Multinational Operations (FX Translation)
READING 10
MULTINATIONAL OPERATIONS
EXAM FOCUS
This topic review covers a detailed discussion of accounting for foreign subsidiaries and operations of multinational firms. The main issue is how to convert the results of a foreign subsidiary into the parent's consolidated financial statements. You have several significant tasks to master. First, you need to become familiar with the terminology of translation. Second, you need to be able to distinguish between and implement the two methods of accounting for foreign operations (i.e., remeasurement via the temporal method or translation via the current rate method). Third, you need to be able to analyze the impact of these two methods on reported earnings, cash flows, and financial ratios for both the subsidiary and the parent. This reading is important and challenging. Begin by concentrating on the examples of each method and then move on to the analysis section.
MODULE 10.1: TRANSACTION EXPOSURE
LOS 10.a: Compare and contrast presentation in (reporting) currency, functional currency, and local currency.
Foreign currency can affect a multinational firm's financial statements in two ways: (1) the multinational firm may engage in business transactions that are denominated in a foreign currency, and (2) the multinational firm may invest in subsidiaries that maintain their books and records in a foreign currency. In both cases, special accounting treatment is required.
Before we move on, we need to define the different currencies that are involved in multinational accounting.
Local currency is the currency of the country being referred to.
Functional currency, determined by management, is the currency of the primary economic environment in which the entity operates. It is usually the currency in which the entity generates and expends cash. The functional currency can be the local currency or some other currency.
Presentation (reporting) currency is the currency in which the parent company prepares its consolidated financial statements.
LOS 10.b: Describe foreign currency transaction exposure, including accounting for and disclosures about foreign currency transaction gains and losses.
Foreign currency-denominated transactions, including sales, are measured in the presentation (reporting) currency at the spot rate on the transaction date. Foreign currency risk arises when the transaction date and the payment date differ.
Example: A U.S. firm sells goods to a company in Italy for €10,000 when the spot exchange rate is $1.60/€. Payment is due in 30 days. When payment is received, the euro has depreciated to $1.50/€.
On the transaction date the U.S. firm recognizes a sale and an account receivable of $16,000 (€10,000 × $1.60). On the payment date the U.S. firm receives €10,000 and converts to $15,000 (€10,000 × $1.50). As a result of the depreciating euro, the U.S. firm recognizes a $1,000 loss in the income statement [€10,000 × ($1.50 - $1.60)]. If instead the euro had appreciated to $1.70, the U.S. firm would have recognized a $1,000 gain [€10,000 × ($1.70 - $1.60)]. Note that the Italian firm recognized no gain or loss since its purchase and settlement were both denominated in euros.
If the balance sheet date occurs before settlement, unrealized gains or losses on foreign currency transactions are recognised based on the exchange rate on the balance sheet date. Once the transaction is settled, any further change in exchange rates between the balance sheet date and settlement date results in an additional realized gain or loss on settlement.
Returning to the earlier example: assume the sale occurred on 15 December when the euro spot rate was $1.60. At 31 December the euro depreciated to $1.56. The transaction was settled on 15 January when the euro was $1.50.
At 31 December the U.S. firm reduces its account receivable by $400 and recognises a $400 loss [€10,000 × ($1.56 - $1.60)] in the December income statement. When the receivable is collected, the U.S. firm converts €10,000 to $15,000 and recognises a further loss of $600 [€10,000 × ($1.50 - $1.56)] in the January income statement.
If the U.S. firm purchases goods denominated in euros from the Italian firm with payment due in 30 days, analogous accounting follows. The U.S. firm records an account payable in euros. If the euro depreciates versus the dollar, the U.S. firm recognises a gain in the income statement because it will take fewer U.S. dollars to buy the euros necessary to settle the payable.
Analyst Issues
Transaction gains and losses are recognised in the income statement, but accounting standards do not specify whether they belong within operating or non-operating income. IFRS requires disclosure of the "amount of exchange rate differences recognised in profit or loss" while US GAAP requires disclosure of "the aggregate transaction gain or loss included in determining net income for the period." Neither standard requires disclosure of the classification (operating or non-operating), which reduces comparability of operating margins across firms if entities classify transaction gains and losses differently.
MODULE QUIZ 10.1
1.
On December 15, 2022, a U.S. firm with a fiscal year end of December 31, 2022, sold merchandise to a Mexican firm. Payment (in pesos) was due in 30 days but was actually received on January 20, 2023. Using the following exchange rates, what is the effect on the U.S. firm's income statement when payment is received?
A. Gain.
B. Loss.
C. No effect.
MODULE 10.2: TRANSLATION
LOS 10.c: Analyze how changes in exchange rates affect the translated sales of the subsidiary and parent company.
LOS 10.d: Compare the current rate method and the temporal method, evaluate how each affects the parent company's balance sheet and income statement, and determine which method is appropriate in various scenarios.
There are two methods used to remeasure or translate the financial statements of a foreign subsidiary to the parent's presentation (reporting) currency.
Remeasurement involves converting the local currency into the functional currency using the temporal method.
Translation involves converting the functional currency into the parent's presentation (reporting) currency using the current rate method, also known as the all-current method.
PROFESSOR'S NOTE
The term "translation" is used in two senses in practice. First, it refers to a specific method of converting account and transaction balances to another currency. Second, it describes generally the process of converting balances from one currency to another without specifying the method. Both remeasurement (temporal) and translation (current rate) are processes that convert balances to another currency; the method chosen depends on the functional currency relative to the parent's presentation currency.
The choice of functional currency involves management judgement. The IASB suggests management consider the following factors in deciding the functional currency:
- The currency that influences sales prices for goods and services.
- The currency of the country whose competitive forces and regulations mainly determine sale prices.
- The currency that influences labour, material, and other costs.
- The currency from which funds are generated.
- The currency in which receipts from operating activities are usually retained.
