How is Translation Adjustment Computed? | Foreign Currency | Accounting

In this article we will discuss about the computation for translation of foreign currency adjustment.

Exchange Rates Used in Translation:

Two types of exchange rates are used in translating financial statements:

1. Historical Exchange Rate:

The exchange rate that exists when a transaction occurs.

2. Current Exchange Rate:

The exchange rate that exists at the balance sheet date.

Translation methods differ as to which balance sheet and income statement accounts to trans­late at historical exchange rates and which to translate at current exchange rates.

Assume that a company began operations in Gualos on December 31, 2008, when the exchange rate was $0.20 per vilsek. When Southwestern Corporation prepared its consolidated balance sheet at December 31, 2008, it had no choice about the exchange rate used to translate the Land account into U.S. dollars. It translated the Land account carried on the foreign subsidiary’s books at 150,000 vilseks at an exchange rate of $0.20; $0.20 was both the historical and current exchange rate for the Land account at December 31, 2008.

Translation Adjustments:

To keep the accounting equation (A = L + OE) in balance, the increase of $4,500 on the asset (A) side of the consolidated balance sheet when the current exchange rate is used must be offset by an equal $4,500 increase in owners’ equity (OE) on the other side of the balance sheet. The increase in owners’ equity is called a positive translation adjustment. It has a credit balance.

The increase in dollar value of the Land due to the vilsek’s appreciation creates a positive translation adjustment. This is true for any asset on the Gualos subsidiary’s balance sheet that is translated at the current exchange rate. Assets translated at the current exchange rate when the foreign currency has appreciated generate a positive (credit) translation adjustment.

Liabilities on the Gualos subsidiary’s balance sheet that are translated at the current exchange rate also increase in dollar value when the vilsek appreciates. For example, South­western would report Notes Payable of 10,000 vilseks at $2,000 on the December 31, 2008, balance sheet and at $2,300 on the March 31, 2009, balance sheet.

To keep the accounting equation in balance, the increase in liabilities (L) must be offset by a decrease in owners’ equity (OE), giving rise to a negative translation adjustment. This has a debit balance. Liabilities translated at the current exchange rate when the foreign currency has appreciated generate a negative (debit) translation adjustment.

Balance Sheet Exposure:

Balance sheet items (assets and liabilities) translated at the current exchange rate change in dollar value from balance sheet to balance sheet as a result of the change in exchange rate. These items are exposed to translation adjustment. Balance sheet items translated at historical exchange rates do not change in dollar value from one balance sheet to the next. These items are not exposed to translation adjustment.

Exposure to translation adjustment is referred to as balance sheet, translation, or accounting exposure. Balance sheet exposure can be contrasted with the transaction exposure that arises when a company has foreign currency receivables and payables in the following way-Transaction exposure gives rise to for­eign exchange gains and losses that are ultimately realized in cash; translation adjustments arising from balance sheet exposure do not directly result in cash inflows or outflows.

Each item translated at the current exchange rate is exposed to translation adjustment. In effect, a separate translation adjustment exists for each of these exposed items. However, neg­ative translation adjustments on liabilities offset positive translation adjustments on assets when the foreign currency appreciates.

If total exposed assets equal total exposed liabilities throughout the year, the translation adjustments (although perhaps significant on an individ­ual basis) net to a zero balance. The net translation adjustment needed to keep the consolidated balance sheet in balance is based solely on the net asset or net liability exposure.

A foreign operation has a net asset balance sheet exposure when assets translated at the current exchange rate are higher in amount than liabilities translated at the current exchange rate. A net liability balance sheet exposure exists when liabilities translated at the current exchange rate are higher than assets translated at the current exchange rate.

The following summarizes the relationship between exchange rate fluctuations, balance sheet exposure, and translation adjustments:

Exactly how to handle the translation adjustment in the consolidated financial statements is a matter of some debate. The major issue is whether the translation adjustment should be treated as a translation gain or loss reported in net income or whether the translation adjust­ment should be treated as a direct adjustment to owners’ equity without affecting net income. We consider this issue in more detail later after examining methods of translation.

Complicating Aspects of the Temporal Method:

Under the temporal method, keeping a record of the exchange rates is necessary when acquir­ing inventory, prepaid expenses, fixed assets, and intangible assets because these assets, car­ried at historical cost, are translated at historical exchange rates. Keeping track of the historical rates for these assets is not necessary under the current rate method. Translating these assets at historical rates makes the application of the temporal method more complicated than the current rate method.

Calculation of Cost of Goods Sold:

Under the current rate method, the account Cost of Goods Sold (COGS) in foreign currency (FC) is simply translated using the average-for-the-period exchange rate (ER):

COGS in FC × Average ER = COGS in $

Under the temporal method, COGS must be decomposed into beginning inventory, pur­chases, and ending inventory, and each component of COGS must then be translated at its appropriate historical rate. For example, if a company acquires beginning inventory (FIFO basis) in the year 2009 evenly throughout the fourth quarter of 2008, then it uses the average exchange rate in the fourth quarter of 2008 to translate beginning inventory. Likewise, it uses the fourth quarter (4thQ) 2009 exchange rate to translate ending inventory.

When purchases can be assumed to have been made evenly throughout 2009, the average 2009 exchange rate is used to translate purchases:

No single exchange rate can be used to directly translate COGS in FC into COGS in dollars.

