where can I find the answers to case 6-1? (i downloaded this from CourseHero)

CHAPTER 6 Foreign Currency Translation Examine the following financial performance commentary. It is extracted from Rio Tinto, a leading multinational company engaged in metal and mineral production. The company operates in over 50 countries and employs in excess of 106,000 people. Rio Tinto's shareholders' equity, earnings and cash flows are influenced by a wide variety of currencies due to the geographic diversity of the Group's sales and the countries in which it operates. The U.S. dollar, however, is the currency in which the great majority of the Group's sales are denominated. Operating costs are influenced by the currencies of those countries where the Group's mines and processing plants are located and also by those currencies in which the costs of imported equipment and services are determined. The Australian and Canadian dollars and the Euro are the most important currencies (apart from the US dollar) influencing costs. In any particular year, currency fluctuations may have a significant impact on Rio Tinto's financial results. A strengthening of the US dollar against the currencies in which the Group's costs are partly determined has a positive effect on Rio Tinto's underlying earnings. The following sensitivities give the estimated effect on underlying earnings assuming that each exchange rate moved in isolation. The relationship between currencies and commodity prices is a complex one and movements in exchange rates can cause movements in commodity prices and vice versa. Where the functional currency of an operation is that of a country for which production of commodities is an important feature of the economy, such as the Australian dollar, there is a certain degree of natural protection against cyclical fluctuations, in that the currency tends to be weak, reducing costs in US dollar terms, when commodity prices are low, and vice versa. 164 Chapter 6 Foreign Currency Translation Earnings sensitivities - exchange rates Australian dollar Canadian dollar Euro Chilean peso New Zealand dollar South African rand UK sterling Average exchange rate for 2008 Effect on net and underlying earnings of 10% change in full year average +/- US$m US$0.86 US$0.94 US$1.47 US$0.0019 US$0.71 US$0.12 US$1.86 502 214 34 17 29 47 22 The exchange rate sensitivities quoted above include the effect on operating costs of movements in exchange rates but exclude the effect of the revaluation of foreign currency financial asssets and liabilities. They should therefore be used with care. Given the dominant role of the US currency in the Group's affairs, the US dollar is the currency in which financial results are presented both internally and externally. It is also the most appropriate currency for borrowing and holding surplus cash, although a portion of surplus cash may also be held in other currencies, most notable Australian dollars, Canadian dollars and the Euro. This cash is held in order to meet short term operational and capital commitments and, for the Australian dollar, dividend payments. The Group finances its operations primarily in US dollars, either directly or using cross currency interest rate swaps. A substantial part of the Group's US dollar debt is located in subsidiaries having a US functional currency. However, certain US dollar debt and other financial assets and liabilities including intragroup balances are not held in the functional currency of the relevant subsidiary. This results in an accounting exposure to exchange gains and losses as the financial assets and liabilities are translated into the functional currency of the subsidiary that accounts for those assets and liabilities. These exchange gains and losses are recorded in the Group's income statement except to the extent that they can be taken to equity under the Group's accounting policy. Gains and losses on US dollar net debt and on intragroup balances are excluded from underlying earnings. Other exchange gains and losses are included in underlying earnings. Under normal market conditions, the group does not generally believe that active currency hedging of transactions would provide long term benefits to shareholders. The Group reviews on a regular basis its exposures and reserves the right to enter into hedges to maintain financial stability. Currency protection measures may be deemed appropriate in specific commercial circumstances and are subject to strict limits laid down by the Rio Tinto board, typically hedging of capital expenditure and other significant financial items such as tax and dividends. There is a legacy of currency forward contracts used to hedge operating cash flow exposures which were acquired with Alcan and the North companies. 