Translation of Foreign Currency Financial Statements: Chapter Outline

Chapter 08 - Translation of Foreign Currency Financial Statements
CHAPTER 8
TRANSLATION OF FOREIGN CURRENCY
FINANCIAL STATEMENTS
Chapter Outline
I. In preparing consolidated financial statements on a worldwide basis, the foreign currency
financial statements prepared by foreign operations must be translated into the parent
company’s reporting currency.
A. The two major issues related to the translation of foreign currency financial
statements are: (1) which method should be used, and (2) where should the resulting
translation adjustment be reported in the consolidated financial statements.
B. Translation methods differ on the basis of which accounts are translated at the
current exchange rate and which are translated at historical rates. Accounts
translated at the current exchange rate are exposed to translation adjustment
(balance sheet exposure).
C. Different translation methods give rise to different concepts of balance sheet
exposure and translation adjustments of differing sign and magnitude.
II. Under the current rate method, all assets and liabilities are translated at the current
exchange rate giving rise to a balance sheet exposure equal to the foreign subsidiary’s
net assets. Stockholders’ equity accounts are translated at historical exchange rates.
Income statement items are translated at the average exchange rate for the current
period.
A. Appreciation of the foreign currency results in a positive translation adjustment;
depreciation of the foreign currency results in a negative translation adjustment.
B. Translating all assets and liabilities at the current exchange rate maintains the
relationships that exist in the foreign currency financial statements.
B. Translating assets carried at historical cost at the current exchange rate results in
amounts being reported on the parent’s consolidated balance sheet that have no
economic meaning.
III. Under the temporal method, assets carried at current or future value (cash, marketable
securities, receivables) and liabilities are remeasured at the current exchange rate.
Assets carried at historical cost and stockholders’ equity accounts are remeasured at
historical exchange rates. Expenses related to assets remeasured at historical exchange
rates are remeasured using the same rates. Other income statements items are
remeasured using the average exchange rate for the period.
A. When liabilities are greater than the sum of cash, marketable securities, and
receivables, a net liability balance sheet exposure exists. Appreciation of the foreign
currency results in a remeasurement loss; depreciation of the foreign currency results
in a remeasurement gain.
B. Remeasuring assets carried at historical cost at historical exchange rates maintains
the underlying valuation method used by the foreign operation in preparing its
financial statements.
C. Remeasuring some assets at historical exchange rates and other assets at the
current exchange rate distorts the relationships that exist among account balances in
the foreign currency financial statements.
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Education.
IV. The appropriate combination of translation method and disposition of translation

