CHAPTER 15

MULTINATIONAL OPERATIONS

Timothy S. Doupnik

Columbia, SC, U.S.A.

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

• Distinguish among presentation currency, functional currency, and local currency.
• Analyze the impact of changes in exchange rates on the translated sales of the subsidiary and parent company.
• Compare and contrast the current rate method and the temporal method, evaluate the effects of each on the parent company’s balance sheet and income statement, and determine which method is appropriate in various scenarios.
• Calculate the translation effects, evaluate the translation of a subsidiary’s balance sheet and income statement into the parent company’s currency, and analyze the different effects of the current rate method and the temporal method on the subsidiary’s financial ratios.
• Analyze the effect on a parent company’s financial ratios of the currency translation method used.
• Analyze the effect of alternative translation methods for subsidiaries operating in hyperinflationary economies.

1. INTRODUCTION

According to the World Trade Organization, merchandise exports worldwide exceeded US$10 trillion in 2005.1 The top five exporting countries, in order, were Germany, the United States, China, Japan, and France. From 2000 to 2005, international trade grew by 62 percent.

The U.S. Department of Commerce identified 239,100 U.S. companies as exporters in 2005. Only 3 percent of those companies were large (more than 500 employees). The vast majority of U.S. companies with export activity were small- or medium-sized entities.

The point made by these statistics is that many companies engage in transactions that cross national borders. The parties to these transactions must agree on the currency in which to settle the transaction. Generally this will be the currency of either the buyer or the seller. Exporters that receive payment in foreign currency and allow the purchaser time to pay must carry a foreign currency receivable on their books. Conversely, importers that agree to pay in foreign currency will have a foreign currency account payable. To be able to include them in the total amount of accounts receivable (payable) reported on the balance sheet, these foreign currency-denominated accounts receivable (payable) must be translated into the currency in which the exporter (importer) keeps its books and presents financial statements.

The prices at which foreign currencies can be purchased or sold are called foreign exchange rates. Because foreign exchange rates fluctuate over time, the value of foreign currency payables and receivables also fluctuates. The major accounting issue related to foreign currency transactions is how to reflect the changes in value for foreign currency payables and receivables in the financial statements.

Many companies have operations located in foreign countries. As examples, the Swiss food products company Nestlé SA reports that it has subsidiaries in more than 90 different countries, and U.S.-based Coca-Cola Company discloses that it has 144 foreign wholly owned subsidiaries located in 40 countries around the world. Foreign subsidiaries are generally required to keep accounting records in the currency of the country in which they are located. To prepare consolidated financial statements, the parent company must translate the foreign currency financial statements of its foreign subsidiaries into its own currency. Nestlé, for example, must translate the assets and liabilities its various foreign subsidiaries carry in foreign currency into Swiss francs to be able to consolidate those amounts with the Swiss franc assets and liabilities located in Switzerland.

A multinational company like Nestlé is likely to have two types of foreign currency activities that require special accounting treatment. Most multinationals (1) engage in transactions that are denominated in a foreign currency, and (2) invest in foreign subsidiaries that keep their books in a foreign currency. To prepare consolidated financial statements, a multinational company must translate the foreign currency amounts related to both types of international activities into the currency in which the company presents its financial statements.

This reading presents the accounting for foreign currency transactions and the translation of foreign currency financial statements. The conceptual issues related to these accounting topics are discussed and the specific rules embodied in International Financial Reporting Standards (IFRS) and U.S. GAAP are demonstrated through examples. Fortunately, differences between IFRS and U.S. GAAP with respect to foreign currency translation issues are minimal.

Analysts need to understand the impact that fluctuations in foreign exchange rates have on the financial statements of a multinational company and how foreign currency gains and losses, whether realized or not, are reflected in the company’s financial statements.

2. FOREIGN CURRENCY TRANSACTIONS

When companies from different countries agree to conduct business with one another, they must decide which currency will be used. For example, if a Mexican electronic components manufacturer agrees to sell goods to a customer in Finland, the two parties must agree whether the Finnish company will pay for the goods in Mexican pesos, euros, or perhaps even a third currency such as the U.S. dollar. If the transaction is denominated in Mexican pesos, the Finnish company has a foreign currency transaction but the Mexican company does not. To account for the inventory being purchased and the account payable in Mexican pesos, the Finnish company must translate the Mexican peso amounts into euros using appropriate exchange rates. Although the Mexican company also has entered into an international transaction (an export sale), it does not have a foreign currency transaction and no translation is necessary. It simply records the sales revenue and account receivable in Mexican pesos, which is the currency in which it keeps its books and prepares financial statements.

The currency in which financial statement amounts are presented is known as the presentation currency. In most cases, the presentation currency of a company will be the currency of the country where the company is located. Finnish companies are required to keep accounting records and present financial results in euros, U.S. companies in U.S. dollars, Chinese companies in Chinese yuan, and so on.

Another important concept in accounting for foreign currency activities is the functional currency, which is the currency of the primary economic environment in which an entity operates. Normally, the functional currency is the currency in which an entity primarily generates and expends cash. In most cases, the functional currency of an entity will be the same as its presentation currency. And, because most companies primarily generate and expend cash in the currency of the country where they are located, the functional and presentation currencies are most often the same as the local currency where the company operates.

Because the local currency generally is an entity’s functional currency, a multinational corporation with subsidiaries in a variety of different countries is likely to have a variety of different functional currencies. The Thai subsidiary of a Japanese parent company, for example, is likely to have the Thai baht as its functional currency whereas the Japanese parent’s functional currency is the Japanese yen. But in some cases, the foreign subsidiary could have the parent’s functional currency as its own. Intel Corporation, for example, has determined that all of its significant foreign subsidiaries have the U.S. dollar as their functional currency.

By definition, a foreign currency is any currency other than the functional currency of a company and foreign currency transactions are transactions that are denominated in a currency other than the company’s functional currency. Foreign currency transactions occur when a company (1) makes an import purchase or an export sale that is denominated in a foreign currency, or (2) borrows or lends funds where the amount to be repaid or received is denominated in a foreign currency. In each of these cases, the company has an asset or a liability that is denominated in a foreign currency.

2.1. Foreign Currency Transaction Exposure to Foreign Exchange Risk

Assume that FinnCo, a Finnish-based company, imports goods from Mexico in January under 90-day credit terms and the purchase is denominated in Mexican pesos. By deferring payment until April, FinnCo runs the risk that from the date the purchase is made until the date of payment, the value of the Mexican peso might increase relative to the euro. FinnCo would then need to spend more euros to settle its Mexican peso account payable. In this case, FinnCo is said to have an exposure to foreign exchange risk. Specifically, FinnCo has a foreign currency transaction exposure. Transaction exposure related to imports and exports can be summarized as follows:

Import purchase: A transaction exposure arises when the importer is obligated to pay in foreign currency and is allowed to defer payment until sometime after the purchase date. The importer is exposed to the risk that from the purchase date until the payment date the foreign currency might increase in value, thereby increasing the amount of functional currency that must be spent to acquire enough foreign currency to settle the account payable.

Export sale: A transaction exposure arises when the exporter agrees to be paid in foreign currency and allows payment to be made sometime after the purchase date. The exporter is exposed to the risk that from the purchase date until the payment date the foreign currency might decrease in value, thereby decreasing the amount of functional currency into which the foreign currency can be converted when it is received.

The major issue in accounting for foreign currency transactions is how to account for the foreign currency risk; that is, how to reflect in the financial statements the change in value of the foreign currency asset or liability. Both International Accounting Standard (IAS) 21, “The Effects of Changes in Foreign Exchange Rates,” and FASB Statement (SFAS) 52, “Foreign Currency Translation,” require the change in the value of the foreign currency asset or liability resulting from a foreign currency transaction to be treated as a gain or loss reported on the income statement.2

2.1.1. Accounting for Foreign Currency Transactions with Settlement before Balance Sheet Date

Example 15-1 demonstrates the accounting that would be done by FinnCo assuming that it purchased goods on account from a Mexican supplier who required payment in Mexican pesos, and that it made payment before the balance sheet date. The basic principle is that all transactions are recorded at the spot rate on the date of the transaction. The foreign currency risk on transactions, therefore, only arises when the transaction date and the payment date are different.

2.1.2. Accounting for Foreign Currency Transactions with Intervening Balance Sheet Dates

Another important issue related to the accounting for foreign currency transactions is what should be done, if anything, if a balance sheet date falls between the initial transaction date and the settlement date. For foreign currency transactions that occur with settlement dates that fall in subsequent accounting periods, both IFRS and U.S. GAAP require adjustments to reflect intervening changes in currency exchange rates. Foreign currency transaction gains and losses are reported on the income statement, creating one of the very few situations in which accounting rules allow, indeed require, companies to include (recognize) an unrealized gain or loss in income before it has been realized.

Subsequent foreign currency transaction gains and losses are recognized from the balance sheet date through the date the transaction is settled. Adding together foreign currency transaction gains and losses for both accounting periods (transaction initiation to balance sheet date and balance sheet date to transaction settlement) produces an amount equal to the actual realized gain or loss on the foreign currency transaction.

In Example 15-2, FinnCo’s British pound account receivable resulted in a net foreign currency transaction gain because the British pound strengthened (increased) in value between the transaction date and the settlement date. In this case FinnCo has an asset exposure to foreign exchange risk. This asset exposure benefited the company because the foreign currency strengthened. If FinnCo instead had a British pound account payable, a liability exposure would have existed. The euro value of the British pound account payable would have increased as the British pound strengthened and FinnCo would have recognized a foreign currency transaction loss as a result.

Whether a change in exchange rate results in a foreign currency transaction gain or loss depends on (1) the nature of the exposure to foreign exchange risk (asset or liability) and (2) the direction of change in the value of the foreign currency (strengthens or weakens).

