Foreign Currency Translation

1
Foreign Currency Translation
2
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.

3
Translation Methods

• Two working parts
• What exchange rate should be used to translate
  each line of the foreign financial statements
  into the domestic currency?
  
• How should exchange rate gains and losses be
  reported in the financial statements?

4

• Three alternatives for the exchange rate
• Current, or closing rate
• Historical rate
• Average Rate for the period

5
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.

6
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?

7
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

8
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.

9
Translation Models

• 4 Major models
• Current/Noncurrent
• Monetary/Nonmonetary
• Temporal
• Current Rate

10
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.

11
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.

12

• 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.)

13

• No theoretical support for this model.
• Translation gains and losses are generally
  included in Net Income, but treatment is
  flexible.
  

14
Translation Models

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

15

• 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.

16
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.
  

17
Nonmonetary items

• Nonmonetary items include fixed assets, long term
  investments, and inventories.
  
• Translated at the historical rate.

18
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)

19
Issues
20

• 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.

21
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.

22

• 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.

23
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

24
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.
  

25
History of US Standard Setting with Respect to
Translation
26
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.

27
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

28

• 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.

29

• 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

30

• 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.

31

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

32
Current Rate Model

• Simplest of all translation methodologies

33
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.

34
Goals of FAS 52

• Present results that were directionally
  sympathetic to the real economic effects of
  exchange rate movements.
  
• Preserve financial results and relationships in
  the foreign financial statements through the
  translation process.

35

• 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.

36
Functional Currency

• FAS 52 introduced the concept of the functional
  currency. The functional currency is used to
  differentiate between two types of foreign
  operations..
• Those that are self-contained and integrated into
  a local environment
  
• Those that are an extension of the parent and
  integrated with the parent.

37

• 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.

38

• 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).

39
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
  

40

• 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.

41

• 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.
  

42
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.

43
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.

44
Indicators

• Cash Flow Indicator Denomination of cash
  flows.
  
• Sales Price Indicator Responsiveness of selling
  prices to exchange rates on a short-term basis.
  
• Sales Market Indicator Existence of an active
  local sales market for the product.
  
• Expense Indicator Existence of a local source
  for operating costs.
  

45

• Financing Indicator denomination of the firm's
  primary financing.
  
• Intercompany Indicator The volume of
  intercompany transactions.

46
Functional Currency

• To determine the functional currency, the most
  heavily weighted factors are indicators related
  to
  
• Cash Flows
• Expense and Revenue Items

47
Functional Currency

• If a foreign operations 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.
  

48

• 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.

49
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.

50

• 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..)

51
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).

52

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

53
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

54
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.

55
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 PL.
  
• Local currency businesses- translation gain or
  loss goes directly to stockholders equity
  (Accumulated Translation Adjustment)
  
• Translation gains or losses do not have a local
  currency cash flow impact.

56
CargillFunctional Currency - France

• Grain U.S. Dollar
• Sugar U.S. Dollar
• Feed French Franc
• Seed French Franc

57
Cargills Accumulated Translation Adjustment

• 1993 6.6
• 1994 (18.7)
• 1995 78.7
• 1996 13.3
• 1997 (46.3)

58
Management Responsibility

• Local currency business managers manage the local
  currency PL and dont manage the translation
  gain or loss.
  
• U.S. Dollar businesses manage the U.S. Dollar PL
  and take steps to manage foreign currency risks.

59
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.