FOREIGN CURRENCY TRANSLATION



FOREIGN CURRENCY TRANSLATION

LEARNING OBJECTIVE

Develop understanding and skills to translate the financial statements of a foreign entity (for example, a subsidiary) measured in units of a foreign currency into units of the presentation currency of a reporting entity (for example, a parent) using the all-current and the monetary-nonmonetary translation methods.

Business firms desiring to sell goods or services in countries other than their home country make at least two important decisions:

1. Location of Product Creation. Should the firm create the good or service in its home country and then export (sell) it abroad or should the firm both create and sell the good or service abroad through a foreign entity (for example, a branch office or subsidiary)?

2. Currency for Denominating Transactions. Should the firm structure transactions so that all cash flows occur in the currency of the home country or should the firm use the currency of the foreign country to denominate all cash flows?

The manner in which a firm structures its foreign operations affects its exposure to exchange-rate changes. A brief overview of exchange rates will enhance an understanding of the effect of exchange rate changes on a firm.

NATURE OF EXCHANGE RATES

An exchange rate is the price of one country’s currency in terms of another country’s currency. For example, the British pound might be worth U.S. $2.00 at a given time. The exchange rate would be stated as “one British pound is worth two dollars,” or “one dollar is worth .50 (= £1/$2) British pound.”

Exchange rates, like the price of any good or service, reflect the forces of demand and supply. Economic and political conditions, as well as prospects within a country relative to those in other countries, affect the level of exchange rates. New, unanticipated information about a country’s economic and political conditions and prospects causes exchange rates to change.

For example, the exchange rate between the U.S. dollar and the British pound might change as follows:

|Date |U.S. Dollars |British Pounds |

| |per British Pound |per U.S. Dollar |

|January 1 |$2.00:£1 |£50:$1 |

|Average during Year |$2.10:£1 |£48:$1 |

|December 31 |$2.20:£1 |£45:$1 |

In this case, the British pound increased in value relative to the U.S. dollar during the year. A purchaser of British pounds needs $2.20 to purchase one British pound on December 31 but needed only $2.00 on January 1. Alternatively, a purchaser of U.S. dollars needs only £.45 to purchase one U.S. dollar on December 31 but needed £.50 on January 1.

EFFECT OF EXCHANGE RATE CHANGES

Consider now how the structure of a firm’s foreign operations and the currency in which it denominates transactions affect its exposure to exchange rate changes.

Example 1 Americo, Inc., a U.S. corporation, desires to expand geographically by selling its products in the United Kingdom (U.K.). It can manufacture the products in the United States and export the goods to the U.K. Americo will invest in new plant facilities in the United States to provide the necessary production capacity. It will purchase all raw materials and labor services in the United States. Americo will set selling prices for its products in U.S. dollars and will require its U.K. customers to pay in U.S. dollars. Assume that the exchange rate between the U.S. dollar and the British pound changed during the first year of operations as shown above (that is, the British pound increased in value relative to the U.S. dollar).

In this case, Americo’s British customers enjoy the benefits and bear the risk of exchange rate changes between the time of sale, when Americo and its customers agree to a selling price in U.S. dollars, and the time of cash collection/payment, when the customer pays the agreed amount in U.S. dollars. Because Americo incurs costs and generates revenues in U.S. dollars, exchange rate changes do not directly affect it. Exchange rate changes may, however, affect the willingness of U.K. customers to purchase products from Americo versus another competitor. The increased value of the British pound relative to the U.S. dollar makes Americo’s products less expensive for U.K. customers. Americo’s competitors may reduce their prices to avoid losing their customers to Americo.

Example 2 Refer to Example 1. Suppose again that Americo locates its manufacturing operations in the United States and then exports finished products. Assume now, however, that Americo sets selling prices in British pounds instead of U.S. dollars. In this case, Americo enjoys the benefits and bears the risk of exchange rate changes between the time of sale and the time of cash collection. The asset at risk is Americo’s accounts receivable denominated in British pounds.

To understand this example, assume that Americo sells goods for £120 million at a time when the exchange rate is $2.1:£1. This account receivable has the U.S. dollar-equivalent value at the time of sale of $252 (= $2.10 × £120) million. The exchange rate on December 31 is $2.2:£1. If this account receivable remains uncollected at year-end, it has the U.S. dollar-equivalent value of $264 (= $2.2 × £120) million. Americo profits by $12 (= $264 – $252) million from the change in the exchange rate.

Example 3 Refer to Example 1. Suppose now that Americo establishes a wholly-owned subsidiary in the U.K. to carry out all manufacturing and selling activities in that country. Americo will invest the necessary funds to build the plant facilities. The subsidiary will purchase raw materials and labor services in the U.K. and denominate sales to U.K. customers in British pounds. To finance future growth, the U.K. subsidiary will retain within the U.K. the net assets generated by earnings.

In this case, Americo has exposed its investment in the net assets of the subsidiary (= assets – liabilities, or shareholders’ equity) to the risk of exchange rate changes. Investing funds in this subsidiary, both initially and through retained earnings, will result in Americo’s later receiving cash (from dividends and from the sale of the subsidiary) in amounts that vary as a result of changes in the value of the British pound.