The FASB provides similar guidance.
General rules for determining conversion method:
- If the functional currency differs from the parent's presentation currency, the current rate method is used. This usually applies to self-contained, decentralised subsidiaries. (See Column 1 of Figure 10.1.)
- If the functional currency is the same as the parent's presentation currency, the temporal method is used to remeasure the foreign currency financial statements. This usually occurs when the subsidiary is integrated with the parent. (See Column 2 of Figure 10.1.)
- If the local currency, the functional currency, and the presentation currency all differ, both methods are used: first the temporal method to remeasure local currency into functional currency, then the current rate method to translate functional currency to presentation currency. (See Column 3 of Figure 10.1.)
- If a subsidiary operates in a hyperinflationary economy, special rules apply: under US GAAP the functional currency is considered to be the parent's presentation currency and the temporal method is used; under IFRS the subsidiary's financial statements are restated for inflation and then translated using the current rate. Hyperinflation is discussed later in this module.
Figure 10.1: Three Methods for Remeasurement/Translation of Local Currencies
Example: Determining the appropriate translation method (1)
A U.S. multinational firm has a Japanese subsidiary. The subsidiary's functional currency is the Japanese yen (¥). The subsidiary's books and records are maintained in yen. The parent's presentation currency is the U.S. dollar. Determine which foreign currency translation method is appropriate.
Answer: Since the functional currency and the parent's presentation currency differ, the current rate method is used to translate the subsidiary's financial statements from yen to U.S. dollars.
Example: Determining the appropriate translation method (2)
Now imagine the Japanese subsidiary's functional currency is the U.S. dollar. Determine which foreign currency translation method is appropriate.
Answer: Since the functional currency and the parent's presentation currency are the same, the temporal method is used to remeasure the subsidiary's financial statements from yen to U.S. dollars.
Definitions of exchange rates used in conversion:
Current rate: the exchange rate on the balance sheet date.
Average rate: the average exchange rate over the reporting period (typically used in practice for income statement translation).
Historical rate: the actual exchange rate in effect when the original transaction occurred (e.g., rate on date of acquisition of an asset).
MODULE QUIZ 10.2
1.
Which of the following is least likely a condition that requires the use of the temporal method for a U.S. parent that reports results in U.S. dollars?
A.
The functional currency is the local currency.
B.
The foreign subsidiary is operating in a highly inflationary economy.
C.
The functional currency is some currency other than the local currency or the U.S. dollar.
2.
Mazeppa, Inc., is a multinational firm with its home office located in Toronto, Canada. Its main foreign subsidiary is located in Paris, but the primary economic environment in which the foreign subsidiary generates and expends cash is in the United States (New York).
A.
The local currency is the U.S. dollar.
B.
The functional currency is the euro.
C.
The presentation (reporting) currency is the Canadian dollar.
MODULE 10.3: TEMPORAL METHOD - Applying the Temporal Method
The temporal method is applied using these procedures:
- Monetary assets and liabilities are remeasured using the current exchange rate. Monetary items are fixed in the amount of currency to be received or paid and include cash, receivables, payables, and short-term and long-term debt.
- All other assets and liabilities are considered nonmonetary and are remeasured at the historical (actual) rate. Common nonmonetary assets include inventory, fixed assets, and intangible assets. An example of a nonmonetary liability is unearned (deferred) revenue.
PROFESSOR'S NOTE
Exception: Nonmonetary assets and liabilities measured on the balance sheet at fair value (for example, inventory carried at market value) are remeasured at the current exchange rate, not the historical rate.
Under the temporal method, common stock and dividends paid are remeasured at the historical (actual) rate.
Expenses related to nonmonetary assets such as COGS, depreciation and amortisation are remeasured based on the historical rates prevailing at the time of purchase.
Revenues and all other expenses are remeasured at the average rate for the period.
Remeasurement gain or loss is recognised in the income statement. As a result, net income is typically more volatile under the temporal method than under the current rate method, because translation items hit earnings directly under the temporal method.
Inventory and COGS under the Temporal Method
The historical rate is the rate in effect when the original transaction occurred. Inventory accounting under the temporal method can be complex because there may be different historical rates for different purchases. The firm's cost flow assumption affects which historical rates apply:
- Under FIFO, ending inventory consists of the most recently purchased goods, so FIFO ending inventory is remeasured using more recent exchange rates; FIFO COGS will be remeasured using older exchange rates corresponding to earlier purchases.
- Under LIFO, ending inventory contains older costs and is remeasured at older exchange rates; LIFO COGS contains recent costs and is remeasured at more recent exchange rates.
- Under the weighted-average cost method, ending inventory and COGS are remeasured at the period weighted-average exchange rate.
MODULE 10.4: CURRENT RATE METHOD
Applying the Current Rate Method
The current rate method is applied as follows:
- All income statement accounts are translated at the rate that existed when the transactions occurred; in practice this is typically approximated by the average rate for the period.
- All balance sheet accounts are translated at the current (ending) rate, except for common stock, which is translated at the historical rate when the stock was issued.
- Dividends are translated at the exchange rate in effect when they were declared.
- Translation gain or loss is reported in shareholders' equity as part of the cumulative translation adjustment (CTA).
Figure 10.2 summarises the impact of changing exchange rates on the parent's exposure.
Calculating the Translation/Remeasurement Gain or Loss
Under the current rate method, translation gain or loss is recorded in equity as the CTA. The CTA acts as a plug to force the accounting equation (A = L + E) to balance after translation.
Example - Calculating the ending balance of the CTA under the current rate method
Given balance sheet data, calculate the ending CTA.
Answer:
First compute the ending balance of retained earnings: ending retained earnings = beginning retained earnings + current period net income - dividends.
Given beginning retained earnings of $175, net income $50, and dividends $25, ending retained earnings = $200 ($175 + $50 - $25).
