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Chapter 07 - Translation of Foreign Currency Financial Statements

CHAPTER 7
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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Chapter 07 - Translation of Foreign Currency Financial Statements

IV. The appropriate combination of translation method and disposition of translation
adjustment is determined under both IAS 21 and SFAS 52 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 only substantive difference in translation rules between IAS 21 and SFAS 52 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.
B. SFAS 52 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.
C. A country is considered highly inflationary if its cumulative three-year inflation rate
exceeds 100%.

VI. 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 IAS 39 and SFAS 133 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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Chapter 07 - Translation of Foreign Currency Financial Statements

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 SFAS 52 and IAS 21, 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 income
Foreign currency Current rate method Separate component of
stockholders' equity

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For foreign entities that report in the currency of a hyperinflationary economy. dollar is the functional currency or an operation is located in a high inflation country.S. Although balance sheet exposure does not result in cash inflows and outflows. By using the same historical rate for translation of fixed assets from one period to the next. SFAS 52. This transaction exposure is speculative in nature. but suggests that a cumulative three-year inflation rate approaching or exceeding 100% is evidence that an economy is hyperinflationary. SFAS 52 requires use of the temporal method for operations in highly inflationary countries. If the foreign currency is the functional currency. The functional currency is the currency of the subsidiary’s primary economic environment. SFAS 52 does not provide any guidance as to how these factors are to be weighted (equally or otherwise) when identifying an entity’s functional currency. remeasurement gains and losses are reported in income. SFAS 52 recommends that several factors such as the location of primary sales markets. the guidance provided by the two standards in determining an entity’s functional currency is consistent. given that there is no underlying inflow or outflow of foreign currency that can be used to satisfy the forward contract. on the other hand. If the U. IAS 21 also provides factors to be considered in determining the functional currency of a foreign subsidiary. gains and losses on the hedging instruments will be offset against the related remeasurement gains and losses. a transaction exposure is created. by agreeing to receive or deliver foreign currency in the future under a forward contract. 7. gains and losses on hedging instruments will be taken to other comprehensive income.Translation of Foreign Currency Financial Statements 6. it does nevertheless affect amounts reported in consolidated financial statements. 8. 7-4 . If the U. 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. translation adjustments will be reported in stockholders’ equity.S. IAS 21 does not provide a definition of hyperinflation. 10. the temporal method avoids this problem. there is an adverse (inflationary) impact on the debt to equity ratio. requires financial statements of such foreign entities to be translated using the temporal method. If the foreign currency is the functional currency. Although the factors listed in IAS 21 are not identical to the characteristics described in SFAS 52. dollar is the functional currency. IAS 29 also provides no specific definition for hyperinflation. may find it necessary to hedge their balance sheet exposure so as to avoid negative translation adjustments being reported. sources of materials and labor.Chapter 07 . a company might incur a realized foreign exchange loss to avoid an unrealized negative translation adjustment or unrealized remeasurement loss. If translation adjustments are negative and therefore reduce total stockholders’ equity. the source of financing. It is usually identified as the currency in which the company generates and expends cash. 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. 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. 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. 9. By hedging balance sheet exposure. and the amount of intercompany transactions should be evaluated in identifying an entity’s functional currency. SFAS 52 specifically defines hyperinflation as cumulative three-year inflation greater than 100%. Companies with restrictive debt covenants requiring them to stay below a maximum debt to equity ratio. 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. The paradox in hedging balance sheet exposure is that.

000 0. The answer is ₣670.380 57.000 b. Armetis Corporation a. Assets carried at historical cost. 9. 7. C Gains and losses on hedges of net investments (whether through a forward contract.000 200. C 4.000]. such as marketable securities. a. dollar is the functional currency. Since the U. The answer is ₣770. C 3.Translation of Foreign Currency Financial Statements Solutions to Exercises and Problems 1.000 0. 8. the temporal method maintains the underlying valuation method used by the foreign subsidiary. C 5.400 ) Cost of goods sold 450.000 + 250. Current Rate Method Exchange BRL Rate CAD Cost of goods sold 450.000 Purchases 500. C 2.000 + 240. All receivables are remeasured at current rates.000 + 120. the temporal method is appropriate. B When the U.Chapter 07 . SFAS 52 requires remeasurement using the temporal method with remeasurement gains and losses reported in income. borrowing.000 (60.000 Ending inventory 150.000 0.000 + 130.400 60. dollar is the functional currency.000 [₣100.S.000 + 300.000 (150.000 + 200. the current rate method is appropriate. All assets accounts are translated at current rates.000 Ending inventory 150.420 210.000 Ending inventory ) 0. C By translating items carried at historical cost by the historical exchange rate.000 7-5 . Temporal Method Exchange BRL Rate CAD Beginning inventory 100. 6. Since the foreign currency is the functional currency.000]. b.000 0.500 50. or other technique) are offset against the translation adjustment being hedged. prepaid insurance and goodwill are remeasured at historical rates.S.000 0.420 189.000 [₣100.