adjustment is determined under both IFRS and U.S. GAAP by identifying the functional
currency of a foreign operation.
A. The financial statements of a foreign operation whose functional currency is different
from the parent’s reporting currency are translated using the current rate method, with
the resulting translation adjustment deferred in stockholders’ equity until the foreign
entity is disposed of. Upon disposal of the foreign operation, the accumulated
translation adjustment is recognized as a gain or loss in net income.
B. The financial statements of foreign operations whose functional currency is the same
as the parent’s reporting currency are remeasured using the temporal method with
the resulting remeasurement gain or loss reported immediately in net income.
V. The factors used to determine the functional currency of a foreign operation differ under
IFRS and U.S. GAAP.
A. IAS 21 indicates that two factors are of primary importance in determining a foreign
entity’s functional currency. If the functional currency is not obvious after evaluating
these factors, then a secondary set of six factors should be considered.
B. The FASB provides six factors that should be considered in determining functional
currency under U.S. GAAP, but no guidance is provided with respect to how these
factors should be weighted in the analysis. As a result, it is possible that a foreign
subsidiary could be viewed as having one functional currency under IFRS and a
different functional currency under U.S. GAAP.
VI. A substantive difference in translation rules between IFRS and U.S. GAAP relates to
foreign operations that report in the currency of a hyperinflationary economy.
A. IAS 21 requires a restate-translate method in translating the financial statements of
foreign operations located in a hyperinflationary economy. The foreign financial
statements are first restated for foreign inflation using rules in IAS 29, and then are
translated into parent company currency using the current rate method. IAS 29 does
not provide a bright-line threshold (as does U.S. GAAP) for determining whether a
foreign country is experiencing hyperinflation.
B. U.S. GAAP requires the financial statements of foreign operations in a highly
inflationary economy to be translated using the temporal method, as if the parent
currency is the functional currency. Under A country is considered highly inflationary if
its cumulative three-year inflation rate exceeds 100%.
VII. Some companies hedge their balance sheet exposures to avoid reporting
remeasurement losses in income and/or negative translation adjustments in stockholder’s
equity. In addition to derivative financial instruments, such as forward contracts and
options, companies often use foreign currency borrowings to hedge their net investment
in a foreign operation.
A. Both IFRS and U.S. GAAP provide that the gain or loss on a hedging instrument that
is designated and effective as a hedge of the net investment in a foreign operation
should be reported in the same manner as the translation adjustment being hedged.
B. The paradox in hedging balance sheet exposure is that by avoiding an unrealized
translation adjustment or remeasurement gain/loss, realized foreign exchange gains
and losses can arise.
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Answers to Questions
1. The two major issues related to the translation of foreign currency financial statements are:
(a) which method should be used and (b) where should the resulting translation adjustment
be reported in the consolidated financial statements. The first issue relates to determining
the appropriate exchange rate (historical, current, or average for the current period) for the
translation of foreign currency balances. Those items translated at the current exchange
rate are exposed to translation adjustment. The second issue relates to whether the
translation adjustment should be treated as a gain or loss in income, or should be deferred
as a separate component of stockholders’ equity.
2. Balance sheet exposure arises when a foreign currency balance is translated at the current
exchange rate. By translating at the current exchange rate, the foreign currency item in
essence is being revalued in U.S. dollar terms on the consolidated financial statements.
There will be either a net asset balance sheet exposure or net liability balance sheet
exposure depending upon whether assets translated at the current rate are greater or less
than liabilities translated at the current rate. Balance sheet exposure generates a
translation adjustment, which does not result in an inflow or outflow of cash. Transaction
exposure, which results from the receipt or payment of foreign currency, generates foreign
exchange gains and losses that are realized in cash.
3. The major concept underlying the current rate method is that the entire foreign investment
is exposed to foreign exchange risk. Therefore all assets and liabilities are translated at
the current exchange rate. Balance sheet exposure under this concept is equal to the net
investment.
The major concept underlying the temporal method is that the translation process should
result in a set of translated U.S. dollar financial statements as if the foreign subsidiary’s
transactions had actually been carried out using U.S. dollars. To achieve this objective,
assets carried at historical cost and stockholders’ equity are translated at historical
exchange rates; assets carried at current value and liabilities (carried at current value) are
translated at the current exchange rate. Under this concept, the foreign subsidiary’s
monetary assets and liabilities are considered to be foreign currency cash, receivables,
and payables of the parent that are exposed to transaction risk. For example, if the
foreign currency appreciates, then the foreign currency receivables increase in U.S. dollar
value and a gain is recognized. Balance sheet exposure under the temporal method is
analogous to the net transaction exposure that exists from having both receivables and
payables in a particular foreign currency.
4. The major differences relate to non-monetary assets carried at historical cost and related
expenses, i.e., inventory and cost of goods sold; property, plant, and equipment and
depreciation expense; and intangible assets and amortization expense. Under the temporal
method, these items are all translated at historical exchange rates. Under the current rate
method, the assets are translated at the current exchange rate and the related expenses
are translated at the average exchange rate for the current period.
5. To determine the appropriate translation method under both IFRS and U.S. GAAP, the
functional currency of a foreign subsidiary must be identified. The functional currency is
the primary currency of the foreign entity’s operating environment. It can be either the
parent’s reporting currency or a foreign currency (generally the local currency). The
functional currency orientation results in the following rule:
Functional Currency Translation Method Translation Adjustment
Parent’s currency Temporal method Gain (loss) in net income
Foreign currency Current rate method Separate component of
stockholders' equity (other
comprehensive income)
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6. For foreign entities that report in the currency of a hyperinflationary economy, IAS 21
requires the parent first to restate the foreign financial statements for inflation using IAS 29
rules and then translate the statements into parent company currency using the current
rate method. U.S. GAAP, on the other hand, requires financial statements of such foreign
entities to be translated using the temporal method. U.S. GAAP specifically defines
hyperinflation as cumulative three-year inflation greater than 100%. IAS 29 provides no
specific definition for hyperinflation, but suggests that a cumulative three-year inflation rate
approaching or exceeding 100% is evidence that an economy is hyperinflationary.
7. The functional currency is the currency of the subsidiary’s primary economic environment.
It is usually identified as the currency in which the company generates and expends cash.
U.S. GAAP stipulates that several factors such as the location of primary sales markets,
sources of materials and labor, the source of financing, and the amount of intercompany
transactions should be evaluated in identifying an entity’s functional currency. U.S. GAAP
does not provide any guidance as to how these factors are to be weighted (equally or
otherwise) when identifying an entity’s functional currency. IAS 21 also provides factors to
be considered in determining the functional currency of a foreign subsidiary. Unlike U.S.
GAAP, IAS 21 provides a hierarchy of factors to consider. Two primary factors are first to
be considered. If evaluation of these primary factors does not clearly indicate a foreign
subsidiary’s functional currency, then a group of six secondary factors should be
considered.
8. U.S. GAAP requires use of the temporal method for operations in highly inflationary
countries. Use of the current rate method without first restating for inflation results in a
“disappearing plant” problem in which fixed assets shrink in terms of their translated
carrying amount. By using the same historical rate for translation of fixed assets from one
period to the next, the temporal method avoids this problem. In developing the current
U.S. GAAP guidance on foreign currency translation, the FASB was unwilling to require
firms to restate foreign operation financial statements for foreign inflation because of the
lack of reliable inflation indices in many countries.
9. Although balance sheet exposure does not result in cash inflows and outflows, it does
nevertheless affect amounts reported in consolidated financial statements. If the foreign
currency is the functional currency, translation adjustments will be reported in stockholders’
equity. If translation adjustments are negative and therefore reduce total stockholders’
equity, there is an adverse (inflationary) impact on the debt to equity ratio. Companies with
restrictive debt covenants requiring them to stay below a maximum debt to equity ratio,
may find it necessary to hedge their balance sheet exposure so as to avoid negative
translation adjustments being reported. If the U.S. dollar is the functional currency or an
operation is located in a high inflation country, remeasurement gains and losses are
reported in income. Companies might want to hedge their balance sheet exposure in this
situation to avoid the adverse impact remeasurement losses can have on consolidated
income and earnings per share.
The paradox in hedging balance sheet exposure is that, by agreeing to receive or deliver
foreign currency in the future under a forward contract, a transaction exposure is created.
This transaction exposure is speculative in nature, given that there is no underlying inflow
or outflow of foreign currency that can be used to satisfy the forward contract. By hedging
balance sheet exposure, a company might incur a realized foreign exchange loss to avoid
an unrealized negative translation adjustment or unrealized remeasurement loss.
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10. The gains and losses arising from financial instruments used to hedge balance sheet
exposure are treated in a similar manner as the item the hedge is intended to cover. If the
foreign currency is the functional currency, gains and losses on hedging instruments will be
taken to other comprehensive income. If the parent’s reporting currency is the functional
currency, gains and losses on the hedging instruments will be offset against the related
remeasurement gains and losses.
Solutions to Exercises and Problems

1. C
2. C
3. C
4. C
5. C By translating items carried at historical cost by the historical exchange rate, the
temporal method maintains the underlying valuation method used by the foreign
subsidiary.
6. B When the U.S. dollar is the functional currency, SFAS 52 requires remeasurement
using the temporal method with remeasurement gains and losses reported in income.
7. C Gains and losses on hedges of net investments (whether through a forward contract,
borrowing, or other technique) are offset against the translation adjustment being
hedged.
8. a. Since the foreign currency is the functional currency, the current rate method is
appropriate. All assets accounts are translated at current rates. The answer is
₣670,000 [₣100,000 + 200,000 + 120,000 + 250,000].
b. Since the U.S. dollar is the functional currency, the temporal method is appropriate. All
receivables are remeasured at current rates. Assets carried at historical cost, such as
marketable securities, prepaid insurance and goodwill are remeasured at historical
rates. The answer is ₣770,000 [₣100,000 + 240,000 + 130,000 + 300,000].
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9. Armetis Corporation
a. Current Rate Method

Exchange
BRL Rate CAD
Cost of goods sold 450,000 0.420 189,000

Ending inventory 150,000 0.380 57,000
b. Temporal Method
Exchange
BRL Rate CAD
Beginning inventory 100,000 0.500 50,000
Purchases 500,000 0.420 210,000
Ending inventory (150,000) 0.400 (60,000)

Cost of goods sold 450,000 200,000
Ending inventory 150,000 0.400 60,000
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10. Simga Company
a. Highly inflationary economy (Temporal method)
Exchange
Equipment TL Rate USD
1/1/Y1 60,000,000,000 0.000007 420,000
1/1/Y3 40,000,000,000 0.000002 80,000
Total 100,000,000,000 500,000
Determination of Accumulated Depreciation at 12/31/Y4

Useful Life Annual Age Accumulated
Cost in years Depreciation in years Depreciation
6,000,000,00 24,000,000,00
1/1/Y1 60,000,000,000 10 0 4 0
1/1/Y3 40,000,000,000 10 4,000,000,000 2 8,000,000,000
100,000,000,000 10,000,000,000 32,000,000,000
Accumulated Exchange
Depreciation TL Rate USD
1/1/Y1 24,000,000,000 0.000007 168,000
1/1/Y3 8,000,000,000 0.000002 16,000
Total 32,000,000,000 184,000
Book value of equipment, 12/31/Y4 (in USD)

Cost 500,000
less: accumulated depreciation (184,000)
Book value 316,000
b. Non-highly inflationary economy (Current rate method)
Exchange
Equipment TL Rate USD
Total 100,000,000,000 0.0000006 60,000
Accumulated Exchange
Depreciation TL Rate USD
Total 32,000,000,000 0.0000006 19,200
Book value of equipment, 12/31/Y4 (in USD)

Cost 60,000
less: accumulated depreciation (19,200)
Book value 40,800
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11. Alliance Corporation
Exchange
Marks Rate A$
Net assets, 1/1/Y1 1,000,000 0.15 150,000
Increase in net assets:
Net income, Year 1 200,000 0.17 34,000
Net assets, 12/31/Y1 1,200,000 184,000
Net assets, 12/31/Y1 at
the current exchange rate 1,200,000 0.21 252,000
Translation adjustment
(positive) (68,000)
12. Zesto Company
Pesos US$
Net monetary assets, 1/1/Y1 1,000,000 $.09 90,000
Increase in monetary items:
Sales, Year 1 500,000 $0.85 42,500
Decrease in monetary items:
Purchases of inventory, Year 1 (300,000) $0.85 (25,500)
Purchase of property and equipment, 1/1/Y1 (600,000) $0.9 (54,000)
Dividends, 12/1/Y1 (100,000) $0.8 (8,000)
Net monetary assets, 12/31/Y1 500,000 (45,000)
Net monetary assets, 12/31/Y1
at the current exchange
rate 500,000 $0.78 (39,000)
Remeasurement loss (6,000)
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13. Alexander Corporation
a. Swiss franc is functional currency (Current rate method)
Swiss Exchange U.S.

Francs Rate Dollars
Net assets, 12/20/Y1 8,200,000 0.70 5,740,000
Change in net assets - -
Net assets, 12/31/Y1 8,200,000 5,740,000
the current exchange rate 8,200,000 0.75 6,150,000
Translation adjustment (positive) (410,000)
b. U.S. dollar is functional currency (Temporal method)
Swiss Exchange U.S.

Francs Rate Dollars
Net monetary liabilities, 12/20/Y1 (800,000) 0.70 (560,000)
Change in net monetary liabilities - -
Net monetary liabilities, 12/31/Y1 (800,000) (560,000)
Net monetary liabilities, 12/31/Y1
at the current exchange rate (800,000) 0.75 (600,000)
Remeasurement loss 40,000
Economic Relevance of Translation Adjustment

The translation adjustment increases stockholders’ equity by $410,000. The positive
translation adjustment arises because the Swiss subsidiary has a net asset position
of CHF8,200,000 and the Swiss franc appreciates by $.05 [CHF8,200,000 x $.05 =
$410,000]. The positive translation adjustment is not realized in terms of U.S. dollar
cash flow. It would be a realized gain only if Alexander sold this operation on
December 31 for exactly CHF8,200,000 and converted the sales proceeds into
dollars at the current exchange rate of $.75 per Swiss franc.
Economic Relevance of Remeasurement Loss
The remeasurement loss arises because the Swiss subsidiary has a net monetary
liability position of CHF800,000 (Cash of CHF1,000,000 less Notes payable of
CHF1,800,000) and the Swiss franc has appreciated by $.05 [CHF800,000 x $.05 =
$40,000]. The loss is unrealized. It would be realized only if the Swiss subsidiary
used its Swiss franc cash to pay off Swiss franc notes payable to the extent possible
(CHF1,000,000), and the parent paid off the remaining Swiss franc notes payable
using U.S. dollars, thereby realizing a transaction loss of $40,000 [CHF800,000 x
($.75-$.70)]. (A CHF 800,000 note payable could have been paid off at December 1
with $560,000 [CHF800,000 x $.70]. At December 31, it takes $600,000 to pay off
the same amount of CHF note payable [CHF800,000 x $.75].)
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14. Gramado Company
Exchange Rates $/Cz

January 1, Year 1 0.84
Average for Year 1 0.80
December 31, Year 1 0.75
Exchange
Cz Rate $
388,80
Sales 540,000 0.72 0
Cost of goods sold (310,000) 0.72 (223,200)
165,60
Gross profit 230,000 0
Operating expenses (108,000) 0.72 (77,760)
Income before tax 122,000 87,840
Income taxes (40,000) 0.72 (28,800)
Net income 82,000 59,040
123,20
Retained earnings, 1/1/Y2 154,000 0.80 0
Net income 82,000 above 59,040
Dividends (20,000) 0.71 (14,200)
168,04
Retained earnings, 12/31/Y2 216,000 0
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14. (continued)
Exchange
Cz Rate $
Cash 50,000 0.70 35,000
Receivables 100,000 0.70 70,000
Inventory 72,000 0.70 50,400
Plant and equipment 300,000 0.70 210,000
Less: accumulated depreciation (70,000) 0.70 (49,000)
Total assets 452,000 316,400
Liabilities 186,000 0.70 130,200

Capital stock 50,000 0.84 42,000
Retained earnings, 12/31/Y2 216,000 above 168,040
Cumulative translation adjustment - (23,840)
Total liabilities and stockholders'
equity 452,000 316,400
Exchange
Cz Rate $
Net assets, 1/1/Y1 50,000 0.84 42,000
Net income, Year 1 154,000 0.80 123,200
Net assets, 12/31/Y1 204,000 165,200
current exchange rate 204,000 0.75 153,000
Translation adjustment, Year 1
(negative) 12,200
Net assets, 1/1/Y2 204,000 0.75 153,000
Net income, Year 2 82,000 0.72 59,040
Dividends, 12/1/Y2 (20,000) 0.71 (14,200)
Net assets, 12/31/Y2 266,000 197,840
Translation adjustment, Year 2
(negative) 11,640
Cumulative translation adjustment,
12/31/Y2 23,840
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15. Brookhurst Company
Exchange Rates USD/ZAR

June 1, Year 1 0.095
November 15, Year 1 0.100
a. South African rand is functional currency (Current rate method)

Exchange
ZAR Rate USD
Sales 1,000,000 0.096 96,000
Gross profit 400,000 38,400
Depreciation expense (50,000) 0.096 (4,800)
Other operating expenses (150,000) 0.096 (14,400)
Income taxes (90,000) 0.096 (8,640)
Net income 110,000 10,560
Retained earnings, 1/1/Y1 - -

Net income, Year 1 110,000 10,560
Dividends, 6/1/Y1 (20,000) 0.095 (1,900)
Dividends, 12/1/Y1 (20,000) 0.105 (2,100)
Retained earnings, 12/31/Y1 70,000 6,560
Cash 80,000 0.110 8,800

Receivables 150,000 0.110 16,500
Inventory 270,000 0.110 29,700
Total assets 950,000 104,500
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15. (continued)
Accounts payable 80,000 0.110 8,800

Long-term debt 500,000 0.110 55,000
Common stock 300,000 0.090 27,000
Cumulative translation adjustment - 7,140
Total liabilities and stockholders' equity 950,000 104,500
Calculation of cumulative translation adjustment

Exchange
ZAR Rate USD
Net assets, 1/1/Y1 300,000 0.090 27,000
Net income, Year 1 110,000 above 10,560
Dividends, 6/1/Y1 (20,000) 0.095 (1,900)
Dividends, 12/1/Y1 (20,000) 0.105 (2,100)
Net assets, 12/31/Y1 370,000 33,560
Translation adjustment, Year 1 (positive) (7,140)
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15. (continued)
b. U.S. dollar is functional currency (Temporal method)

Exchange
ZAR Rate USD
Sales 1,000,000 0.096 96,000
Cost of goods sold (600,000) Sched. A (56,520)
Remeasurement gain (loss) - below (5,940)
Income taxes (90,000) 0.096 (8,640)
Net income 110,000 6,000
Retained earnings, 1/1/Y1 - -

Net income 110,000 6,000
Dividends, 6/1/Y1 (20,000) 0.095 (1,900)
Dividends, 12/1/Y1 (20,000) 0.105 (2,100)
Cash 80,000 0.110 8,800

Receivables 150,000 0.110 16,500
Inventory 270,000 0.100 27,000
Total assets 950,000 92,800
Accounts payable 80,000 0.110 8,800

Long-term debt 500,000 0.110 55,000
Common stock 300,000 0.090 27,000
Total liabilities and stockholders' equity 950,000 92,800
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15. (continued)
Schedule A. Exchange
Calculation of cost of goods sold ZAR Rate USD
Beginning inventory - -
Purchases 870,000 0.0960 83,520
Calculation of remeasurement gain

(loss)
Exchange
ZAR Rate USD
Net monetary liabilities, 1/1/Y1 (200,000) 0.090 (18,000)
Increase in monetary assets
Sales 1,000,000 0.096 96,000
Decrease in monetary assets -
Purchases of inventory (870,000) 0.096 (83,520)
Income taxes (90,000) 0.096 (8,640)
Dividends, 6/1/Y1 (20,000) 0.095 (1,900)
Dividends, 12/1/Y1 (20,000) 0.105 (2,100)
Net monetary liabilities, 12/31/Y1 at
current exchange rate (350,000) 0.110 (38,500)
Remeasurement loss 5,940
16. The solutions to this problem will depend upon the U.S.-based MNC selected by each
student for examination.
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17. This problem requires students to examine disclosures made by ExxonMobil and
Chevron with respect to foreign currency translation. The solutions to the requirements
of this problem will depend upon the annual reports (which year) examined.
(a) In its 2012 Form 10-K, ExxonMobil disclosed the following in its Summary of Accounting
Policies: “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 countries with a history of high inflation
(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” (page 68). Thus, a
substantial number of ExxonMobil’s foreign operations have the local currency as
functional currency.
In contrast, Chevron indicated that substantially all of its foreign operations had the U.S.
dollar as functional currency (2012 Form 10-K, page FS-30).
This difference in predominant functional currency presents two kinds of comparability

problems. First, while Chevron primarily uses the temporal method of translation,
ExxonMobil primarily uses the current rate method. Second, Chevron primarily reports
translation gains/losses in net income (as remeasurement gains/losses), whereas most of
ExxonMobil’s translation gains/losses are deferred on the balance sheet in Accumulated
other comprehensive income.
(b) In 2012, ExxonMobil reported translation adjustments (in other comprehensive income) of
+$584 million, -$843 million, and +$842 million, in 2010, 2011, and 2012, respectively
(page 69). Chevron reported translation adjustments of only +$23 million, +$17 million,
and +$6 million for the same three years. The difference in magnitude is at least partially
explained by the fact that Chevron reports most of its translation adjustments in net
income rather than in other comprehensive income (as explained in the preceding
paragraph).
(c) In 2012, neither company mentioned hedges of net investment in foreign operations.
ExxonMobil indicated that it makes limited use of derivatives, with no further description.
Exxon explains that its geographic diversity reduces the company’s enterprise-wide risk
from changes in currency rates (page 54). Chevron indicated that although the company
“may enter into foreign currency derivative contracts to manage some of its foreign
currency exposures,” “there were no open foreign currency derivative contracts at
December 31, 2012” (page FS-14). Thus, it appears that neither ExxonMobil nor
Chevron hedge the net investments in foreign operations.
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Case 8-1 Columbia Corporation
Part I
Exchange Rates $/PLN
Average Year 2 0.175
August 5, Year 2 0.17
Fourth quarter, Year 2 0.16
Part I (a). Polish zloty is the functional currency – Current rate method
Exchange
PLN Rate U.S. $
Sales 12,500,000 0.175 2,187,500
Cost of goods sold (6,000,000) 0.175 (1,050,000)
Depreciation expense-equipment (1,250,000) 0.175 (218,750)
Depreciation expense-building (900,000) 0.175 (157,500)
Research and development expense (600,000) 0.175 (105,000)
Other expenses (including taxes) (500,000) 0.175 (87,500)
Net income 3,250,000 568,750
Plus: Retained earnings, 1/1/Y2 250,000 Given 56,250
Less: Dividends paid (750,000) 0.155 (116,250)
Retained earnings, 12/31/Y2 2,750,000 508,750
Cash 1,000,000 0.150 150,000

Accounts receivable (net) 1,650,000 0.150 247,500
Inventory 4,250,000 0.150 637,500
Equipment 12,500,000 0.150 1,875,000
Less: accumulated depreciation (4,250,000) 0.150 (637,500)
Building 36,000,000 0.150 5,400,000
Less: accumulated depreciation (15,150,000) 0.150 (2,272,500)
Land 3,000,000 0.150 450,000
Total assets 39,000,000 5,850,000
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Case 8-1 Columbia Corporation (continued)
Accounts payable 1,250,000 0.150 187,500

Long-term debt 25,000,000 0.150 3,750,000
Common stock 2,500,000 0.250 625,000
Additional paid-in capital 7,500,000 0.250 1,875,000
Retained earnings 2,750,000 Above 508,750
Translation adjustment - to balance (1,096,250)
Total 39,000,000 5,850,000
Calculation of Cumulative Translation Adjustment
Exchange
PLN Rate U.S. $
Net assets, 1/1/Y2 10,250,000 0.200 2,050,000

Net income, Year 2 3,250,000 0.175 568,750
Dividends, 12/15/Y2 (750,000) 0.155 (116,250)
Net assets, 12/31/Y2 12,750,000 2,502,500
Net assets, 12/31/Y2 at 12,750,000 0.150 1,912,500

current exchange rate
Translation adjustment, Year 2 (negative) 590,000
Translation adjustment, Year 1 (negative) given 506,250
Cumulative translation adjustment, 12/31/Y2 (negative) 1,096,250
8-18
Education.
Part I (b). U.S. dollar is the functional currency – Temporal method
Exchange
PLN Rate U.S. $
Sales 12,500,000 0.175 2,187,500
Cost of goods sold (6,000,000) Sched. A (1,233,750)
Depreciation expense-equipment (1,250,000) Sched. B (295,000)
Depreciation expense-building (900,000) Sched. C (213,000)
Research and development expense (600,000) 0.175 (105,000)
Income before remeasurement gain 3,250,000 253,250
Remeasurement gain, Year 2 - 1,020,000
Net income 3,250,000 1,273,250
Plus: Retained earnings, 1/1/Y2 250,000 Given 882,500
Retained earnings, 12/31/Y2 2,750,000 2,039,500
Cash 1,000,000 0.150 150,000

Inventory 4,250,000 0.160 680,000
Equipment 12,500,000 Sched. B 2,950,000
Less: accumulated depreciation (4,250,000) Sched. B (1,045,000)
Building 36,000,000 Sched. C 8,520,000
Less: accumulated depreciation (15,150,000) Sched. C (3,775,500)
Land 3,000,000 0.250 750,000
Total assets 39,000,000 8,477,000

Long-term debt 25,000,000 0.150 3,750,000
Common stock 2,500,000 0.250 625,000
Retained earnings 2,750,000 Above 2,039,500
Total 39,000,000 8,477,000
8-19
Education.
Schedule A - Cost of goods

sold
Exchange
PLN Rate U.S. $
Beginning inventory 3,000,000 0.215 645,000
Purchases 7,250,000 0.175 1,268,750
Ending inventory (4,250,000) 0.160 (680,000)

Cost of goods sold 6,000,000 1,233,750
Schedule B - Equipment
Exchange
PLN Rate U.S. $
Old Equipment - at 1/1/Y1 10,000,000 0.250 2,500,000
New Equipment-acquired 1/3/Y2 2,500,000 0.180 450,000
Total 12,500,000 2,950,000
Acc. Deprec.-Old Equipment 4,000,000 0.250 1,000,000

Acc.Deprec.-New Equipment 250,000 0.180 45,000
Total 4,250,000 1,045,000
Deprec. Expense - Old Equip. 1,000,000 0.250 250,000

Deprec. Expense - New Equip. 250,000 0.180 45,000
Total 1,250,000 295,000
Schedule C - Building
Exchange
PLN Rate U.S. $
Old Building - at 1/1/Y1 30,000,000 0.250 7,500,000
New Building-acquired 3/5/Y2 6,000,000 0.170 1,020,000
Total 36,000,000 8,520,000
Acc.Deprec.-Old Building 15,000,000 0.250 3,750,000

Acc.Deprec.-New Building 150,000 0.170 25,500
Total 15,150,000 3,775,500
Deprec. Expense - Old Building 750,000 0.250 187,500

Deprec. Expense - New Building 150,000 0.170 25,500
Total 900,000 213,000
8-20
Education.
Calculation of Remeasurement Gain
Exchange
PLN Rate U.S. $
Net monetary liabilities, 1/1/Y2 (18,500,000) 0.200 (3,700,000)
Increase in monetary assets:
Sales 12,500,000 0.175 2,187,500
Decrease in monetary assets:
Purchase of inventory (7,250,000) 0.175 (1,268,750)
Research & development (600,000) 0.175 (105,000)
Other expenses (500,000) 0.175 (87,500)
Dividends paid, 12/15/Y2 (750,000) 0.155 (116,250)
Purchase of equipment, 1/3/Y2 (2,500,000) 0.180 (450,000)
Purchase of buildings, 8/5/Y2 (6,000,000) 0.170 (1,020,000)
Net monetary liabilities, 12/31/Y2 (23,600,000) (4,560,000)
Net monetary liabilities, 12/31/Y2 at (23,600,000) 0.150 (3,540,000)

Remeasurement gain - Year 2 (1,020,000)
8-21
Education.
Part I (c). U.S. dollar is the functional currency – Temporal method (no long-term debt)
Exchange
PLN Rate U.S. $
Sales 12,500,000 0.175 2,187,500
Cost of goods sold (6,000,000) Sched. A (1,233,750)
Depreciation expense-equipment (1,250,000) Sched. B (295,000)
Depreciation expense-building (900,000) Sched. C (213,000)
Research and development
expense (600,000) 0.175 (105,000)
Income before remeasurement gain 3,250,000 253,250
Remeasurement loss, Year 2 - (230,000)
Net income 3,250,000 23,250
Plus: Retained earnings, 1/1/Y2 250,000 Given (367,500)
Retained earnings, 12/31/Y2 2,750,000 from below (460,500)
Cash 1,000,000 0.150 150,000

Inventory 4,250,000 0.160 680,000
Equipment 12,500,000 Sched. B 2,950,000
Less: accumulated depreciation (4,250,000) Sched. B (1,045,000)
Building 36,000,000 Sched. C 8,520,000
Less: accumulated depreciation (15,150,000) Sched. C (3,775,500)
Land 3,000,000 0.250 750,000
Total assets 39,000,000 8,477,000

Long-term debt - 0.150 -
Common stock 10,000,000 0.250 2,500,000
Retained earnings 2,750,000 to balance (460,500)
Total 39,000,000 8,477,000
8-22
Education.
Calculation of Remeasurement Loss
Exchange
PLN Rate U.S. $
Net monetary assets, 1/1/Y2 6,500,000 0.200 1,300,000
Sales 12,500,000 0.175 2,187,500
Purchase of inventory (7,250,000) 0.175 (1,268,750)
Research & development (600,000) 0.175 (105,000)
Other expenses (500,000) 0.175 (87,500)
Dividends paid, 12/15/Y2 (750,000) 0.155 (116,250)
Purchase of equipment, 1/3/Y2 (2,500,000) 0.180 (450,000)
Purchase of buildings, 8/5/Y2 (6,000,000) 0.170 (1,020,000)
Net monetary assets, 12/31/Y2 1,400,000 440,000
Net monetary assets, 12/31/Y2 at 1,400,000 0.150 210,000

Remeasurement loss - Year 2 230,000
Part II. Explain the negative translation adjustment in Part I (a) and remeasurement gain
or loss in Parts 1(b) and 1(c).
The negative translation adjustment in part 1(a) arises because of two factors: (1) there is a
net asset balance sheet exposure and (2) the Polish zloty has depreciated against the U.S.
dollar during Year 2 (from $.020 at 1/1/Y2 to $.0150 at 12/31/Y2). A net asset balance sheet
exposure exists because all assets are translated at the current exchange rate and exceeds
total liabilities which are also translated at the current exchange rate.
The remeasurement gain in part I(b) arises because of two factors: (1) there is a net liability
balance sheet exposure and (2) the Polish zloty has depreciated against the U.S. dollar.
Under the temporal method, Cash and Accounts Receivable are the only assets translated at
the current exchange rate (total PLN 2,650,000). Accounts Payable and Long-Term Debt also
are translated at the current exchange rate (total PLN 26,250,000). Because the Polish zloty
amount of liabilities translated at the current rate exceeds the Polish zloty amount of assets
translated at the current rate, a net liability balance sheet exposure exists.
The remeasurement loss in part I(c) arises because of two factors: (1) there is a net asset
balance sheet exposure and (2) the Polish zloty has depreciated against the U.S. dollar during
Year 2.
Cash and Accounts Receivable are the only assets translated at the current exchange rate
(total PLN 2,650,000). Because there is no Long-term Debt in part 1(c), Accounts Payable is
the only liability translated at the current exchange rate (total PLN 1,250,000). Because the
Polish zloty amount of the assets translated at the current rate exceeds the Polish zloty
amount of liabilities translated at the current rate, a net asset balance sheet exposure exists.
8-23
Education.
Case 8-2 Palmerstown Company
Exchange Rates $/pound

January 1-31, Year 1 1.00
Average Year 1 0.90
When inventory purchases made 0.86
When ending inventory acquired 0.83
1. Pound is the functional currency – Current rate method
Exchange
Pounds Rate U.S. $
Sales 15,000 0.900 13,500
Selling and administrative expense (3,000) 0.900 (2,700)
Depreciation expense (1,000) 0.900 (900)
Income taxes (600) 0.900 (540)
Net income 1,400 1,260
Plus: Retained earnings, 1/1/Y1 - -
Cash 2,400 0.800 1,920

Inventory 4,000 0.800 3,200
Fixed assets 10,000 0.800 8,000
Less: accumulated depreciation (1,000) 0.800 (800)
Current liabilities 2,000 0.800 1,600

Long-term debt 4,000 0.800 3,200
Contributed capital 8,000 1.000 8,000
Retained earnings 1,400 from above 1,260
Translation adjustment - from below (1,740)
Total 15,400 12,320
8-24
Education.
Case 8-2 Palmerstown Company (continued)
Calculation of Cumulative Translation Adjustment
Exchange
Pounds Rate U.S. $
Net assets, 1/1/Y1 8,000 1.000 8,000
Net income, Year 1 1,400 0.900 1,260
Net assets, 12/31/Y1 9,400 9,260

Translation adjustment, Year 1 (negative) 1,740
2. U.S. dollar is the functional currency – Temporal method
Exchange
Pounds Rate U.S. $
Sales 15,000 0.900 13,500
Cost of goods sold (9,000) Sched. A (8,000)
Selling and administrative expense (3,000) 0.900 (2,700)
Remeasurement gain (loss) - from below 180
Income taxes (600) 0.900 (540)
Net income 1,400 1,440
Plus: Retained earnings, 1/1/Y1 - -
Cash 2,400 0.800 1,920

Inventory 4,000 0.830 3,320
Fixed assets 10,000 1.000 10,000
Current liabilities 2,000 0.800 1,600