Then force the balance sheet to balance: CTA = assets - liabilities - common stock - ending retained earnings = $50 ($1,000 - $600 - $150 - $200).
The CTA is an accumulated balance of translation gains and losses to date. To find the translation gain or loss for a specific period, take the change in the CTA. For example, if beginning CTA = $20 and ending CTA = $50, the translation gain for the period = $30.
Under the temporal method, there is no CTA reported in shareholders' equity; instead, the remeasurement gain or loss is recognised in the income statement. The remeasurement gain or loss is the plug that equates the earnings before and after the remeasurement.
Summary of the Two Methods
Figure 10.3 summarises the key differences between the temporal method and the current rate method. This summary is frequently tested and should be memorised: the rates used for monetary vs nonmonetary items, treatment of equity, and where gains/losses are reported (income statement vs equity).
Exposure to Changing Exchange Rates
Under the current rate method, exposure is defined as the subsidiary's net asset position (total assets - total liabilities). Because all assets and liabilities are translated at the current rate, the subsidiary's equity (net assets) is exposed to exchange rate changes. If the subsidiary has net assets and the local currency appreciates, a translation gain results; if the local currency depreciates, a translation loss results.
Under the temporal method, only monetary assets and liabilities are remeasured at current rates; nonmonetary items are remeasured at historical rates. Therefore exposure under the temporal method is defined as the subsidiary's net monetary asset or net monetary liability position. If monetary liabilities exceed monetary assets (net monetary liability) and the foreign currency depreciates, a remeasurement gain results; if monetary assets exceed monetary liabilities and the foreign currency depreciates, a remeasurement loss results.
Because relatively few items are monetary (mainly cash and receivables), most firms often have net monetary liability exposure. Under the temporal method, firms can eliminate exposure by matching monetary assets and monetary liabilities. Under the current rate method, eliminating exposure requires balancing total assets and total liabilities, which would eliminate shareholders' equity and is therefore impractical.
PROFESSOR'S NOTE
Other techniques exist to manage exposure (for example, financial hedging instruments), but a full discussion of hedging techniques is beyond the scope of this module.
MODULE QUIZ 10.3, 10.4
1.
Which of the following statements is most accurate regarding foreign currency translation? Under the:
A.
temporal method, the monetary asset accounts of a foreign subsidiary are translated using the current rate.
B.
temporal method, the nonmonetary asset accounts of a foreign subsidiary are translated using the current rate.
C.
current rate method, all balance sheet accounts of a foreign subsidiary are translated using the average rate.
2.
Which of the following statements about the temporal method and the current rate method is least accurate?
A.
Net income is generally more volatile under the temporal method than under the current rate method.
B.
Subsidiaries that operate in highly inflationary environments will generally use the temporal method under U.S. GAAP.
C.
Subsidiaries whose operations are well integrated with the parent will generally use the current rate method.
3.
If a foreign subsidiary's functional currency and the parent's reporting currency are the same, the parent's exposure to changing exchange rates is based on:
A.
total assets minus total liabilities.
B.
monetary assets minus monetary liabilities.
C.
nonmonetary assets minus nonmonetary liabilities.
4.
XYZ Company is a U.S. subsidiary that operates in the United Kingdom where the functional currency is the British pound (£). XYZ's income statement shows £400 of net income and a £100 dividend declared on October 31 when the exchange rate was $1.60 per £. The current exchange rate is $1.70 per £, and the average rate is $1.55 per £. The change in retained earnings for the period in U.S. dollars is closest to:
A.
$460.
B.
$465.
C.
$480.
5.
A foreign subsidiary is operating in a country where the local currency is depreciating relative to the parent's presentation currency. Assuming the subsidiary is a FIFO firm, which accounting method will result in the highest gross profit margin reported in the parent's consolidated income statement?
A.
Current rate method.
B.
Temporal method.
C.
The current rate method and the temporal method will result in the same COGS.
6.
How many of the following situations might result in a translation gain?
Total assets exceed total liabilities when the foreign currency is depreciating using the current rate method.
Monetary liabilities exceed monetary assets when the foreign currency is appreciating using the temporal method.
Monetary assets exceed monetary liabilities when the foreign currency is depreciating using the temporal method.
Total assets equal total liabilities when the foreign currency is appreciating using the current rate method.
A.
None.
B.
One.
C.
Two.
Use the following information to answer Questions 7 and 8.
Gila Sailing and Fishing, Inc. (Gila), is a subsidiary of Sea of Cortez Unlimited Boating Adventures, Inc. (Cortez), a multinational organisation headquartered in Tempe, Arizona. Gila is located in the Sonora Valley and sells fishing trips off the coast of the Sea of Cortez. Cortez accounts for Gila using the temporal method. Gila's current balance sheet (denominated in pesos) is as follows:
7.
Nonmonetary assets less nonmonetary liabilities are:
A.
5,000,000.
B.
41,000,000.
C.
43,000,000.
8.
Cortez is concerned about depreciation of the peso and would like to change Gila's capital structure. This would be best accomplished by:
A.
borrowing pesos and reducing equity.
B.
using cash to reduce accounts payable.
C.
selling receivables and using the proceeds to pay down long-term debt.
MODULE 10.5: EXAMPLE
Extended examples of both translation methods appear below. These examples illustrate the practical mechanics and the effect on reported assets, liabilities, equity, and profit.
LOS 10.e: Calculate the translation effects and evaluate the translation of a subsidiary's balance sheet and income statement into the parent company's presentation currency.
CURRENT RATE METHOD - EXAMPLE: The current rate method
FlexCo International (U.S.) has a subsidiary, Vibrant, Inc., located in Martonia. Vibrant was acquired by FlexCo on 31 December 2021. FlexCo reports in U.S. dollars. The currency of Martonia is the loca (LC). Vibrant's financial statements for 2022 are shown in the following figures (balance sheet 2021 & 2022 and 2022 income statement).