Application of the Lower of Cost or Market Rule:

Under the current rate method, the ending inventory reported on the foreign currency balance sheet is translated at the current exchange rate regardless of whether it is carried at cost or a lower market value. Application of the temporal method requires the inventory’s foreign currency cost and foreign currency market value to be translated into U.S. dollars at appro­priate exchange rates, and the lower of the dollar cost and dollar market value is reported on the consolidated balance sheet.

As a result, inventory can be carried at cost on the foreign currency balance sheet and at market value on the U.S. dollar consolidated balance sheet, and vice versa.

Fixed Assets, Depreciation, and Accumulated Depreciation:

The temporal method requires translating fixed assets acquired at different times at different (historical) exchange rates. The same is true for depreciation of fixed assets and accumulated depreciation related to fixed assets.

For example, assume that a company purchases a piece of equipment on January 1, 2008, for FC 1,000 when the exchange rate is $ 1.00 per FC. It purchases another item of equipment on January 1, 2009, for FC 5,000 when the exchange rate is $1.20 per FC. Both pieces of equipment have a five-year useful life.

The temporal method reports the amount of the equip­ment on the consolidated balance sheet on December 31, 2010, when the exchange rate is $1.50 per FC, as follows:

Similar procedures apply for intangible assets as well.

The current rate method reports equipment on the December 31, 2010, balance sheet at FC 6,000 × $1.50 = $9,000. Depreciation expense is translated at the average ex­change rate of $1.40, FC 1,200 × $1.40 = $1,680, and accumulated depreciation is FC 2,600 × $1.50 = $3,900.

In this example, the foreign subsidiary has only two fixed assets requiring translation. In comparison with the current rate method, the temporal method can require substantial addi­tional work for subsidiaries that own hundreds and thousands of fixed assets.

Gain or Loss on the Sale of an Asset:

Assume that a foreign subsidiary sells land that cost FC 1,000 at a selling price of FC 1,200. The subsidiary reports an FC 200 gain on the sale of land on its income statement. It acquired the land when the exchange rate was $1.00 per FC; it made the sale when the exchange rate was $1.20 per FC; and the exchange rate at the balance sheet date is $1.50 per FC.

The current rate method translates the gain on sale of land at the exchange rate in effect at the date of sale:

FC 200 × $1.20 = $240

The temporal method cannot translate the gain on the sale of land directly. Instead, it requires translating the cash received and the cost of the land sold into U.S. dollars separately, with the difference being the US. Dollar value of the gain.

In accordance with the rules of the temporal method, the Cash account is translated at the exchange rate on the date of sale, and the Land account is translated at the historical rate:

Disposition of Translation Adjustment:

The first issue related to the translation of foreign currency financial statements is selecting the appropriate method. The second issue in financial statement translation relates to deciding where to report the resulting translation adjustment in the consolidated financial statements.

There are two prevailing schools of thought with regard to this issue:

1. Translation Gain or Loss:

This treatment considers the translation adjustment to be a gain or loss analogous to the gains and losses arising from foreign currency transactions and reports it in net income in the period in which the fluctuation in the exchange rate occurs.

The first of two conceptual problems with treating translation adjustments as gains or losses in income is that the gain or loss is unrealized; that is, no cash inflow or outflow accom­panies it. The second problem is that the gain or loss could be inconsistent with economic real­ity. For example, the depreciation of a foreign currency can have a positive impact on the foreign operation’s export sales and income, but the particular translation method used gives rise to a translation loss.

2. Cumulative Translation Adjustment in other Comprehensive Income:

The alternative to reporting the translation adjustment as a gain or loss in net income is to include it in Other Comprehensive Income. In effect, this treatment defers the gain or loss in stockholders’ equity until it is realized in some way. As a balance sheet account, the cumulative translation adjust­ment is not closed at the end of an accounting period and fluctuates in amount over time.

The two major translation methods and the two possible treatments for the translation adjustment give rise to these four possible combinations:

U.S. Rules:

Prior to 1975, the United States had no authoritative rules about which translation method to use or where to report the translation adjustment in the consolidated financial statements. Dif­ferent companies used different combinations. As an indication of the importance of this par­ticular accounting issue, the first official pronouncement issued by the newly created FASB in 1974 was SFAS 1, “Disclosure of Foreign Currency Translation Information.” It did not express a preference for any particular combination but simply required disclosure of the method used and the treatment of the translation adjustment.

The use of different combinations by different companies created a lack of comparability across companies. To eliminate this non-comparability, in 1975 the FASB issued SFAS 8, “Accounting for the Translation of Foreign Currency Transactions and Foreign Currency Finan­cial Statements.” It mandated use of the temporal method with all companies reporting translation gains or losses in net income for all foreign operations.

U.S. multinational companies (MNCs) strongly opposed SFAS 8. Specifically, they consid­ered reporting translation gains and losses in income to be inappropriate because they are unrealized. Moreover, because currency fluctuations often reversed themselves in subsequent quarters, artificial volatility in quarterly earnings resulted.

After releasing two exposure drafts proposing new translation rules, the FASB finally issued SFAS 52, “Foreign Currency Translation,” in 1981. This resulted in a complete overhaul of U.S. GAAP with regard to foreign currency translation. A narrow four-to-three vote of the board approving SFAS 52 indicates how contentious the issue of foreign currency translation has been.