Highly inflationary economy (Temporal method) Exchange Equipment TL Rate USD 1/1/Y1 60.000.000 10 0 2 8.00 100.Chapter 07 . Non-highly inflationary economy (Current rate method) Exchange Equipment TL Rate USD Total 100.000 Determination of Accumulated Depreciation at 12/31/Y4 Useful Life Annual Age Accumulated Cost in years Depreciation in years Depreciation 6.000 1/1/Y3 8.000.000 Book value of equipment.000 0.000.00 32.000.000 0.000.000) Book value 316.000.00 24.000. 12/31/Y4 (in USD) Cost 60.000 10.0000006 19.Translation of Foreign Currency Financial Statements 10.000.200 Book value of equipment.000.000007 420.000.000 0.000002 16.000 0.000 Total 32.000 7-6 .000.000.000.000.000 Total 100.000.000.000.000.000 500.000.000 Accumulated Exchange Depreciation TL Rate USD Total 32.000.000. 12/31/Y4 (in USD) Cost 500.000 0 0 Accumulated Exchange Depreciation TL Rate USD 1/1/Y1 24.000002 80.000 10 0 4 0 4.000.000.000.000.000.00 1/1/Y1 60.000 1/1/Y3 40.00 1/1/Y3 40.000.000 less: accumulated depreciation (184.000.000.000 b.000007 168.000.000.000 0.000.000 0. Simga Company a.0000006 60.000 184.000.000.

Chapter 07 .200) Book value 40.800 7-7 .Translation of Foreign Currency Financial Statements less: accumulated depreciation (19.

000 (positive) ) 12.Chapter 07 .21 252.000.000 Increase in net assets: Net income. Year 1 500. Alliance Corporation Exchang e Marks Rate A$ Net assets. 12/31/Y1 1.000) $0. 12/31/Y1 at the current exchange rate 500. 12/31/Y1 at the current exchange rate 1.09 90.000 $. 12/31/Y1 500. 1/1/Y1 (600.000) $0.000 Increase in monetary items: Sales.000) 7-8 .000 Net assets. Year 1 (300.000 0.000 (45. 1/1/Y1 1.000) Net monetary assets.9 (54.000) $0.000.8 (8.200. 1/1/Y1 1. Year 1 200.000) Remeasurement loss (6.500) Purchase of property and equipment.200.Translation of Foreign Currency Financial Statements 11.15 150.500 Decrease in monetary items: Purchases of inventory.000 184.85 (25.000 Net assets.000) Dividends.78 (39.000 $0. 12/1/Y1 (100.000 $0.000 0.000) Net monetary assets.17 34.000 Translation adjustment (68.000 0. Zesto Company Pesos US$ Net monetary assets.85 42.

It would be a realized gain only if Alexander sold this operation on December 31 for exactly CHF8.000 [CHF800.Translation of Foreign Currency Financial Statements 13.000 Economic Relevance of Translation Adjustment The translation adjustment increases stockholders’ equity by $410.75-$.000. 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 Translation adjustment (positive) ) b.000.000 x $. 12/31/Y1 at the current exchange rate 8. thereby realizing a transaction loss of $40. 12/31/Y1 (800. dollar is functional currency (Temporal method) Swiss Exchange U.200.000].000 (410.000 at the current exchange rate ) 0.000 Net assets.000 x ($.000 0.05 [CHF800. and the parent paid off the remaining Swiss franc notes payable using U.000 and converted the sales proceeds into dollars at the current exchange rate of $.70 5.000) Change in net monetary liabilities . Alexander Corporation a.000 less Notes payable of CHF1. The positive translation adjustment arises because the Swiss subsidiary has a net asset position of CHF8.000 x $. 12/20/Y1 ) 0.70].000 5.200. - Net assets.000).000) and the Swiss franc has appreciated by $.000].200.150.Chapter 07 . 12/20/Y1 8.75 (600. 12/31/Y1 8. The positive translation adjustment is not realized in terms of U.000 0.000) Remeasurement loss 40.000 x $.S.200.000) Net monetary liabilities.000 x $.200.70)].200.740.05 [CHF8.75 6. Economic Relevance of Remeasurement Loss The remeasurement loss arises because the Swiss subsidiary has a net monetary liability position of CHF800.75].000 note payable could have been paid off at December 1 with $560. it takes $600.75 per Swiss franc.S.000 and the Swiss franc appreciates by $. U. (A CHF 800.000.S.000 (Cash of CHF1.70 (560. Francs Rate Dollars Net assets.S. 12/31/Y1 ) (560. dollars.000 Net monetary liabilities. Swiss franc is functional currency (Current rate method) Swiss Exchange U.S.800. At December 31.05 = $40.000 [CHF800.000 Net monetary liabilities.000 to pay off the same amount of CHF note payable [CHF800.000 Change in net assets . The loss is unrealized.05 = $410. Francs Rate Dollars (800. dollar cash flow. - (800.740.) 7-9 .