Exchange rates observed:
31 December 2021: $0.50 = LC1.00.
31 December 2022: $0.4545 = LC1.00.
Average for 2022: $0.4762 = LC1.00.
Historical rate for equity: $0.50 = LC1.00.
Historical rate for PP&E and depreciation: $0.4881 = LC1.00.
Historical rate for beginning and ending inventory: $0.52/LC and $0.456/LC, respectively.
Purchases were made evenly throughout the year.
The majority of Vibrant's operational, financial, and investment decisions are made locally in Martonia; Vibrant is relatively self-contained.
Use the appropriate method to translate Vibrant's 2022 balance sheet and income statement into U.S. dollars.
Answer:
Because Vibrant is relatively self-contained, the loca is likely the functional currency. Since the functional currency differs from the parent's presentation currency, the current rate method is used to translate Vibrant's financial statements from loca to U.S. dollars.
Under the current rate method, the balance sheet accounts (except common stock) are translated at the current rate, income statement accounts at the average rate, common stock at historical rate, and dividends at the rate when declared. The translation gain or loss is included in equity as the CTA (part of other comprehensive income).
Vibrant's translated 2022 income statement is prepared first (using the average rate) to derive net income, which is then used to calculate translated retained earnings on the balance sheet. Vibrant's translated 2022 balance sheet is then prepared. Because Vibrant was acquired at end of 2021, beginning CTA is zero; the change in CTA from 2021 to 2022 equals the translation loss attributable to the depreciating loca. The ending CTA changed by -$37.9, resulting in a translation loss of $37.9 for 2022 because Vibrant had a net asset exposure (assets > liabilities) and the loca depreciated relative to the dollar.
TEMPORAL METHOD - EXAMPLE: The temporal method
Suppose instead that the majority of Vibrant's operational, financial, and investment decisions are made by the parent, FlexCo. In that case Vibrant's functional currency is likely the same as FlexCo's presentation currency. The temporal method would then be used to remeasure the loca into U.S. dollars. All other facts remain the same.
Under the temporal method, monetary assets and liabilities are remeasured at the current rate, nonmonetary items at historical rates, revenues and certain expenses at average rates, and remeasurement gains or losses are reported in the income statement.
Vibrant's 2022 remeasured balance sheet and remeasured income statement (temporal method) are prepared accordingly. In this scenario the remeasurement gain occurred because Vibrant had a net monetary liability exposure (monetary liabilities > monetary assets) and the loca depreciated relative to the dollar; a depreciating foreign currency with net monetary liabilities produces a gain under the temporal method.
Why do the two methods report significantly different results?
The two methods can produce very different outcomes, especially for translation/remeasurement gain or loss, net income and total assets. Observations:
- Income before translation gain/loss differs between methods because COGS and depreciation are converted at different rates: under the current rate method these items are translated at the average rate; under the temporal method they are remeasured at historical rates.
- Translation gain or loss can differ in magnitude and even in sign. In the Vibrant example the current rate method produced a translation loss while the temporal method produced a remeasurement gain. This difference comes from which items are exposed under each method: net assets under current rate, net monetary position under temporal.
- Net income differs because the gain or loss under each method is reported in different statements; under the current rate method the translation loss is reported in shareholders' equity (CTA), while under the temporal method the remeasurement gain is reported in the income statement, causing more volatile net income under the temporal method.
- Total assets differ because inventory and net fixed assets are translated at current rates under the current rate method (reflecting the depreciating loca) but are measured at historical rates under the temporal method.
Comparing subsidiary results to translated results under the Current Rate Method
A side-by-side comparison of Vibrant's 2022 LC financial statements and their translated U.S. dollar equivalents demonstrates the effects described above.
MODULE 10.6: RATIOS
LOS 10.f: Analyze how the current rate method and the temporal method affect financial statements and ratios.
Pure balance sheet and pure income statement ratios
Pure ratios are composed entirely of balance sheet items or entirely of income statement items. Under the current rate method, such ratios are preserved by translation because both numerator and denominator are translated at the same rate.
Example: the current ratio (current assets / current liabilities) is a pure balance sheet ratio; both items translate at the current rate and the exchange rate cancels out. Similarly, profit margin measures are pure income statement ratios because both numerator and denominator are translated at the average rate; profit margins remain unchanged by translation under the current rate method.
Figure 10.6 presents selected pure ratios from Vibrant showing that the current rate method preserves local currency ratios for pure measures.
Mixed balance sheet/income statement ratios
Mixed ratios combine income statement and balance sheet inputs (for example, return on assets uses net income and ending assets). Under the current rate method these ratios will generally change when translated because the income statement item(s) are translated at the average rate whereas the balance sheet item(s) are translated at the current rate. The change tends to be small; its direction depends on the relation between the rates used for numerator and denominator.
When analysing mixed ratios we usually assume end-of-period balance sheet figures for the denominator. Under that assumption:
- If the foreign currency is depreciating, the average rate (used for net income) is greater than the ending rate (used for ending assets). Consequently a mixed ratio with income in the numerator and an end-period balance sheet item in the denominator will be larger after translation.
- If the foreign currency is appreciating, the same mixed ratio will be smaller after translation.
Figure 10.7 presents selected mixed ratios for Vibrant in a depreciating-loca scenario: translated mixed ratios are larger than original LC ratios.
PROFESSOR'S NOTE
Interest coverage (EBIT / interest expense) is another pure income statement ratio and will not change under current rate translation.
Comparing Results Using the Temporal Method and Current Rate Method
To evaluate how choice of method affects any given ratio, follow this procedure:
- Determine whether the foreign currency is appreciating or depreciating.
- Determine which exchange rate (historical, average, current) is used for the numerator under each method; decide whether the numerator will be the same, larger, or smaller under the temporal method compared with the current rate method.