SFAS 52:

Implicit in the temporal method is the assumption that foreign subsidiaries of U.S. MNCs have very close ties to their parent companies and that they would actually carry out their day-to-day operations and keep their books in the U.S. dollar if they could. To reflect the integrated nature of the foreign subsidiary with its U.S. parent, the translation process should create a set of U.S. dollar-translated financial statements as if the foreign subsidiary had actually used the dollar in carrying out its activities. This is the U.S. dollar perspective to translation that SFAS 8 adopted.

In SFAS 52, the FASB recognized two types of foreign entities. First, some foreign entities are so closely integrated with their parents that they conduct much of their business in U.S. dollars. Second, other foreign entities are relatively self-contained and integrated with the local economy; primarily, they use a foreign currency in their daily operations. For the first type of entity, the FASB determined that the U.S. dollar perspective still applies and, therefore, SFAS 8 rules are still relevant.

For the second relatively independent type of entity, a local currency perspective to trans­lation is applicable. For this type of entity, the FASB determined that a different translation methodology, namely the current rate method, should be used for translation and that transla­tion adjustments should be reported as a separate component in other comprehensive income. In addition, the FASB requires using the average-for-the- period exchange rate to translate income when the current rate method is used.

In rationalizing the placement of the translation adjustment in stockholders’ equity rather than net income, SFAS 52 offered two contrasting positions on the concep­tual nature of the translation adjustment. One view is that the “change in the dollar equivalent of the net investment is an unrealized enhancement or reduction, having no effect on the func­tional currency net cash flow generated by the foreign entity which may be currently rein­vested or distributed to the parent.”

Philosophically, this position holds that even though changes in the exchange rate create gains and losses, they are unrealized in nature and should therefore, not be included within net income.

The alternative perspective put forth by the FASB “regards the translation adjustment as merely a mechanical by-product of the translation process.” This second contention argues that exchange rate fluctuation creates no meaningful effect; the resulting translation adjustment merely serves to keep the balance sheet in equilibrium.

Interestingly enough, the FASB chose not to express preference for either of these theoreti­cal views. The board felt no need to offer a hint of guidance as to the essential nature of the translation adjustment because both explanations point to its exclusion from net income. Thus, a balance sheet figure that can amount to millions of dollars is basically undefined.

Functional Currency:

To determine whether a specific foreign operation is integrated with its parent or self-con­tained and integrated with the local economy, SFAS 52 created the concept of the functional currency. The functional currency is the primary currency of the foreign entity’s operating environment. It can be either the parent’s currency (U.S. $) or a foreign currency (generally the local currency).

SFAS 52’s functional currency orientation results in the following rule:

In addition to introducing the concept of the functional currency, SFAS 52 introduced some new terminology. The reporting currency is the currency in which the entity prepares its finan­cial statements. For U.S.-based corporations, this is the U.S. dollar. If a foreign operation’s functional currency is the U.S. dollar, foreign currency balances must be remeasured into US.

Dollars using the temporal method with translation adjustments reported as remeasurement gains and losses in income. When a foreign currency is the functional currency, foreign cur­rency balances are translated using the current rate method and a translation adjustment is reported on the balance sheet.

The functional currency is essentially a matter of fact. However, SFAS 52 states that for many cases, “management’s judgment will be required to determine the functional currency in which financial results and relationships are measured with the greatest degree of rel­evance and reliability.” SFAS 52 lists indicators to guide parent company management in its determination of a foreign entity’s functional currency (see Exhibit 10.2).

SFAS 52 provides no guidance as to how to weight these indicators in determining the functional currency. Leaving the decision about identifying the functional currency up to management allows some leeway in this process.

Different companies approach this selection in different ways:

“For us it was intuitively obvious” versus “It was quite a process. We took the six criteria and developed a matrix. We then considered the dollar amount and the related percentages in devel­oping a point scheme. Each of the separate criteria was given equal weight (in the analytical methods applied).”

Research has shown that the weighting schemes used by U.S. multinationals to determine the functional currency might be biased toward selection of the foreign currency as the func­tional currency. This would be rational behavior for multinationals because, when the foreign currency is the functional currency, the translation adjustment is reported in stockholders’ equity and does not affect net income.

Highly Inflationary Economies:

Multinationals do not need to determine the functional currency of those foreign entities located in a highly inflationary economy, SFAS 52 mandates the use of the temporal method with remeasurement gains or losses reported in income.

A country is defined as having a highly inflationary economy when its cumulative three- year inflation exceeds 100 percent. With compounding, this equates to an average of approxi­mately 26 percent per year for three years in a row. Countries that have met this definition at some time after SFAS 52 implementation include Argentina, Brazil, Israel, Mexico, and Turkey. In any given year, a country may or may not be classified as highly inflationary, depending on its most recent three-year experience with inflation.

One reason for this rule is to avoid a “disappearing plant problem” caused by using the cur­rent rate method in a country with high inflation. Remember that under the current rate method all assets (including fixed assets) are translated at the current exchange rate. To see the problem this creates in a highly inflationary economy, consider the following hypothetical example.

The Brazilian subsidiary of a U.S. parent purchased land at the end of 1984 for 10,000,000 cruzeiros (Cr$) when the exchange rate was $0,001 per Cr$.