To understand this example, assume that Americo invested $200 million in a newly created U.K. subsidiary on January 1 in return for all of the subsidiary’s stock. The exchange rate on January 1 was $2:£1. Thus, the U.K. equivalent amount for this investment is £100 (= $200/$2) million. During the first year of operations, the subsidiary generated earnings of £80 million and paid no dividends to Americo. The average exchange rate during the year was $2.1:£1, and the exchange rate on December 31 was $2.2:£1. The increasing value of the British pound relative to the U.S. dollar increases the dollar valuation of Americo’s investment in the net assets of the subsidiary by $28 million, derived as follows (amounts in millions):

| |British |Exchange |U.S. |

| |Pounds |Rate |Dollars |

|Initial Investment |

|Factors for Identifying the Functional Currency of a Foreign Unit under U.S. GAAP |

| |Currency of Foreign Entity is the Functional |Reporting Currency is the Functional Currency |

|Attributes |Currency | |

|Cash Flows of Foreign Entity |Receivables and payables denominated in foreign|Receivables and payables denominated in |

| |currency and not usually remitted to parent |reporting currency and readily available for |

| |currently |remittance to parent |

|Sales Prices |Influenced primarily by local competitive |Influenced by worldwide competitive conditions |

| |conditions and not responsive on a short-term |and responsive on a short-term basis to |

| |basis to exchange rate changes |exchange rate changes |

|Cost Factors |Foreign entity obtains labor, materials, and |Foreign entity obtains labor, materials, and |

| |other inputs primarily within its own country |other inputs primarily from the country of the |

| | |reporting entity |

|Financing |Financing denominated in currency of foreign |Financing denominated in currency of the |

| |entity or generated internally by the foreign |reporting entity or ongoing fund transfers from|

| |entity |the parent |

|Relations between Parent and Foreign Entity |Low volume of intercompany transactions and |High volume of intercompany transactions and |

| |little operational interrelations between |extensive operational interrelations between |

| |parent and foreign entity |parent and foreign entity |

The facts need not clearly signal a unique classification: a particular foreign operation can combine aspects of the self-contained entity while still being integrated with the parent. For example, a foreign unit may acquire raw materials from the reporting entity and remit 50 percent of its earnings back to the reporting entity but may obtain funds within the foreign country and sell primarily to local customers. Management must weigh all of the evidence to decide which characterization better describes the foreign operation.

International Accounting Standard (IAS) 21 uses similar factors to SFAS No. 52 in identifying the functional currency but places different weights on the various factors. The primary economic environment in which a foreign entity operates, the determinant of the functional currency, is the one in which it generates and expends cash. The cash flows of primary importance are those related to the purchase and sale of goods and services. Firms consider:

1. The currency that primarily influences sales prices for goods and services (usually the currency in which the foreign entity denominates and settles sales of its goods and services).

2. The currency of the country whose competitive forces and regulations primarily influence the sales prices.

3. The currency that primarily influences labor, material, and other costs of providing goods and services (usually the currency in which suppliers denominate and require settlement of such goods and services).

These three factors are the primary factors in identifying the functional currency under IFRS. Additional factors to consider if these three factors do not clearly identify the functional currency include the following:

1. The currency in which the foreign entity generates funds from financing.

2. The currency in which the foreign entity retains cash flows from operating activities.

3. The proportion of the activities of the foreign entity with the reporting entity.

4. The extent to which the cash flows from the activities of the foreign entity remain with the foreign entity or are readily available for remittance to the reporting entity.

5. The extent to which the cash flows of the foreign entity are sufficient to service debt obligations without funds from the reporting entity.

6. Whether the activities of the foreign entity are an extension of the reporting entity instead of carried out with a significant degree of autonomy.

Note two important differences between U.S. GAAP and IFRS with respect to identifying the functional currency:

1. U.S. GAAP uses a broad set of operating and financing criteria, whereas IFRS places heavier weight on the currency in which a foreign entity makes purchases and sales of goods and services.

2. U.S. GAAP uses the distinction between an autonomous foreign unit and a unit operating as an extension of the as a primary scheme for identifying the functional currency, whereas IFRS treats this distinction as only one additional factor to consider.

Thus, the functional currency of a foreign entity might differ depending on whether a reporting entity uses U.S. GAAP or IFRS.

Foreign Currency Translation Provisions

The following summarizes the provisions for foreign currency translation[2]:

1. Both SFAS No. 52 and IAS 21 require the all-current translation method for self-contained, or autonomous, foreign entities (functional currency is that of the foreign entity or some foreign currency other than that of the reporting entity).

2. SFAS No. 52 requires the monetary-nonmonetary translation method for foreign entities that operate as extensions of the reporting entity (functional currency is that of the reporting entity). IAS 21 also requires use of the monetary-nonmonetary method in these cases, but recall that for the functional currency of a foreign entity to be that of the reporting entity under IFRS requires use of the additional factors in identifying the functional currency.

Rationale for Foreign Currency Translation Provisions Implicitly underlying the foreign currency translation procedures required by U.S. GAAP and IFRS are two types of U.S. management control patterns for foreign operations:

▪ When a domestic parent invests in self-contained foreign operations and does not expect to recapture its investment for several years, it puts its investment at risk to exchange rate changes. It delegates to managers in the foreign country the day-to-day management decisions. Whether those foreign managers choose highly leveraged or conservative financing, the U.S. parent considers only its own investment at risk and has put that investment at risk for several years. The next section illustrates the method required for self-contained foreign operations—the all-current translation accounting method. This method calculates an exchange adjustment based on the parent’s investment in the shareholders’ equity (= assets – liabilities) of the foreign unit. Because the parent intends to allow the foreign unit to retain the net assets represented by its investment for many years, U.S. GAAP and IFRS require firms to include the exchange adjustment in Accumulated Other Comprehensive Income, a separate shareholders’ account, not in periodic net income. For the investor in a self-contained foreign operation, U.S. GAAP and IFRS attempt to present results as though the investor sees only its investment at risk, not the individual assets and liabilities or the results of day-to-day operations.

