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FOREX Transilition
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Foreign Currency Translation FCT commonly known as Accounting
Exposure, arises because financial statements of foreign affiliates which are stated in a foreign currency, must be restated in the parent company's reporting currency to prepare consolidated financial statements
Foreign Currency Translation To consolidate statements, the following
must be consolidated:LanguageAccounting Concepts Currency
What should be included in consolidated statements?Narrow View: Consolidated statements should
include the parent firm and all domestic subsidiaries
Wide View: All subsidiaries, regardless of location, should be consolidated.
Why currency Translation needed?
• Manny company having subsidiary company in other country
• Different country having different accounting rules
Translation Methods: Example• Suppose you had 100 British pounds on deposit
in a London bank at the end of 1993 when the exchange rate is $1.80. To report the deposit on your 1994 Balance Sheet stated in dollars, you would translate the deposit at the current rate and you would report an asset of $180.
• At the end of 1994, you still have the 100 pounds in the bank, but now the exchange rate is $1.70. To report the deposit on your 1994 Balance Sheet, it would now translate into $170 and you would have an imbalance of $10 to deal with.
Translation Methods: Example If you translated at the historical rate, you
would still translate into $180 and there would be no imbalance
Exchange Rates
Current rate--exchange rate prevailing as of the financial statement date
Historical rate--exchange rate prevailing when a foreign currency asset was first acquired or a foreign currency liability was first incurred
Average rate--simple or weighted average of either current or historical exchange rates
Two Major Issues
Which exchange rate should be used to translate foreign currency balances to domestic currency?
How should translation gains and losses be accounted for? Should they be included in income?
Translation methods may employ a single rate or multiple rates.
Translation Methods
Current/Noncurrent Method Monetary/Nonmonetary Method Temporal Method Current Rate Method
Translation Models• Current-Noncurrent Model
– Current items on the balance sheet are translated at the current rate.
– Long-term items on the balance sheet are translated at the historical rate.
– This method of foreign currency translation was generally accepted in the United States from the 1930 to1975
COGS is translated at the current rate (it is based on inventory, a current asset)
Depreciation is translated at the appropriate historical rate based on the date of acquisition of the assets
Under this method, a foreign subsidiary with current assets in excess of current liability will cause a translation gain (loss) if the local currency appreciates (depreciates)
Current/Noncurrent MethodCurrent
assets translated at the spot rate.
e.g. DM2=$1Noncurrent
assets translated at the historical rate in effect when the item was first recorded on the books.
e.g. DM3=$1
Balance Sheet Local Currency
Current/ Noncurrent
Cash 2,100 DM $1,050 Inventory 1,500 DM $750 Net fixed assets 3,000 DM $1,000
Total Assets 6,600 DM $2,800 Current liabilities 1,200 DM $600 Long-Term debt 1,800 DM $600 Common stock 2,700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and
Equity6,600 DM $2,800
Monetary/Nonmonetary Method• All monetary balance sheet accounts (cash,
marketable securities, accounts receivable, notes payable, accounts payable etc.) of a foreign subsidiary are translated at the current exchange rate.
• All other nonmonetary balance sheet accounts (owners’ equity, fixed assets, long term investments, and inventories) are translated at the historical exchange rate in effect when the account was first recorded.
Monetary/Nonmonetary Method All monetary balance sheet accounts are translated at the current exchange rate. e.g. DM2=$1
All other balance sheet accounts are translated at the historical exchange rate in effect when the account was first recorded. e.g.DM3=$1
Balance Sheet Local Currency
Monetary/ Nonmonetary
Cash 2,100 DM $1,050 Inventory 1,500 DM $500 Net fixed assets 3,000 DM $1,000
Total Assets 6,600 DM $2,550 Current liabilities 1,200 DM $600 Long-Term debt 1,800 DM $900 Common stock 2,700 DM $900 Retained earnings 900 DM $150CTA -------- --------Total Liabilities and
Equity6,600 DM $2,550
difference between Current-Noncurrent and Monetary-Nonmonetary
This method differs substantially
with respect to accounts such as inventory, long-term receivables and long-term debt
Temporal Method
• The underlying principal is that assets and liabilities should be translated based on how they are carried on the firm’s books.