000 59. Year 2 0.80 Sales 540.000 above 59.000 0.04 Retained earnings.000 Inventory 72.400 210.70 Exchange Cz Rate $ 388.20 Liabilities 186.72 0 (310.760 Operating expenses ) 0.000 0.040 (14.000 87.70 (49.800 Income taxes (40.00 Plant and equipment 300.200 Cost of goods sold ) 0.80 0 Net income 82.000) 0.71 ) 168.20 Retained earnings.70 35. Gramado Company Exchange Rates $/Cz January 1. 1/1/Y2 154.60 Gross profit 230.000 0.000 0 (108.000 (223.840 (28.Chapter 07 . Year 1 0.72 December 1.40 Total assets 452.70 50.72 ) Net income 82. Year 1 0.000) 0.200 Dividends (20.75 Average for Year 2 0.040 123.000 (77. 12/31/Y2 216.000 0.72 ) 165.80 December 31.84 Average for Year 1 0.70 0 Less: accumulated depreciation (70.000 0.000 Receivables 100.Translation of Foreign Currency Financial Statements 14.000) 0.70 70.72 ) Income before tax 122.71 December 31.000 0 130.70 0 7-10 .000 0.000) 316. Year 2 0.000 0.000 0 Exchange Cz Rate $ Cash 50.

Chapter 07 .84 42.000 0 7-11 . (23.000 above 0 Cumulative translation adjustment .840) Total liabilities and stockholders' 316.000 168.40 equity 452.000 0. 12/31/Y2 216.Translation of Foreign Currency Financial Statements Capital stock 50.04 Retained earnings.

00 current exchange rate 204.000 0. 1/1/Y1 50.72 59.75 0 Net income.20 Net assets.000 0.84 Net assets.000 0 Net assets.000) 0. Year 1 (negative) 12.00 Net assets. Year 2 82.Translation of Foreign Currency Financial Statements Exchange Cz Rate $ Net assets.640 Cumulative translation adjustment. 12/31/Y1 at 153. 12/1/Y2 (20.040 Dividends.000 0.840 7-12 . Year 2 (negative) 11.20 Net income. 12/31/Y2 266.000 0 Net assets. 12/31/Y2 at 186. 12/31/Y2 23.20 current exchange rate 266.Chapter 07 .000 0. 12/31/Y1 204.000 0.75 0 Translation adjustment. Year 1 154.000 0.200) 197.000 123.200 153.70 0 Translation adjustment. 1/1/Y2 204.84 42.80 0 165.71 (14.

Year 1 0. Year 1 110.000 38.105 December 31.Chapter 07 . 12/31/Y1 70.096 ) Income before tax 200.095 Average for Year 1 0.000) 0. Year 1 0. - Net income.090 June 1.000) 0.110 a.800 Long-term debt 500.000 0.800 Depreciation expense (50.000) 0.110 16.000 0.000 0.000 6.096 ) Gross profit 400.000 0.800 Receivables 150.000 0.560 7-13 .900 Dividends.500 Accounts payable 80.600 Cost of goods sold (600.000 10.000 Retained earnings. Year 1 0.096 November 15.096 ) (14.500 Inventory 270. 6/1/Y1 (20.000 19. Year 1 0. 12/1/Y1 (20.096 96.700 Plant and equipment 500.560 (1.Translation of Foreign Currency Financial Statements 15.400 Other operating expenses (150.110 29.000.000 0.110 55.096 ) Net income 110.000 10.000 (5.100 December 1.000) 0. 12/31/Y1 70.110 55.640 Income taxes (90.110 8.100 Dividends.000 (57.000 0.560 Cash 80.400 (4. Year 1 0.200 (8. Brookhurst Company Exchange Rates USD/ZAR January 1.000 6.000) 0.000 0.110 ) Total assets 950. South African rand is functional currency (Current rate method) Exchange ZAR Rate USD Sales 1. 1/1/Y1 .105 ) Retained earnings.500 Less: accumulated depreciation (50.110 8.000) 0.000 Common stock 300.000) 0.095 ) (2.090 27.000 104.560 Retained earnings.

Translation of Foreign Currency Financial Statements Cumulative translation adjustment .000 104. 7.140 Total liabilities and stockholders' equity 950.Chapter 07 .500 7-14 .

090 27. 1/1/Y1 300.000 Net income. Year 1 (7.095 ) (20. 12/31/Y1 370.560 (20.110 40.000 0.000 (1.560 Net assets.000 0.700 Translation adjustment.000 33. 12/31/Y1 at current exchange rate 370. Year 1 110.Translation of Foreign Currency Financial Statements Calculation of cumulative translation adjustment Exchange ZAR Rate USD Net assets.140 (positive) ) 7-15 .100 Dividends.000 above 10. 6/1/Y1 ) 0. 12/1/Y1 ) 0.000 (2.Chapter 07 .900 Dividends.105 ) Net assets.