- Determine which exchange rate is used for the denominator under each method; decide whether the denominator will be the same, larger, or smaller under the temporal method compared with the current rate method.
- Decide whether the ratio will increase, decrease, or remain the same based on the relative changes in numerator and denominator.
Example: fixed asset turnover = revenue / fixed assets. Assume the foreign currency is depreciating. Revenue is converted at the average rate under both methods (same numerator). Fixed assets are converted at the historical rate under the temporal method and at the current rate under the current rate method. Because the historical rate (the rate when assets were acquired) is likely higher than the current rate when the foreign currency is depreciating, fixed assets will be higher under the temporal method. Therefore fixed asset turnover will be lower under the temporal method (with a higher denominator).
MODULE QUIZ 10.5, 10.6
1.
Which of the following ratios may be larger in the presentation currency versus the local currency when translated under the current rate method?
A.
Current ratio.
B.
Return on assets.
C.
Net profit margin.
Use the following information to answer Questions 2 through 5.
This information continues the FlexCo/Vibrant example. Suppose it is now the end of 2023 and Vibrant reports the operating results shown in the supporting table.
The following exchange rates between the U.S. dollar and the loca were observed:
31 December 2022: USD/LC 0.4545.
31 December 2023: USD/LC 0.4000.
Average for 2023: USD/LC 0.4292.
Historical rate for fixed assets, inventory, and equity: USD/LC 0.5000.
The CTA at the end of 2022 was -$37.9 under the current rate method.
2.
Assume for this question only that Vibrant operates relatively independently from FlexCo. For 2023, FlexCo most likely will report a cumulative translation loss on the consolidated:
A.
income statement of $77.1 related to Vibrant.
B.
balance sheet of $77.1 related to Vibrant.
C.
balance sheet of $115.0 related to Vibrant.
3.
The gross profit margin ratio and the return on ending assets ratio from Vibrant's 2023 U.S. dollar financial statements translated using the current rate method are closest to:
4.
The gross profit margin ratio from Vibrant's 2023 U.S. dollar financial statements remeasured using the temporal method is:
A.
lower.
B.
the same.
C.
higher.
5.
As compared to the current rate method, which of the following best describes the impact of the temporal method on accounts receivable turnover from Vibrant's 2023 U.S. dollar financial statements?
A.
Higher.
B.
Lower.
C.
The same.
6.
Bob Haskell, CFA, is analysing the financial statements of a U.S.-based company called Seriev Motor. Seriev has a foreign subsidiary located in Japan. Seriev translates the subsidiary results using the current rate method. Haskell determines that the following four ratios will remain the same after translation from yen into U.S. dollars:
Gross profit margin.
Interest coverage (EBIT/interest expense).
Return on assets.
Quick ratio.
The dollar has depreciated against the yen during the most recent year. Haskell is correct in his analysis of:
A.
all four ratios.
B.
three of the four ratios.
C.
two of the four ratios.
MODULE 10.7: HYPERINFLATION
In a hyperinflationary environment the local currency rapidly loses purchasing power and often depreciates substantially versus the parent's presentation currency. Using the current exchange rate to translate all balance sheet accounts will produce very low asset and liability values in the presentation currency so the subsidiary may appear small or insignificant in consolidated statements even though real economic values (for example, real estate) may have increased with inflation.
Accounting standards differ on the treatment of subsidiaries operating in hyperinflationary economies:
- US GAAP: defines a hyperinflationary environment as cumulative inflation exceeding 100% over a 3-year period (equivalent to about >26% per annum compounded). Under US GAAP the functional currency is considered to be the parent's presentation currency; the temporal method is required.
- IFRS: does not give a strict numerical threshold but indicates cumulative inflation over 100% in three years is an indicator of hyperinflation. Under IFRS, the foreign currency financial statements are restated for inflation and then translated using the current exchange rate.
IFRS inflation restatement procedure
When restating for inflation under IFRS:
- Nonmonetary assets and liabilities are restated using a price index. For historical-cost items, multiply original cost by the change in the price index from acquisition date to balance sheet date.
- Monetary assets and liabilities are not restated for inflation.
- Components of shareholders' equity (other than retained earnings) are restated by applying the change in the price index from the beginning of the period or the date of contribution if later.
- Retained earnings is the plug figure that balances the balance sheet after restatement.
- In the statement of retained earnings, net income is the plug that balances the statement after restatement.
- Income statement items are restated by multiplying by the change in the price index from the date the transactions occurred.
- The net purchasing power gain or loss is recognised in the income statement based on the subsidiary's net monetary asset or liability position: holding monetary assets during inflation produces a purchasing power loss; holding monetary liabilities produces a purchasing power gain.
Example: Adjusting financial statements for inflation
Imagine a foreign subsidiary created on 31 December 2021. The subsidiary's balance sheets for 2021 and 2022 and the 2022 income statement are provided, along with price indices. Prepare an inflation-adjusted balance sheet and income statement for 2022.
Answer:
Nonmonetary assets (for example, supplies) and common stock are inflation-adjusted using the price index changes relevant to the periods they were outstanding. Revenue and expenses (which occur throughout the year) are adjusted using the change in the average and ending price index. Monetary assets and liabilities (cash, accounts payable) are not restated for inflation; instead, purchasing power gains and losses are calculated. In the example the net purchasing power gain is LC6,900 computed from changes in beginning cash, increase in cash, and accounts payable as shown. Because 2022 is the first year, beginning retained earnings = 0; the balance sheet plug requires that retained earnings equal net income minus dividends. If dividends = 0 but translated net income does not equal the plug, an income statement plug (the net purchasing power gain or loss) is used to make net income equal the retained earnings plug.
Notably, adjustment for inflation is analogous to the temporal method: both expose monetary assets and liabilities to change and both recognise the gain/loss in the income statement. Under IFRS, once restated for inflation, the financial statements are translated into the parent's reporting currency using the current exchange rate.
