International accounting: foreign currency

INTERNATIONAL ACCOUNTING

Frederick D. S. Choi

Gary K. Meek

Chapter 6: Foreign Currency

Translation

LEARNING OBJECTIVE:

1. Describe the nature of foreign currency transactions done in the spot, forward, and swap markets.

2. Understand the foreign currency translation terms.

3. Explain the difference between a translation gain or loss and a transaction gain or loss.

4. Comprehend alternative foreign currency translation methods that exist and their rationale.

LEARNING OBJECTIVE:

5. Evaluate which of the available foreign currency translation methods are best under which specific business and currency market conditions.

6. Compare and contrast the financial statement effects of the temporal versus the current rate method of foreign currency translation.

7. Understand the relationship between foreign currency translation and inflation.

8. Appreciate how foreign currency translation is handled outside the United States.

FOREIGN CURRENCY TRANSACTIONS

FOREIGN CURRENCY TRANSACTIONS

SINGLE-TRANSACTION PERSPECTIVE

TWO-TRANSACTION PERSPECTIVE

Under a two-transaction perspective, collection of

the foreign currency receivable is considered a

separate event from the sale that gave rise to it.

EXAMPLE 1

On September 1, 2015, Cormorant Company purchasedmerchandise from Osaka Company of Japan for20,000,000 yen payable on October 1, 2015. The spotrate for yen was $0.0079 on September 1 and the spotrate was $0.0077 on October 1.

Required:

1. Did the exchange rate strength or weaken fromSeptember to October and what are the implicationsfor Cormorant’s business?

2. What journal entry did Cormorant record onSeptember 1, 2015?

3. What journal entry did Cormorant record on October 1,2015?

EXAMPLE 2

On October 15, 2015, Ibis Corporation, a Frenchcompany, ordered merchandise listed on the Internet for20,000 Euros from Spoonbill Corporation, a UScorporation, which immediately accepted the order. TheEuro rate was $1.20 US on October 15. On November15, 2015 Spoonbill shipped the goods and billed Ibis thepurchase price of 20,000 Euros when the Euro rate was$1.30 US. Ibis paid the bill on December 10, 2015.Three days later Spoonbill exchanged the 20,000 Eurosfor US dollars when the Euro rate was $1.28US.

Required:

Compute the foreign currency gains or losses on the December 31, 2015 financial statements and show your calculations.

EXAMPLE 3

On November 1, 2013, the Penguin Corporation, a UScorporation, purchased an extruding machine fromShearwater Corporation, a UK company. The purchaseprice was $10,000 and Penguin agreed to pay in poundson February 1, 2014. Both corporations are on acalendar year accounting period. Assume that the spotrates for the British pound on November 1, 2013,December 31, 2013, and February 1, 2014, are $1.60,$1.62, and $1.66, respectively.

Required:

Record the November 1, December 31, and February 1 transactions in the General Journals of Penguin Corporation and Shearwater Corporation. If no entry is required on a particular date, indicate “No entry” in the General Journal.

FOREIGN CURRENCY TRANSLATION

Companies operating internationally use a variety

of methods to express, in terms of their domestic

currency, the assets, liabilities, revenues, and

expenses that are stated in a foreign currency.

SINGLE RATE METHOD

The single rate method, long popular in Europe,

applies a single exchange rate, the current or

closing rate, to all foreign currency assets and

liabilities. Foreign currency revenues and expenses

are generally translated at exchange rates

prevailing when these items are recognized. For

convenience, however, revenues and expenses are

typically translated by an appropriately weighted

average of current exchange rates for the period.

MULTIPLE RATE METHODS

CURRENT–NONCURRENT METHOD

a foreign subsidiary’s current assets (assets that

are usually converted to cash within a year) and

current liabilities (obligations that mature within a

year) are translated into their parent company’s

reporting currency at the current rate. Noncurrent

assets and liabilities are translated at historical

rates.



Income statement items (except for depreciation

and amortization charges) are translated at average

rates applicable to each month of operation or on

the basis of weighted averages covering the whole

period being reported. Depreciation and

amortization charges are translated at the historical

rates in effect when the related assets were

acquired.



Unfortunately, this method does not often square

with reality. Using the year-end rate to translate

current assets implies that all foreign currency

cash, receivables, and inventories are equally

exposed to exchange risk; that is, will be worth

more or less in parent currency if the exchange rate

changes during the year.


MONETARY–NONMONETARY METHOD

a balance sheet classification scheme to determine

appropriate translation rates. Monetary assets and

liabilities; that is, claims to and obligations to pay a

fixed amount of currency in the future are translated

at the current rate. Nonmonetary items—fixed

assets, long-term investments, and inventories are

translated at historical rates. Income statement

items are translated under procedures similar to

those described for the current–noncurrent

framework.