▪ In contrast, management of a domestic parent extending its operations into a foreign country has day-today control of assets, liabilities, and operations. It intends to require the foreign entity to remit assets generated by earnings to the parent on an ongoing basis. Remitting assets generated by periodic earnings will likely require the foreign entity frequently to convert foreign currency into currency of the reporting entity. Thus, the assets generated by foreign earnings are subject to exchange rate changes on a current basis. U.S. GAAP and IFRS require such firms to include the exchange adjustment in net income each period by using the monetary-nonmonetary translation method. The managers of the parent concern themselves with the affiliate’s day-to-day operations. The monetary-nonmonetary translation method attempts to reflect, in the reporting entity’s financial statements, this day-to-day control that managers have over their integrated and extended foreign operations.

The next section describes and illustrates these translation methods using information for Domestic Company.

Data for Illustrating Foreign Currency Translations Methods Domestic Company, a U.S. parent company, establishes a foreign subsidiary in the U.K. by investing $200 on January 1, 2009, in return for all of the subsidiary’s common stock. The U.S. dollar and the U.K. pound exchange at the rate of $2:£1 on this date. The subsidiary engages in the following transactions during 2009:

1. Acquires property, plant, and equipment on January 2, 2009, costing £500. It finances the acquisition with £450 of long-term debt and £50 of cash.

2. Acquires inventory on account totaling £850. The subsidiary uses a weighted-average cost flow assumption.

3. Sells on account, for £1,000, inventory costing £700.

4. Pays selling and administrative expenses of £80, interest expense of £50, and income tax expense of £40.

5. Collects £880 from customers for sales on account and pays £680 to suppliers for purchases of inventory on account.

6. Recognizes £50 as depreciation expense for 2009.

7. Pays no dividends to the U.S. parent company.

The average exchange rate during 2009 was $2.1:£1, and the exchange rate on December 31, 2009, is $2.2:£1. The increase in the number of U.S. dollars required to purchase one U.K. pound means that the U.S. dollar declined in value relative to the U.K. pound during the year.

Exhibit 2 translates the balance sheet, and Exhibit 3 translates the income statement, both exhibits showing the all-current method and the monetary-nonmonetary method.

ALL-CURRENT TRANSLATION METHOD

Self-contained foreign operations (where the functional currency is a foreign currency) must use the all-current translation method. The all-current method translates assets and liabilities using the exchange rate on the date of the balance sheet. It translates revenues, expenses, and net income using the actual exchange rate at the date of transactions during the period (or the average exchange rate during the period as an approximation). The foreign exchange adjustment that results from applying the all-current method appears in other comprehensive income and then Accumulated Other Comprehensive Income, a separate shareholders’ equity account, and does not affect net income each period. The rationale for the all-current method for self-contained foreign operations results from the fact that only an investor’s investment in the net assets of the foreign unit is at risk to exchange rate changes. That is, the U.S. investor has put at risk an amount equal to the shareholders’ equity of the foreign unit. A decision to invest in a foreign unit and to permit the foreign unit to retain, for internal growth, assets generated by earnings means that the parent will not realize the benefit or incur the loss from exchange rate changes inherent in its net asset position until either the foreign unit remits a dividend or the parent sells the foreign unit. Because such events will not likely occur for many years, net income excludes the foreign exchange adjustment each period under the all-current translation method.

Refer to Exhibits 2 and 3. The all-current method translates assets and liabilities using the exchange rate on December 31, 2009, of $2.2:£1. The all-current method translates common stock using the exchange rate of $2.0:£1 on January 1, 2009, the date the domestic parent company established the subsidiary by investing $200. Retained earnings at the end of 2009 equals net income for 2009 because the subsidiary paid no dividends. The translation of revenues, expenses, and net income uses the average exchange rate during 2009 of $2.1:£1.

The foreign exchange adjustment is $28, the amount by which the U.S. investor’s investment, when translated into dollars from the foreign books, exceeds the dollar amount carried on the U.S. books. Exhibit 4 calculates this $28 amount, a credit because it resembles a gain, although the all-current method will not report it as a gain.

|EXHIBIT 2 |

|DOMESTIC COMPANY |

|Translation of Balance Sheet |

|December 31, 2009 |

| |All-Current Method |Monetary-Nonmonetary Method |

| |Pounds |Exchange Rate |Dollars |Pounds |Exchange Rate|Dollars |

|ASSETS | | | | | | |

|Cash |

|DOMESTIC COMPANY |

|Translation of Income Statement for 2009 |

| |All-Current Method |Monetary-Nonmonetary Method |

| |Exchange | | |Exchange | |

| |Rate | | |Rate | |

| |Pounds | |Dollars |Pounds | |Dollars |

|Sales |

|DOMESTIC COMPANY |

|Calculation of Foreign Exchange Adjustment |

|All-Current Method for 2009 |

| |Pounds |Exchange Rate |Dollars |

|Net Assets Position, January 1, 2009 | | |£10| | |$2.0:£| |

| | | |0 | | |1 | |

| | | | | | | |

The net assets of the subsidiary on January 1, 2009, equal the £100 (or $200) invested by Domestic Company. The U.K. pound increased in value relative to the U.S. dollar during 2009. If the subsidiary converted net assets of £100 on December 31, 2009, into U.S. dollars and remitted them to its parent company, Domestic Company would receive net assets of $220 (= £100 × 2.2:£1). The parent company has enjoyed an increase in wealth of $20 by the end of 2009 from placing the $200 in a subsidiary whose currency increased in value relative to the U.S. dollar. That is, the $220 exceeds by $20 the amount the firm would have on deposit if it had left the funds in its U.S. bank account.