Analysing Foreign Currency Disclosure
In reality a parent may have many foreign subsidiaries, and the consolidated CTA, remeasurement gains/losses and ratios reflect the aggregate of all subsidiaries. Disclosures are limited and it can be difficult for an analyst to determine the functional currency choices and translation methods used by the parent for each subsidiary. Useful information is found in financial statement footnotes and the Management Discussion & Analysis (MD&A).
Because management judgement affects the functional currency choice, firms in the same industry may apply different translation methods, complicating comparisons. One analytical adjustment is to add the change in the CTA (translation gain or loss for the period) back to net income; bringing translation gains or losses into the income statement makes comparisons with firms using the temporal method more consistent. This principle can be extended to add other non-owner changes in equity (for example, unrealised gains/losses in OCI) back to net income. The approach of including equity-reported gains and losses in net income is referred to as clean-surplus accounting among analysts; gains/losses reported in equity only are sometimes called dirty-surplus items.
MODULE QUIZ 10.7
1.
Barkley Corporation, a wholly-owned subsidiary of a U.S. firm, is located in a country that is experiencing hyperinflation. Barkley's functional currency and the parent's presentation currency differ. What exchange rate should be used to convert Barkley's intangible assets into U.S. dollars according to U.S. GAAP?
A.
Historical rate.
B.
Current rate.
C.
Prime rate.
2.
Tiny Company, a subsidiary of Large Corporation, operates in a country that is experiencing hyperinflation. Assuming Large follows IFRS, which of the following exposures will result in a net purchasing power gain?
A.
Nonmonetary assets and current liabilities.
B.
Monetary liabilities.
C.
Nonmonetary assets and nonmonetary liabilities.
MODULE 10.8: TAX, SALES GROWTH, FINANCIAL RESULTS
LOS 10.h: Describe how multinational operations affect a company's effective tax rate.
Tax Implications of Multinational Operations
Multinational companies operate under multiple tax jurisdictions with differing tax laws and statutory rates. In many countries, including the United States, domestic tax rules provide relief (for example, foreign tax credits) for taxes paid abroad, which affects the company's consolidated effective tax rate.
Effective tax rate is defined as tax expense in the income statement divided by pretax profit. The statutory tax rate is the rate specified by the home country tax code. Accounting standards require a reconciliation of effective tax rate to statutory tax rate; this disclosure assists analysts in forecasting future tax expense. Changes in effective tax rate due to foreign operations may arise from:
- Changes in the mix of profits among countries with different tax rates.
- Changes in tax rates in jurisdictions where the company operates.
Example: Analysis of reconciliation of effective tax rate
The reconciliation between statutory and effective tax rate for two companies (Amco and Bianco) for 2024 is provided.
Questions:
- Which company benefited from lower tax expense due to foreign operations?
- If the mix of foreign operations increases over time, which company is most likely to report a lower effective tax rate in the future, assuming statutory tax rates are constant?
Answer:
Foreign operations increased effective tax rate for Amco by 3.4% but decreased it for Bianco by 1.2%. Thus Bianco benefited from foreign operations in reducing its effective tax rate and tax expense. If the mix of foreign operations increases and statutory rates do not change, Bianco would likely see its effective tax rate decrease further whereas Amco would see it increase.
LOS 10.i: Explain how changes in the components of sales affect the sustainability of sales growth.
Consolidated financial statements show sales in the presentation currency although sales occur in many currencies. Currency movements affect translated sales values. Growth in sales from increased volumes or prices (organic growth) is more sustainable than growth from currency appreciation. Analysts therefore separate organic growth from currency and acquisition/divestiture effects; companies often disclose foreign currency effects in MD&A to help analysts forecast sales more accurately.
Example: Analysis of sales components
BCN, Inc. reported sales growth in several markets in its MD&A for 2024. Comment: BCN experienced the highest growth in North America excluding the U.S. Excluding the negative translation effect (due to depreciation of the foreign currency for that region), revenue growth would have been 5% due to volume/price increases. In Europe revenue grew 2% overall but this was driven by currency appreciation; excluding currency effects, sales declined in Europe by 1%. In Asia the 2% growth was due entirely to price or volume changes.
LOS 10.j: Analyze how currency fluctuations potentially affect financial results, given a company's countries of operation.
Major Sources of Foreign Exchange Risk
Foreign exchange risk arises from the effect of currency movements on a firm's assets and liabilities and on forecasted future sales. Earlier sections covered transaction and translation exposures and their impact on reported profits. MD&A disclosures may include management's estimate of the impact of currency movements on profits; if such disclosures are absent analysts can run sensitivity analyses. Analysts should also investigate hedging policies disclosed by the company to understand how exposures are being managed.
Example: Walmart's foreign exchange risk management practice
Excerpt: The firm reports exposure to currency fluctuations due to net investments and operations outside the U.S. For fiscal 2015, currency movements and translation of subsidiary balance sheets in Canada, the UK, Japan, Mexico and Chile were the primary cause of a $3.6 billion net loss in accumulated other comprehensive income. The company hedges a portion of its foreign currency risk using currency swaps and designating some foreign currency-denominated long-term debt as net investment hedges. Aggregate fair value of these swaps was a liability of $110 million at 31 January 2015 and an asset of $550 million at 31 January 2014. The change in fair value was due to currency fluctuations (primarily strengthening of the U.S. dollar). A hypothetical 10% increase/decrease in the underlying currency exchange rates at 31 January 2015 would have resulted in a loss/gain of $435 million on the swaps. A hypothetical 10% change in interest rates underlying these swaps would have resulted in a loss/gain of $20 million.
MODULE QUIZ 10.8
1.
Suparna, Inc., is a U.S.-based multinational engineering company specialising in advanced water management solutions. Outside the United States, Suparna has extensive operations in Asia-Pacific, Europe, and Latin America.
