Chapter 8 Flashcards
What are the two major conceptual issues that must be resolved in translating foreign currency financial statements?
The two major issues related to the translation of foreign currency financial statements are: (a) which method should be used and (b) where should the resulting translation adjustment be reported in the consolidated financial statements. The first issue relates to determining the appropriate exchange rate (historical, current, or average for the current period) for the translation of foreign currency balances. Those items translated at the current exchange rate are exposed to translation adjustment. The second issue relates to whether the translation adjustment should be treated as a gain or loss in income, or should be deferred as a separate component of stockholders’ equity.
What factors create a balance sheet (or translation) exposure to foreign exchange risk? How does balance sheet exposure compare with transaction exposure?
Balance sheet exposure arises when a foreign currency balance is translated at the current exchange rate. By translating at the current exchange rate, the foreign currency item in essence is being revalued in U.S. dollar terms on the consolidated financial statements. There will be either a net asset balance sheet exposure or net liability balance sheet exposure depending upon whether assets translated at the current rate are greater or less than liabilities translated at the current rate. Balance sheet exposure generates a translation adjustment, which does not result in an inflow or outflow of cash. Transaction exposure, which results from the receipt or payment of foreign currency, generates foreign exchange gains and losses that are realized in cash.
What is the concept underlying the current rate method of translation? What is the concept underlying the temporal method of translation? How does balance sheet exposure differ under these two methods?
The major concept underlying the current rate method is that the entire foreign investment is exposed to foreign exchange risk. Therefore all assets and liabilities are translated at the current exchange rate. Balance sheet exposure under this concept is equal to the net investment.
The major concept underlying the temporal method is that the translation process should result in a set of translated U.S. dollar financial statements as if the foreign subsidiary’s transactions had actually been carried out using U.S. dollars. To achieve this objective, assets carried at historical cost and stockholders’ equity are translated at historical exchange rates; assets carried at current value and liabilities (carried at current value) are translated at the current exchange rate. Under this concept, the foreign subsidiary’s monetary assets and liabilities are considered to be foreign currency cash, receivables, and payables of the parent that are exposed to transaction risk. For example, if the foreign currency appreciates, then the foreign currency receivables increase in U.S. dollar value and a gain is recognized. Balance sheet exposure under the temporal method is analogous to the net transaction exposure that exists from having both receivables and payables in a particular foreign currency.
What are the major procedural differences in applying the current rate and temporal methods of translation?
The major differences relate to non-monetary assets carried at historical cost and related expenses, i.e., inventory and cost of goods sold; property, plant, and equipment and depreciation expense; and intangible assets and amortization expense. Under the temporal method, these items are all translated at historical exchange rates. Under the current rate method, the assets are translated at the current exchange rate and the related expenses are translated at the average exchange rate for the current period.
How does a parent company determine the appropriate method for translating the financial statements of a foreign subsidiary?
To determine the appropriate translation method under both IFRS and U.S. GAAP, the functional currency of a foreign subsidiary must be identified. The functional currency is the primary currency of the foreign entity’s operating environment. It can be either the parent’s reporting currency or a foreign currency (generally the local currency). The functional currency orientation results in the following rule:
Functional Currency Translation Method Translation Adjustment
Parent’s currency Temporal method Gain (loss) in net income
Foreign currency Current rate method Separate component of stockholders’ equity (other comprehensive income)
What are the major differences between IFRS and U.S. GAAP in the translation of foreign currency financial statements?
For foreign entities that report in the currency of a hyperinflationary economy, IAS 21 requires the parent first to restate the foreign financial statements for inflation using IAS 29 rules and then translate the statements into parent company currency using the current rate method. U.S. GAAP, on the other hand, requires financial statements of such foreign entities to be translated using the temporal method. U.S. GAAP specifically defines hyperinflation as cumulative three-year inflation greater than 100%. IAS 29 provides no specific definition for hyperinflation, but suggests that a cumulative three-year inflation rate approaching or exceeding 100% is evidence that an economy is hyperinflationary.
What does the term functional currency mean? How is the functional currency determined under IFRS and under U.S. GAAP?
The functional currency is the currency of the subsidiary’s primary economic environment. It is usually identified as the currency in which the company generates and expends cash. U.S. GAAP stipulates that several factors such as the location of primary sales markets, sources of materials and labor, the source of financing, and the amount of intercompany transactions should be evaluated in identifying an entity’s functional currency. U.S. GAAP does not provide any guidance as to how these factors are to be weighted (equally or otherwise) when identifying an entity’s functional currency. IAS 21 also provides factors to be considered in determining the functional currency of a foreign subsidiary. Unlike U.S. GAAP, IAS 21 provides a hierarchy of factors to consider. Two primary factors are first to be considered. If evaluation of these primary factors does not clearly indicate a foreign subsidiary’s functional currency, then a group of six secondary factors should be considered.
Which translation method does U.S. GAAP require for operations in highly inflationary countries? What is the rationale for mandating use of this method?
U.S. GAAP requires use of the temporal method for operations in highly inflationary countries. Use of the current rate method without first restating for inflation results in a “disappearing plant” problem in which fixed assets shrink in terms of their translated carrying amount. By using the same historical rate for translation of fixed assets from one period to the next, the temporal method avoids this problem. In developing the current U.S. GAAP guidance on foreign currency translation, the FASB was unwilling to require firms to restate foreign operation financial statements for foreign inflation because of the lack of reliable inflation indices in many countries.
Why might a company want to hedge its balance sheet exposure? What is the paradox associated with hedging balance sheet exposure?
Although balance sheet exposure does not result in cash inflows and outflows, it does nevertheless affect amounts reported in consolidated financial statements. If the foreign currency is the functional currency, translation adjustments will be reported in stockholders’ equity. If translation adjustments are negative and therefore reduce total stockholders’ equity, there is an adverse (inflationary) impact on the debt to equity ratio. Companies with restrictive debt covenants requiring them to stay below a maximum debt to equity ratio, may find it necessary to hedge their balance sheet exposure so as to avoid negative translation adjustments being reported. If the U.S. dollar is the functional currency or an operation is located in a high inflation country, remeasurement gains and losses are reported in income. Companies might want to hedge their balance sheet exposure in this situation to avoid the adverse impact remeasurement losses can have on consolidated income and earnings per share.
The paradox in hedging balance sheet exposure is that, by agreeing to receive or deliver foreign currency in the future under a forward contract, a transaction exposure is created. This transaction exposure is speculative in nature, given that there is no underlying inflow or outflow of foreign currency that can be used to satisfy the forward contract. By hedging balance sheet exposure, a company might incur a realized foreign exchange loss to avoid an unrealized negative translation adjustment or unrealized remeasurement loss.
How are gains and losses on foreign currency borrowings used to hedge the net investment in a foreign subsidiary reported in the consolidated financial statements?
The gains and losses arising from financial instruments used to hedge balance sheet exposure are treated in a similar manner as the item the hedge is intended to cover. If the foreign currency is the functional currency, gains and losses on hedging instruments will be taken to other comprehensive income. If the parent’s reporting currency is the functional currency, gains and losses on the hedging instruments will be offset against the related remeasurement gains and losses.
Describe the conceptual issues involved in translating foreign currency financial statements.
?
Explain balance sheet exposure and how it differs from transaction exposure.
?
Describe the concepts underlying the current rate and temporal methods of translation.
?
Apply the current rate and temporal methods of translation and compare the results of the two methods.
?
Describe the requirements of applicable International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (GAAP).
?