During 2009, the net assets of the subsidiary increased by £80 from earnings. Domestic Company permitted net assets equal to this £80 of earnings to remain in the subsidiary when it could have required the subsidiary to remit them to the parent company as a dividend. Had the foreign subsidiary remitted the dividend in U.K. pounds and had the U.S. parent converted those pounds to dollars on receiving them, the U.S. parent would have had U.S. dollars of $168 (= £80 × $2.1:£1). By leaving the assets in the foreign company rather than taking them out via dividends, the parent had a year-end total of assets denominated in U.K. pounds with a U.S. dollar equivalent value on December 31, 2009, of $176 (= £80 × $2.2:£1). Domestic Company has increased its wealth by $8 (= $176 – $168) from leaving the net assets generated by earnings in the U.K. subsidiary instead of transferring them back to the United States. The foreign exchange adjustment for 2009 totals $28 [= $20 (on initial investment) + $8 (on earnings retention)].

MONETARY-NONMONETARY TRANSLATION METHOD

The accounting for foreign operations either highly integrated with a U.S. parent company (U.S. GAAP) or where the functional currency of a foreign entity is the reporting currency must use the monetary-nonmonetary translation method. The monetary-nonmonetary translation method provides translated amounts for a foreign unit similar to the amounts that the parent would report if it engaged in export transactions to carry out its foreign operations (that is, if it manufactured goods in the country of the parent and then sold them to customers abroad) instead of operating through a foreign entity. Because the operations of integrally related foreign units resemble export activities, domestic firms achieve comparable reported amounts for both types of activities by using the monetary-nonmonetary translation method.

The monetary-nonmonetary method translates monetary assets and liabilities using the current exchange rate and translates nonmonetary assets and liabilities using the historical exchange rate. Monetary items represent claims receivable or payable in a fixed number of foreign currency units regardless of changes in exchange rates. Monetary items include cash, accounts receivable, accounts payable, bonds payable, and most liabilities other than Advances from Customers. Because firms translate monetary items using the current exchange rate, a foreign exchange adjustment arises for these items when exchange rates change. The firm includes the foreign exchange adjustment as an exchange gain or loss in measuring net income each period under the monetary-nonmonetary method. The rationale results from noting that the foreign unit must regularly convert currency (in this case from dollars to pounds or vice versa) to settle its receivables or payables and will therefore realize the gain or loss in the near term. This near-term realization contrasts with the longer-term realizability of the foreign exchange adjustment from self-contained foreign operations translated using the all-current method.

Nonmonetary items include inventories, prepayments, property, plant and equipment, intangible assets, advances from customers, and common stock. Unlike monetary items, nonmonetary items do not result in a fixed future cash inflow or outflow. Translating nonmonetary items using the historical exchange rate results in reporting them at constant reporting-currency amounts regardless of changes in the exchange rate.

Refer to Exhibits 2 and 3. The monetary-nonmonetary method translates monetary items at the exchange rate of $2.2:£1 on December 31. Monetary items include cash, accounts receivable, accounts payable, and bonds payable. The accountant translates nonmonetary items at their historical exchange rates. The subsidiary acquired inventory items evenly during 2009 and uses a weighted-average cost flow assumption. Thus, the ending inventory translates using the average exchange rate of $2.1:£1. A FIFO cost flow assumption requires the use of an exchange rate later in the year for inventory items. A LIFO cost flow assumption requires the use of the exchange rate for the year of each LIFO inventory layer. The property, plant, and equipment translate using the exchange rate at the time of their acquisition of $2.0:£1. The common stock translates at the exchange rate at the time of its issue of $2.0:£1. Most revenues and expenses result from transactions recorded evenly during 2009 and therefore translate using the average exchange rate of $2.1:£1. Cost of goods sold represents an allocation of a cost initially recorded when the subsidiary purchased the inventory items. Because the subsidiary uses a weighted-average cost flow assumption, cost of goods sold translates at the average exchange rate of $2.1:£1. A FIFO cost flow assumption in this illustration requires the use of an exchange rate earlier in the year for cost of goods sold. A LIFO cost flow assumption requires the use of an exchange rate later in the year (unless a firm dips into LIFO layers of earlier years). Depreciation expense likewise represents an allocation of a cost initially recorded when the subsidiary purchased the depreciable assets. Depreciation expense translates at the historical exchange rate of $2.0:£1.

The foreign exchange loss for the year, computed in Exhibit 5, is $82. The U.K. subsidiary held a net monetary liability position (that is, its monetary liabilities exceeded its monetary assets) during most of the year as a result of its long-term borrowing to finance purchases of property, plant, and equipment. The U.S. dollars needed to repay this net liability position in pounds increased during 2009 as a result of the decline in the value of the U.S. dollar. This causes a foreign exchange loss.