000) 0. - Net income 110.000 Plant and equipment 500.000) Sched.096 ) Net income 110.090 27.090 ) (14.096 96.000 Retained earnings.000 (56.000) 0.000) 0.000 0.Chapter 07 .110 8.090 45.110 16.000) 0.000 Total liabilities and stockholders' equity 950.800 Receivables 150.500 Less: accumulated depreciation (50.000.000 0.000 92.100 Dividends.100 27. dollar is functional currency (Temporal method) Exchange ZAR Rate USD Sales 1.000 6.800 Long-term debt 500.940 Remeasurement gain (loss) .000 0. U. 1/1/Y1 . 6/1/Y1 (20.110 55.095 ) (2.500 Inventory 270.000 39.000) 0.400 Other operating expenses (150. 12/31/Y1 70.000 0.000 (1.000 (4.000 Common stock 300.105 ) Retained earnings.000 2.000 0.640 Income taxes (90.000 0.800 Accounts payable 80.110 8.900 Dividends. below ) Income before tax 200.520 Cost of goods sold (600.800 7-16 .S.000 14.000 92.090 ) Total assets 950.500 Depreciation expense (50.000) 0.000 6.000 Cash 80. 12/31/Y1 70.000 Retained earnings.Translation of Foreign Currency Financial Statements b.000 2. A ) Gross profit 400.640 (8.000 0.480 (4.096 ) (5.000 0. 12/1/Y1 (20.

00 Sales 0 0.096 96.000 0 83.000 (1. 1/1/Y1 ) 0.000 (14.000 Decrease in monetary assets - (870.400 Other operating expenses ) 0.096 ) (20.000 (2.520 Purchases of inventory ) 0.000 Net monetary liabilities.000 (8.110 ) Remeasurement loss 5.000 (18.500 current exchange rate ) 0.520 (270.100 (27.000 56.000 Ending inventory ) 0 ) Cost of goods sold 600.100 Dividends.Translation of Foreign Currency Financial Statements Exchang Schedule A. - 0.095 ) (20.Chapter 07 .560 Net monetary liabilities.000 (32.520 Calculation of remeasurement gain (loss) Exchang e ZAR Rate USD (200. 12/31/Y1 at (350.000 (83. 6/1/Y1 ) 0. 12/31/Y1 ) ) Net monetary liabilities.900 Dividends.105 ) (350.096 ) (150. 12/1/Y1 ) 0.096 Purchases 870.090 ) Increase in monetary assets 1.640 Income taxes ) 0.940 7-17 .000 (38.000 0.096 ) (90. e Calculation of cost of goods sold ZAR Rate USD Beginning inventory .000.

Second. in 2007. in 2005.2 billion. 17. respectively. In contrast. dollar as functional currency. Chevron reported translation adjustments of only -$5 million. Chevron indicated that substantially all of its foreign operations had the U. The difference in magnitude is at least partially explained by the fact that Chevron reports most of its translation adjustments in net income (as explained in the preceding paragraph). with no further description. Chevron indicated using forward contracts but only to hedge foreign currency revenue and purchase transactions. Exxon Mobil reported translation adjustments (in other comprehensive income) of -$2. in 2007. Exxon Mobil indicated that most of its foreign operations had the local currency as functional currency and some are located in highly inflationary countries. +$55 million. whereas most of Exxon Mobil’s translation gains/losses are deferred in Accumulated other comprehensive income. Exxon Mobil indicated that it makes limited use of derivatives. Exxon Mobil primarily uses the current rate method. neither company mentions hedges of the net investment in foreign operations. and +$4. in 2007. 2007. 7-18 . For requirement (b). 2006.-based MNC selected by each student for examination. Exxon explains that its geographic diversity reduces the company’s enterprise-wide risk from changes in currency rates. For requirement (c).S.Translation of Foreign Currency Financial Statements 16.S. This difference in predominant functional currency presents two kinds of comparability problems. The solutions to the requirements of this problem will depend upon the annual reports (which year) examined. This problem requires students to examine disclosures made by Exxon Mobil and Chevron with respect to foreign currency translation. First.Chapter 07 . and +$31 million for the same three years. while Chevron primarily uses the temporal method of translation. With respect to requirement (a).6 billion. Chevron primarily reports translation gains/losses in net income (as remeasurement gains/losses). The solutions to this problem will depend upon the U. +$2.7 billion.

155 December 31. Year 2 0.16 December 15. Year 2 0.175 August 5.25 December 15.215 January 1. Year 2 0.Translation of Foreign Currency Financial Statements Case 7-1 Columbia Corporation (continued) Part I Exchange Rates $/PLN January 1.18 Average Year 2 0. Year 2 0.17 Fourth quarter.15 7-19 . Year 1 0.2 January 3. Year 1 0. Year 2 0. Year 2 0.Chapter 07 .