Under the current rate method, the land is reported in the parent’s consolidated balance sheet (B.S.) at $10,000:

In 1985, Brazil experienced roughly 200 percent inflation. Accordingly, with the forces of purchasing power parity at work, the cruzeiro plummeted against the U.S. dollar to a value of $0.00025 at the end of 1985.

Under the current rate method the parent’s consolidated balance sheet reports land at $2,500, and a negative translation adjustment of $7,500 results:

1985 Cr$ 10,000,000 × $0.00025 = $2,500

Using the current rate method the land has lost 75 percent of its U.S. dollar value in one year—and land is not even a depreciable asset!

High rates of inflation continued in Brazil and reached the high point of roughly 1,800 percent in 1993. As a result of applying the current rate method, the land originally reported on the 1984 consolidated balance sheet at $10,000 was carried on the 1993 balance sheet at less than $1.00.

In the exposure draft leading to SFAS 52, the FASB proposed requiring companies with operations in highly inflationary countries to first restate the historical costs for inflation and then translate using the current rate method. For example, with 200 percent inflation in 1985, the Land account would have been written up to Cr$ 40,000,000 and then translated at the current exchange rate of $0.00025, producing a translated amount of $10,000, the same as in 1984.

Companies objected to making inflation adjustments, however, because of a lack of reli­able inflation indices in many countries. The FASB backed off from requiring the restate/translate approach; instead SFAS 52 requires using the temporal method in highly inflationary countries. In the previous example, under the temporal method, a firm uses the historical rate of $0,001 to translate the land value year after year. The firm carries land on the consolidated balance sheet at $10,000 each year, thereby avoiding the disappearing plant problem.

The Process Illustrated:

To provide a basis for demonstrating the translation and remeasurement procedures prescribed by SFAS 52, assume that USCO (a U.S. based company) forms a wholly owned subsidiary in Switzerland (SWISSCO) on December 31, 2008. On that date, USCO invested $300,000 in exchange for all of the subsidiary’s common stock.

Given the exchange rate of $0.60 per Swiss franc (CHF), the initial capital investment was CHF 500,000, of which CHF 150,000 was immediately invested in inventory and the remainder held in cash. Thus, SWISSCO began operations on January 1, 2009, with stockholders’ equity (net assets) of CHF 500,000 and net monetary assets of CHF 350,000.

During 2009, SWISSCO purchased property and equipment, acquired a patent, and pur­chased additional inventory, primarily on account. It negotiated a five-year loan to help finance the purchase of equipment. It sold goods, primarily on account, and incurred expenses. It generated income after taxes of CHF 470,000 and declared dividends of CHF 150,000 on October 1, 2009.

As a company incorporated in Switzerland SWISSCO must account for its activities using Swiss accounting rules, which differ from U.S. GAAP in many respects. To prepare consolidated financial statements, USCO must first convert SWISSCO’s financial statements to a U.S. GAAP basis. SWISSCO’s U.S. GAAP financial statements for the year 2008 in Swiss francs appear in Exhibit 10.3.

To properly translate the Swiss franc financial statements into U.S. dollars, USCO must gather exchange rates between the Swiss franc and US. Dollar at various points in time.

Rele­vant exchange rates (in U.S. dollars) are as follows:

As you can see, the Swiss franc steadily appreciated against the dollar during the year.

Translation of Financial Statements—Current Rate Method:

The first step in translating foreign currency financial statements is to determine the func­tional currency. Assuming that the Swiss franc is the functional currency, the income statement and statement of retained earnings are translated into U.S. Dollars using the current rate method as shown in Exhibit 10.4.

All revenues and expenses are translated at the exchange rate in effect at the date of accounting recognition. We utilize the weighted average exchange rate for 2009 here because each revenue and expense in this illustration would have been recognized evenly throughout the year. However, when an income account, such as a gain or loss, occurs at a specific point in time, the exchange rate as of that date is applied.

Depreciation and amortization expense also are translated at the average rate for the year. These expenses accrue evenly throughout the year even though the journal entry could have been delayed until year-end for convenience.

The translated amount of net income for 2009 is brought down from the income statement into the statement of retained earnings. Dividends are translated at the exchange rate on the date of declaration.

Translation of the Balance Sheet:

Looking at SWISSCO’s translated balance sheet in Exhibit 10.5, note that all assets and liabilities are translated at the current exchange rate. Common stock and additional paid-in capital are translated at the exchange rate on the day the common stock was originally sold.

Retained earnings at December 31, 2009, is brought down from the statement of retained earnings. Application of these procedures results in total assets of $1,169,000 and total liabilities and equities of $1,100,000. The balance sheet is brought back into balance by creating a positive translation adjustment of $69,000 that is treated as an increase in Stock holders’ Equity.

Note that the translation adjustment for 2009 is a positive $69,000 (credit balance).

The sign of the translation adjustment (positive or negative) is a function of two factors:

(1) The nature of the balance sheet exposure (asset or liability), and

(2) The change in the exchange rate (appreciation or depreciation).

In this illustration, SWISSCO has a net asset exposure (total assets translated at the current exchange rate are more than total liabilities at the cur­rent exchange rate), and the Swiss franc has appreciated, creating a positive translation adjustment.

The translation adjustment can be derived as the amount needed to bring the balance sheet back into balance.