Exhibit 5 demonstrates the calculation of the foreign exchange loss. Translating each transaction affecting the net monetary position at the exchange rate at the time of the transaction results in a net monetary liability of $842 at the end of the year. The actual net monetary liability position at the end of the year in pounds comprises cash (£80) plus accounts receivable (£120) minus accounts payable (£170) minus bonds payable (£450), or a negative £420. The U.S. dollar-equivalent of the net monetary liability at the end of the year is $924. That is, the U.S. dollar amount needed at year-end to discharge the net monetary liability would be $924. Had the U.S. firm discharged each net U.K. pound monetary liability with dollars as it arose, the U.S. firm would have $82 more at year-end than if it discharged the net monetary liability all at year-end. By letting the liabilities accumulate in pounds while the dollar was losing value relative to the pound, the U.S. firm lost $82. Note that the issuance of bonds, the collection of accounts receivable, and the payment of accounts payable cause no change in the net monetary position because each of these transactions involves simultaneous increases (or decreases) in both monetary assets and monetary liabilities. For example, the issuance of bonds increases the monetary asset Cash while it increases the monetary liability Bonds Payable.

|EXHIBIT 5 |

|DOMESTIC COMPANY |

|Calculation of Foreign Exchange Adjustment |

|Monetary-Nonmonetary Method for 2009 |

| |Pounds |Exchange Rate |Dollars |

|Net Monetary Asset (Liability) Position, | |£ 00 | |$2.0:£1 | |$ 200 | |

|January 1, 2009. | | | | | | | |

|Increases in Net Monetary Assets | | |1,000 | |$2.1:£1 | | |2,100 | |

|Cash or Accounts Receivable from Sales | | | | | | | | | |

|Decreases in Net Monetary Assets | | |(500 |) |$2.0:£1 | | |(1,000 |) |

|Purchase of Property, Plant, and Equipment | | | | | | | | | |

|Purchase of Inventory on Account | | |(850 |) |$2.1:£1 | | |(1,785 |) |

|Payment of Selling and Administrative Expenses | | |(80 |) |$2.1:£1 | | |(168 |) |

|Payment of Interest Expenses | | |(50 |) |$2.1:£1 | | |(105 |) |

|Payment of Income Taxes | | (40 |) |$2.1:£1 | | (84 |) |

|Net Monetary Asset (Liability) Position, | |£ (420 |) | | | |(84 |) |

|December 31, 2009 | | | | | | | | |

| | | | | |$2.2:£1 | | | 924 | |

|Foreign Exchange Loss | | | | | | | |$ 82 | |

| | | | | | | | | | |

PROBLEM FOR SELF-STUDY

Translating foreign currency financial statements. Refer to the preceding illustration for Domestic Company and its U.K. subsidiary for 2009. The following information relates to the U.K. subsidiary for 2010. All transactions occur evenly during 2010.

1. Acquires inventory on account totaling £850.

2. Sells inventory costing £800 on account for £1,200.

3. Pays selling and administrative expenses of £160, interest expense of £50, and income tax expense of

£45.

4. Collects £1,160 from customers for sales on account and pays £820 to suppliers for purchases of inventory on account.

5. Pays dividends of £25 evenly during 2010.

6. Recognizes £50 of depreciation expense.

The exchange rates were as follows:

|When Subsidiary Issued Bonds and Common Stock | |$2.0:£1 |

|When Subsidiary Acquired Property, Plant, and Equipment | |$2.0:£1 |

|December 31, 2009 | |$2.2:£1 |

|Average during 2010 | |$2.0:£1 |

|When Subsidiary Acquired Inventory Available for Sale during 2010 | |$2.015:£1 |

|December 31, 2010 | |$1.8:£1 |

a. Prepare a balance sheet for the U.K. subsidiary in U.K. pounds and in U.S. dollars on December 31, 2010, using (1) the all-current translation method and (2) the monetary-nonmonetary translation method. Include the foreign exchange adjustment in a separate shareholders’ equity account under the all-current method and in net income (and, therefore, retained earnings) under the monetary-nonmonetary method.

b. Prepare a statement of net income and retained earnings for the U.K. subsidiary for 2010 in U.K. pounds and U.S. dollars using (1) the all-current translation method and (2) the monetary-nonmonetary translation method. This statement should reconcile the change in retained earnings during 2010 in both U.K. pounds and U.S. dollars. Note that retained earnings on January 1, 2010, is $168 under the all-current method and $91 under the monetary-nonmonetary method (see Exhibit 2).

c. Prepare analyses that show the calculation of the foreign exchange adjustment for 2010 under the all-current method and the monetary-nonmonetary method. Refer to Exhibits 4 and 5 for the formats for these analyses.

SUGGESTED SOLUTION TO PROBLEM FOR SELF-STUDY

(Domestic Company; translating foreign currency financial statements.)

a. Exhibit 6 presents the translated balance sheet.

b. Exhibit 7 presents the translated income statement.

c. Exhibit 8 presents the calculation of the foreign exchange adjustment under the all-current method, and Exhibit 9 presents the calculation of the foreign exchange gain or loss under the monetary-nonmonetary method.

KEY TERMS AND CONCEPTS

Foreign currency translation

Historical exchange rate

Current exchange rate

Foreign exchange adjustment

Reporting currency

Functional currency

All-current translation method

Monetary-nonmonetary translation method

Monetary items

Nonmonetary items

|EXHIBIT 6 |

|Translation of Balance Sheet |

|December 31, 2010 |

|(Problem for Self-Study) |

| |All-Current Method |Monetary-Nonmonetary Method |

| |Pounds |Exchange |Dollars |Pounds |Exchange Rate |Dollars |

| | |Rate | | | | |

|ASSETS |

|Translation of Income Statement and Retained Earnings for 2010 |

|(Problem for Self-Study) |

| |All-Current Method |Monetary-Nonmonetary Method |

| |Exchange | |Exchange |

| |Pounds |Rate |Dollars |Pounds |Rate |Dollars |

|Sales |

|Calculation of Foreign Exchange Adjustment for 2010 |Pounds |Exchange Rate |Dollars |