750 Plus: Retained earnings.187.000.175 (218.750.750.000 Less: accumulated depreciation (15.500.150 1.Chapter 07 .750.150 150.S.000.500) Building 36.175 (157.000.500.000 Above 508.050. $ Sales 12.000) 0.150 247.150 5.000 0.000 Retained earnings 2.000 0.500 Inventory 4. to balance (1. Polish zloty is the functional currency – Current rate method Exchange PLN Rate U.000) Other expenses (including taxes) (500.000 0.000 508.850.175 (1.000) 0. 12/31/Y2 2.875.000 568.000 0.000 Total assets 39.150 637.000) 0.000) 0.000 0.150.272.250 Less: Dividends paid (750.250.000) Depreciation expense-equipment (1.500) Net income 3.500 Long-term debt 25.150 3.000) 0.400.000 0.150 450.500) Land 3.175 (87.500 Equipment 12.000 0.250.250 1.000 0.175 (105.000) 0.Translation of Foreign Currency Financial Statements Case 7-1 Columbia Corporation (continued) Part I (a).000 0.150 187.000 Accounts receivable (net) 1.875.000.096.000 5.000 Accounts payable 1.000 Additional paid-in capital 7.250.000 0.000) 0.250.000 Given 56. 1/1/Y2 250.500.000 Less: accumulated depreciation (4.155 (116.850.150 (2.250 625.150 (637.500.000 5.000) 0.750) Depreciation expense-building (900.250.500 Cost of goods sold (6.000.000 Common stock 2.650.175 2.750 Cash 1.750 Translation adjustment .000 0.250) Total 39.000.500) Research and development expense (600.000 7-20 .000.250) Retained earnings.

250 7-21 . 12/15/Y2 (750.155 (116. $ Net assets.150 1.250.000 0.750.500 Net assets. Year 2 3.500 current exchange rate Translation adjustment.Translation of Foreign Currency Financial Statements Case 7-1 Columbia Corporation (continued) Calculation of Cumulative Translation Adjustment Exchange PLN Rate U.250 Cumulative translation adjustment.000 0. Year 1 (negative) given 506.250) Net assets. 1/1/Y2 10.000) 0.000 Net income.750 Dividends.000 0.000 2.S. 12/31/Y2 12.200 2.050.912. 12/31/Y2 at 12.250.096.000 Translation adjustment.Chapter 07 .502.175 568. Year 2 (negative) 590.750. 12/31/Y2 (negative) 1.

000) Sched.S.045.S. U.750) Depreciation expense-equipment (1.500.500 Cost of goods sold (6.175 (105.250.000. B (1.187.000 0.000.500.500.000 0.000.150.150 247.000) 0.000. 1/1/Y2 250.160 680.477.000) Other expenses (including taxes) (500.500) Land 3.000 0.500) Income before remeasurement gain 3.000.000 8.500 Inventory 4.750.950.000 1.250) Retained earnings.000 Total assets 39.175 2.000 2.000 Accounts receivable (net) 1.000 0.000) Building 36.000 7-22 .500 Total 39. Year 2 .150 187.000) Sched.000 Net income 3. B 2.000) Depreciation expense-building (900.000 Additional paid-in capital 7.000.000 Retained earnings 2.039.039.175 (87.000 Less: accumulated depreciation (15. A (1.250.000 Above 2.000) 0.000) Sched.000 253. C (213.500 Cash 1.150 150.750.000 Equipment 12.000 0.000 Given 882. $ Sales 12.250.000 Common stock 2.233.020.000) Sched.000 0.000 Sched.000 Less: accumulated depreciation (4.500 Less: Dividends paid (750.000 8. C 8.000 0.875. B (295.000. 1. C (3.000 Accounts payable 1.250 1.000) 0.250 625.750.000 0.775.500.250.000 Sched.250 750.650.250.155 (116. dollar is the functional currency – Temporal method Exchange PLN Rate U.477.000) Research and development expense (600.Translation of Foreign Currency Financial Statements Case 7-1 Columbia Corporation (continued) Part I (b).520.000) Sched.250 Plus: Retained earnings. 12/31/Y2 2.000 0.250.500 Long-term debt 25.250 Remeasurement gain.273.150 3.Chapter 07 .