Note, however, that the monetary–nonmonetary

method also relies on a classification scheme to

determine appropriate translation rates. This may

lead to inappropriate results. For example, this

method translates all nonmonetary assets at historical

rates, which is not reasonable for assets stated at

current market values (such as investment securities

and inventory and fixed assets written down to

market).



Multiplying the current market value of a

nonmonetary asset by a historical exchange rate

yields an amount in the domestic currency that is

neither the item’s current equivalent nor its

historical cost. This method also distorts profit

margins by matching sales at current prices and

translation rates against cost of sales measured at

historical costs and translation rates.


TEMPORAL METHOD

In the temporal method, monetary items such as

cash, receivables, and payables are translated at the

current rate. Nonmonetary items are translated at

rates that preserve their original measurement bases.

Specifically, assets carried on the foreign currency

statements at historical cost are translated at the

historical rate.


TEMPORAL METHOD

When nonmonetary items abroad are valued at

historical cost, the translation procedures resulting

from the temporal method are virtually identical to

those produced by the monetary–nonmonetary

method. The two translation methods differ only if

other asset valuation bases are employed, such as

replacement cost, market values, or discounted cash

flows.


The current rate method presumes that the entire foreign

operation is exposed to exchange rate risk since all assets

and liabilities are translated at the year-end exchange rate.

The current–noncurrent rate method presumes that only

the current assets and liabilities are so exposed,

while the monetary–nonmonetary method presumes that

monetary assets and liabilities are exposed.

In contrast, the temporal method is designed to preserve

the underlying theoretical basis of accounting

measurement used in preparing the financial statements

being translated.

WHICH IS BEST?

The object of translation is to change the unit of

measure for financial statements of foreign

subsidiaries to the domestic currency, and to make

the foreign statements conform to accounting

principles generally accepted in the country of the

parent company. We think these objectives are best

achieved by translation methods that use historical

rates of exchange.

WHICH IS BEST?

The temporal principle is appropriate, as it changes a

measurement in foreign currency into a measurement

in domestic currency without changing the basis of

measurement. The temporal translation method is

easily adapted to processes that make accounting

adjustments during the translation.

WHICH IS BEST?

When this is so, adjustments for differences between

two or more sets of accounting concepts and

practices are made along with the translation of

currency amounts. For example, inventories or

certain liabilities may be restated according to

accounting practices different from those originally

used. The temporal principle can accommodate any

asset valuation framework, be it historical cost,

current replacement price, or net realizable values.

WHICH IS BEST?

The current rate method is also useful when the

accounts of an independent company are translated

for the convenience of foreign stockholders or other

external user groups.

WHICH IS BEST?

It is also appropriate when price-level-adjusted

account are translated to another currency. If reliable

price-level adjustments are made in a given set of

accounts and if domestic price-level changes for the

currency are reflected closely in related foreign

exchange rate movements, the current rate

translation of price-level adjusted data yields results

that are comparable to translating historical cost

accounts under the historical rate translation method.

APPROPRIATE CURRENT RATE

Thus far we have referred to rates of exchange used

in translation methods as either historical or current.

Average rates are often used in income statements

for expediency. The choice of an appropriate

exchange rate is not clear-cut because several

exchange rates are in effect for any currency at any

time. There are buying and selling (bid and ask)

rates, spot rates and forward rates, official rates and

free-market rates, and so on.

APPROPRIATE CURRENT RATE

We believe that an appropriate translation rate

should reflect economic and business reality as

closely as possible. The free-market rate quoted for

spot transactions in the country where the accounts

to be translated originate is a rate that appropriately

measures current transaction values.

TRANSLATION GAINS AND LOSSES

Exclusion of translation adjustments in current

income is generally advocated because these

adjustments merely result from a restatement

process. Changes in the domestic currency

equivalents of a foreign subsidiary’s net assets are

unrealized and have no effect on the local currency

cash flows generated by the foreign entity. Therefore,

it would be misleading to include such adjustments in

current income. Under these circumstances,

translation adjustments are accumulated separately

as a part of consolidated equity.

TRANSLATION WHEN LOCAL CURRENCY IS

THE FUNCTIONAL CURRENCY

If the functional currency is the foreign currency in

which the foreign entity’s records are kept, its

financial statements are translated to dollars using

the current rate method. Resulting translation gains or

losses are disclosed in a separate component of

consolidated equity. This preserves the financial

statement ratios as calculated from the local currency

statements. The following current rate procedures are

used:

TRANSLATION WHEN LOCAL CURRENCY IS


1. All foreign currency assets and liabilities aretranslated to dollars using the exchange rateprevailing as of the balance sheet date; capitalaccounts are translated at historical rates.

2. Revenues and expenses are translated using theexchange rate prevailing on the transaction date,although weighted average rates can be used forexpediency.

3. Translation gains and losses are reported in aseparate component of consolidated stockholders’equity. These exchange adjustments do not go intothe income statement until the foreign operation issold or the investment is judged to have permanentlylost value.

TRANSLATION WHEN THE PARENT CURRENCY IS


When the parent currency is a foreign entity’s

functional currency, its foreign currency financial

statements are remeasured to dollars using the

temporal method. All translation gains and losses

resulting from the translation process are included in

determining current period income. Specifically:

TRANSLATION WHEN THE PARENT CURRENCY IS


1. Monetary assets and liabilities and nonmonetaryassets valued at current market prices are translatedusing the rate prevailing as of the financial statementdate; other nonmonetary items and capital accountsare translated at historical rates.

2. Revenues and expenses are translated usingaverage exchange rates for the period except thoseitems related to nonmonetary items (e.g., cost ofsales and depreciation expense), which aretranslated using historical rates.

3. Translation gains and losses are reflected incurrent income.

TRANSLATION WHEN FOREIGN CURRENCY IS THE

FUNCTIONAL CURRENCY

A foreign entity may keep its records in on foreign

currency when its functional currency is another

foreign currency. In this situation, the financial

statements are first remeasured from the local

currency into the functional currency (temporal

method) and then translated into U.S. dollars using

the current rate method. Assume a German parent

company owns a wholly-owned affiliate in Mexico.

The Mexican affiliate subcontracts most of its

production to Brazilian vendors. Hence, the Mexican

affiliate’s functional currency is deemed to be the

Brazilian real.

EXAMPLE 1:

For each of the 12 accounts listed in the table below,

select the correct exchange rate to use when either

remeasuring or translating a foreign subsidiary for its

US parent company.

Codes

C = Current exchange rate

H = Historical exchange rate

A = Average exchange rate

… EXAMPLE 1:

US dollar is

the functional

Currency

The foreign

currency is the

functional

Currency

1. Accounts receivable

2. Marketable debt securities

carried at cost

3. Inventories carried at cost

4. Deferred income

5. Goodwill

6. Other paid-in capital

7. Depreciation

8. Refundable deposits

9. Common stock

10. Accumulated depreciation on

Buildings

11. Deferred income tax liabilities

12. Accounts payable

The following assets of Oriole Corporation’s Romanian

subsidiary have been converted into US dollars at the following exchange rates:

CurrentRates

HistoricalRates

Accounts receivable

$ 850,000 $ 875,000

Trademark 600,000 575,000

Property plant and equipment

1,200,000 900,000

Totals $ 2,650,000 $ 2,350,000

If the functional currency of the subsidiary is the US dollar, the assets should

be reported in the consolidated financial statements of Oriole Corporation and Subsidiary in the total amount of

TRANSLATE FINANCIAL STATEMENT:

EXAMPLE 2

On January 1, 20X5, Pegler Corporation, a US company, acquired 100%

of Selmic Corporation of Canada, paying an excess of 90,000 Canadian

dollars over the book value of Selmic’s net assets. The excess was

allocated to undervalued equipment with a three-year remaining useful

life. Selmic’s functional currency is the Canadian dollar. Exchange

rates for Canadian dollars for 20X5 are:

January 1, 20X5 $.77

Average rate for 20X5 .75

December 31, 20X5 .73

Required:

1. Determine the depreciation expense stated in US dollars on the

excess allocated to equipment for 20X5.

2. Determine the unamortized excess allocated to equipment on

December 31, 20X5.

3. If Selmic’s functional currency was the US dollar, what would be

the depreciation expense on the excess allocated to the

equipment for 20X5?


EXAMPLE 3


EXAMPLE 4

Peake Corporation, a US company, formed a British subsidiary on January

1, 20X5 by investing £450,000 in exchange for all of the subsidiary’s

no-par common stock. The British subsidiary, Searle Corporation,

purchased real property on April 1, 20X5 at a cost of £500,000, with

£100,000 allocated to land and £400,000 allocated to a building. The

building is depreciated over a 40-year estimated useful life on a

straight-line basis with no salvage value. The British pound is Searle’s

functional currency and its reporting currency. The British economy does

not have high rates of inflation. Exchange rates for the pound on

various dates were:

January 01, 20X5 = 1£ = $1.50

April 01, 20X5 = 1£ = $1.51

December 31, 20X5 = 1£ = $1.58

20X5 average rate = 1£ = $1.56

Searle's adjusted trial balance is presented below for the year ended

December 31, 20X5.


EXAMPLE 4 (CONT.)