|All-Current Method | | | |

|(Problem for Self-Study) | | | |

|Net Assets Position, January 1, 2010 | |£180| |$2.2:£1 | | |$396 | |

|Net Income for 2010 | |95 | |$2.0:£1 | | |190 | |

|Dividends | (25 |) |$2.0:£1 | | | (50|) |

| | | | | | | | | |

|Net Assets, December 31, 2010 | |£250| | | | |$536 | |

| | |$1.8:£1 | | | 450 | |

|Change in Foreign Exchange Adjustment for 2010 | | | | |$ (86 |) |

|Foreign Exchange Adjustment, January 1, 2010 | | | | | 28| |

|Foreign Exchange Adjustment, December 31, 2010 | | | | |$ (58 |) |

| | | | | | |

|EXHIBIT 9 |

|Calculation of Foreign Exchange Adjustment |

|Monetary-Nonmonetary Method for 2010 |

|(Problem for Self-Study) |

| |Pounds |Exchange Rate |Dollars |

|Net Monetary Asset (Liability) Position, |£ (420 |) | |$2.2:£1 | |$ (924 |) |

|January 1, 2010 | | | | | | | |

|Increases in Net Monetary Assets | | | | | | | | | |

|Cash and Accounts Receivable from Sales | |1,200 | | |$2.0:£1 | | |2,400 | |

|Decreases in Net Monetary Assets | | | | | | | | | |

|Purchase of Inventory on Account | |(850 |) | |$2.0:£1 | | |(1,700|) |

|Payment of Selling and Administrative Expenses | |(160 |) | |$2.0:£1 | | |(320 |) |

|Payment of Interest Expense | |(50 |) | |$2.0:£1 | | |(100 |) |

|Payment of Investments | |(45 |) | |$20:£1 | | |(90 |) |

|Payment of Dividends | (25 |) | |$2.0:£1 | | (50 |) |

| | | | | | | | | | |

|Net Monetary Asset (Liability) Position, | | | | | | | | | |

|December 31, 2010 |£ (350 |) | | | |$ (784 |) |

| | | | | |$1.8:£1 | | 630 | |

|Foreign Exchange Gain, 2010 | | | | | | |$ 154 | |

| | | | | | | | | |

QUESTIONS, EXERCISES, PROBLEMS, AND CASES

QUESTIONS

FORCUR 1. Review the meaning of the terms and concepts listed above in Key Terms and Concepts.

FORCUR 2.

a. The all-current translation method assumes that exchange-rate changes affect a foreign entity’s net assets position (= assets minus liabilities = shareholders’ equity). Why are net assets the appropriate base for measuring exchange rate exposure when a foreign entity’s operations are self-contained within the foreign country?

b. The monetary-nonmonetary translation method assumes that exchange-rate changes affect a foreign entity’s monetary assets and monetary liabilities. Why are net monetary items the appropriate base for measuring exchange-rate exposure when a foreign entity’s operations are an integrated extension of the parent company (U.S. GAAP) or the functional currency of the foreign entity is the reporting currency (IFRS)?

FORCUR 3. The foreign exchange adjustment using the all-current translation method does not affect net income each period but appears in Accumulated Other Comprehensive Income, a separate shareholders’ equity account. The foreign exchange adjustment using the monetary-nonmonetary translation method affects net income and retained earnings each period. Why do these two translation methods treat the exchange adjustment differently?

FORCUR 4. The functional currency of a foreign entity may increase or decrease in value relative to the reporting currency. Which direction of change in the value of the foreign functional currency relative to the reporting currency will result in a credit change in other comprehensive income under the all-current translation method? Which direction of change results in a debit change in other comprehensive income? Explain.

FORCUR 5. The foreign functional currency of a foreign entity may increase or decrease in value relative to the reporting currency during a particular period. Under what circumstances will a foreign exchange gain arise from the translation of a foreign entity’s financial statements into the reporting currency using the monetary-nonmonetary translation method? Under what circumstance will a foreign exchange loss arise? Explain.

FORCUR 6.

a. “One can convert an income statement based on the all-current translation method into an income statement based on the monetary-nonmonetary translation method simply by including in net income the change during the period in the foreign exchange adjustment account under the all-current method.” Do you agree? Why or why not?

b. “One can convert a balance sheet based on the all-current translation method into a balance sheet based on the monetary-nonmonetary method simply by reclassifying the exchange adjustment under the all-current method from a separate shareholders’ equity account into the retained earnings account.” Do you agree? Why or why not?

FORCUR 7. Translating the financial statements of a particular foreign entity into the reporting currency results in a debit change in other comprehensive income under the all-current translation method but a foreign exchange gain under the monetary-nonmonetary translation method for a particular period. Why does the direction of the foreign exchange adjustment differ for these two translation methods?

EXERCISES

FORCUR 8. Selecting the exchange rate for foreign currency translation. Firms might translate financial statement items using the historical exchange rate (H), the average exchange rate during the current period (C–A), or the exchange rate at the end of the current period (C–E). Indicate the exchange rate used for each financial statement item below under (1) the all-current translation method and (2) the monetary-nonmonetary translation method.

a. Cash

b. Accounts Receivable

c. Inventories

d. Prepaid Rent

e. Investment in Securities (10 percent ownership)

f. Land

g. Building

h. Accumulated Depreciation

i. Patent

j. Goodwill

k. Accounts Payable

l. Bank Loan Payable

m. Bonds Payable

n. Common Stock

o. Sales

p. Cost of Goods Sold

q. Depreciation Expense

r. Interest Expense

s. Income Tax Expense

FORCUR 9. Identifying the foreign currency translation method. Indicate whether each of the statements below refers to the all-current translation method (C), the monetary-nonmonetary translation method (MN), to both translation methods (B), or to neither translation method (N).

a. Firms use this translation method when the foreign entity engages in frequent transactions with its U.S. parent company.

b. Firms use this translation method when the foreign entity acquires and sells goods and services within the foreign country and pays no dividends to its U.S. parent company.

c. A foreign exchange gain or loss will not likely appear in the income statement each period when firms use this translation method.

d. Firms use the current exchange rate to translate accounts receivable under this translation method.

e. Firms use the current exchange rate to translate inventories under this translation method.

f. Firms use the historical exchange rate to translate bonds payable under this translation method.

g. Firms include cumulative foreign exchange gains and losses in retained earnings under this translation method.

h. Firms use the current exchange rate to translate common stock under this translation method.

i. Firms use the average exchange rate during the current period to translate income tax expense under this translation method.