• Balance sheet account are translated at the current exchange rate if they are carried on the books at their current value.
• Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books.
Temporal Method• Items carried on
the books at their current value are translated at the spot exchange rate.e.g. DM2=$1
• Items that are carried on the books at historical costs are translated at the historical exchange rates. e.g. DM3=$1
Balance Sheet Local Currency
Temporal
Cash 2,100 DM $1,050 Inventory 1,500 DM $900Net fixed assets 3,000 DM $1,000
Total Assets 6,600 DM $2,950 Current liabilities 1,200 DM $600 Long-Term debt 1,800 DM $900 Common stock 2,700 DM $900 Retained earnings 900 DM $550CTA -------- --------Total Liabilities and
Equity6,600 DM $2,950
Current Rate Method All balance sheet items (except for
stockholder’s equity) are translated at the current exchange rate.
Very simple method in application. A “plug” equity account named cumulative
translation adjustment is used to make the balance sheet balance
Translation gains or losses do not go through the income statement according to this method
Current Rate Method• All balance
sheet items (except for stockholder’s equity) are translated at the current exchange rate.
• A “plug” equity account named cumulative translation adjustment is used to make the balance sheet balance
Balance Sheet Local Currency
Current Rate
Cash DM2,100 $1,050 Inventory DM1,500 $750 Net fixed assets DM3,000 $1,500
Total Assets DM6,600 $3,300 Current liabilities DM1,200 $600 Long-Term debt DM1,800 $900 Common stock DM2,700 $900 Retained earnings DM900 $360 CTA -------- $540
Total Liabilities and Equity
DM6,600 $3,300
How Various Translation Methods Deal with a Change from DM3 to DM2 = $1Balance Sheet Local
CurrencyCurrent/
Noncurrent Monetary/
NonmonetaryTemporal Current
RateCash 2,100 DM $1,050 $1,050 $1,050 $1,050 Inventory 1,500 DM $750 $500 $900 $750 Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300 Current liabilities
1,200 DM $600 $600 $600 $600
Long-Term debt
1,800 DM $600 $900 $900 $900
Common stock 2,700 DM $900 $900 $900 $900 Retained earnings
900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540
Total Liabilities and
Equity
6,600 DM $2,800 $2,550 $2,950 $3,300
Spot exchange rate
earnings
How Various Translation Methods Deal with a Change from DM3 to DM2 = $1Balance Sheet Local
CurrencyCurrent/
Noncurrent Monetary/
NonmonetaryTemporal Current
RateCash 2,100 DM $1,050 $1,050 $1,050 $1,050 Inventory 1,500 DM $750 $500 $900 $750 Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300 Current liabilities
1,200 DM $600 $600 $600 $600
Long-Term debt
1,800 DM $600 $900 $900 $900
Common stock 2,700 DM $900 $900 $900 $900 Retained earnings
900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540
Total Liabilities and
Equity
6,600 DM $2,800 $2,550 $2,950 $3,300
Book value of inventory at spot exchange rate
Book value of
inventory historic
rate
Current value of inventory at spot exchange rate.
earnings
How Various Translation Methods Deal with a Change from DM3 to DM2 = $1Balance Sheet Local
CurrencyCurrent/
Noncurrent Monetary/
NonmonetaryTemporal Current
RateCash 2,100 DM $1,050 $1,050 $1,050 $1,050 Inventory 1,500 DM $750 $500 $900 $750 Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300 Current liabilities
1,200 DM $600 $600 $600 $600
Long-Term debt
1,800 DM $600 $900 $900 $900
Common stock 2,700 DM $900 $900 $900 $900 Retained earnings
900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540
Total Liabilities and
Equity
6,600 DM $2,800 $2,550 $2,950 $3,300
historic rate
spot exchange rate.