The translation adjustment also can be calculated by considering the impact of exchange rate changes on the beginning balance and subsequent changes in the net asset position summarized as follows:

1. Translate the net asset balance of the subsidiary at the beginning of the year at the exchange rate in effect on that date.

2. Translate individual increases and decreases in the net asset balance during the year at the rates in effect when those increases and decreases occurred. Only a few events, such as net income, dividends, stock issuance, and the acquisition of treasury stock, actually change net assets. Transactions such as the acquisition of equipment or the payment of a liability have no effect on total net assets.

3. Combine the translated beginning net asset balance- (a) and the translated value of the indi­vidual changes (b) to arrive at the relative value of the net assets being held prior to the impact of any exchange rate fluctuations.

4. Translate the ending net asset balance at the current exchange rate to determine the reported value after all exchange rate changes have occurred.

5. Compare the translated value of the net assets prior to any rate changes- (c) with the ending translated value (d). The difference is the result of exchange rate changes during the period. If (c) is higher than (d), a negative (debit) translation adjustment arises. If (d) is higher than (c), a positive (credit) translation adjustment results.

Computation of Translation Adjustment:

Based on the process just described, the translation adjustment for SWISSCO in this example is calculated as follows:

Because this subsidiary began operations at the beginning of the current year, the $69,000 translation adjustment is the only amount applicable for reporting purposes. If translations had already created a balance in previous years, that beginning balance would have been combined with the $69,000 to arrive at an appropriate year-end total to be presented as other compre­hensive income within stockholders’ equity.

The translation adjustment is reported in other comprehensive income only until the foreign operation is sold or liquidated. SFAS 52 stipulates that, in the period in which sale or liquidation occurs, the cumulative translation adjustment related to the particular entity must be removed from other comprehensive income and reported as part of the gain or loss on the sale of the investment. In effect, the accumulated unrealized foreign exchange gain or loss that has been deferred in other comprehensive income becomes realized when the entity is disposed of.

Translation of the Statement of Cash Flows:

The current rate method requires translating all operating items in the statement of cash flows, at the average-for-the-period exchange rate (see Exhibit 10.6). This is the same rate used for translating income statement items. Although the ending balances in Accounts Receivable, Inventory, and Accounts Payable on the balance sheet are translated at the current exchange rate, the average rate is used for the changes in these accounts because those changes are caused by operating activities (such as sales and purchases) that are translated at the average rate.

Investing and financing activities are translated at the exchange rate on the day the activity took place. Although long-term debt is translated in the balance sheet at the current rate, in the statement of cash flows, it is translated at the historical rate when the debt was incurred.

The $(4,500) “effect of exchange rate change on cash” is a part of the overall translation adjustment of $69,000. It represents that part of the translation adjustment attributable to a decrease in Cash and is derived as a plug figure.

Remeasurement of Financial Statements—Temporal Method:

Now assume that a careful examination of the functional currency indicators outlined in SFAS 52 leads USCO’s management to conclude that SWISSCO’s functional currency is the U.S. dollar. In that case, the Swiss franc financial statements must be remeasured into U.S. dollars using the temporal method and the remeasurement gain or loss reported in income. To ensure that the remeasurement gain or loss is reported in income, it is easiest to remeasure the balance sheet first (as shown in Exhibit 10.7).

According to the procedures outlined in Exhibit 10.1, the temporal method remeasure cash, receivables, and liabilities into U.S. dollars using the current exchange rate of $0.70. Inventory (carried at FIFO cost), property and equipment, patents, and the contributed capital accounts (Common Stock and Additional Paid-in Capital) are remeasured at historical rates. These procedures result in total assets of $ 1,076,800 and liabilities and contributed capital of $895,000. To balance the balance sheet, Retained Earnings must total $181,800. We verify the accuracy of this amount later.

Remeasurement of the Income Statement:

Exhibit 10.8 shows the remeasurement of SWISSCO’s income statement and statement of retained earnings. Revenues and expenses incurred evenly throughout the year (sales, other expenses, and income taxes) are remeasured at the average exchange rate. Expenses related to assets remeasured at historical exchange rates (depreciation expense and amortization expense) are remeasured at relevant historical rates.

The following procedure remeasures cost of goods sold at historical exchange rates. Beginning inventory acquired on January 1 is remeasured at the exchange rate on that date ($0.60). Purchases made evenly throughout the year are remeasured at the average rate for the year ($0.65). Ending inventory (at FIFO cost) is purchased evenly throughout the fourth quar­ter of 2009 and the average exchange rate for the quarter ($0.68) is used to remeasure that component of cost of goods sold.

These procedures result in Cost of Goods Sold of $1,930,500, calculated as follows:

The ending balances in Retained Earnings on the balance sheet and on the statement of retained earnings must reconcile with one another. Because dividends are remeasured into a U.S. dollar equivalent of $100,500 and the ending balance in Retained Earnings on the balance sheet is $181,800, net income must be $282,300.

Reconciling the amount of income reported in the statement of retained earnings and in the income statement requires a remeasurement loss of $47,000 in calculating income. Without this remeasurement loss, the income statement, statement of retained earnings, and balance sheet are not consistent with one another.

The remeasurement loss can be calculated by considering the impact of exchange rate changes on the subsidiary’s balance sheet exposure. Under the temporal method, SWISSCO’s balance sheet exposure is defined by its net monetary asset or net monetary liability position. SWISSCO began 2009 with net monetary assets (cash) of CHF 350,000.