165 166 Chapter 6 Foreign Currency Translation Earnings sensitivities - exchange on financial assets/liabilities Closing exchange rate US cents Effect on net earnings of 10% US$ strengthening US$ Effect of items impacting directly on equity US$ Functional currency of business unit: Australian dollar Canadian dollar South African rand Euro New Zealand dollar 69 82 11 141 58 (12) 159 13 249 21 5 56 -- 2 -- The functional currency of many operations within the Rio Tinto Group is the local currency of operation. The former Alcan aluminum and alumina producing operations primarily use a US dollar functional currency. Foreign currency gains or losses arising on translation to US dollars of the net assets of non US functional currency operations are taken to equity and, with effect from 1 January 2004, recorded in a currency translation reserve. A weakening of the US dollar would have a positive effect on equity. The approximate translation effects on the Group's net assets of ten per cent movements from the year end exchange rates are as follows: Net assets' sensitivities - exchange on translation Australian dollar euro Canadian dollar Closing exchange rate U.S. cents 2008 Effect on net assets of 10% change in Closing rate +/- U.S. $m 69 141 82 1,264 621 180 The paragraphs in the preceding commentary suggest a variety of ways in which Alcan's reported performance, which the company chooses to report in U.S. dollars1, is impacted by foreign currencies. The first paragraph suggests that the company's sales and operating costs are impacted by fluctuating exchange rates. In particular, earnings are benefitted by a strengthening of the U.S. dollar in relation to the currencies in which the company's costs are partly determined. To understand the effects of exchange rates on both revenues and expenses, assume that Rio Tinto is selling aluminum products , priced in U.S. dollars, to an importer in Italy. As Italy is a member of the European Union2, the Italian importer must exchange euros for dollars to effect payment. Assume further that the value of the U.S. dollar unexpectedly falls in relation to the euro. The Italian buyer benefits from having to exchange less euros for dollars than would otherwise be the case, 1 The dollar is the currency most used to set prices for raw materials and the currency most used to conduct trade. See, Robert J. Samuelson, \"Why the Buck Is on the Edge,\" Newsweek, December 11, 2006, p. 49. 2 Members of the European Union include Austria, Belgium, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Slovakia, Slovenia, Spain, Sweden, and the U.K. Chapter 6 Foreign Currency Translation effectively lowering the price of Rio Tinto's products. If the euro does not change in value relative to other national currencies, this would make Rio Tinto's products cheaper relative to similar aluminum products supplied from other countries. The result would be increased demand for Rio Tinto's products in Italy and other EU countries adopting the euro as their national currency, and hence, larger sales volume than originally anticipated. Similarly, an unexpected fall in the value of the dollar relative to the euro would have an adverse impact on Rio Tinto's future expenses, such as planned advertising expenditures in Italy and all EU countries mentioned above. The effect of changes in foreign currency values on a firm's future sales and future costs is referred to as economic exposure and is a major concern of business entities engaged in global commerce and investment. Strategies to minimize the risk of loss arising from unexpected changes in the prices of foreign currencies is the subject of Chapter 11. In discussing the effect of exchange rate changes on earnings, the company is careful to note that these effects exclude the revaluation of foreign currency financial statements, the principle subject of this chapter. These effects relate to a process in which accounts denominated in foreign currency are translated to Rio Tinto's s reporting currency, U.S. dollars. The currency effects on Rio Tinto's sales and operating costs result from translating revenues and operating expenses denominated in say Canadian dollars to a devalued U.S. dollar. A Canadian dollar revenue and expense will translate to a higher U.S. dollar equivalent, other things remaining the same. The currency effects illustrated in the exhibits entitled, Earnings sensitivitesexchange on financial assets/liabilities, and Net assets' sensitivitiesexchange on translation, respectively, occur because Rio Tinto prepares a single set of financial statements that consolidates the results of all of its subsidiaries to afford its readers a more holistic view of Rio Tinto's s total operations, both foreign and domestic. Consolidated statements, in turn, require that financial statements expressed in foreign currency be translated to the reporting currency of the parent company. Rio Tinto's discussion of exchange rate effects raises two initial questions. First, what does the firm mean by the term, functional currency? Does it matter which currency is deemed functional and why? This and related terms are initially defined in Exhibit 6-2 and explained in subsequent sections of this chapter. Second, \"Do reported currency effects resulting from the translation process matter?