The following information is collected from the MD&A section of Suparna's annual report for 2022:
Reconciliation of the Statutory Tax Rate
Due to its foreign operations, Suparna's effective tax rate was most likely:
A.
higher than the prior year's effective tax rate.
B.
lower than its statutory tax rate.
C.
higher than the statutory tax rate.
Use the following information to answer Questions 2 and 3.
IBM's 2012 annual report includes excerpts describing how currency fluctuations affect reported performance and noting that management uses constant-currency measures that do not incorporate operational responses such as pricing changes. The report states that total revenue decreased 2.3% as reported and was flat at constant currency versus 2011. On a pre-tax income basis, translation impacts offset by hedging activities resulted in a theoretical maximum decrease of approximately $100 million in 2012; the same exercise resulted in an increase of approximately $600 million in 2011. Management views these as theoretical maximum impacts and notes that operational responses and hedging reduce actual impact.
2.
IBM's 2012 revenue growth excluding the impact of currency rate movements was most likely:
A.
higher than as reported in the financial statements.
B.
lower than as reported in the financial statements.
C.
the same as reported in the financial statements.
3.
The most likely impact of currency fluctuations on IBM's 2011 pre-tax earnings net of hedging activities is that pre-tax earnings were:
A.
lower by $600 million.
B.
lower by $100 million.
C.
higher by $600 million.
KEY CONCEPTS
LOS 10.a
The local currency is the currency of the country to which it refers.
The functional currency, determined by management, is the currency of the primary economic environment in which the entity operates; it is usually the currency in which the entity generates and expends cash and may be the local currency or another currency.
The presentation (reporting) currency is the currency in which the entity prepares its financial statements.
LOS 10.b
Foreign currency-denominated transactions, including sales, are measured in the presentation (reporting) currency at the spot rate on the transaction date. If the exchange rate changes between the transaction date and settlement, gain or loss is recognised. If the balance sheet date occurs before the transaction is settled, unrealised gain or loss is recognised using the balance sheet date rate, and any further change between balance sheet date and settlement is recognised on settlement. Standards do not prescribe whether such gains/losses should be reported in operating or non-operating income, reducing comparability between firms.
LOS 10.c
Revenues are translated at the average exchange rate under both the temporal method and the current rate method (in practice the average is used to approximate the set of transaction-date rates).
LOS 10.d
If the functional currency and the parent's presentation currency differ, the current rate method is used; this generally applies when the subsidiary is relatively independent. Under the current rate method, all assets and liabilities are translated at the current rate; common stock and dividends at historic rates; revenues and expenses at the average rate. Translation gains and losses are reported in equity as the CTA (plug to balance the accounting equation).
If the functional currency is the same as the parent's presentation currency, the temporal method is used; this generally applies when the subsidiary is well integrated with the parent. Under the temporal method:
- Monetary assets and liabilities are remeasured at the current rate.
- Nonmonetary assets and liabilities are remeasured at historical rates.
- Common stock and dividends are remeasured at historical rates.
- COGS, depreciation, and amortisation are remeasured at historical rates.
- All other revenues and expenses are remeasured at the average rate.
- Remeasurement gains and losses are reported in the income statement.
LOS 10.e
Under the current rate method exposure is defined as the subsidiary's net asset position (assets - liabilities). Under the temporal method exposure is defined as the subsidiary's net monetary asset or net monetary liability position. When exposed assets are held in a depreciating foreign currency, a loss results; when exposed liabilities are held in a depreciating foreign currency, a gain results. The current rate method preserves pure balance sheet and pure income statement ratios in translation; mixed ratios will generally change.
LOS 10.f
To compare ratio effects under the temporal and current rate methods:
- Determine whether the local currency is appreciating or depreciating.
- Determine which rate (historical, average, current) is used to convert the numerator under both methods and analyse the effect.
- Determine which rate is used to convert the denominator under both methods and analyse the effect.
- Decide whether the ratio will increase, decrease, or remain the same based on the direction of change in numerator and denominator.
LOS 10.g
A hyperinflationary environment is indicated by cumulative inflation exceeding 100% over a 3-year period (more than ≈26% annual compounded). Under US GAAP the temporal method is required when the subsidiary operates in hyperinflation. Under IFRS the foreign currency financial statements are first restated for inflation and then translated using the current exchange rate. Restatement for inflation recognises a net purchasing power gain or loss based on the net monetary asset or liability position.
LOS 10.h
Earnings of multinationals are subject to multiple tax jurisdictions, so the statutory tax rate often differs from the effective tax rate. Changes in the mix of profits among jurisdictions can be used by analysts to forecast future tax expense.
LOS 10.i
Revenues denominated in multiple currencies are translated for reporting. Revenue growth may result from price/volume changes or from exchange rate movements. Growth due to price/volume is considered more sustainable; analysts commonly separate currency effects and acquisition/divestiture effects from organic growth.
LOS 10.j
Foreign exchange risks include the impact of changes in currency values on assets and liabilities and on future sales. Disclosures in MD&A and footnotes help analysts evaluate potential currency impacts; where disclosures are limited, sensitivity analysis can be used. Analysts should also consider hedging activities disclosed by management.
ANSWER KEY FOR MODULE QUIZZES
Module Quiz 10.1
1.
A This is an indirect quotation from the perspective of the U.S. firm. Since the peso depreciated from the sale date to the end of 2022, a loss is recognised in 2022. However, the peso appreciated from the end of 2022 to the payment date on January 20, 2023. Thus, a gain is recognised in 2023. ((LOS 10.b))
Module Quiz 10.2
1.
A If the functional currency is the local currency, then the functional currency and the parent's presentation currency are different. In this case, the current rate method is used. ((LOS 10.a))
2.