earnings
How Various Translation Methods Deal with a Change from DM3 to DM2 = $1Balance Sheet Local
CurrencyCurrent/
Noncurrent Monetary/
NonmonetaryTemporal Current
RateCash 2,100 DM $1,050 $1,050 $1,050 $1,050 Inventory 1,500 DM $750 $500 $900 $750 Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300 Current liabilities
1,200 DM $600 $600 $600 $600
Long-Term debt
1,800 DM $600 $900 $900 $900
Common stock 2,700 DM $900 $900 $900 $900 Retained earnings
900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540
Total Liabilities and
Equity
6,600 DM $2,800 $2,550 $2,950 $3,300
spot rate
earnings
How Various Translation Methods Deal with a Change from DM3 to DM2 = $1Balance Sheet Local
CurrencyCurrent/
Noncurrent Monetary/
NonmonetaryTemporal Current
RateCash 2,100 DM $1,050 $1,050 $1,050 $1,050 Inventory 1,500 DM $750 $500 $900 $750 Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300 Current liabilities
1,200 DM $600 $600 $600 $600
Long-Term debt
1,800 DM $600 $900 $900 $900
Common stock 2,700 DM $900 $900 $900 $900 Retained earnings
900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540
Total Liabilities and
Equity
6,600 DM $2,800 $2,550 $2,950 $3,300
spot ratehistorical rate
earnings
How Various Translation Methods Deal with a Change from DM3 to DM2 = $1Balance Sheet Local
CurrencyCurrent/
Noncurrent Monetary/
NonmonetaryTemporal Current
RateCash 2,100 DM $1,050 $1,050 $1,050 $1,050 Inventory 1,500 DM $750 $500 $900 $750 Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300 Current liabilities
1,200 DM $600 $600 $600 $600
Long-Term debt
1,800 DM $600 $900 $900 $900
Common stock 2,700 DM $900 $900 $900 $900 Retained earnings
900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540
Total Liabilities and
Equity
6,600 DM $2,800 $2,550 $2,950 $3,300
historical rate
earnings
How Various Translation Methods Deal with a Change from DM3 to DM2 = $1Balance Sheet Local
CurrencyCurrent/
Noncurrent Monetary/
NonmonetaryTemporal Current
RateCash 2,100 DM $1,050 $1,050 $1,050 $1,050 Inventory 1,500 DM $750 $500 $900 $750 Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300 Current liabilities
1,200 DM $600 $600 $600 $600
Long-Term debt
1,800 DM $600 $900 $900 $900
Common stock 2,700 DM $900 $900 $900 $900 Retained earnings
900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540
Total Liabilities and
Equity
6,600 DM $2,800 $2,550 $2,950 $3,300
From income statement
earnings
How Various Translation Methods Deal with a Change from DM3 to DM2 = $1
Balance Sheet Local Currency
Current/ Noncurrent
Monetary/ Nonmonetary
Temporal Current Rate
Cash 2,100 DM $1,050 $1,050 $1,050 $1,050 Inventory 1,500 DM $750 $500 $900 $750 Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500
Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300 Current liabilities
1,200 DM $600 $600 $600 $600
Long-Term debt
1,800 DM $600 $900 $900 $900
Common stock 2,700 DM $900 $900 $900 $900 Retained earnings
900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540
Total Liabilities and
Equity
6,600 DM $2,800 $2,550 $2,950 $3,300
Under the current rate method, a “plug” equity account named cumulative translation adjustment makes the balance sheet balance.