FORCUR 10. Identifying the nature of a foreign exchange adjustment. A condensed balance sheet for a Japanese foreign subsidiary in yen (¥) for 2009 appears in Exhibit 10.

a. Assume that the Japanese yen increased in value relative to the reporting currency during 2009.What is the likely sign of the foreign exchange adjustment under the all-current translation method (adjustment included in other comprehensive income) and under the monetary-nonmonetary translation method (adjustment included in net income) for 2009? Explain.

b. Repeat part a, but assume that the Japanese yen decreased in value relative to the reporting currency.

FORCUR 11. Interpreting translated financial statements. Exhibit 11 presents the translated financial statements of a U.K. subsidiary of a German parent company for its first year of operations. The first column shows the statements using the all-current translation method, and the second column shows the statements using the monetary-nonmonetary translation method.

a. Did the British pound increase or decrease in value relative to the euro during the year? Explain.

b. Describe the cause of the negative foreign exchange adjustment of €25,200 on the balance sheet.

c. Describe the cause of the foreign exchange gain of €10,000 on the income statement.

|EXHIBIT 10 |

|Balance Sheet for Japanese Subsidiary |

|(Exercise 10) |

| |January 1, |December 31, |

| |2009 |2009 |

|Cash | |¥ 10 | | |¥ 15 | |

|Accounts Receivable | | |50 | | | |60 | |

|Inventories | | |40 | | | |55 | |

|Fixed Assets (net) | | 100 | | | 110 | |

|Total Assets | |¥ 200 | | |¥ 240 | |

|Current Liabilities | |¥ 80 | | |¥ 110 | |

|Long-term Debt | | |50 | | | |50 | |

|Shareholders’ Equity | | 70 | | | 80 | |

|Total Liabilities and Shareholders’ Equity | |¥ 200 | | |¥ 240 | |

| | | | | | | | | |

|EXHIBIT 11 |

|FOREIGN SUB | |

|Translated Financial Statements | |

|(Exercise 11) | |

| |All-Current |Monetary-Nonmonetary |

| |Translation Method |Translation Method |

|BALANCE SHEET |

|Cash | |€|12,000 | | |€|12,000 | |

|Accounts Receivable | | |48,000 | | | |48,000 | |

|Inventories (FIFO) | | |36,000 | | | |40,000 | |

|Property, Plant, and Equipment | | |80,000 | | | |100,000 | |

|Total Assets | |€|176,000 | | |€|200,000 | |

|Accounts Payable | |€|60,000 | | |€|60,000 | |

|Long-term Debt | | |48,000 | | | |48,000 | |

|Common Stock | | |80,000 | | | |80,000 | |

|Foreign Exchange Adjustment | | |(25,200 |) | | |— | |

|Retained Earnings | | |13,200 | | | |12,000 | |

|Total Liabilities and Shareholders’ Equity | |€|176,000 | | |€|200,000 | |

|INCOME STATEMENT | | | | | | | | |

|Sales | |€|152,000 | | |€|152,000 | |

|Cost of Goods Sold | | |(72,000 |) | | |(80,000 |) |

|Selling and Administrative | | |(36,000 |) | | |(36,000 |) |

|Depreciation | | |(12,800 |) | | |(16,000 |) |

|Interest | | |(4,000 |) | | |(4,000 |) |

|Income Taxes | | |(14,000 |) | | |(14,000 |) |

|Foreign Exchange Gain | | |— | | | |10,000 | |

|Net Income | |€|13,200 | | |€|12,000 | |

| | | | | | | | | |

PROBLEMS

FORCUR 12. Translating foreign currency financial statements. U.S. Manufacturing, Inc., established a wholly-owned subsidiary in France on January 2, 2009, by contributing $600 for the subsidiary’s common stock. The subsidiary issued long-term bonds for €200 and acquired plant and equipment costing €500 on January 2, 2009. Exhibit 12 presents a balance sheet on December 31, 2009, and a statement of income and retained earnings for 2009 for this subsidiary. The subsidiary accrued revenues and expenses evenly during 2009 and uses a weighted-average cost flow assumption for inventories and cost of goods sold. The exchange rates on various dates appear below:

|Average 2009 |$1.50: €1 |

|December 31, 2009 |$1.00: €1 |

a. Prepare a balance sheet as of December 31, 2009, and a statement of income and retained earnings for 2009 in U.S. dollars using the all-current translation method. Include a separate schedule showing the calculation of the foreign exchange adjustment included in other comprehensive income for 2009.

b. Repeat part a using the monetary-nonmonetary translation method. Include a separate calculation of the foreign exchange gain or loss for 2009.

c. Why is the sign (debit or credit) of the foreign exchange adjustment for 2009 under the all-current translation method different from the sign under the monetary-nonmonetary translation method?

d. Compute the ratio of net income to sales (1) in Euros, the foreign currency of the subsidiary, (2) in U.S. dollars using the all-current translation method, and (3) in U.S. dollars using the monetary-nonmonetary translation method. Why are the ratios under (1) and (2) the same? Why do the ratios under (2) and (3) differ?