During the year, however, expenditures of cash and the incurrence of liabilities caused monetary liabilities (accounts payable + long-term debt = CHF 850,000) to exceed monetary assets (cash + accounts receivable = CHF 330,000). A net monetary liability position of CHF 520,000 exists at December 31, 2009.

The remeasurement loss is computed by translating the beginning net monetary asset position and subsequent changes in monetary items at appropriate exchange rates and then comparing this with the dollar value of net monetary liabilities at year-end based on the current exchange rate:

Had SWISSCO maintained its net monetary asset position (cash) of CHF 350,000 for the entire year, a $35,000 remeasurement gain would have resulted. The CHF held in cash was worth $210,000 (CHF 350,000 × $0.60) at the beginning of the year and $245,000 (CHF 350,000 × $0.70) at year-end. However, the net monetary asset position is not main­tained. Indeed, a net monetary liability position arises. The foreign currency appreciation coupled with an increase in net monetary liabilities generates a remeasurement loss for the year.

Remeasurement of the Statement of Cash Flows:

In remeasuring the statement of cash flows (shown in Exhibit 10.9), the U.S. dollar value for net income comes directly from the remeasured income statement. Depreciation and amorti­zation are remeasured at the rates used in the income statement, and the remeasurement loss is added back to net income because it is a noncash item. The increases in accounts receivable and accounts payable relate to sales and purchases and therefore are remeasured at the average rate. The U.S. dollar value for the increase in inventory is determined by referring to the remeasurement of the cost of goods sold.

The resulting U.S. dollar amount of “net cash from operations” ($474,500) is exactly the same as when the current rate method was used in translation. In addition, the investing and financing activities are translated in the same manner under both methods. This makes sense; the amount of cash inflows and outflows is a matter of fact and is not affected by the particu­lar translation methodology employed.

Nonlocal Currency Balances:

One additional issue related to the translation of foreign currency financial statements needs to be considered. If any of the accounts of the Swiss subsidiary are denominated in a currency other than the Swiss franc, those balances would first have to be restated into francs. Both the foreign currency balance and any related foreign exchange gain or loss would then be translated (or remeasured) into U.S. dollars. For example, a note payable of 10,000 British pounds first would be remeasured into Swiss francs before the translation process could commence.

Comparison of the Results from Applying the two Different Methods:

The determination of the foreign subsidiary’s functional currency (and the use of different translation methods) can have a significant impact on consolidated financial statements.

The following chart shows differences for SWISSCO in several key items under the two different translation methods:

In this illustration if the Swiss franc is determined to be SWISSCO’s functional currency (and the current rate method is applied), net income reported in the consolidated income state­ment would be 8.2 percent more than if the U.S. dollar is the functional currency (and the tem­poral method is applied). In addition, total assets would be 8.6 percent more and total equity would be 19.1 percent more using the current rate method. Because of the larger amount of equity, return on equity using the current rate method is 9.2 percent less.

Note that the current rate method does not always result in higher net income and a higher amount of equity than the temporal method. For example, had SWISSCO maintained its net mon­etary asset position, it would have computed a remeasurement gain under the temporal method leading to higher income than under the current rate method. Moreover, if the Swiss franc had depreciated during 2009, the temporal method would have resulted in higher net income.

The important point is that determining the functional currency and resulting translation method can have a significant impact on the amounts a parent company reports in its consol­idated financial statements. The appropriate determination of the functional currency is an important issue.

“Within rather broad parameters,” says Peat, Marwick, Mitchell partner James Weir, choosing the functional currency is basically a management call. So much so, in fact, that Texaco, Occi­dental, and Unocal settled on the dollar as the functional currency for most of their foreign oper­ations, whereas competitors Exxon, Mobil, and Amoco chose primarily the local currencies as the functional currencies for their foreign businesses.

Different functional currencies selected by different companies in the same industry could have a significant impact on the comparability of financial statements within that industry. Indeed, one concern that those FASB members dissenting on SFAS 52 raised was that the func­tional currency rules might not result in similar accounting for similar situations.

In addition to differences in amounts reported in the consolidated financial statements, the results of the SWISSCO illustration demonstrate several conceptual differences between the two translation methods.

Underlying Valuation Method:

Using the temporal method, SWISSCO remeasured its property and equipment as follows:

Property and equipment CHF 1,000,000 × $0.61 H = $610,000

By multiplying the historical cost in Swiss francs by the historical exchange rate, $610,000 represents the U.S. dollar-equivalent historical cost of this asset. It is the amount of U.S. dollars that the parent company would have had to pay to acquire assets having a cost of CHF 1,000,000 when the exchange rate was $0.61 per Swiss franc.

Property and equipment were translated under the current rate method as follows:

Property and equipment CHF 1,000,000 × $0.70 C = $700,000

The $700,000 amount is not readily interpretable. It does not represent the U.S. dollar equiva­lent historical cost of the asset; that amount is $610,000. Nor does it represent the U.S. dollar equivalent current cost of the asset because CHF 1,000,000 is not the current cost of the asset in Switzerland. The $700,000 amount is simply the product of multiplying two numbers together!

