CHAPTER 8
TRANSLATION OF FOREIGN CURRENCY
FINANCIAL STATEMENTS
Chapter Outline
I. In preparing consolidated financial statements on a worldwide basis, the foreign currency
financial statements prepared by foreign operations must be translated into the parent
company’s reporting currency.
A. The two major issues related to the translation of foreign currency financial statements
are: (1) which method should be used, and (2) where should the resulting translation
adjustment be reported in the consolidated financial statements.
B. Translation methods differ on the basis of which accounts are translated at the current
exchange rate and which are translated at historical rates. Accounts translated at the
current exchange rate are exposed to translation adjustment (balance sheet
exposure).
C. Different translation methods give rise to different concepts of balance sheet exposure
and translation adjustments of differing sign and magnitude.
II. Under the current rate method, all assets and liabilities are translated at the current
exchange rate giving rise to a balance sheet exposure equal to the foreign subsidiary’s net
assets. Stockholders’ equity accounts are translated at historical exchange rates. Income
statement items are translated at the average exchange rate for the current period.
A. Appreciation of the foreign currency results in a positive translation adjustment;
depreciation of the foreign currency results in a negative translation adjustment.
B. Translating all assets and liabilities at the current exchange rate maintains the
relationships that exist in the foreign currency financial statements.
B. Translating assets carried at historical cost at the current exchange rate results in
amounts being reported on the parent’s consolidated balance sheet that have no
economic meaning.
III. Under the temporal method, assets carried at current or future value (cash, marketable
securities, receivables) and liabilities are remeasured at the current exchange rate. Assets
carried at historical cost and stockholders’ equity accounts are remeasured at historical
exchange rates. Expenses related to assets remeasured at historical exchange rates are
remeasured using the same rates. Other income statements items are remeasured using
the average exchange rate for the period.
A. When liabilities are greater than the sum of cash, marketable securities, and
receivables, a net liability balance sheet exposure exists. Appreciation of the foreign
currency results in a remeasurement loss; depreciation of the foreign currency results
in a remeasurement gain.
B. Remeasuring assets carried at historical cost at historical exchange rates maintains
the underlying valuation method used by the foreign operation in preparing its financial
statements.
C. Remeasuring some assets at historical exchange rates and other assets at the current
exchange rate distorts the relationships that exist among account balances in the
foreign currency financial statements.
IV. The appropriate combination of translation method and disposition of translation
adjustment is determined under both IFRS and U.S. GAAP by identifying the functional
currency of a foreign operation.
A. The financial statements of a foreign operation whose functional currency is different
from the parent’s reporting currency are translated using the current rate method, with
the resulting translation adjustment deferred in stockholders’ equity until the foreign
entity is disposed of. Upon disposal of the foreign operation, the accumulated
translation adjustment is recognized as a gain or loss in net income.
B. The financial statements of foreign operations whose functional currency is the same
as the parent’s reporting currency are remeasured using the temporal method with the
resulting remeasurement gain or loss reported immediately in net income.
V. The factors used to determine the functional currency of a foreign operation differ under
IFRS and U.S. GAAP.
A. IAS 21 indicates that two factors are of primary importance in determining a foreign
entity’s functional currency. If the functional currency is not obvious after evaluating
these factors, then a secondary set of six factors should be considered.
B. The FASB provides six factors that should be considered in determining functional
currency under U.S. GAAP, but no guidance is provided with respect to how these
factors should be weighted in the analysis. As a result, it is possible that a foreign
subsidiary could be viewed as having one functional currency under IFRS and a
different functional currency under U.S. GAAP.
VI. A substantive difference in translation rules between IFRS and U.S. GAAP relates to
foreign operations that report in the currency of a hyperinflationary economy.
A. IAS 21 requires a restate-translate method in translating the financial statements of
foreign operations located in a hyperinflationary economy. The foreign financial
statements are first restated for foreign inflation using rules in IAS 29, and then are
translated into parent company currency using the current rate method. IAS 29 does
not provide a bright-line threshold (as does U.S. GAAP) for determining whether a
foreign country is experiencing hyperinflation.
B. U.S. GAAP requires the financial statements of foreign operations in a highly
inflationary economy to be translated using the temporal method, as if the parent
currency is the functional currency. Under A country is considered highly inflationary if
its cumulative three-year inflation rate exceeds 100%.
VII. Some companies hedge their balance sheet exposures to avoid reporting remeasurement
losses in income and/or negative translation adjustments in stockholder’s equity. In
addition to derivative financial instruments, such as forward contracts and options,
companies often use foreign currency borrowings to hedge their net investment in a
foreign operation.
A. Both IFRS and U.S. GAAP provide that the gain or loss on a hedging instrument that is
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.
B. The paradox in hedging balance sheet exposure is that by avoiding an unrealized
translation adjustment or remeasurement gain/loss, realized foreign exchange gains
and losses can arise.