A foreign currency receivable arising from an export sale creates an asset exposure to foreign exchange risk. If the foreign currency strengthens, the receivable increases in value in terms of the company’s functional currency and a foreign currency transaction gain arises. The company will be able to convert the foreign currency when received into more units of functional currency because the foreign currency has strengthened. Conversely, if the foreign currency weakens, the foreign currency receivable loses value in terms of the functional currency and a loss results.

A foreign currency payable resulting from an import purchase creates a liability exposure to foreign exchange risk. If the foreign currency strengthens, the payable increases in value in terms of the company’s functional currency and a foreign currency transaction loss arises. The company will have to spend more units of functional currency to be able to settle the foreign currency liability because the foreign currency has strengthened. Conversely, if the foreign currency weakens, the foreign currency payable loses value in terms of the functional currency and a gain exists.

2.2. Analytical Issues

Both IFRS (IAS 21) and U.S. GAAP (FASB 52) require foreign currency transaction gains and losses to be reported in net income (even if they have not yet been realized), but neither standard indicates where on the income statement these gains and losses should be placed. The two most common treatments are (1) as a component of other operating income/expense or (2) as a component of nonoperating income/expense, in some cases as a part of net financing cost. The calculation of operating profit margin is affected by where foreign currency transaction gains or losses are placed on the income statement.

Because accounting standards do not provide guidance on the placement of foreign currency transaction gains and losses on the income statement, companies are free to choose among the alternatives. Two companies in the same industry could choose different alternatives, which would distort the direct comparison of operating profit and operating profit margins between those companies.

A second issue that should be of interest to analysts relates to the fact that unrealized foreign currency transaction gains and losses are included in net income when the balance sheet date falls between the transaction and settlement dates. The implicit assumption underlying this accounting requirement is that the unrealized gain or loss as of the balance sheet date is reflective of the ultimate net gain or loss to the company. In reality, though, the ultimate net gain or loss may vary dramatically because of the possibility for changes in trend and volatility of currency prices.

This effect was seen in the previous hypothetical Example 15-2 with FinnCo. Using actual currency exchange rate data shows that the real-world effect can also be quite dramatic. Assume that a French company purchased goods from a Canadian supplier on 1 December 2006, with payment of 100,000 Canadian dollars (C$) to be made on 15 May 2007. Actual exchange rates between the Canadian dollar and euro during the period 1 December 2006 and 15 May 2007, the euro value of the Canadian dollar account payable, and foreign currency transaction gain or loss are shown here:

As the Canadian dollar weakened against the euro in late 2006 and early 2007, the French company would have recorded a foreign currency transaction gain of €1,520 in the fourth quarter of 2006 and an additional transaction gain of €140 in the first quarter of 2007. The Canadian dollar reversed course and strengthened against the euro in the second quarter of 2007, resulting in a transaction loss of €1,680. At the time payment is made on 15 May 2007, the French company realizes a net foreign currency transaction loss of €20 (€66,580 − €66,560). In this case, the transaction gains reported in net income in 2006 and the first quarter of 2007 did not accurately reflect the loss that ultimately was realized.

2.3. Disclosures Related to Foreign Currency Transaction Gains and Losses

Because accounting rules allow companies to choose where they present foreign currency transaction gains and losses on the income statement it is useful for companies to disclose both the amount of transaction gain or loss that is included in income and the presentation alternative they have selected. IAS 21 requires disclosure of “the amount of exchange differences recognized in profit or loss” and SFAS 52 requires disclosure of “the aggregate transaction gain or loss included in determining net income for the period,” but neither standard specifically requires disclosure of the line item in which these gains and losses are located.

Exhibit 15-1 provides disclosures from BASF AG’s 2006 Annual Report that the German company made related to foreign currency transaction gains and losses. Exhibit 15-2 presents similar disclosures found in the Netherlands-based Heineken NV’s 2006 Annual Report. Both companies use IFRS to prepare their consolidated financial statements.

BASF’s income statement in Exhibit 15-1 does not include a separate line item for foreign currency gains and losses. From Note 5 in Exhibit 15-1, an analyst can determine that BASF has chosen to include “Gains from foreign currency transactions” in Other operating income. Of the total amount of €934.1 million reported as Other operating income in 2006, €119.7 million is attributable to foreign currency transaction gains. It is not possible to determine from BASF’s financial statements whether these gains were realized in 2006 or not. And any unrealized gain reported in 2006 income might or might not be realized in 2007.

Note 6 in Exhibit 15-1 indicates that “Losses from foreign currency transactions” in 2006 were €48.4 million, making up 2.5 percent of Other operating expenses. Combining foreign currency transaction gains and losses results in a net gain of €71.3 million, which comprised 1.06 percent of BASF’s Income from operations.

In Exhibit 15-2, Heineken’s Note 2, Basis of Preparation, part (c) explicitly states that the euro is the company’s functional currency. Note 3(b)(i) indicates that monetary assets and liabilities denominated in foreign currencies at the balance sheet are translated to the functional currency and foreign currency differences arising on the translation (i.e., translation gains and losses) are recognized on the income statement. Note 3(o) discloses that foreign currency gains are included in Other finance income and foreign currency losses are included in Other finance expense. These two amounts are combined into a part of the line item reported on the income statement as Other net finance income. Note 11, Other net finance income, shows that a net translation loss of €16 million existed in 2006 and a net gain of €19 million arose in 2005. The net foreign currency transaction gain in 2005 amounted to 1.63 percent of Heineken’s profit before income tax that year, while the net translation loss in 2006 represented 0.94 percent of the company’s profit before income tax in that year.

In applying U.S. GAAP’s SFAS 52 to account for its foreign currency transactions, Yahoo! Inc. reported the following in its Quantitative and Qualitative Disclosures about Market Risk in its 2006 Annual Report:

In the year ended December 31, 2006, we recorded net foreign currency transaction gains, realized and unrealized, of approximately $5 million, net losses of $8 million and net gains of $6 million in 2005 and 2004, respectively, which were recorded in other income, net on the consolidated statements of income.

Yahoo! explicitly acknowledges that both realized and unrealized foreign currency transaction gains and losses are reflected in income, specifically as a part of nonoperating activities. The net foreign currency transaction gain in 2006 of $5 million represented only 0.6 percent of the company’s net income for the year.

Companies often neglect to disclose either the location or the amount of foreign currency transaction gains and losses, presumably because the amounts involved are immaterial. The disclosure made by Altria Group, Inc. in its 2006 Annual Report is indicative of this approach. Note 2, Summary of Significant Accounting Policies, contains a subheading “Foreign Currency Translation,” in which the company states:

Transaction gains and losses are recorded in the consolidated statements of earnings and were not significant for any of the periods presented.

There are several reasons why the amount of transaction gains and losses can be immaterial for a company:

The two most common types of hedging instruments used to minimize foreign exchange risk are foreign currency forward contracts and foreign currency options. Corning, Inc. describes its foreign exchange risk management approach in its 2006 Annual Report in Note 15, Hedging Activities. An excerpt from that note follows:

We operate and conduct business in many foreign countries and as a result are exposed to movements in foreign currency exchange rates. Our exposure to exchange rate effects includes:

• Exchange rate movements on financial instruments and transactions denominated in foreign currencies that impact earnings, and
• Exchange rate movements upon translation of net assets in foreign subsidiaries for which the functional currency is not the U.S. dollar that impact our net equity.4

Our most significant foreign currency exposures related to Japan, Korea, Taiwan, and western European countries. We selectively enter into foreign exchange forward and option contracts with durations generally 15 months or less to hedge our exposure to exchange rate risk on foreign source income and purchases. The hedges are scheduled to mature coincident with the timing of the underlying foreign currency commitments and transactions. The objective of these contracts is to neutralize the impact of exchange rate movements on our operating results.

We engage in foreign currency hedging activities to reduce the risk that changes in exchange rates will adversely affect the eventual net cash flows resulting from the sale of products to foreign customers and purchases from foreign suppliers. The hedge contracts reduce the exposure to fluctuations in exchange rate movements because the gains and losses associated with foreign currency balances and transactions are generally offset with gains and losses of the hedge contracts. Because the impact of movements in foreign exchange rates on the value of hedge contracts offsets the related impact on the underlying items being hedged, these financial instruments help alleviate the risk that might otherwise result from currency exchange rate fluctuations.

Corning goes on to indicate that “changes in the fair value of undesignated hedges are recorded in current period earnings in the other income, net component, along with the foreign currency gains and losses arising from the underlying monetary assets or liabilities in the consolidated statement of operations” (p. 171, emphasis added). Amounts, however, are not disclosed, presumably because they are immaterial.

3. TRANSLATION OF FOREIGN CURRENCY FINANCIAL STATEMENTS

Many companies have operations in foreign countries. Most operations located in foreign countries keep their accounting records and prepare financial statements in the local currency. For example, the U.S. subsidiary of German automaker BMW AG keeps its books in U.S. dollars. IFRS and U.S. GAAP require parent companies to prepare consolidated financial statements in which the assets, liabilities, revenues, and expenses of both domestic and foreign subsidiaries are added to those of the parent company. To prepare worldwide consolidated statements, parent companies must translate the foreign currency financial statements of their foreign subsidiaries into the parent company’s presentation currency. BMW AG, for example, must translate the U.S. dollar financial statements of its U.S. subsidiary and the South African rand financial statements of its South African subsidiary into euros to consolidate these foreign operations.

The IASB (in IAS 21) and FASB (in SFAS 52) have established very similar rules for the translation of foreign currency financial statements. To fully understand the results from applying these rules, however, several conceptual issues must first be examined.

3.1. Translation Conceptual Issues

In translating foreign currency financial statements into the parent company’s presentation currency, two questions must be addressed:

These issues and the basic concepts underlying the translation of financial statements are demonstrated through the following example.