earnings
How Various Translation Methods Deal with a Change from DM3 to DM2 = $1
Income StatementLocal
CurrencyCurrent/
Noncurrent Monetary/
NonmonetaryTemporal Current
RateSales 10,000 DM $4,000 $4,000 $4,000 $4,000COGS 7,500 DM $3,000 $2,500 $3,000 $3,000Depreciation 1,000 DM $333 $333 $333 $400Net operating income 1,500 DM $667 $1,167 $667 $600Income tax (40%) 600 DM $267 $467 $267 $240Profit after tax 900 DM $400 $700 $400 $360
$300 -$550 $150Net income 900 DM $700 $150 $550 $360Dividends 0 DM $0 $0 $0 $0Addition to Retained
Earnings 900 DM $700 $150 $550 $360
Foreign exchange gain (loss)
Sales translate at average exchange rate over the period, DM2.50 = $1
How Various Translation Methods Deal with a Change from DM3 to DM2 = $1
Income StatementLocal
CurrencyCurrent/
Noncurrent Monetary/
NonmonetaryTemporal Current
RateSales 10,000 DM $4,000 $4,000 $4,000 $4,000COGS 7,500 DM $3,000 $2,500 $3,000 $3,000Depreciation 1,000 DM $333 $333 $333 $400Net operating income 1,500 DM $667 $1,167 $667 $600Income tax (40%) 600 DM $267 $467 $267 $240Profit after tax 900 DM $400 $700 $400 $360
$300 -$550 $150Net income 900 DM $700 $150 $550 $360Dividends 0 DM $0 $0 $0 $0Addition to Retained
Earnings 900 DM $700 $150 $550 $360
Foreign exchange gain (loss)
Translate at DM2.50 = $1 Translate at new exchange rate, DM3.00 = $1
How Various Translation Methods Deal with a Change from DM3 to DM2 = $1
Income StatementLocal
CurrencyCurrent/
Noncurrent Monetary/
NonmonetaryTemporal Current
RateSales 10,000 DM $4,000 $4,000 $4,000 $4,000COGS 7,500 DM $3,000 $2,500 $3,000 $3,000Depreciation 1,000 DM $333 $333 $333 $400Net operating income 1,500 DM $667 $1,167 $667 $600Income tax (40%) 600 DM $267 $467 $267 $240Profit after tax 900 DM $400 $700 $400 $360
$300 -$550 $150Net income 900 DM $700 $150 $550 $360Dividends 0 DM $0 $0 $0 $0Addition to Retained
Earnings 900 DM $700 $150 $550 $360
Foreign exchange gain (loss)
Translate at DM3 = $1 Translate at average exchange rate, DM2.5 = $1
How Various Translation Methods Deal with a Change from DM3 to DM2 = $1
Income StatementLocal
CurrencyCurrent/
Noncurrent Monetary/
NonmonetaryTemporal Current
RateSales 10,000 DM $4,000 $4,000 $4,000 $4,000COGS 7,500 DM $3,000 $2,500 $3,000 $3,000Depreciation 1,000 DM $333 $333 $333 $400Net operating income 1,500 DM $667 $1,167 $667 $600Income tax (40%) 600 DM $267 $467 $267 $240Profit after tax 900 DM $400 $700 $400 $360
$300 -$550 $150Net income 900 DM $700 $150 $550 $360Dividends 0 DM $0 $0 $0 $0Addition to Retained
Earnings 900 DM $700 $150 $550 $360
Foreign exchange gain (loss)
Note the effect on after-tax profit.
How Various Translation Methods Deal with a Change from DM3 to DM2 = $1
Income StatementLocal
CurrencyCurrent/
Noncurrent Monetary/
NonmonetaryTemporal Current
RateSales 10,000 DM $4,000 $4,000 $4,000 $4,000COGS 7,500 DM $3,000 $2,500 $3,000 $3,000Depreciation 1,000 DM $333 $333 $333 $400Net operating income 1,500 DM $667 $1,167 $667 $600Income tax (40%) 600 DM $267 $467 $267 $240Profit after tax 900 DM $400 $700 $400 $360
$300 -$550 $150Net income 900 DM $700 $150 $550 $360Dividends 0 DM $0 $0 $0 $0Addition to Retained
Earnings 900 DM $700 $150 $550 $360
Foreign exchange gain (loss)
Note the effect that foreign exchange gains (losses) has on net income.