C As a multinational firm, the location of Mazeppa's head office would most likely determine the currency to be used to prepare its final, consolidated financial statements. Since Mazeppa's is located in Canada, the presentation currency is likely the Canadian dollar. Based on the facts, the local currency is the euro and the functional currency is the U.S. dollar. ((LOS 10.a))
Module Quiz 10.3, 10.4
1.
A Monetary asset accounts of a foreign subsidiary are translated using the current rate under the temporal method. ((Module 10.3, LOS 10.d))
2.
C Subsidiaries whose operations are well integrated with the parent will generally use the parent's currency as the functional currency. Remeasurement from the local currency to the functional currency is done with the temporal method. ((Module 10.3, LOS 10.a))
3.
B If the functional currency is the same as the parent's presentation currency, the temporal method is used. Under the temporal method, the subsidiary's net monetary asset or net monetary liability position is exposed to changing exchange rates. ((Module 10.3, LOS 10.e))
4.
A Since the functional currency (£) differs from the parent's presentation currency ($), the current rate method is used. Under the current rate method, net income is translated at the average rate. Dividends are translated at the historical rate on the date the dividends were declared.
Calculation: ($1.55/£ × £400) - ($1.60/£ × £100) = $460 ((Module 10.4, LOS 10.c))
5.
A The current rate method will result in higher gross profit in a depreciating environment. Under the temporal method, the subsidiary's COGS will be remeasured at the historical rate. This means that COGS will be relatively less affected by the depreciating currency. Sales, however, will be affected by the depreciating currency. Thus, gross profit margin will be lower under the temporal method. Under the current rate method, both sales and COGS will be affected by the depreciating currency. ((Module 10.4, LOS 10.d))
6.
A None of the situations will result in a gain. When total assets equal total liabilities, net assets are zero; thus, no gain or loss is recognised as a result of changing exchange rates. The other situations would result in a translation loss. ((LOS 10.c))
7.
B Fixed assets are the only nonmonetary assets. Deferred revenue is the only nonmonetary liability. Equity is not relevant to this question. ((LOS 10.c))
8.
A Reducing equity and increasing peso liabilities would be most effective in reducing currency risk to the parent. The other options leave the net exposure unchanged since there is a one-for-one reduction in both monetary assets and monetary liabilities. ((LOS 10.c))
Module Quiz 10.5, 10.6
1.
B All pure income statement and balance sheet ratios are unaffected by the application of the current rate method. What we mean by "pure" is that the components of the ratio all come from the balance sheet, or the components all come from the income statement. Return on assets is a "mixed ratio" because assets come from the balance sheet and are translated at the current rate and net income is translated at the average rate. Unless the exchange rate doesn't change during the year, the two inputs will be translated at different rates, and the local currency value of the ratio will change when translated into the reporting currency. The other ratios will always be the same using the current rate method. ((Module 10.6, LOS 10.f))
2.
C If Vibrant operates independently from FlexCo, the functional currency is the loca and the current rate method applies.
Steps:
Compute ending retained earnings: $555 = $383.3 beginning retained earnings + (LC400 net income × $0.4292).
Translate assets, liabilities and common stock at current/historical rates: assets = $1,340 (LC3,350 × 0.4), liabilities = $700 (LC1,750 × 0.4), common stock = $200 (LC400 × 0.5).
CTA = $1,340 - $700 - $200 - $555 = -$115 (plug to balance). ((Module 10.2, LOS 10.c))
3.
B Pure income statement ratios like gross profit margin will be the same after translation. The gross profit margin measured in LC is LC1,700 / LC5,500 = 30.9%; it remains 30.9% after translation. Mixed ratios like ROA will change. Since the loca is depreciating, the translated ROA will be larger than the original ROA because net income (numerator) is translated at the higher average rate and ending assets (denominator) at the lower current rate. LC ROA = LC400 / LC3,350 = 11.9%. The translated ROA will be higher; 12.8% is the only reasonable answer. ((Module 10.6, LOS 10.f))
4.
A The local currency is depreciating, so gross profit margin remeasured in U.S. dollars using the temporal method will be lower than gross profit margin translated using the current rate method. This occurs because COGS under the temporal method is measured using higher historical rates while under the current rate method COGS is translated at the lower average rate. Thus temporal method COGS > current rate method COGS, so temporal gross margin < current rate gross margin. ((Module 10.6, LOS 10.f))
5.
C Accounts receivable turnover will be the same under both methods because sales (numerator) are converted at the average rate under both methods and accounts receivable (denominator) are converted at the current rate under both methods. ((Module 10.6, LOS 10.f))
6.
B Gross profit margin and interest coverage are pure income statement ratios that will not change. The quick ratio is a pure balance sheet ratio that will not change. Return on assets is a mixed ratio and will change as long as average and current exchange rates differ. Given the dollar is depreciating against the yen, the current and average rates are likely different. Therefore Haskell is correct about three of the four ratios: gross profit margin, interest coverage, and quick ratio. ((Module 10.6, LOS 10.f))
Module Quiz 10.7
1.
A In an inflationary environment, the temporal method is required under U.S. GAAP even if the functional currency and the parent's presentation currency differ. Under the temporal method, inventory, fixed assets and intangible assets are remeasured at the historical rate, i.e., the rate when the assets were purchased. ((LOS 10.g))
2.
B Nonmonetary items are not exposed to purchasing power gains or losses; monetary assets result in purchasing power losses during inflation and monetary liabilities result in purchasing power gains. ((LOS 10.g))
Module Quiz 10.8
1.
B Suparna's effective tax rate was lowered by 1.9% due to the effect of taxes in foreign jurisdictions. ((LOS 10.h))
2.
A Per the annual report, total revenue decreased 2.3% as reported and was flat at constant currency versus 2011. Hence the constant currency growth rate was higher than the reported growth rate. ((LOS 10.i))
3.
C Pre-tax earnings offset by the net impact of hedging activities decreased approximately $100 million in 2012 and increased by approximately $600 million due to currency translation effects. ((LOS 10.j))