\" The evidence is mixed. Some studies suggest that they do not.3 Recent studies suggest that they do. Bartov and Bodner, for example, provide evidence of a lagged relation between changes in currency values and stock returns but not for all translation methods employed by reporting entities.4 Pinto initially reports that lagged values of per share foreign currency translation adjustments are useful in predicting year to year changes in earnings per share. More recently, she finds that the currency translation 3 See T.D. Garlicki, F.J. Fabozzi, and R. Fonfeder, \"The Impact of Earnings Under FASB 52 on Equity Returns,\" Financial Management (Autumn 1987): 36-44; B.S. Soo and L. Gilbert Soo, \"Accounting for the Multinational Firm: Is the Translation Process Valued by the Stock Market?\" The Accounting Review, Vol. 69 (October 1994): 617-637; D. Dhaliwal, K. Subra and R. Trezevant, \"Is Comprehensive Income Superior to Net Income as a Measure of Firm Performance?\" Journal of Accounting and Economics, Vol. 26 (1999): 43-67; Steven F. Cahan, Stephen M. Courtnay, Paul L. Gronewoller, and David Upton, \"Value relevance of Mandated Comprehensive Income Disclosures,\" Journal of Business Finance and Accounting, Vol. 27 nos. 9&10 (2000): 1273-1301. 4 See E. Bartov, \"Foreign Currency Exposure of Multinatioinal Firms: Accounting Measures and Market Valuation,\" Contemporary Accounting Research, 14 (1997): 623-652. 167 168 Chapter 6 Foreign Currency Translation adjustments, when measured properly, are value relevant in providing a measure of a firm's exchange rate exposure.5 Financial executives also attach mixed importance to gains and losses associated with foreign currency translation. While some assert that accounting gains and losses generated by accounting measurements have no impact on their operational decisions, others express great concern over the distortions they cause in reported corporate earnings. History is replete with instances of management expending resources to minimize the effects of balance sheet translation gains and losses on reported performance. Differing opinions notwithstanding, all agree that foreign currency translation can have significant effects on repoted earnings. What are the implications of the foregoing discussion? To properly interpret the reported performance of multinational companies, statement readers must understand the nature of foreign exchange gains and losses, how these numbers are derived, and what they mean. To facilitate this understanding, we begin with an examination of why foreign currency translation is necessary. REASONS FOR TRANSLATION To reiterate, companies with significant overseas operations prepare consolidated financial statements that afford their statement readers an aggregate view of the firm's global operations. To accomplish this, financial statements of foreign subsidiaries that are denominated in foreign currencies are restated to the reporting currency of the parent company. This process of restating financial information from one currency to another is called translation. Many of the problems associated with currency translation stem from the fact that the relative value of foreign currencies are seldom fixed. Variable rates of exchange, combined with a variety of translation methods that can be used and different treatments of translation gains and losses, make it difficult to compare financial results from one company to another, or in the same company from one period to the next. In these circumstances, it becomes a challenge for multinational enterprises to make informative disclosures of operating results and financial position as per Rio Tinto's example. Financial analysts find that interpreting such information can also be quite challenging and these troubles extend to evaluating managerial performance. There are three additional reasons for foreign currency translation. These include recording foreign currency transactions, measuring a firm's exposure to the effects of currency gyrations, and communicating with foreign audiences-of-interest. Foreign currency transactions, such as the purchase of merchandise from China by a Canadian importer, must be translated because financial statements cannot be prepared from accounts that are expressed in more than one currency. How, for example, 5 Jo Ann M. Pinto, \"Foreign Currency Translation Adjustments as Predictors of Earnings Changes,\" Journal of International Accounting, Auditing and Taxes (2001): 51-69 and \"How Comprehensive is Comprehensive Income? The Value Relevance of Foreign Currency Translation Adjustments,\" Journal of International Financial Management and Accounting, Vol. 16, no. 2 (2005): 97-122. Chapter 6 Foreign Currency Translation is one to prepare cost of goods sold when purchases are denominated in Chinese renminbi, Russian rubles, and Argentine pesos? For accounting purposes, a foreign currency asset or liability is said to be exposed to currency risk if a change in the rate at which currencies are exchanged causes the parent (reporting) currency equivalent to change. The measurement of this exposure will vary depending on the translation method a firm chooses to employ. Finally, the expanded scale of international investment increases the need to convey accounting information about companies domiciled in one country to users in others. This need occurs