Underlying Relationships:

The following table reports the values for selected financial ratios calculated from the original foreign currency financial statements and from the U.S. dollar-translated statements using the two different translation methods:

The temporal method distorts all of the ratios measured in the foreign currency. The sub­sidiary appears to be less liquid more highly leveraged and more profitable than it does in Swiss franc terms.

The current rate method maintains the first three ratios but distorts return on equity. The distortion occurs because income was translated at the average-for-the-period exchange rate whereas total equity was translated at the current exchange rate. In fact, the use of the average rate for income and the current rate for assets and liabilities distorts any ratio combining bal­ance sheet and income statement figures, such as turnover ratios.

Conceptually, when the current rate method is employed income statement items can be translated at either the average or the current exchange rate. SFAS 52 requires using the aver­age exchange rate. In this illustration, if revenues and expenses had been translated at the cur­rent exchange rate, net income would have been $329,000 (CHF 470,000 × $0.70), and the return on equity would have been 57.3 percent ($329,000/$574,000), exactly the amount reflected in the Swiss franc financial statements.

Hedging Balance Sheet Exposure:

When the US. Dollar is the functional currency or when a foreign operation is located in a highly inflationary economy, remeasurement gains and losses are reported in the consolidated income statement. Management of U.S. multinational companies could wish to avoid report­ing remeasurement losses in net income because of the perceived negative impact this has on the company’s stock price. Likewise, when the foreign currency is the functional currency, management could wish to avoid negative translation adjustments because of the adverse impact on the debt to equity ratio.

More and more corporations are hedging their translation exposure—the recorded value of inter­national assets such as plant, equipment and inventory—to prevent gyrations in their quarterly accounts. Though technically only paper gains or losses, translation adjustments can play havoc with balance-sheet ratios and can spook analysts and creditors alike.

Translation adjustments and remeasurement gains or losses are functions of two factors:

(1) Changes in the exchange rate, and

(2) Balance sheet exposure.

Although a company can do little if anything to influence exchange rates, parent companies can use several techniques to hedge the balance sheet exposures of their foreign operations.

Parent companies can hedge balance sheet exposure by using a derivative financial instru­ment, such as a forward contract or foreign currency option, or a non-derivative hedging instru­ment, such as a foreign currency borrowing. To illustrate, assume that SWISSCO’s functional currency is the Swiss franc; this creates a net asset balance sheet exposure. USCO believes that the Swiss franc will depreciate, thereby generating a negative translation adjustment that will reduce consolidated stockholders’ equity. USCO could hedge this balance sheet exposure by borrowing Swiss francs for a period of time, thus creating an offsetting Swiss franc liabil­ity exposure.

As the Swiss franc depreciates the U.S. dollar value of the Swiss franc borrowing decreases and USCO will be able to repay the Swiss franc borrowing using fewer U.S. dollars. This generates a foreign exchange gain, which offsets the negative translation adjustment aris­ing from the translation of SWISSCO’s financial statements. As an alternative to the Swiss franc borrowing, USCO might have acquired a Swiss franc put option to hedge its balance sheet exposure. A put option gives the company the right to sell Swiss francs at a predeter­mined strike price.

As the Swiss franc depreciates, the fair value of the put option should increase, resulting in a gain. SFAS 133 provides that the gain or loss on a hedging instrument designated and effective as a hedge of the net investment in a foreign operation should be reported in the same manner as the translation adjustment being hedged.

Thus, the foreign exchange gain on the Swiss franc borrowing or the gain on the foreign currency option would be included in Other Comprehensive Income along with the negative translation adjustment arising from the translation of SWISSCO’s financial statements. In the event that the gain on the hedging instrument is larger than the translation adjustment being hedged, the excess is taken to net income.

The paradox of hedging a balance sheet exposure is that in the process of avoiding an unrealized translation adjustment, realized foreign exchange gains and losses can result. Consider USCO’s foreign currency borrowing to hedge a Swiss franc exposure. At the initiation of the loan, USCO converts the borrowed Swiss francs into U.S. dollars at the spot exchange rate.

When the liability matures, USCO purchases Swiss francs at the spot rate prevailing at that date to repay the loan. The change in exchange rate over the life of the loan generates a realized gain or loss. If the Swiss franc depreciates as expected, a realized foreign exchange gain that offsets the negative translation adjustment in Other Compre­hensive Income results. Although the net effect on Other Comprehensive Income is zero, a net increase in cash occurs as a result of the hedge.

If the Swiss franc unexpectedly appre­ciates, a realized foreign exchange loss occurs. This is offset by a positive translation adjustment in Other Comprehensive Income, but a net decrease in cash exists. While a hedge of a net investment in a foreign operation eliminates the possibility of reporting a negative translation adjustment in Other Comprehensive Income, gains and losses realized in cash can result.

Disclosures Related to Translation:

SFAS 52 requires firms to present an analysis of the change in the cumulative trans­lation adjustment account in the financial statements or notes thereto. Many companies com­ply with this requirement by including an Other Comprehensive Income column in their statement of stockholders’ equity. Other companies provide separate disclosure in the notes; see Exhibit 10.10 for an example of this disclosure for Sonoco Products Company.

An analysis of the Foreign Currency Translation Adjustments column indicates a positive translation adjustment $36,917 in 2004 and a negative translation adjustment of $12,844 in 2005. From the signs of these adjustments, one can infer that, in aggregate, the foreign curren­cies in which Sonoco has operations appreciated against the U.S. dollar in 2004 and depreciated against the U.S. dollar in 2005.