Spanco is a hypothetical Spanish-based company that uses the euro as its presentation currency. Spanco establishes a wholly owned subsidiary, Amerco, in the United States on 31 December 2008 by investing €10,000 when the exchange rate between the euro and the U.S. dollar is €1 = US$1. The equity investment of €10,000 is physically converted into US$10,000 to begin operations. In addition, Amerco borrows US$5,000 from local banks on 31 December 2008. Amerco purchases inventory that costs US$12,000 on 31 December 2008, and retains US$3,000 in cash. Amerco’s balance sheet at 31 December 2008 appears as follows:

Amerco Balance Sheet at 31 December 2008 (in U.S. Dollars)

To prepare a consolidated balance sheet in euros at 31 December 2008, Spanco must translate all of the U.S. dollar balances on Amerco’s balance sheet at the €1 = US$1 exchange rate. The translation worksheet at 31 December 2008 is as follows:

Translation Worksheet for Amerco, 31 December 2008

By translating each U.S. dollar balance at the same exchange rate (€1.00), Amerco’s translated balance sheet in euros reflects an equal amount of total assets and total liabilities plus equity and remains in balance.

During the first quarter of 2009, Amerco engages in no transactions. However, during that period the U.S. dollar weakens against the euro such that the exchange rate at 31 March 2009 is €0.80 = US$1.

To prepare a consolidated balance sheet at the end of the first quarter 2009, Spanco now must choose between the current exchange rate of €0.80 and the historical exchange rate of €1.00 to translate Amerco’s balance sheet amounts into euros. The original investment made by Spanco of €10,000 is a historical fact, so the company wants to translate Amerco’s common stock in such a way that it continues to reflect this amount. This is achieved by translating common stock of US$10,000 into euros using the historical exchange rate of €1 = US$1.

Two different approaches for translating the foreign subsidiary’s assets and liabilities are:

These two different approaches are demonstrated and the results analyzed in turn.

3.1.1. All Assets and Liabilities Are Translated at the Current Exchange Rate

The translation worksheet at 31 March 2009 in which all assets and liabilities are translated at the current exchange rate (€0.80) is as follows:

Translation Worksheet for Amerco, 31 March 2009

By translating all assets at the lower current exchange rate, total assets are written down from 31 December 2008 to 31 March 2009 in terms of their euro value by €3,000. Liabilities are written down by €1,000. To keep the euro translated balance sheet in balance, a negative translation adjustment of €2,000 is created and included in stockholders’ equity on the consolidated balance sheet.

Those foreign currency balance sheet accounts that are translated using the current exchange rate are revalued in terms of the parent’s functional currency. This process is very similar to the revaluation of foreign currency receivables and payables related to foreign currency transactions. The net translation adjustment that results from translating individual assets and liabilities at the current exchange rate can be viewed as the net foreign currency translation gain or loss caused by a change in the exchange rate:

(€600)	loss on cash
(€2,400)	loss on inventory
€1,000	gain on notes payable
(€2,000)	net translation loss

The negative translation adjustment (net translation loss) does not result in a cash outflow of €2,000 for Spanco and thus is unrealized. The loss could be realized, however, if Spanco were to sell Amerco at its book value of US$10,000. The proceeds from the sale would be converted into euros at €0.80 per US$1, resulting in a cash inflow of €8,000. Because Spanco originally invested €10,000 in its U.S. operation, a realized loss of €2,000 would result.

The second conceptual issue related to the translation of foreign currency financial statements is whether the unrealized net translation loss should be included in the determination of consolidated net income currently or should be deferred in the stockholders’ equity section of the consolidated balance sheet until the loss is realized through sale of the foreign subsidiary. There is some debate as to which of these two treatments is most appropriate. This issue is discussed in more detail after considering the second approach for translating assets and liabilities.

3.1.2. Only Monetary Assets and Monetary Liabilities Are Translated at the Current Exchange Rate

Now assume only monetary assets and monetary liabilities are translated at the current exchange rate. The translation worksheet at 31 March 2009 in which only monetary assets and liabilities are translated at the current exchange rate (€0.80) is as follows:

Translation Worksheet for Amerco, 31 March 2009

Using this approach, cash is written down by €600 but inventory continues to be carried at its euro historical cost of €12,000. Notes payable is written down by €1,000. To keep the balance sheet in balance, a positive translation adjustment of €400 must be included in stockholders’ equity. The translation adjustment reflects the net translation gain or loss related to monetary items only:

(€600)	loss on cash
€1,000	gain on notes payable
€400	net translation gain

The positive translation adjustment (net translation gain) also is unrealized. However, the gain could be realized if:

• The subsidiary uses its cash (US$3,000) to pay as much of its liabilities as possible.
• The parent sends enough euros to the subsidiary to pay its remaining liabilities (US$5,000 − US$3,000 = US$2,000). At 31 December 2008, at the €1.00 per US$1 exchange rate, Spanco would have sent €2,000 to Amerco to pay liabilities of US$2,000. At 31 March 2009, given the €0.80 per US$1 exchange rate, the parent needs to send only €1,600 to pay US$2,000 of liabilities. As a result, Spanco would enjoy a foreign exchange gain of €400.

The second conceptual issue again arises under this approach. Should the unrealized foreign exchange gain be recognized in current period net income or deferred on the balance sheet as a separate component of stockholders’ equity? The answer to this question, as provided by IFRS and U.S. GAAP, is described in Section 3.2, Translation Methods.

3.1.3. Balance Sheet Exposure

Those assets and liabilities translated at the current exchange rate are revalued from balance sheet to balance sheet in terms of the parent company’s presentation currency. These items are said to be exposed to translation adjustment. Balance sheet items translated at historical exchange rates do not change in parent currency value and therefore are not exposed to translation adjustment. Exposure to translation adjustment is referred to as balance sheet translation, or accounting exposure.

A foreign operation will have a net asset balance sheet exposure when assets translated at the current exchange rate are greater 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 greater than assets translated at the current exchange rate. Another way to think about the issue is to realize that there is a net asset balance sheet exposure when exposed assets are greater in amount than exposed liabilities and a net liability balance sheet exposure when exposed liabilities are greater in amount than exposed assets. The sign (positive or negative) of the current period’s translation adjustment is a function of two factors: (1) the nature of the balance sheet exposure (asset or liability) and (2) the direction of change in the exchange rate (strengthens or weakens). The relationship between exchange rate fluctuations, balance sheet exposure, and the current period’s translation adjustment can be summarized as follows:

	Foreign Currency (FC)
Balance Sheet Exposure	Strengthens	Weakens
Net asset	Positive translation adjustment	Negative translation adjustment
Net liability	Negative translation adjustment	Positive translation adjustment

These relationships are the same as those summarized in Section 2.2 with respect to foreign currency transaction gains and losses. In reference to the example in Section 3.1.2, for instance, exposed assets ($3,000) were less than exposed liabilities ($5,000), implying that there was a net liability exposure. Further, the foreign currency (US$) weakened, resulting in a positive translation adjustment.

The combination of balance sheet exposure and direction of exchange rate change determines whether the current period’s translation adjustment will be positive or negative. After the initial period of operations, a cumulative translation adjustment is required to keep the translated balance sheet in balance. The cumulative translation adjustment will be the sum of the translation adjustments that arise over successive accounting periods. For example, assume that Spanco translates all of Amerco’s assets and liabilities using the current exchange rate (a net asset balance sheet exposure exists), which due to a weakening U.S. dollar in the first quarter of 2009 resulted in a negative translation adjustment at 31 March 2009 of €2,000 (as shown in Section 3.1.1). Assume further that in the second quarter of 2009, the U.S. dollar strengthens against the euro and there still is a net asset balance sheet exposure, which results in a positive translation adjustment of €500 for that quarter. Although the current period translation adjustment for the second quarter of 2009 is positive, the cumulative translation adjustment at 30 June 2009 still will be negative, but the amount now will be only €1,500.

3.2. Translation Methods

The two approaches to translating foreign currency financial statements described in the previous section are known as (1) the current rate method (all assets and liabilities are translated at the current exchange rate), and (2) the monetary/nonmonetary method (only monetary assets and liabilities are translated at the current exchange rate). A variation of the monetary/nonmonetary method requires not only monetary assets and liabilities but also nonmonetary assets and liabilities that are measured at their current value on the balance sheet date to be translated at the current exchange rate. This variation of the monetary/nonmonetary method sometimes is referred to as the temporal method. The basic idea underlying the temporal method is that assets and liabilities should be translated in such a way that the measurement basis (either current value or historical cost) in the foreign currency is preserved after translating to the parent’s presentation currency. To achieve this objective, assets and liabilities carried on the foreign currency balance sheet at a current value should be translated at the current exchange rate, and assets and liabilities carried on the foreign currency balance sheet at historical costs should be translated at historical exchange rates. Although neither the IASB nor the FASB specifically refer to translation methods by name, the procedures required by IFRS and U.S. GAAP in translating foreign currency financial statements essentially require the use of either the current rate or the temporal method.

Which method is appropriate for an individual foreign entity depends on that entity’s functional currency. As noted earlier, the functional currency is the currency of the primary economic environment in which an entity operates. A foreign entity’s functional currency can be either the parent’s presentation currency or another currency, typically the currency of the country in which the foreign entity is located. Exhibit 15-3 lists the factors that IAS 21 indicates should be considered in determining a foreign entity’s functional currency. Although not identical, SFAS 52 provides similar indicators for determining a foreign entity’s functional currency.

When the functional currency indicators listed in Exhibit 15-3 are mixed and the functional currency is not obvious, IAS 21 indicates that management should use its best judgment in determining the functional currency. However, in this case, indicators 1 and 2 should be given priority over indicators 3 through 9.

The following three steps outline the functional currency approach required by both IFRS and U.S. GAAP in translating foreign currency financial statements into the parent’s presentation currency:

To illustrate how this approach is applied, consider a U.S. parent company with a Mexican subsidiary that keeps its accounting records in Mexican pesos. Assume that the vast majority of the subsidiary’s transactions are carried out in Mexican pesos but it also has an account payable in Guatemalan quetzals. In applying the three steps, the U.S. parent company first determines that the Mexican peso is the functional currency of the Mexican subsidiary. Second, the Mexican subsidiary translates its foreign currency balances, that is, the Guatemalan quetzal account payable, into Mexican pesos using the current exchange rate. In step 3, the Mexican peso financial statements (including the translated account payable) are translated into U.S. dollars using the current rate method.

Now assume that the primary operating currency of the Mexican subsidiary is the U.S. dollar, which thus is identified as the Mexican subsidiary’s functional currency. In that case, in addition to the Guatemalan quetzal account payable, all of the subsidiary’s accounts that are denominated in Mexican pesos also are considered to be foreign currency balances (because they are not denominated in the subsidiary’s functional currency, which is the U.S. dollar). Along with the Guatemalan quetzal balance, each of the Mexican peso balances must be translated into U.S. dollars as if the subsidiary kept its books in U.S. dollars. Assets and liabilities carried at current value in Mexican pesos are translated into U.S. dollars using the current exchange rate, and assets and liabilities carried at historical cost in Mexican pesos are translated into U.S. dollars using historical exchange rates. After completing this step, the Mexican subsidiary’s financial statements are stated in terms of U.S. dollars, which is both the subsidiary’s functional currency and the parent’s presentation currency. As a result, there is no need to apply step 3.

The procedures to be followed in applying the functional currency approach embodied in IFRS and U.S. GAAP are described in more detail in the following two sections.

3.2.1. Foreign Currency is the Functional Currency

In most cases, a foreign entity will primarily operate in the currency of the country where it is located, which will be different from the currency in which the parent company presents its financial statements. For example, the Japanese subsidiary of a French parent company is likely to have the Japanese yen as its functional currency, whereas the French parent company must prepare consolidated financial statements in euros. When a foreign entity has a functional currency that is different from the parent’s presentation currency, the foreign entity’s foreign currency financial statements are translated into the parent’s presentation currency using the following procedures:

• All assets and liabilities are translated at the current exchange rate at the balance sheet date.
• Stockholders’ equity accounts are translated at historical exchange rates.
• Revenues and expenses are translated at the exchange rate that existed when the transactions took place. For practical reasons, a rate that approximates the exchange rates at the dates of the transactions, such as an average exchange rate, may be used.

These procedures essentially describe the current rate method.

Under both IAS 21 and SFAS 52, when the current rate method is used, the cumulative translation adjustment needed to keep the translated balance sheet in balance is reported as a separate component of stockholders’ equity.

The basic concept underlying the current rate method is that the entire investment in a foreign entity is exposed to translation gain or loss. Therefore, all assets and all liabilities must be revalued at each successive balance sheet date. But the net translation gain or loss that results from this procedure is unrealized and will be realized only when the entity is sold. In the meantime, the unrealized translation gain or loss that accumulates over time is deferred on the balance sheet as a separate component of stockholders’ equity. When a specific foreign entity is sold, the cumulative translation adjustment related to that entity is reported as a realized gain or loss in net income.

The current rate method results in a net asset balance sheet exposure (except in the rare case in which an entity has negative stockholders’ equity):

Items Translated at Current Exchange Rate

When the foreign currency increases in value (strengthens), application of the current rate method results in an increase in the positive cumulative translation adjustment (or a decrease in the negative cumulative translation adjustment) reflected in stockholders’ equity. When the foreign currency decreases in value (weakens), the current rate method results in a decrease in the positive cumulative translation adjustment (or increase in the negative cumulative translation adjustment) in stockholders’ equity.

3.2.2. Parent’s Presentation Currency is the Functional Currency

In some cases, a foreign entity might have the parent’s presentation currency as its functional currency. For example, a German-based manufacturer might have a 100 percent–owned distribution subsidiary in Switzerland that primarily uses the euro in its day-to-day operations. But as a Swiss company, the subsidiary is required to record its transactions and keep its books in Swiss francs. In that situation, the subsidiary’s Swiss franc financial statements must be translated into euros as if the subsidiary’s transactions had originally been recorded in euros. SFAS 52 refers to this process as remeasurement. IAS 21 does not refer to this process as remeasurement, but instead describes this situation as “reporting foreign currency transactions in the functional currency.” To achieve the objective of translating to the parent’s presentation currency as if the subsidiary’s transactions had been recorded in that currency, the following procedures are used:

These procedures essentially describe the temporal method.

Under the temporal method, companies must keep record of the exchange rates that exist when nonmonetary assets (inventory, prepaid expenses, fixed assets, and intangible assets) are acquired, because these assets (normally measured at historical cost) are translated at historical exchange rates. Keeping track of the historical exchange rates for these assets is not necessary under the current rate method. Translating these assets (and their related expenses) at historical exchange rates complicates application of the temporal method.

The historical exchange rates used to translate inventory (and cost of goods sold) under the temporal method will differ depending on the cost flow assumption—first in, first out (FIFO), last in, first out (LIFO), or average cost—used to account for inventory. Ending inventory reported on the balance sheet is translated at the exchange rate that existed when the inventory assumed to still be on hand at the balance sheet date (using FIFO or LIFO) was acquired. If FIFO is used, ending inventory is assumed to be composed of the most recently acquired items and thus inventory will be translated at relatively recent exchange rates. If LIFO is used, ending inventory is assumed to consist of older items and thus inventory will be translated at older exchange rates. The weighted average exchange rate for the year is used when inventory is carried at weighted average cost. Similarly, cost of goods sold is translated using the exchange rates that existed when the inventory items assumed to have been sold during the year (using FIFO or LIFO) were acquired. If weighted average cost is used to account for inventory, cost of goods sold will be translated at the weighted average exchange rate for the year.

Under both IAS 21 and SFAS 52, when the temporal method is used, the translation adjustment needed to keep the translated balance sheet in balance is reported as a gain or loss in net income. SFAS 52 refers to these as remeasurement gains and losses.

The basic assumption supporting the recognition of a translation gain or loss in income when the temporal method is used is that if the foreign entity primarily uses the parent’s currency in its day-to-day operations, then the foreign entity’s monetary items that are denominated in a foreign currency generate translation gains and losses that will be realized in the near future and thus should be reflected in current net income.

The temporal method generates either a net asset or a net liability balance sheet exposure, depending on whether assets translated at the current exchange rate, that is, monetary assets and nonmonetary assets measured on the balance sheet date at current value (exposed assets), are greater than or less than liabilities translated at the current exchange rate, that is, monetary liabilities and nonmonetary liabilities measured on the balance sheet date at current value (exposed liabilities):

Items Translated at Current Exchange Rate

Most liabilities are monetary liabilities. Only cash and receivables are monetary assets, and nonmonetary assets generally are measured at their historical cost. As a result, liabilities translated at the current exchange rate (exposed liabilities) often exceed assets translated at the current exchange rate (exposed assets), which results in a net liability balance sheet exposure when the temporal method is applied.

3.2.3. Translation of Retained Earnings

Stockholders’ equity accounts are translated at historical exchange rates under both the current rate and the temporal methods. This creates somewhat of a problem in translating retained earnings (R/E), which is the accumulation of previous years’ income less dividends over the life of the company. At the end of the first year of operations, foreign currency (FC) retained earnings are translated into the parent’s currency (PC) as follows:

Retained earnings in parent currency at the end of the first year becomes the beginning retained earnings in parent currency for the second year, and the translated retained earnings in the second year (and subsequent years) is then calculated in the following manner:

Exhibit 15-4 summarizes the translation rules as discussed in Sections 3.2.1 and 3.2.2.

EXHIBIT 15-4 Rules for the Translation of a Foreign Subsidiary’s Foreign Currency Financial Statements into the Parent’s Presentation Currency under IFRS and U.S. GAAP

	Foreign Subsidiary’s Functional Currency
	Foreign Currency	Parent’s Presentation Currency
Translation method:	Current Rate Method	Temporal Method
Exchange rate at which financial statement items are translated from the foreign subsidiary’s bookkeeping currency to the parent’s presentation currency:
Assets
Monetary, e.g., cash; receivables	Current rate	Current rate
Nonmonetary
Measured at current value, e.g., marketable securities; inventory measured at market under the lower of cost or market rule	Current rate	Current rate
Measured at historical costs, e.g., inventory measured at cost under the lower of cost or market rule; property, plant, & equipment; intangible assets	Current rate	Historical rates
Liabilities
Monetary, e.g., accounts payable; accrued expenses; long-term debt; deferred income taxes	Current rate	Current rate
Nonmonetary
Measured at current value	Current rate	Current rate
Not measured at current value, e.g., deferred revenue	Current rate	Historical rates
Equity
Other than retained earnings	Historical rates	Historical rates
Retained earnings	Beginning balance plus translated net income less dividends translated at historical rate	Beginning balance plus translated net income less dividends translated at historical rate
Revenues	Average rate	Average rate
Expenses
Most expenses	Average rate	Average rate
Expenses related to assets translated at historical exchange rate, e.g., cost of goods sold; depreciation; amortization	Average rate	Historical rates
Treatment of the translation adjustment in the parent’s consolidated financial statements	Accumulated as a separate component of equity	Included as gain or loss in net income

3.2.4. Highly Inflationary Economies

When a foreign entity is located in a highly inflationary economy, the entity’s functional currency is irrelevant in determining how to translate its foreign currency financial statements into the parent’s presentation currency. IAS 21 requires that the financial statements of the foreign entity first be restated for local inflation using the procedures outlined in IAS 29, “Financial Reporting in Hyperinflationary Economies.” Then, the inflation-restated foreign currency financial statements are translated into the parent’s presentation currency using the current exchange rate.

U.S. GAAP requires a very different approach for translating the foreign currency financial statements of foreign entities located in highly inflationary economies. SFAS 52 does not allow restatement for inflation, but instead requires the temporal method to translate financial statements kept in a highly inflationary currency. However, despite the use of the temporal method, the resulting translation adjustment is included as a gain or loss in determining net income.

SFAS 52 defines a highly inflationary economy as one in which the cumulative three-year inflation rate exceeds 100 percent. This equates to an average of approximately 26 percent per year. IAS 21 does not provide a specific definition of high inflation, but IAS 29 does indicate that a cumulative inflation rate approaching or exceeding 100 percent over three years would be one indicator of hyperinflation. If a country in which a foreign entity is located ceases to be classified as highly inflationary, the functional currency of that foreign entity must be identified to determine the appropriate method for translating the entity’s foreign currency financial statements.