Long-term debt 4,000 0.800 3,200
Contributed capital 8,000 1.000 8,000
Retained earnings 1,400 to balance 1,440
Total 15,400 14,240
8-25
Education.
Schedule A - Cost of goods sold
Exchange
Pounds Rate U.S. $
Purchase, January 10 1,000 1.000 1,000
Additional purchases 12,000 0.860 10,320
Calculation of Remeasurement Gain
Exchange
Pounds Rate U.S. $
Net monetary assets, 1/1/Y1 8,000 1.000 8,000
Sales 15,000 0.900 13,500
Acquisition of beginning inventory (1,000) 1.000 (1,000)
Purchase of inventory during year (12,000) 0.860 (10,320)
Selling and administrative expenses (3,000) 0.900 (2,700)
Income taxes (600) 0.900 (540)
Purchase of fixed assets (10,000) 1.000 (10,000)
Net monetary liabilities, 12/31/Y1 at
current exchange rate (3,600) 0.800 (2,880)
Remeasurement gain - Year 1 (180)
3. With the pound as functional currency, the U.S. dollar net income reflected in the
consolidated income statement is $1,260. If the U.S. dollar were the functional currency,
the amount reflected in consolidated net income would be $1,560, 24% higher. The
amount of total assets reported on the consolidated balance sheet is 17% smaller than if
the U.S. dollar were functional currency [($14,360 – $12,320)/$12,320].
The relations between the current ratio, the debt to equity ratio, and profit margin
calculated from the FC financial statements and from the translated U.S. dollar financial
statements are shown below.
8-26
Education.
U.S. $ U.S $
Pounds Current Rate Temporal
Current ratio:
Current assets 6,400 5,120 5,240
Current liabilities 2,000 1,600 1,600
3.2 3.2 3.275
Debt to equity ratio:

Total liabilities 6,000 4,800 4,800
Total stockholders' equity 9,400 7,520 9,440
0.638 0.638 0.508
Profit margin:
Net income 1,400 1,260 1,440
Sales 15,000 13,500 13,500
0.093 0.093 0.107
A comparison of the ratios calculated using pounds and using U.S.$ translated amounts shows
that the temporal method distorts all ratios as calculated from the original foreign currency
financial statements. The current rate method maintains all ratios that use numbers in the
numerator and denominator from the balance sheet only (current ratio, debt-to-equity ratio) or
the income statement only (profit margin). Note: For ratios that combine numbers from the
income statement and balance sheet (return on equity, inventory turnover), even the current
rate method creates distortions.
The U.S. dollar amounts reported under the temporal method for inventory and fixed assets
reflect the equivalent U.S. dollar cost of those assets as if the parent had sent dollars to the
subsidiary to purchase the assets. For example, to purchase 10,000 pounds worth of fixed
assets when the exchange rate was $1.00/pound, the parent would have had to provide the
subsidiary with $10,000.
The U.S. dollar amounts reported under the current rate method for inventory and fixed assets
reflect neither the equivalent U.S. dollar cost of those assets nor their U.S. dollar current value.
By multiplying the pound historical cost amounts by the current exchange rate, these assets
are reported at what they would have cost in U.S. dollars if the current exchange rate had
been in effect when they were purchased. This is a hypothetical number with little, if any,
meaning.
8-27
Education.

Translation of Foreign Currency Financial Statements: Chapter Outline

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Translation of Foreign Currency Financial Statements: Chapter Outline

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Chapter 08 - Translation of Foreign Currency Financial Statements

IV. The appropriate combination of translation method and disposition of translation

Solutions to Exercises and Problems

a. Current Rate Method

Cost of goods sold 450,000 0.420 189,000

Ending inventory (150,000) 0.400 (60,000)

Ending inventory 150,000 0.400 60,000

10. Simga Company

a. Highly inflationary economy (Temporal method)

Determination of Accumulated Depreciation at 12/31/Y4

Book value of equipment, 12/31/Y4 (in USD)

b. Non-highly inflationary economy (Current rate method)

Book value of equipment, 12/31/Y4 (in USD)

11. Alliance Corporation

12. Zesto Company

13. Alexander Corporation

a. Swiss franc is functional currency (Current rate method)

Swiss Exchange U.S.

b. U.S. dollar is functional currency (Temporal method)

Swiss Exchange U.S.

Economic Relevance of Translation Adjustment

14. Gramado Company

Exchange Rates $/Cz

Liabilities 186,000 0.70 130,200

15. Brookhurst Company

Exchange Rates USD/ZAR

a. South African rand is functional currency (Current rate method)

Retained earnings, 1/1/Y1 - -

Cash 80,000 0.110 8,800

Accounts payable 80,000 0.110 8,800

Calculation of cumulative translation adjustment

b. U.S. dollar is functional currency (Temporal method)

Retained earnings, 1/1/Y1 - -

Cash 80,000 0.110 8,800

Accounts payable 80,000 0.110 8,800

Calculation of remeasurement gain

This difference in predominant functional currency presents two kinds of comparability

Case 8-1 Columbia Corporation

Cash 1,000,000 0.150 150,000

Case 8-1 Columbia Corporation (continued)

Accounts payable 1,250,000 0.150 187,500

Calculation of Cumulative Translation Adjustment

Net assets, 1/1/Y2 10,250,000 0.200 2,050,000

Net assets, 12/31/Y2 at 12,750,000 0.150 1,912,500

Case 8-1 Columbia Corporation (continued)

Part I (b). U.S. dollar is the functional currency – Temporal method

Cash 1,000,000 0.150 150,000

Accounts payable 1,250,000 0.150 187,500

Case 8-1 Columbia Corporation (continued)

Schedule A - Cost of goods

Ending inventory (4,250,000) 0.160 (680,000)

Acc. Deprec.-Old Equipment 4,000,000 0.250 1,000,000

Deprec. Expense - Old Equip. 1,000,000 0.250 250,000

Acc.Deprec.-Old Building 15,000,000 0.250 3,750,000

Deprec. Expense - Old Building 750,000 0.250 187,500

Case 8-1 Columbia Corporation (continued)

Calculation of Remeasurement Gain