Although not specifically required to do so, many companies describe their translation pro­cedures in their “summary of significant accounting policies” in the notes to the financial statements.

The following excerpt from International Business Machines Corporation’s 2005 annual report illustrates this type of disclosure:

Translation of Non-U.S. Currency Amounts:

Assets and liabilities of non-U.S. subsidiaries that have a local functional currency are translated to U.S. dollars at year-end exchange rates. Income and expense items are translated at weighted-average rates of exchange prevailing dur­ing the year. Translation adjustments are recorded in Accumulated gains and losses not affecting retained earnings in the Consolidated Statement of Stockholders’ Equity.

Inventories, plant, rental machines and other properties—net, and other non-monetary assets and liabilities of non-U.S. subsidiaries and branches that operate in U.S. dollars, or whose eco­nomic environment is highly inflationary, are translated at approximate exchange rates prevail­ing when the company acquired the assets or liabilities. All other assets and liabilities are translated at year-end exchange rates.

Cost of sales and depreciation are translated at historical exchange rates. All other income and expense items are translated at the weighted-average rates of exchange prevailing during the year. These translation gains and losses are included in net income for the period in which exchange rates change.

Consolidation of a Foreign Subsidiary:

The procedures used to consolidate a foreign subsidiary’s financial statements with those of its parent is demonstrated here. The treatment of the excess of fair value over book value requires special attention. As an item denominated in foreign cur­rency, translation of the excess gives rise to a translation adjustment recorded on the con­solidation worksheet.

On January 1, 2008, Altman, Inc., a U.S.-based manufacturing firm, acquired 100 percent of Bradford Ltd. in Great Britain. Altman paid £25,000,000, which was equal to Bradford’s fair value.

The £2,300,000 excess of fair value over book value resulted from undervalued land (part of plant and equipment) and therefore is not subject to amortization. Altman uses the equity method to account for its investment in Bradford.

On December 31, 2009, two years after the acquisition date, Bradford submitted the fol­lowing trial balance for consolidation (credit balances are in parentheses):

Translation of Foreign Subsidiary Trial Balance:

The initial step in consolidating the foreign subsidiary is to translate its trial balance from British pounds into U.S. dollars. Because the British pound has been determined to be the functional currency, this translation uses the current rate method. The historical exchange rate for translating Bradford’s common stock and January 1, 2008, retained earnings is the exchange rate that existed at the acquisition date—$ 1.51.

A positive (credit balance) cumulative translation adjustment is required to make the trial balance actually balance.

The cumulative translation adjustment is calculated as follows:

The translation adjustment in 2008 is positive because the British pound appreciated that year; the translation adjustment in 2009 is negative because the British pound depreciated.

Determination of Balance in Investment Account—Equity Method:

The original value of the investment in Bradford the net income earned by Bradford and the div­idends paid by Bradford are all denominated in British pounds. Relevant amounts must be trans­lated from pounds into U.S. dollars so Altman can account for its investment in Bradford under the equity method. In addition, the translation adjustment calculated each year is included in the Investment in Bradford account to update the foreign currency investment to its US. Dollar equivalent.

The counterpart is recorded as a translation adjustment on Altman’s books:

In addition to Altman’s $44,783,000 investment in Bradford, it has equity income on its December 31, 2009, trial balance in the amount of $6,122,500.

Consolidation Worksheet:

Once the subsidiary’s trial balance has been translated into dollars and the carrying value of the investment is known, the consolidation worksheet at December 31, 2009, can be prepared. As is true in the consolidation of domestic subsidiaries, the investment account, the sub­sidiary’s equity accounts, and the effects of intercompany transactions must be eliminated. The excess of fair value over book value at the date of acquisition also must be allocated to the appropriate accounts (in this example, plant and equipment).

Unique to the consolidation of foreign subsidiaries is the fact that the excess of fair value over book value, denominated in foreign currency, also must be translated into the parent’s reporting currency. When the foreign currency is the functional currency, the excess is translated at the current exchange rate with a resulting translation adjustment. The excess is not carried on either the parent’s or the subsidiary’s books but is recorded only in the consolidation worksheet.

Neither the parent nor the subsidiary has recognized the translation adjustment related to the excess, and it must be recorded in the consolidation worksheet. Exhibit 10.11 presents the consolidation worksheet of Altman and Bradford at December 31, 2009.

Explanation of Consolidation Entries:

S—Eliminates the subsidiary’s stockholders’ equity accounts as of the beginning of the current year along with the equivalent book value component within the original value of the Investment in Bradford account.

A—Allocates the excess of fair value over book value at the date of acquisition to land (plant and equipment) and eliminates that amount within the original value of the Invest­ment in Bradford account.

I—Eliminates the amount of equity income recognized by the parent in the current year and included in the Investment in Bradford account under the equity method.

D—Eliminates the subsidiary’s dividend payment that was a reduction in the Investment in Bradford account under the equity method.

T—Eliminates the cumulative translation adjustment included in the Investment in Brad­ford account under the equity method and eliminates the cumulative translation adjust­ment carried on the parent’s books.

E—Revalues the excess of fair value over book value for the change in exchange rate since the date of acquisition with the counterpart recognized as an increase in the consoli­dated cumulative translation adjustment.

The revaluation is calculated as follows: