CHAPTER 15

MULTINATIONAL OPERATIONS

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.

SUMMARY OVERVIEW

• 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.