The FASB initially proposed that companies restate for inflation and then translate the financial statements, but this approach met with stiff resistance from U.S. multinational corporations. By requiring the temporal method, SFAS 52 ensures that companies avoid a “disappearing plant problem” that exists when the current rate method is used in a country with high inflation. In a highly inflationary economy, as the local currency loses purchasing power within the country, it also tends to weaken in value in relation to other currencies. Translating the historical cost of assets such as land and buildings at progressively lower exchange rates causes these assets to slowly disappear from the parent company’s consolidated financial statements. Example 15-4 demonstrates the effect of three different translation approaches when books are kept in the currency of a highly inflationary economy.

3.3. Illustration of Translation Methods (Excluding Hyperinflationary Economies)

To demonstrate the procedures required by IAS 21 and SFAS 52 in translating foreign currency financial statements, assume that Interco is a European-based company that has the euro as its presentation currency. On 1 January 2008, Interco establishes a wholly owned subsidiary in Canada, Canadaco. In addition to Interco making an equity investment in Canadaco, a long-term note payable to a Canadian bank was negotiated to purchase property and equipment. The subsidiary begins operations with the following balance sheet in Canadian dollars (C$):

Canadaco Balance Sheet 1 January 2008 (in Canadian Dollars)

Assets
Cash	$1,500,000
Property and equipment	3,000,000
	$4,500,000
Liabilities and Equity
Long-term note payable	$3,000,000
Capital stock	1,500,000
	$4,500,000

Canadaco purchases and sells inventory in 2008, generating net income of C$1,180,000, out of which C$350,000 in dividends are paid. The company’s income statement and statement of retained earnings for 2008 and balance sheet at 31 December 2008 follow:

Canadaco Income Statement and Statement of Retained Earnings 2008 (in Canadian Dollars)

Sales	$12,000,000
Cost of sales	(9,000,000)
Selling expenses	(750,000)
Depreciation expense	(300,000)
Interest expense	(270,000)
Income tax	(500,000)
Net income	1,180,000
Less: Dividends, 1 Dec. 2008	(350,000)
Retained earnings, 31 Dec. 2008	$830,000

Canadaco Balance Sheet 31 December 2008 (in Canadian Dollars)

Inventory is measured at historical cost on a FIFO basis.

To translate Canadaco’s Canadian dollar financial statements into euros for consolidation purposes, the following exchange rate information was gathered:

Date	€ per C$
1 January 2008	0.70
Average, 2008	0.75
Weighted average rate when inventory was acquired	0.74
1 December 2008 when dividends were declared	0.78
31 December 2008	0.80

During 2008, the Canadian dollar strengthened steadily against the euro from an exchange rate of €0.70 at the beginning of the year to €0.80 at year-end.

The translation worksheet following shows Canadaco’s translated financial statements under each of the two translation methods. Assume first that Canadaco’s functional currency is the Canadian dollar and therefore the current rate method must be used. The Canadian dollar income statement and statement of retained earnings are translated first. Income statement items for 2008 are translated at the average exchange rate for 2008 (€0.75), and dividends are translated at the exchange rate that existed when they were declared (€0.78). The ending balance in retained earnings at 31 December 2008 of €612,000 is transferred to the C$ balance sheet. The remaining balance sheet accounts are then translated. Assets and liabilities are translated at the current exchange rate on the balance sheet date of 31 December 2008 (€0.80), and the capital stock account is translated at the historical exchange rate (€0.70) that existed on the date that Interco made the capital contribution. A positive translation adjustment of €202,000 is needed as a balancing amount, which is reported in the stockholders’ equity section of the balance sheet.

If instead Interco determines that Canadaco’s functional currency is the euro, the parent’s presentation currency, the temporal method must be applied as shown in the far right columns of the table. The differences in procedure from the current rate method are that inventory, property, and equipment (and accumulated depreciation), as well as their related expenses (cost of goods sold and depreciation), are translated at the historical exchange rates that existed when the assets were acquired: €0.70 in the case of property and equipment, and €0.74 for inventory. The balance sheet is translated first, with €472,000 determined as the amount of retained earnings needed to keep the balance sheet in balance. This amount is transferred to the income statement and statement of retained earnings as the ending balance in retained earnings at 31 December 2008. Income statement items then are translated, with cost of goods sold and depreciation expense being translated at historical exchange rates. A negative translation adjustment of €245,000 is determined as the amount that is needed to arrive at the ending balance in retained earnings of €472,000, and is reported as a translation loss on the income statement.

The positive translation adjustment under the current rate method can be explained by the fact that Canadaco has a net asset balance sheet exposure (total assets exceed total liabilities) during 2008 and the Canadian dollar strengthened against the euro. The negative translation adjustment (translation loss) under the temporal method is due to the fact that Canadaco has exposed liabilities (accounts payable plus notes payable) that exceed exposed assets (cash plus receivables) during 2008 when the Canadian dollar strengthened against the euro.

Canadaco Income Statement and Statement of Retained Earnings 2008

Canadaco Balance Sheet 31 December 2008

3.4. Translation Analytical Issues

The two different translation methods used to translate Canadaco’s C$ financial statements into euros result in very different amounts that will be included in Interco’s consolidated financial statements. The chart following summarizes some of these differences:

In this particular case, the current rate method results in a significantly larger net income than the temporal method. This occurs because under the current rate method the translation adjustment is not included in the calculation of income. If the translation loss were excluded from net income, the temporal method would result in a significantly larger amount of net income. The combination of smaller net income under the temporal method and a positive translation adjustment reported on the balance sheet under the current rate method results in a much larger amount of total equity under the current rate method. Total assets also are larger under the current rate method because all assets are translated at the current exchange rate, which is higher than the historical exchange rates at which inventory and fixed assets are translated under the temporal method.

To examine the impact that translation has on the underlying relationships that exist in Canadaco’s C$ financial statements, several significant ratios are calculated from the original C$ financial statements and the translated (€) financial statements and presented in the table following.

Comparing the current rate method (€) and temporal method (€) columns in the previous table shows that financial ratios calculated from Canadaco’s translated financial statements (in €) differ significantly depending on which method of translation is used. Of the ratios presented, only receivables turnover is the same under both translation methods. This is the only ratio presented in which there is no difference in the type of exchange rate used to translate the items that comprise the numerator and the denominator. Sales are translated at the average exchange rate and receivables are translated at the current exchange rate under both methods. For each of the other ratios, at least one of the items included in either the numerator or the denominator is translated at a different type of rate (current, average, or historical rate) under the temporal method than under the current rate method. For example, the current ratio has a different value under the two translation methods because inventory is translated at the current exchange rate under the current rate method and at the historical exchange rate under the temporal method. In this case, because the €/C$ exchange rate at 31 December 2008 (€0.80) is higher than the historical exchange rate when the inventory was acquired (€0.74), the current ratio is larger under the current rate method of translation.

Comparing the ratios in the C$ and current rate method (€) columns of the previous table shows that many of the underlying relationships that exist in Canadaco’s C$ financial statements are preserved when the current rate method of translation is used (that is, the ratio calculated from the C$ and € translated amounts is the same). The current ratio, the leverage ratios (debt-to-assets and debt-to-equity ratios), the interest coverage ratio, and the profit margins (gross profit margin, operating profit margin, and net profit margin) are the same in the C$ and current rate method (€) columns of the earlier table. This occurs because each of the ratios is calculated using information from either the balance sheet or the income statement, but not both. Those ratios that compare amounts from the balance sheet with amounts from the income statement (e.g., turnover and return ratios) are different. In this particular case, each of the turnover and return ratios is larger when calculated from the C$ amounts than when calculated using the current rate (€) amounts. The underlying C$ relationships are distorted when translated using the current rate method because the balance sheet amounts are translated using the current exchange rate while revenues and expenses are translated using the average exchange rate. (These distortions would not exist if revenues and expenses also were translated at the current exchange rate.)

Comparing the ratios in the C$ and temporal method (€) columns of the table shows that translation using the temporal method distorts all of the underlying relationships that exist in the C$ financial statements, except inventory turnover. Moreover, it is not possible to generalize the direction of the distortion across ratios. In Canadaco’s case, using the temporal method results in a larger gross profit margin and operating profit margin but a smaller net profit margin as compared with the values of these ratios calculated from the original C$ amounts. Similarly, receivables turnover is smaller, inventory turnover is the same, and fixed asset turnover is larger when calculated from the translated amounts.

In translating Canadaco’s C$ financial statements into euros, the temporal method results in a smaller amount of net income than the current rate method only because IFRS and U.S. GAAP require the resulting translation loss to be included in net income when the temporal method is used. The translation loss arises because the C$ strengthened against the euro and Canadaco has a larger amount of liabilities translated at the current exchange rate (monetary liabilities) than it has assets translated at the current exchange rate (monetary assets). If Canadaco had a net monetary asset exposure (i.e., if monetary assets exceeded monetary liabilities), a translation gain would arise and net income under the temporal method (including the translation gain) would be greater than under the current rate method. Example 15-5 demonstrates how different types of balance sheet exposure under the temporal method can affect translated net income.

For Canadaco, in 2008, applying the current rate method results in larger euro amounts of total assets and total equity being reported in the consolidated financial statements than would result from applying the temporal method. The direction of these differences between the two translation methods is determined by the direction of change in the exchange rate between the Canadian dollar and the euro. For example, total exposed assets are greater under the current rate method because all assets are translated at the current exchange rate. The current exchange rate at 31 December 2008 is greater than the exchange rates that existed when the nonmonetary assets were acquired, which is the translation rate for these assets under the temporal method. Therefore, the current rate method results in a larger amount of total assets because the Canadian dollar strengthened against the euro. The current rate method would result in a smaller amount of total assets than the temporal method if the Canadian dollar had weakened against the euro.