045.75 Cost of goods sold 6. Expense .250.Equipment Exchange PLN Rate U.00 Old Building .500.-New Equipment 250. $ 7.Deprec.215 645.250 0 Acc.250 3.at 1/1/Y1 30.Chapter 07 .000 0.950.250.000 Schedule C .000 0.000 2.250.000 1.-Old Equipment 4.000 0 Acc.500.160 ) 1.00 Total 36.000 295.000 Deprec.250 0 1.500.000 1.-Old Building 15.000.000.000 (680.000.250 0 New Equipment-acquired 1/3/Y2 2.000 0.233.at 1/1/Y1 10.000 0 1.00 New Building-acquired 3/5/Y2 6.750.Cost of goods sold Exchange PLN Rate U.000 Ending inventory ) 0.00 Old Equipment .000 0.268.New Equip.000.500. $ 2.Old Equip.180 450.00 Total 12.000.00 7-23 .000 0.000 0. Deprec.000 0.000.Building Exchange PLN Rate U.75 Purchases 7.Translation of Foreign Currency Financial Statements Case 7-1 Columbia Corporation (continued) Schedule A .S.000.520.000 0. $ Beginning inventory 3.020.000 0.170 0 8.000.000.000 0 Deprec. 1.S.180 45. Expense .00 Acc.000 0 Schedule B .000. 250.250 250.Deprec.000 0.250.000 Total 1.S.175 0 (4.00 Total 4.180 45.000 0.

Old Building 750. Expense .Chapter 07 .170 25.500 Deprec.000 0.Deprec.Translation of Foreign Currency Financial Statements 0 Acc.500 Total 900.50 Total 15.000 213.775.New Building 150.150.000 0.500 3. Expense .170 25.250 187.000 7-24 .000 0.-New Building 150.000 0 Deprec.

500. 12/31/Y2 (23. 12/15/Y2 (750.500) Dividends paid.000) current exchange rate Remeasurement gain .Year 2 (1.020.150 (3.700.500.180 (450.600.000) 0.000) Net monetary liabilities. 8/5/Y2 (6.000) 0.000) 7-25 .200 (3.000) 0.560.500. 1/3/Y2 (2.268.020.600.540.000.000) (4.175 (87.000 0.Chapter 07 . 1/1/Y2 (18.000) 0. 12/31/Y2 at (23.000) 0.000) 0.Translation of Foreign Currency Financial Statements Case 7-1 Columbia Corporation (continued) Calculation of Remeasurement Gain Exchange PLN Rate U.187.175 (105.750) Research & development (600.170 (1.000) Net monetary liabilities.000) 0.000) Other expenses (500. $ Net monetary liabilities.250.000) Purchase of buildings.S.155 (116.175 (1.000) 0.175 2.500 Decrease in monetary assets: Purchase of inventory (7.000) Increase in monetary assets: Sales 12.250) Purchase of equipment.

750 Cost of goods sold ) Sched.250.175 2.000.477.500.500 Long-term debt .500.000 8.155 (116. U.S.000 (4.175 (105.000) (900. B (295.500) Income before remeasurement gain 3.000 7-26 .Translation of Foreign Currency Financial Statements Case 7-1 Columbia Corporation (continued) Part I (c).250.750.520.950.150 150.S.000 Sched.150 247.000 Less: accumulated depreciation ) Sched.250 6.000 below (460.000 0.000.000 0.000 0.187.250.000 (1.250) from Retained earnings.250.000 to balance (460. B ) Building 36.000 Retained earnings 2. C (213.000 (1.000 0.000 Other expenses (including taxes) ) 0. C 8.000 8. A ) (1. C ) Land 3.150 - Common stock 10.000.000 Less: Dividends paid ) 0.250.000.250 750.750.150 187.000 0.500) (750.500 Less: accumulated depreciation ) Sched.250 Plus: Retained earnings.650. Year 2 .000 (15.000) Research and development (600.500 (6.000 253.250 2.000) Net income 3. (230.500.775.250. 12/31/Y2 2.045. 1/1/Y2 250.500) Cash 1.250.233.000 Depreciation expense-building ) Sched.500) Total 39.000. 0.000 0.000 Additional paid-in capital 25.175 (87. B 2.477.000. $ Sales 12.000 Equipment 12.000 Accounts payable 1.500 Inventory 4.Chapter 07 .000.000.000 expense ) 0.250 Remeasurement loss. dollar is the functional currency – Temporal method (no long-term debt) Exchange PLN Rate U.150.000 Sched.000 (3.000 Accounts receivable (net) 1.000 Given (367.000 23.000) (500.000 0.000 0.000 Depreciation expense-equipment ) Sched.160 680.000 Total assets 39.