Debits:

Cash £ 220,000

Accounts receivable 52,000

Inventory 59,000

Building 400,000

Land 100,000

Depreciation expense 7,500

Other expenses 110,000

Cost of good sold 220,000

Total debits £ 1,168,500

Credits

Accumulated depreciation £ 7,500

Accounts payable 111,000

Common stock 450,000

Retained earnings 0

Equity adjustment 0

Sales revenue 600,000

Total credits £ 1,168,500

Required: Prepare Searle's:

1. Translation working papers;

2. Translated income statement; and

3. Translated balance sheet.

EXAMPLE 4 … Searle Corporation

Translation Working Papers

Debits

Cash 220,000 x $1.58 = $ 347,600

Accounts receivable 52,000 x $1.58 = 82,160

Inventory 59,000 x $1.58 = 93,220

Building 400,000 x $1.58 = 632,000

Land 100,000 x $1.58 = 158,000

Depreciation expense 7,500 x $1.56 = 11,700

Other expenses 110,000 x $1.56 = 171,600

Cost of goods sold 220,000 x $1.56 = 343,200

Total debits $ 1,839,480

Credits

Accumulated depreciation 7,500 x $1.58 = $ 11,850

Accounts payable 111,000 x $1.58 = 175,380

Common stock 450,000 x $1.50 = 675,000

Sales revenue 600,000 x $1.56 = 936,000

Retained earnings 0

Total credits $ 1,798,230

Credit differential $ 41,250

EXAMPLE 4 …

Searle Corporation

Translated Income Statement

For the Year Ended December 31, 20X5

Sales revenue $ 936,000

Expenses:

Cost of goods sold ( 343,200 )

Depreciation expense ( 11,700 )

Other expenses ( 171,600 )

Net income $ 409,500

EXAMPLE 4 …

Searle Corporation

Translated Balance Sheet

December 31, 20X5

Cash $ 347,600


Inventory 93,220

Building-net 620,150

Land 158,000

Total assets $ 1,301,130

Accounts payable $ 175,380


Retained earnings 409,500

Accumulated comprehensive income 41,250

Total liabilities & equities $ 1,301,130


EXAMPLE 5

Searle Corporation, a British subsidiary of Peake Corporation (a US

company) was formed by Peake on January 1, 20X5 in exchange for all of

the subsidiary's common stock. Searle has now ended its second year of

operations on December 31, 20X6. Relevant exchange rates are:

January 01, 20X5 = 1£ = $1.50

December 31, 20X6 = 1£ = $1.65

20X6 average rate = 1£ = $1.63

Searle's adjusted trial balance is presented below for the calendar year

20X6. The amount of equity adjustment carried over from 20X5 is a credit

balance of $41,250 (in dollars).


EXAMPLE 5 (CONT.)

In Pounds

Debits:

Cash £ 75,000


Inventory 41,000

Building 400,000

Land 100,000

Depreciation expense 10,000

Other expenses 133,000

Cost of good sold 380,000

Total debits £ 1,501,000

Credits

Accumulated depreciation £ 17,500

Accounts payable 154,750



Sales revenue 616,250

Total credits £ 1,501,000

EXAMPLE 5…

Searle Corporation

Translation Working Papers

DebitsCash 75,000 x $1.65 = $ 123,750

Accounts receivable 362,000 x $1.65 = 597,300

Inventory 41,000 x $1.65 = 67,650

Building 400,000 x $1.65 = 660,000

Land 100,000 x $1.65 = 165,000

Depreciation expense 10,000 x $1.63 = 16,300

Other expenses 133,000 x $1.63 = 216,790

Cost of goods sold 380,000 x $1.63 = 619,400

Total debits $ 2,466,190

Credits

Accumulated depreciation 17,500 x $1.65 = $ 28,875

Accounts payable 154,750 x $1.65 = 255,338

Common stock 450,000 x $1.50 = 675,000

Sales revenue 616,250 x $1.63 = 1,004,487

Retained earnings 262,500 409,500

Accumulated comprehensive

income 41,250

Total credits $ 2,414,450

Credit differential $ 51,740

EXAMPLE 5…

Searle Corporation

Translated Income Statement

for the year ended December 31, 20X6

Sales revenue $ 1,004,487

Expenses:

Cost of goods sold ( 619,400 )

Depreciation expense ( 16,300 )

Other expenses ( 216,790 )

Net income $ 151,997

Retained earnings, January 1, 20X6 409,500

Retained earnings, December 31, 20X6 $ 561,497

EXAMPLE 5…

Searle Corporation

Translated Balance Sheet

December 31, 20X6

Cash $ 123,750


Inventory 67,650

Building-net 631,125

Land 165,000

Total assets $ 1,584,825

Accounts payable $ 255,338



Accumulated comprehensive income ($41,250 + $51,740) 92,990

Total liabilities & equities $ 1,584,825

International accounting: foreign currency

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