Applying the current rate method also results in a much larger amount of stockholders’ equity than the temporal method. A positive translation adjustment arises under the current rate method, which is included in equity, whereas a translation loss reduces total equity (through retained earnings) under the temporal method.

Example 15-6 shows the effect that the direction of change in the exchange rate has on the translated amounts. Canadaco’s Canadian dollar financial statements are translated into euros, first assuming no change in the exchange rate during 2008, and then assuming the Canadian dollar strengthens and weakens against the euro. Using the current rate method to translate the foreign currency financial statements into the parent’s presentation currency, the foreign currency strengthening increases the revenues, income, assets, liabilities, and total equity reported on the parent company’s consolidated financial statements. Likewise, smaller amounts of revenues, income, assets, liabilities, and total equity would be reported if the foreign currency weakens against the parent’s presentation currency.

When the temporal method is used to translate the foreign currency financial statements, foreign currency strengthening still increases revenues, assets, and liabilities reported in the parent’s consolidated financial statements. Net income and stockholders’ equity, however, translate into smaller amounts (assuming that the foreign subsidiary has a net monetary liability position) because of the translation loss. The opposite results are obtained when the foreign currency weakens against the parent’s presentation currency.

Exhibit 15-5 summarizes the relationships illustrated in Examples 15-5 and 15-6, focusing on the typical effect that a strengthening or weakening of the foreign currency has on financial statement amounts compared to what these amounts would be if the foreign currency were to remain stable.

3.5. Translation When a Foreign Subsidiary Operates in a Hyperinflationary Economy

As noted earlier, IAS 21 and SFAS 52 differ substantially in their approach to translating the foreign currency financial statements of foreign entities operating in the currency of a hyperinflationary economy. SFAS 52 simply requires the foreign currency financial statements of such an entity to be translated as if the parent’s currency is the functional currency, that is, the temporal method must be used with the resulting translation gain or loss reported in net income. IAS 21 requires the foreign currency financial statements first to be restated for inflation using the procedures of IAS 29, and then the inflation-adjusted financial statements are translated using the current exchange rate.

IAS 29 requires the following procedures in adjusting financial statements for inflation:

EXHIBIT 15-5 Effect of Currency Exchange Rate Movement on Financial Statements

Balance Sheet

• Monetary assets and monetary liabilities are not restated because they are already expressed in terms of the monetary unit current at the balance sheet date. Monetary items consist of cash, receivables, and payables.
• Nonmonetary assets and nonmonetary liabilities are restated for changes in the general purchasing power of the monetary unit. Most nonmonetary items are carried at historical cost. In these cases, the restated cost is determined by applying to the historical cost the change in the general price index from the date of acquisition to the balance sheet date. Some nonmonetary items are carried at revalued amounts, for example, property, plant, and equipment revalued according to the allowed alternative treatment in IAS 16, “Property, Plant and Equipment.” These items are restated from the date of revaluation.
• All components of stockholders’ equity are restated by applying the change in the general price level from the beginning of the period or, if later, from the date of contribution to the balance sheet date.

Income Statement

• All income statement items are restated by applying the change in the general price index from the dates when the items were originally recorded to the balance sheet date.
• The net gain or loss in purchasing power that arises from holding monetary assets and monetary liabilities during a period of inflation is included in net income.

The procedures for adjusting financial statements for inflation are similar in concept to the procedures followed when using the temporal method for translation. By restating nonmonetary assets and liabilities along with stockholders’ equity in terms of the general price level at the balance sheet date, these items are carried at their historical amount of purchasing power. Only the monetary items, which are not restated for inflation, are exposed to inflation risk. The effect of that exposure is reflected through the purchasing power gain or loss on the net monetary asset or liability position.

Holding cash and receivables during a period of inflation results in a purchasing power loss, whereas holding payables during inflation results in a purchasing power gain. This can be demonstrated through the following examples.

Assume that the general price index (GPI) at 1 January 2008 is 100; that is, a representative basket of goods and services can be purchased on that date for $100. At the end of 2008, the same basket of goods and services costs $120; thus, the country has experienced an inflation rate of 20 percent ([$120 − $100]/$100). Cash of $100 can be used to acquire one basket of goods at 1 January 2008. One year later, however, when the GPI stands at 120, the same $100 in cash can now purchase only 83.3 percent of a basket of goods and services. At the end of 2008 it now takes $120 to purchase the same amount as $100 could purchase at the beginning of the year. The difference between the amount of cash needed to purchase one market basket at year-end ($120) and the amount actually held ($100) results in a purchasing power loss of $20 from holding cash of $100 during the year.

Borrowing money during a period of inflation increases purchasing power. Assume that a company expects to receive $120 in cash at the end of 2008. If it waits until the cash is received, the company will be able to purchase exactly 1.0 baskets of goods and services when the GPI stands at 120. If instead, the company borrows $120 at 1 January 2008 when the GPI is 100, it can acquire 1.2 baskets of goods and services. This results in a purchasing power gain of $20. Of course, there is an interest cost associated with the borrowing that offsets a portion of this gain.

A net purchasing power gain will arise when a company holds a greater amount of monetary liabilities than monetary assets, and a net purchasing power loss will result when the opposite situation exists. As such, purchasing power gains and losses are analogous to the translation gains and losses that arise when the currency is weakening in value and the temporal method of translation is applied.

Although the procedures required by SFAS 52 and IAS 21 for translating the foreign currency financial statements in high inflation countries are fundamentally different, the results, in a rare occurrence, can be very similar. Indeed, if the exchange rate between two currencies changes by exactly the same percentage amount as the change in the general price index in the highly inflationary country, then the two methodologies produce the same results. This is demonstrated in Example 15-7.

3.6. Companies Use Both Translation Methods at the Same Time

Under both IFRS and U.S. GAAP it is possible that a multinational corporation will need to use both the current rate and the temporal methods of translation at a single point in time. This will be true when some foreign subsidiaries have a foreign currency as their functional currency (and therefore are translated using the current rate method) and other foreign subsidiaries have the parent’s currency as their functional currency (and therefore are translated using the temporal method). As a result, the consolidated financial statements of a multinational corporation can reflect at the same time both a net translation gain or loss that is included in the determination of net income (from foreign subsidiaries translated using the temporal method) and a separate cumulative translation adjustment that is reported on the balance sheet in stockholders’ equity (from foreign subsidiaries translated using the current rate method).

Exxon Mobil Corporation is an example of a company that has a mixture of foreign currency and parent currency functional currency subsidiaries, as evidenced by the following excerpt from its 2006 Annual Report:

Exxon Mobil Corporation, Note 1. Summary of Significant Accounting Policies Foreign Currency Translation. The Corporation selects the functional reporting currency for its international subsidiaries based on the currency of the primary economic environment in which each subsidiary operates. Downstream and Chemical operations primarily use the local currency. However, the U.S. dollar is used in highly inflationary countries (primarily in Latin America) and Singapore, which predominantly sells into the U.S. dollar export market. Upstream operations which are relatively self-contained and integrated within a particular country, such as Canada, the United Kingdom, Norway and continental Europe, use the local currency. Some Upstream operations, primarily in Asia, West Africa, Russia and the Middle East, use the U.S. dollar because they predominantly sell crude and natural gas production into U.S. dollar-denominated markets. For all operations, gains or losses from remeasuring foreign currency transactions into the functional currency are included in income.

Because of the judgment involved in determining the functional currency of foreign operations, two companies operating in the same industry might apply this judgment differently. For example, while Exxon Mobil has identified the local currency as the functional currency for many of its international subsidiaries, Chevron Corporation has designated the U.S. dollar as the functional currency for substantially all of its overseas operations as indicated in the company’s 2006 Annual Report:

Chevron Corporation, Note 1. Summary of Significant Accounting Policies Currency Translation. The U.S. dollar is the functional currency for substantially all of the company’s consolidated operations and those of its equity affiliates. For those operations, all gains and losses from currency translations are currently included in income. The cumulative translation effects for those few entities, both consolidated and affiliated, using functional currencies other than the U.S. dollar are included in the currency translation adjustment in “Stockholders’ Equity.”

Evaluating net income reported by Exxon Mobil against net income reported by Chevron presents a comparability problem. This problem can be partially resolved by adding the translation adjustments reported in stockholders’ equity to net income for both companies. The feasibility of this solution is dependent on the level of detail disclosed by multinational corporations with respect to the translation of foreign currency financial statements.

3.7. Disclosures Related to Translation Methods

Both IAS 21 and SFAS 52 require two types of disclosures related to foreign currency translation:

SFAS 52 also specifically requires disclosure of the amount of translation adjustment transferred from stockholders’ equity and included in current net income as a result of the disposal of a foreign entity.

The amount of exchange differences recognized in net income consists of

• Foreign currency transaction gains and losses.
• Translation gains and losses resulting from application of the temporal method.

Neither IAS 21 nor SFAS 52 requires disclosure of the two separate amounts that comprise the total exchange difference recognized in net income, and most companies do not provide disclosure at that level of detail. However, BASF AG (shown in Exhibit 15-1) is an exception. Note 5 in BASF’s annual report separately discloses gains from foreign currency transactions and gains from translation of financial statements, both of which are included in the line item “Other Operating Income” on the income statement, as shown here:

5. Other Operating Income

(€ in millions)	2006	2005
Reversal and adjustment of provisions	275.2	118.4
Revenue from miscellaneous revenue-generating activities	62.3	85.3
Gains from foreign currency transactions	119.7	43.3
Gains from the translation of financial statements in foreign currencies	10.8	57.3
Gains from disposal of property, plant, and equipment and divestitures	127.8	107.4
Gains on the reversal of allowance for doubtful receivables	89.0	92.1
Other	249.3	96.4
	934.1	600.2

The company provides a similar level of detail in Note 6 related to “Other Operating Expenses.”