650.500. dollar during Year 2 (from $.000).000 Increase in monetary assets: Sales 12.170 (1.300. 7-27 . 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. 1/3/Y2 (2.S.500 Decrease in monetary assets: Purchase of inventory (7.000. 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.175 (1. Cash and Accounts Receivable are the only assets translated at the current exchange rate (total PLN 2. Because the Polish zloty amount of liabilities translated at the current rate exceeds the Polish zloty amount of assets translated at the current rate.500.400.650. a net asset balance sheet exposure exists. Explain the negative translation adjustment in Part I (a) and remeasurement gain or loss in Parts 1(b) and 1(c).500.155 (116.S.268.0150 at 12/31/Y2).000) 0.000). 12/15/Y2 (750.400.250.000) Purchase of buildings.250. 12/31/Y2 1.187.S.200 1. Accounts Payable and Long-Term Debt also are translated at the current exchange rate (total PLN 26. 1/1/Y2 6.750) Research & development (600.175 (105.000 Part II.S.020 at 1/1/Y2 to $. $ Net monetary assets. dollar during Year 2.000) Other expenses (500. Cash and Accounts Receivable are the only assets translated at the current exchange rate (total PLN 2.000 0.000 Net monetary assets.000).000) Net monetary assets.250.150 210.000) 0.000) 0.175 (87. dollar.020. 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.Chapter 07 . 12/31/Y2 at 1. Accounts Payable is the only liability translated at the current exchange rate (total PLN 1. 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.000 current exchange rate Remeasurement loss .000 0. a net liability balance sheet exposure exists. 8/5/Y2 (6.000 0.000) 0.Translation of Foreign Currency Financial Statements Case 7-1 Columbia Corporation (continued) Calculation of Remeasurement Loss Exchange PLN Rate U.500) Dividends paid.000). Under the temporal method. Because there is no Long-term Debt in part 1(c).000 440.Year 2 230.175 2.180 (450.250) Purchase of equipment.000) 0.000) 0. 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.

83 December 31.400 1. 12/31/Y1 1.000 5.700) Depreciation expense (1.260 Translation adjustment .80 1.400 Selling and administrative expense (3.800 3.000 0.90 When inventory purchases made 0.000) 0.320 Current liabilities 2. Pound is the functional currency – Current rate method Exchange Pounds Rate U.800 Income taxes (600) 0.400 0.320 7-28 .S.000 8.00 Average Year 1 0.000 1.86 When ending inventory acquired 0.000 0.920 Inventory 4.800 1. 1/1/Y1 .800 (800) Total assets 15.400 12.100) Gross profit 6.000 0.400 from above 1.200 Fixed assets 10.900 (8.Translation of Foreign Currency Financial Statements Case 7-2 Palmerstown Company Exchange Rates $/pound January 1.800 1. Year 1 1.200 Contributed capital 8. $ Sales 15.900 (900) Income before tax 2.000) 0.800 8. from below (1. - Retained earnings.000) 0.000 Retained earnings 1.740) Total 15.000 1.00 January 1-31. Year 1 1.000 Less: accumulated depreciation (1. Year 1 0.800 3.900 (2.900 13.500 Cost of goods sold (9.000 0.Chapter 07 .000 0.400 12.000) 0.600 Long-term debt 4.900 (540) Net income 1.400 1.260 Cash 2.260 Plus: Retained earnings.

400 0.520 Translation adjustment.000 1.400 9. Year 1 1.240 Current liabilities 2. 1/1/Y1 8.920 4.440 2.Translation of Foreign Currency Financial Statements Case 7-2 Palmerstown Company (continued) Calculation of Cumulative Translation Adjustment Exchange Pounds Rate U.000 0.000) 1.S. 1/1/Y1 .800 1.320 10. $ Sales 15.000 10. from below 180 Income before tax 2.600 7-29 .440 Plus: Retained earnings.000 0.Chapter 07 . 12/31/Y1 at current exchange rate 9. - 1.000) 1.000 Cost of goods sold (9.260 Net assets.980 (540 Income taxes (600) 0.40 Total assets 0 14.000 8.500 (2. $ Net assets. 12/31/Y1 0 1.S.00 Fixed assets 0 1.700 Selling and administrative expense (3.000) 15.S.500 (8.900 ) (1. dollar is the functional currency – Temporal method Exchange Pounds Rate U.900 1.400 0.800 7.00 Inventory 0 0.000) 0. Year 1 (negative) 1. A ) Gross profit 6.000 Less: accumulated depreciation (1.40 Cash 0 0.40 Retained earnings.260 Net assets. 12/31/Y1 9.000 1.740 2.830 3.900 13.000) Sched.000 ) Remeasurement gain (loss) . U.000 Net income.000 Depreciation expense (1.400 1.000 5.000 (1.900 ) Net income 1.800 1.

000 8.240 7-30 .40 Total 0 14.000 1.Translation of Foreign Currency Financial Statements Long-term debt 4.40 Retained earnings 0 to balance 1.800 3.440 15.000 1.000 0.Chapter 07 .200 Contributed capital 8.