|EXHIBIT 12 |

|FRENCH SUBSIDIARY | |

|Financial Statement Data | |

|(Problem 12) | |

|BALANCE SHEET |December 31, 2009 |

|Assets | | |

|Cash | |€ 100 | |

|Accounts Receivable | | |200 | |

|Inventories | | |300 | |

|Fixed Assets (net) | | 400 | |

|Total Assets | |€ 1,000 | |

|Liabilities and Shareholders’ Equity | | | | |

|Accounts Payable | |€ 400 | |

|Bonds Payable | | 200 | |

|Total Liabilities | |€ 600 | |

|Common Stock | |€ 300 | |

|Retained Earnings | | 100 | |

|Total Shareholders’ Equity | |€ 400 | |

|Total Liabilities and Shareholders’ Equity | |€ 1,000 | |

|STATEMENT OF INCOME AND RETAINED EARNINGS |For 2009 |

|Sales | |€ 2,000 | |

|Cost of Goods Sold | | |(1,200 |) |

|Selling and Administrative Expenses | | |(400 |) |

|Depreciation Expense | | |(100 |) |

|Interest Expense | | |(20 |) |

|Income Tax Expense | | (120 |) |

|Net Income . | |€ 160 | |

|Dividends (Declared and Paid on December 31, 2009) | | (60 |) |

|Retained Earnings, December 31, 2009 | |€ 100 | |

| | | | | |

FORCUR 13. Translating foreign currency financial statements using the all-current method. Casatu Corporation, a multinational Japanese company, established McGann Corporation, a wholly-owned Irish subsidiary, by contributing ¥300,000 on January 1, 2009. Exhibit 13 presents the financial statements of McGann Corporation for 2009 and 2010 measured in Euros, its functional currency. The exchange rates on various dates appear below:

|January 1, 2009. |¥|150:£1 |

|Average, 2009 |¥|148:£1 |

|December 31, 2009 |¥|145:£1 |

|Average, 2010 . |¥|149:£1 |

|December 31, 2010 |¥|152:£1 |

a. Prepare a balance sheet as of December 31, 2009, and an income statement and retained earnings statement for 2009 in Japanese yen, the reporting currency, using the all-current translation method. Include a separate calculation of the foreign exchange adjustment for 2009.

b. Repeat part a for 2010.

c. Explain the reason for the sign (debit versus credit) of the foreign exchange adjustment for 2009.

d. Explain the reason for the sign (debit versus credit) of the foreign exchange adjustment for 2010.

e. Compute the ratio of net income to sales revenue for each year using financial data expressed in Euros and in Japanese yen. Why is this ratio the same in each year regardless of whether the calculation uses Euros or Japanese yen?

|EXHIBIT 13 |

|MCGANN CORPORATION |

|Financial Statement Data |

|(Problem 13) |

|December 31, 2009 |December 31, 2010 |

|BALANCE SHEET | | |

|Cash | | |€ 40,000 | | | |€ 75,000|

|Net Income | | |€ 20,000 | | | |€ 30,000|

|Balance, End of Year | |

|Average, 2009 |US$.85:C$1.00 |

|December 31, 2010 |US$.80:C$1.00 |

|Average, 2010 |US$.82:C$1.00 |

a. Prepare a balance sheet as of December 31, 2009, and an income statement and retained earnings statement for 2009 in U.S. dollars using the all-current translation method. Include a separate calculation of the foreign exchange adjustment for 2009.

b. Repeat part a using the monetary-nonmonetary translation method. Include a separate calculation of the foreign exchange gain or loss for 2009.

c. Repeat part a using the all-current translation method for 2010.

d. Repeat part a using the monetary-nonmonetary translation method for 2010.

|EXHIBIT 14 |

|CANADIAN SUBSIDIARY |

|Financial Statement Data |

|(Problem 14) |

| |December 31 |

|BALANCE SHEET |2009 | |2010 |

|Assets | | | |

|Cash | |C$ 77,555 | | |C$116,555 | |

|Rent Receivable | | |25,000 | | | |30,000 | |

|Building (net) | | 475,000 | | | 450,000 | |

|Total Assets | |C$577,555 | | |C$596,555 | |

| | | | | | | |

|Liabilities and Shareholders’ Equity | | | | | | | | |

|Accounts Payable | |C$ 6,000 | | |C$ 7,500 | |

|Salaries Payable | | |4,000 | | | |5,500 | |

|Common Stock | | |555,555 | | | |555,555 | |

|Retained Earnings | | 12,000 | | | 28,000| |

|Total Liabilities and Shareholders’ Equity | |C$577,555 | | |C$596,555 | |

| | | | | | | | | |

| | | | | | | | | |

|INCOME STATEMENT |For the Year Ended |

| |December 31 |

| |2009 |2010 |

|Rent Revenue | |C$125,000 | | | |C$150,000 | |

|Operating Expense | | |(28,000 |) | | | |(34,000 |) |

|Depreciation Expense | | |(25,000 |) | | | |(25,000 |) |

|Income Tax Expense | | (30,000|) | | | |) |

| | | | | | |(36,000 | |

|Net Income | |C$ 42,000 | | | |C$ 55,000 | |

| | | | | | | | | | |

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[1] Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 52, “Foreign Currency Translation,” 1981; International Accounting Standards Board, “International Accounting Standard 21, “The Effects of Changes in Foreign Exchange Rates,” revised 2003.

[2] We do not consider the foreign currency translation procedures when a foreign entity operates in a highly inflationary country.

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