Disclosures related to foreign currency translation commonly are found in both the Management Discussion & Analysis (MD&A) and the Notes to Financial Statements sections of an annual report. Exhibit 15-6 provides foreign currency-related disclosures made by Swedish appliance manufacturer Electrolux AB in its 2006 annual report along with an analysis of those disclosures. As a company based in the European Union, Electrolux uses IFRS in preparing its consolidated financial statements.

Exhibit 15-7 provides an analysis of the foreign currency-related disclosures made in 2006 by Yahoo! Inc., a U.S.-based company that prepares financial statements in accordance with U.S. GAAP.

As noted in the previous section, because of the judgment involved in determining the functional currency of foreign operations, two companies operating in the same industry might use different predominant translation methods. As a result, income reported by these companies is not directly comparable. Exxon Mobil Corporation and Chevron Corporation, both operating in the petroleum industry, are an example of two companies for which this is the case. Whereas Chevron has identified the U.S. dollar as the functional currency for substantially all of its foreign subsidiaries, Exxon Mobil indicates that its downstream and chemical operations, as well as some of its upstream operations, primarily use the local currency as the functional currency. As a result Chevron primarily uses the temporal method with translation gains and losses included in income, while Exxon Mobil uses the current rate method to a much greater extent, with the resulting translation adjustments excluded from income. To make the income of these two companies more comparable, an analyst can use the disclosures related to translation adjustments to include these as gains and losses in determining an adjusted amount of income. Example 15-8 demonstrates this process for Exxon Mobil and Chevron.

Some analysts believe that all nonowner changes in stockholders’ equity, such as translation adjustments, should be included in the determination of net income. This is referred to as clean-surplus accounting, as opposed to dirty-surplus accounting, in which some income items are reported as part of stockholders’ equity rather than as gains and losses on the income statement. One of the dirty-surplus items found in both IFRS and U.S. GAAP financial statements is the translation adjustment that arises when a foreign currency is determined to be the functional currency of a foreign subsidiary. Disclosures made in accordance with IFRS and U.S. GAAP provide analysts with the detail needed to be able to calculate net income on a clean-surplus basis. In fact, both sets of standards allow (but do not specifically require) companies to prepare a statement of comprehensive income in which unrealized gains and losses that have been deferred in stockholders’ equity are included in a measure of comprehensive income. Chevron Corporation is one U.S. company that has elected to prepare a statement of comprehensive income. Exhibit 15-8 presents Chevron’s consolidated statement of comprehensive income as shown in the company’s 2006 annual report.

4. SUMMARY

The translation of foreign currency amounts is an important accounting issue for companies with multinational operations. Fluctuations in foreign exchange rates cause the functional currency values of foreign currency assets and liabilities resulting from foreign currency transactions as well as from foreign subsidiaries to change over time, giving rise to foreign exchange differences that must be reflected in the financial statements. Determining how to measure these foreign exchange differences and whether to include them in the calculation of net income are the major issues in accounting for multinational operations.

• The local currency is the national currency of the country where an entity is located. The functional currency is the currency of the primary economic environment in which an entity operates. Normally, the local currency is an entity’s functional currency. For accounting purposes, any currency other than an entity’s functional currency is a foreign currency for that entity. The currency in which financial statement amounts are presented is known as the presentation currency. In most cases, the presentation currency will be the same as the local currency.
• When an export sale (import purchase) on account is denominated in a foreign currency, the sales revenue (inventory) and foreign currency account receivable (account payable) are translated into the seller’s (buyer’s) functional currency using the exchange rate on the transaction date. Any change in the functional currency value of the foreign currency account receivable (account payable) that occurs from the transaction date to the settlement date is recognized as a foreign currency transaction gain or loss in net income.
• If a balance sheet date falls between the transaction date and the settlement date, the foreign currency account receivable (account payable) is translated at the exchange rate at the balance sheet date. The change in the functional currency value of the foreign currency account receivable (account payable) is recognized as a foreign currency transaction gain or loss in income. Analysts should understand that these gains and losses are unrealized at the time they are recognized, and might or might not be realized when the transactions are settled.
• A foreign currency transaction gain arises when an entity has a foreign currency receivable and the foreign currency strengthens or it has a foreign currency payable and the foreign currency weakens. A foreign currency transaction loss arises when an entity has a foreign currency receivable and the foreign currency weakens or it has a foreign currency payable and the foreign currency strengthens.
• Companies must disclose the net foreign currency gain or loss included in income. They may choose to report foreign currency transaction gains and losses as a component of operating income or as a component of nonoperating income. If two companies choose to report foreign currency transaction gains and losses differently, making a direct comparison of operating profit and operating profit margin between the two companies is questionable.
• To prepare consolidated financial statements, foreign currency financial statements of foreign operations must be translated into the parent company’s presentation currency. The major conceptual issues related to this translation process are what is the appropriate exchange rate for translating each financial statement item and how should the resulting translation adjustment be reflected in the consolidated financial statements. Two different translation methods are used worldwide.
• Under the current rate method, assets and liabilities are translated at the current exchange rate, equity items are translated at historical exchange rates, and revenues and expenses are translated at the exchange rate that existed when the underlying transaction occurred. For practical reasons, an average exchange rate is often used to translate income items.
• Under the temporal method, monetary assets (and nonmonetary assets measured at current value) and monetary liabilities (and nonmonetary liabilities measured at current value) are translated at the current exchange rate. Nonmonetary assets and liabilities not measured at current value and equity items are translated at historical exchange rates. Revenues and expenses, other than those expenses related to nonmonetary assets, are translated at the exchange rate that existed when the underlying transaction occurred. Expenses related to nonmonetary assets are translated at the exchange rates used for the related assets.
• Under both IFRS and U.S. GAAP, the functional currency of a foreign operation determines the method to be used in translating its foreign currency financial statements into the parent’s presentation currency and whether the resulting translation adjustment is recognized in income or as a separate component of equity.
• The foreign currency financial statements of a foreign operation that has a foreign currency as its functional currency are translated using the current rate method and the translation adjustment is accumulated as a separate component of equity. The cumulative translation adjustment related to a specific foreign entity is transferred to net income when that entity is sold or otherwise disposed of. The balance sheet risk exposure associated with the current rate method is equal to the foreign subsidiary’s net asset position.
• The foreign currency financial statements of a foreign operation that has the parent’s presentation currency as its functional currency are translated using the temporal method and the translation adjustment is included as a gain or loss in income. U.S. GAAP refers to this process as remeasurement. The balance sheet exposure associated with the temporal method is equal to the foreign subsidiary’s net monetary asset/liability position (adjusted for nonmonetary items measured at current value).
• IFRS and U.S. GAAP differ with respect to the translation of foreign currency financial statements of foreign operations located in a highly inflationary country. Under IFRS, the foreign currency statements are first restated for local inflation and then translated using the current exchange rate. Under U.S. GAAP, the foreign currency financial statements are translated using the temporal method, without any restatement for inflation.
• Application of the different translation methods for a given foreign operation can result in very different amounts reported in the parent’s consolidated financial statements.
• Companies must disclose the total amount of translation gain or loss reported in income and the amount of translation adjustment included in a separate component of stockholders’ equity. Companies are not required to separately disclose the component of translation gain or loss arising from foreign currency transactions and the component arising from application of the temporal method.
• Disclosures related to translation adjustments reported in equity can be used to include these as gains and losses in determining an adjusted amount of income following a clean-surplus approach to income measurement.

Foreign currency translation rules are well established in both IFRS and U.S. GAAP. Fortunately, except for the treatment of foreign operations located in highly inflationary countries, there are no major differences between the two sets of standards in this area. The ability to understand the impact of foreign currency translation on the financial results of a company using IFRS should apply equally as well in the analysis of financial statements prepared in accordance with U.S. GAAP.

PROBLEMS

The following information relates to Questions 1 through 6.

Pedro Ruiz is an analyst for a credit rating agency. One of the companies he follows, Eurexim SA, is based in France and complies with International Financial Reporting Standards (IFRS). Ruiz has learned that Eurexim used €220 million of its own cash and borrowed an equal amount to open a subsidiary in Ukraine. The funds were converted into hryvnia (UAH) on 31 December 2007 at an exchange rate of €1.00 = UAH 6.70 and used to purchase UAH 1,500 million in fixed assets and UAH 300 of inventories.

Ruiz is concerned about the effect that the subsidiary’s results might have on Eurexim’s consolidated financial statements. He calls Eurexim’s Chief Financial Officer, but learns little. Eurexim is not willing to share sales forecasts and has not even made a determination as to the subsidiary’s functional currency.

Absent more useful information, Ruiz decides to explore various scenarios to determine the potential impact on Eurexim’s consolidated financial statements. Ukraine is not currently in a hyperinflationary environment, but Ruiz is concerned that this situation could change. Ruiz also believes the euro will appreciate against the hryvnia for the foreseeable future.

1. If Ukraine’s economy becomes highly inflationary, Eurexim will most likely translate inventory by:

A. restating for inflation and using the temporal method.

B. restating for inflation and using the current exchange rate.

C. using the temporal method with no restatement for inflation.

2. Given Ruiz’s belief about the direction of exchange rates, Eurexim’s gross profit margin would be highest if it accounts for the Ukraine subsidiary’s inventory using:

A. FIFO and the temporal method.

B. weighted average cost and the temporal method.

C. FIFO and the current rate method.

3. If the euro is chosen as the Ukraine subsidiary’s functional currency, Eurexim will translate its fixed assets using the:

A. average rate for the reporting period.

B. rate in effect when the assets were purchased.

C. rate in effect at the end of the reporting period.

4. If the euro is chosen as the Ukraine subsidiary’s functional currency, Eurexim will translate its accounts receivable using the:

A. rate in effect at the transaction date.

B. average rate for the reporting period.

C. rate in effect at the end of the reporting period.

5. If the hryvnia is chosen as the Ukraine subsidiary’s functional currency, Eurexim will translate its inventory using the:

A. average rate for the reporting period.

B. rate in effect at the end of the reporting period.

C. rate in effect at the time the inventory was purchased.

6. Based on the information available and Ruiz’s expectations regarding exchange rates, if the hryvnia is chosen as the Ukraine subsidiary’s functional currency, Eurexim will most likely report:

A. an addition to the cumulative translation adjustment.

B. a subtraction from the cumulative translation adjustment.

C. a translation gain or loss as a component of net income.

The following information relates to Questions 7 through 12.