12/31/Y1 (3. 1/1/Y1 8.000) 0.000 1.Year 1 ) 7-31 .000 0.900 ) (10.000 1.Cost of goods sold Exchange Pounds Rate U. 12/31/Y1 at (2.000 ) (3.600) ) Net monetary liabilities.880 current exchange rate (3.060 Net monetary liabilities.S.000 Increase in monetary assets: Sales 15.600) 0.900 13.000) 1.00 Cost of goods sold 0 8.S.700 Selling and administrative expenses (3.000 8.860 ) (2.500 Decrease in monetary assets: (1.900 ) (540 Income taxes (600) 0.320) 9. January 10 1. $ Purchase.320 Purchase of inventory during year (12.000 Calculation of Remeasurement Gain Exchange Pounds Rate U.830 (3.000 Acquisition of beginning inventory (1.000) 1.000 0.000) 0.Translation of Foreign Currency Financial Statements Case 7-2 Palmerstown Company (continued) Schedule A .860 10.Chapter 07 .000 Additional purchases 12.000 1.000 ) (10. $ Net monetary assets.000 Purchase of fixed assets (10.000) 0.320 Ending inventory (4.800 ) (180 Remeasurement gain .

320].Translation of Foreign Currency Financial Statements Case 7-2 Palmerstown Company (continued) 3. 24% higher.440 0.093 0. dollar financial statements are shown below.560.S.107 A comparison of the ratios calculated using pounds and using U. The relations between the current ratio.Chapter 07 .600 3. For example.638 0.508 Profit margin: Net income 1.000. 7-32 . The current rate method maintains all ratios that use numbers in the numerator and denominator from the balance sheet only (current ratio. inventory turnover). U. even the current rate method creates distortions. Note: For ratios that combine numbers from the income statement and balance sheet (return on equity.320)/$12.000 13.000 1.2 3.S. the debt to equity ratio.000 4.S.093 0.600 1.440 Sales 15.275 Debt to equity ratio: Total liabilities 6.$ translated amounts shows that the temporal method distorts all ratios as calculated from the original foreign currency financial statements.260.240 Current liabilities 2. $ U. to purchase 10.000 pounds worth of fixed assets when the exchange rate was $1.800 4. dollar amounts reported under the temporal method for inventory and fixed assets reflect the equivalent U. If the U.360 – $12.400 7. The amount of total assets reported on the consolidated balance sheet is 17% smaller than if the U.S.638 0. dollar cost of those assets as if the parent had sent dollars to the subsidiary to purchase the assets.520 9. the U.260 1. debt-to-equity ratio) or the income statement only (profit margin).2 3. dollar were the functional currency.S.500 0. the amount reflected in consolidated net income would be $1.400 1.120 5. dollar net income reflected in the consolidated income statement is $1.S. and profit margin calculated from the FC financial statements and from the translated U. With the pound as functional currency.400 5. the parent would have had to provide the subsidiary with $10. The U.00/pound.S.S. dollar were functional currency [($14.500 13.800 Total stockholders' equity 9.S $ Pounds Current Rate Temporal Current ratio: Current assets 6.

Chapter 07 .Translation of Foreign Currency Financial Statements The U. 7-33 . if any. these assets are reported at what they would have cost in U. By multiplying the pound historical cost amounts by the current exchange rate. dollars if the current exchange rate had been in effect when they were purchased.S. This is a hypothetical number with little. dollar cost of those assets nor their U.S. meaning. dollar current value. dollar amounts reported under the current rate method for inventory and fixed assets reflect neither the equivalent U.S.S.

the unrealized loss will become smaller.Chapter 07 . dollar loss being reported by BellSouth. the loss will become even larger if the real continues to depreciate. dollar translated income (loss) of the operations. Alternatively.S. which excluded a large loss.S.S. The company appears to be signaling its belief that the foreign currency loss is a nonrecurring (extraordinary) item. dollar. and the devaluation caused a large enough remeasurement loss that a net U. The Brazilian operations are equity method investments. dollar liabilities were revalued upward by the Brazilian operations with offsetting foreign exchange losses reported in Brazilian real (BRL) income. it is likely that BRL assets exceed BRL liabilities generating a net BRL asset exposure. Whether financial analysts would use normalized EPS rather than reported EPS in making decisions about BellSouth is an empirical question. On the other hand. dollar denominated liabilities. which excluded a large gain.S. The objective of reporting normalized net income is to remove from net income the effect of one-time only events that do not qualify under U. which means that BellSouth must report investment income (loss) for its percentage ownership interest in the U. dollar liabilities might have been large enough to cause negative net income (a net loss) in BRL terms. The company appears to be saying that the exchange loss is not yet realized. dollars.Translation of Foreign Currency Financial Statements Case 7-3 BellSouth Corporation 1. GAAP as extraordinary items or discontinued operations. The company states that its Brazilian operations had net U. with normalized diluted EPS in the first quarter of 1998. Given that liabilities were denominated in U. subsequent to the January 1999 devaluation. 7-34 . which when translated at the average exchange rate for the quarter (under the current rate method) resulted in a U.S. the Brazilian operations had net BRL asset exposures. 4. and therefore are not reported separately in the income statement. If. the Brazilian real appreciates against the U. 2.S.S. The foreign exchange loss on U. This assessment is valid if one compares normalized diluted EPS in the first quarter of 1999.S. The U. dollar loss resulted. 3.S. the temporal method of translation was used.