temporal method is very similar to monetary/nonmonetary and unless there are significant difference in GAAP may present identical results.

• Differences occur for items that have been revalued. If no revaluation is allowed, the two methods yield identical results.

Temporal Model

• Foreign balance sheet items are measured according to three different bases:

• past exchange prices (HC)• current exchange prices (current value)• future values• The underlying measurement base is the

primary criterion for selecting an exchange rate

Temporal Method

• Cost of Goods Sold and Depreciation Expense are translated at their historical rate.

• Exchange gains and losses from translation are included in current net income.

History of US Standard Setting with Respect to Translation

FAS # 8

• FAS 8 required the use of the temporal method in the US. In the Fall of 1978, the FASB invited comments on the first 12 standards that had been issued. Approximately 200 written responses were received; 176 dealt in some manner with FAS 8, and 88% were negative.

Criticisms of Temporal Method• The results of translation frequently do not

reflect the underlying economic reality of foreign operations

• This is underscored by the volatility of reported earnings using this method

• Financial results and relationships are distorted

• Sources of these problems are the requirement for current recognition of the unrealized exchange adjustment and

• Translation of inventories and fixed assets at historical rates, while the debt used to acquire these assets is translated at current rates.

• The use of the temporal method can cause distortions such that a net income in the foreign currency translates to a net loss in the home currency…

• Companies changed their foreign exchange risk management practices as a result of FAS 8

• The potential translation impact of FAS 8 had led a number of firms to refrain from making otherwise acceptable foreign direct investments, and

• Firms had made important changes in their foreign currency borrowing patterns.

• So rather than reporting the results of management operations, accounting began to define management decisions and form was overriding substance….

Current Rate Model

• Simplest of all translation methodologies

Current Rate Model

• Translate all assets and liabilities at the rate in effect on the financial statement date.

• In the purest form, translates both cost of goods sold and depreciation expense at current rate, but they may be translated at the average rate to be consistent with the other income statement items.

• This model is a key component of FAS 52.

Goals of FAS 52

1 Present results that were directionally sympathetic to the real economic effects of exchange rate movements.

2 Preserve financial results and relationships in the foreign financial statements through the translation process.

• Under SFAS 52, all exchange gains and losses from the application of the current rate method will be reported in the Balance Sheet as an adjustment to Owners' Equity (now on the Statement of Comprehensive Income in the US). These gains and losses do NOT flow through the Income Statement.

Functional Currency

• FAS 52 introduced the concept of the functional currency. The functional currency is used to differentiate between two types of foreign operations..

1 Those that are self-contained and integrated into a local environment

2 Those that are an extension of the parent and integrated with the parent.

• For the first kind of operation above, SFAS 52 requires that the foreign financial statements first be expressed in their functional currency (likely the local currency) and then translated into dollars using the current rate method. Translation gains and losses go on the statement of comprehensive income.

• For the second type of operation, the functional currency is the dollar and the temporal method is applied to convert from the local currency to the US dollar (with gains and losses going to the income statement).

Functional Currency

• The functional currency is the currency of the country that represents the primary economic environment for the foreign operation. It is the currency in which the operations and the cash flows are domiciled.

• It may be the reporting currency or the foreign (local) currency

• Reporting currency is the currency in which the parent company prepares its financial statements.

• Foreign currency is anything other than the reporting currency.

• Local currency is the currency in the country where the foreign firm is operating.

• The US parent must determine a single functional currency for each of its foreign operations.

• The foreign financial statements must first be expressed in the functional currency before being translated into dollars.

International Accounting Issues

• Determining the correct functional currency is complex, important and drives the behavior of people in a business.

• Teamwork between Accounting, Treasury, Financial Trading and Product Line Managers is Key.

FAS 52

• The functional currency for a given foreign operation is a matter of fact,

• Management judgement is required in the functional currency determination process.

Indicators1 Cash Flow Indicator: Denomination of

cash flows.

2 Sales Price Indicator: Responsiveness of selling prices to exchange rates on a short-term basis.

3 Sales Market Indicator: Existence of an active local sales market for the product.

4 Expense Indicator: Existence of a local source for operating costs.

5 Financing Indicator: denomination of the firm's primary financing.

6 Intercompany Indicator: The volume of intercompany transactions.

Functional Currency

• To determine the functional currency, the most heavily weighted factors are indicators related to:

– Cash Flows

– Expense and Revenue Items

Functional Currency

• If a foreign operation’s transactions are denominated in other than its functional currency, the financial statements must first be translated using the temporal method.

• Gain or Loss is included in the net income of the subsidiary.

• After translating to the functional currency, the current rate method is used to restate the information into US dollars for consolidation with the parent company financial information.

FAS NO. 52• The functional currency of a particular

foreign entity is defined as the currency of the primary economic environment in which it operates and generates cash flows.

• Determination of the functional currency is a key feature of FAS No. 52 as it determines the choice of translation method and disposition of exchange gains and losses.

• If the US dollar is determined to be the functional currency, a foreign entity's financial statements are re-measured to a dollar perspective using the temporal method (and gains and losses go to the income statement..)

Exception to the Current Rate Method

• An exception to the current rate method is required for subsidiaries located in environments in which the cumulative rate of inflation during the preceding three years exceeds 100 percent. (26% annual rate with compounding).

• In such hyper inflationary environments, the dollar becomes the functional currency, requiring the use of the temporal translation method.

What is the Functional Currency

• U.S. Dollar or local currency

• U.S. Dollar if:– Highly inflationary country– U.S. Dollar is the currency of the business,

(e.g., Financial Trading, World Grain Trading)

• Local Currency if:– Stable Country– Local Currency is used for the Business

Feed/Spain, Seed/Germany

When Should a Local Currency be the Functional Currency in a Stable Economy?

• Cash flows are local currency.

• Sales prices are determined by local conditions / in local currency.

• Expenses are paid in local currency / driven by local conditions.

• Financing done in local currencies.

• Inventory value liked to local conditions.

Translation Gain or Loss

• Impacts of change in exchange rates on the balance sheet.

• U.S. Dollar based businesses - translation gain or loss to the P&L.

• Local currency businesses- translation gain or loss goes directly to stockholder’s equity (Accumulated Translation Adjustment)

• Translation gains or losses do not have a local currency cash flow impact.

CargillFunctional Currency - France

Grain U.S. Dollar

Sugar U.S. Dollar

Feed French Franc

Seed French Franc

Cargill’s Accumulated Translation Adjustment

• 1993 6.6

• 1994 (18.7)

• 1995 78.7

• 1996 13.3

• 1997 (46.3)

Management Responsibility

• Local currency business managers manage the local currency P&L and don’t manage the translation gain or loss.

• U.S. Dollar businesses manage the U.S. Dollar P&L and take steps to manage foreign currency risks.

Focus

• Local currency businesses focus on maximizing the local currency profit performance.

• U.S. Dollar businesses are evaluated on U.S. Dollar profitability and take action to maximize same.

• Foreign exchange risk hedging practices will vary.

• Incentive compensation programs will be different.