Consolidated Motors is a U.S.-based corporation that sells mechanical engines and components used by electric utilities. Its Canadian subsidiary, Consol-Can, operates solely in Canada. It was created on 31 December 2006 and Consolidated Motors determined at that time that it should use the U.S. dollar as its functional currency.

Chief Financial Officer Monica Templeton was asked to explain to the Board of Directors how exchange rates affect the financial statements of both Consol-Can and the consolidated financial statements of Consolidated Motors. For the presentation, Templeton collects Consol-Can’s balance sheets for the years ended 2006 and 2007 (Exhibit A), as well as relevant exchange rate information (Exhibit B).

EXHIBIT A Consol-Can Condensed Balance Sheet Fiscal Years Ending 31 December (Canadian $, in Millions)

Account	2007	2006
Cash	135	167
Accounts receivable	98	—
Inventory	77	30
Fixed assets	100	100
Accumulated depreciation	(10)	—
Total assets	400	297
Accounts payable	77	—
Long-term debt	175	175
Common stock	100	100
Retained earnings	48	—
Total liabilities and shareholders’ equity	400	275

EXHIBIT B Exchange Rate Information

	U.S. $/Canadian $
Rate on 31 December 2006	0.86
Average rate in 2007	0.92
Weighted average rate for inventory purchases	0.92
Rate on 31 December 2007	0.95

Templeton explains that Consol-Can uses the FIFO inventory accounting method, and that purchases of C$300 million and the sell-through of that inventory occurred evenly throughout 2007. Her presentation includes reporting the translated amounts in U.S. currency for each item, as well as associated translation-related gains and losses. The Board responds with several questions.

• Would there be a reason to change the functional currency to the Canadian dollar?
• Would there be any translation effects for Consolidated Motors if the functional currency for Consol-Can were changed to the Canadian dollar?
• Would a change in the functional currency have any impact on financial statement ratios for the parent company?
• What would be the balance sheet exposure to translation effects if the functional currency were changed?

7. After translating Consol-Can’s inventory and long-term debt into the parent currency (US$), the amounts reported on Consolidated Motor’s financial statements at 31 December 2007 would be closest to (in millions):

A. $71 for inventory and $161 for long-term debt.

B. $71 for inventory and $166 for long-term debt.

C. $73 for inventory and $166 for long-term debt.

8. After translating Consol-Can’s 31 December 2007 balance sheet into the parent currency, the translated value of retained earnings will be closest to:

A. $41 million.

B. $44 million.

C. $46 million.

9. In response to the Board’s first question, Templeton should reply that such a change would be most justified if:

A. the inflation rate in the United States became hyperinflationary.

B. management wanted to flow more of the gains through net income.

C. Consol-Can were making autonomous decisions about operations, investing, and financing.

10. In response to the Board’s second question, Templeton should note that if the change is made, the consolidated financial statements for Consolidated Motors would begin to recognize:

A. realized gains and losses on monetary assets and liabilities.

B. realized gains and losses on nonmonetary assets and liabilities.

C. unrealized gains and losses on nonmonetary assets and liabilities.

11. In response to the Board’s third question, Templeton should note that the change will most likely affect:

A. the cash ratio.

B. fixed asset turnover.

C. receivables turnover.

12. In response to the Board’s fourth question, the balance sheet exposure (in C$ millions) would be closest to:

A. −19.

B. 148.

C. 400.

The following information relates to Questions 13 through 18.

Romulus Corp. is a U.S.-based company that prepares its financial statements in accordance with U.S. GAAP. Romulus Corp. has two European subsidiaries: Julius and Augustus. Anthony Marks, CFA, is an analyst trying to forecast Romulus’s 2008 results. Marks has prepared separate forecasts for both Julius and Augustus, as well as for Romulus’s other operations (prior to consolidating the results.) He is now considering the impact of currency translation on the results of both the subsidiaries and the parent company’s consolidated financials. His research has provided the following insights:

• The results for Julius will be translated into U.S. dollars using the current rate method.
• The results for Augustus will be translated into U.S. dollars using the temporal method.
• Both Julius and Augustus use the FIFO method to account for inventory.
• Julius had year-end 2007 inventory of €340 million. Marks believes Julius will report €2,300 in sales and €1,400 in cost of sales in 2008.

Marks also forecasts the 2008 year-end balance sheet for Julius (Exhibit C). Data and forecasts related to euro/dollar exchange rates are presented in Exhibit D.

EXHIBIT C Forecasted Balance Sheet Data for Julius, 31 December 2008 (€ Millions)

Cash	50
Accounts receivable	100
Inventory	700
Fixed assets	1,450
Total assets	2,300
Liabilities	700
Common stock	1,500
Retained earnings	100
Total liabilities and shareholder equity	2,300

EXHIBIT D Exchange Rates ($/€)

31 December 2007	1.47
31 December 2008	1.61
2008 average	1.54
Rate when fixed assets were acquired	1.25
Rate when 2007 inventory was acquired	1.39
Rate when 2008 inventory was acquired	1.49

13. Based on the translation method being used for Julius, the subsidiary is most likely:

A. a sales outlet for Romulus’s products.

B. a self-contained, independent operating entity.

C. using the U.S. dollar as its functional currency.

14. To account for its foreign operations, Romulus has most likely designated the euro as the functional currency for:

A. Julius only.

B. Augustus only.

C. both Julius and Augustus.

15. When Romulus consolidates the results of Julius, any unrealized exchange rate holding gains on monetary assets should be:

A. reported as part of operating income.

B. reported as a nonoperating item on the income statement.

C. reported directly to equity as part of the cumulative translation adjustment.

16. When Marks translates his forecasted balance sheet for Julius into U.S. dollars, total assets at 31 December 2008 (dollars in millions) will be closest to:

A. $1,429.

B. $2,392.

C. $3,703.

17. When Marks converts his forecasted income statement data into U.S. dollars, the 2008 gross profit margin for Julius will be closest to:

A. 39.1%.

B. 40.9%.

C. 44.6%.

18. Relative to the gross margins the subsidiaries report in local currency, Romulus’s consolidated gross margin most likely:

A. will not be distorted by currency translations.

B. would be distorted if Augustus were using the same translation method as Julius.

C. will be distorted due to the translation and inventory accounting methods Augustus is using.

The following information relates to Questions 19 through 24.

Redline Products, Inc. is a U.S.-based multinational with subsidiaries around the world. One such subsidiary, Acceletron, operates in Singapore, which has seen mild but not excessive rates of inflation. Acceletron was acquired in 2000 and has never paid a dividend. It records inventory using the FIFO method.

Chief Financial Officer Margot Villiers was asked by Redline’s Board of Directors to explain how the functional currency selection and other accounting choices affect Redline’s consolidated financial statements. She gathers Acceletron’s financial statements denominated in Singapore dollars (SGD) in Exhibit E and the U.S. dollar/Singapore dollar exchange rates in Exhibit F. She does not intend to identify the functional currency actually in use, but rather to use Acceletron as an example of how the choice of functional currency affects the consolidated statements.

EXHIBIT E Selected Financial Data for Acceletron, 31 December 2007 (SGD Millions)

Cash	SGD	125
Accounts receivable		230
Inventory		500
Fixed assets		1,640
Accumulated depreciation		(205)
Total assets	SGD	2,290
Accounts payable		185
Long-term debt		200
Common stock		620
Retained earnings		1,285
Total liabilities and equity		2,290
Total revenues	SGD	4,800
Net income	SGD	450

EXHIBIT F Exchange Rates Applicable to Acceletron

Exchange Rate in Effect at Specific Times	USD per SGD
Rate when first 1,000 of fixed assets were acquired	0.568
Rate when remaining 640 of fixed assets were acquired	0.606
Rate when long-term debt was issued	0.588
31 December 2006	0.649
Weighted average rate when inventory was acquired	0.654
Average rate in 2007	0.662
31 December 2007	0.671

19. Compared to using the Singapore dollar as Acceletron’s functional currency for 2007, if the U.S. dollar were the functional currency, it is most likely that Redline’s consolidated:

A. inventories will be higher.

B. receivable turnover will be lower.

C. fixed asset turnover will be higher.

20. If the U.S. dollar were chosen as the functional currency for Acceletron in 2007, Redline could reduce its balance sheet exposure to exchange rates by:

A. selling SGD 30 of fixed assets for cash.

B. issuing SGD 30 of long-term debt to buy fixed assets.

C. issuing SGD 30 in short-term debt to purchase marketable securities.

21. Redline’s consolidated gross profit margin for 2007 would be highest if Acceletron accounted for inventory using:

A. FIFO, and its functional currency were the U.S. dollar.

B. LIFO, and its functional currency were the U.S. dollar.

C. FIFO, and its functional currency were the Singapore dollar.

22. If the current rate method is used to translate Acceletron’s financial statements into U.S. dollars, Redline’s consolidated financial statements will most likely include Acceletron’s:

A. $3,178 in revenues.

B. $118 in long-term debt.

C. negative translation adjustment to shareholder equity.

23. If Acceletron’s financial statements are translated into U.S. dollars using the temporal method, Redline’s consolidated financial statements will most likely include Acceletron’s:

A. $336 in inventory.

B. $956 in fixed assets.

C. $152 in accounts receivable.

24. When translating Acceletron’s financial statements into U.S. dollars, Redline is least likely to use an exchange rate of USD per SGD:

A. 0.671.

B. 0.588.

C. 0.654.

1World Trade Organization, International Trade Statistics 2006, Table A6.

2The content of SFAS 52 is included in FASB ASC Topic 830 [Foreign Currency Matters].

3Note that this excerpt uses “retranslation” in the same way that “translation” is used throughout the rest of this reading.

4The translation of currency for foreign subsidiaries will be covered in the next section.