when a company wishes to list its shares on a foreign stock exchange, contemplates a foreign acquisition or joint venture, or wants to communicate its operating results and financial position to its foreign stockholders. Many Japanese companies translate their entire financial statements from Japanese yen to U.S. dollars when reporting to interested American audiences. This practice is often called a convenience translation and is described more fully in Chapter 9. BACKGROUND AND TERMINOLOGY Translation is not the same as conversion, which is the physical exchange of one currency for another. Translation is simply a change in monetary expression, as when a balance sheet expressed in British pounds is restated in U.S. dollar equivalents. No physical exchange occurs, and no accountable transaction takes place as it does in conversion. Foreign currency balances are translated to domestic currency equivalents by the foreign exchange rate: the price of a unit of one currency expressed in terms of another. The currencies of major trading nations are bought and sold in global markets. Linked by sophisticated telecommunications networks, market participants include banks and other currency dealers, business enterprises, individuals, and professional traders. By providing a venue for buyers and sellers of currencies, the foreign exchange market facilitates the transfer of international payments (e.g., from importers to exporters), allows international purchases or sales to be made on credit (e.g., bank letters of credit that permit goods to be shipped in advance of payment to an unfamiliar buyer), and provides a means for individuals or businesses to protect themselves from the risks of unstable currency values. (Chapter 11 gives a fuller discussion of exchange risk management.) Foreign currency transactions take place in the spot, forward, or swap markets. Currency bought or sold spot normally must be delivered immediately, that is, within 2 business days. Thus, an American tourist departing for Paris can purchase and immediately receive euros by paying the spot rate in dollars. Spot market rates are influenced by many factors, including different inflation rates among countries, differences in national interest rates, and expectations about the direction of future rates. Spot market exchange rates may be direct or indirect.6 In a direct quote, the exchange rate specifies the number of domestic currency units needed to acquire a unit of foreign currency. For example, on a given day, the U.S. dollar price of a euro might be $1.4116. An indirect quote is the reciprocal of the direct quote: the price of a unit of the domestic currency in terms of the foreign currency. In this example, it would take approximately : 0.7084 euros to acquire 1 U.S. dollar. Translation of foreign currency balances is straightforward with either direct or indirect quotes. Domestic currency equivalents are obtained by multiplying foreign 6 For a daily listing of foreign exchange rates, visit www.ozforex.com. 169 170 Chapter 6 Foreign Currency Translation currency balances by direct exchange rate quotations or dividing foreign currency balances by indirect quotations. To illustrate, suppose that the cash balance of a U.S. subsidiary located in Bombay, India, on July 15 is INR1,000,000. The direct (spot) exchange rate on that date is $.020546. The U.S. dollar equivalent of the rupee cash balance on January 31 is $20,546, calculated by translating INR1,000,000 in either of the following ways: INR1,000,000 * $0.020546 = $20,546 or INR1,000,000 , INR 48.6700 = $20,546 Transactions in the forward market are agreements to exchange a specified amount of one currency for another at a future date. Quotations in the forward market are expressed at either a discount or a premium from the spot rate, or as outright forward rates. We will illustrate the latter. Moreover, spot and forward rates may often include bid and ask quotes. The bid quote is what the foreign exchange dealer would pay you for foreign currency; the ask quote is the rate that the dealer would sell you foreign currency. If spot roubles (Russian) are quoted at $0.031584, while the 6-month forward rouble is offered at $0.030807, forward roubles are selling at a discount of 9.8 percent in the United States, calculated as follows: forward premium (discount) = (forward rate - spot rate)/spot rate * 12, where n is the number of months in the forward contract. Thus, ($0.030807 - $0.031584)/$0.031584 * 12/3 = -0.098. Had the euro been quoted indirectly, the premium would have been determined as: forward premium (discount) = (spot rate - forward rate)/forward rate * 12, or rouble (31.6615 -32.4597)/32.4597 * 12/3 = -0.098. Spot and forward quotes for major foreign currencies on any business day can be found in the business section of many major newspapers. Exhibit 6-1 contains spot and forward quotes for selected currencies. A more comprehensive listing can be found on www.fxstreet.com. EXHIBIT 6-1 Sample of Spot and Forward Foreign Exchange Quotes (Foreign Currency in Dollars) Currency Spot Czech Rep. koruna Russian rouble Swedish krona Swiss franc Turkish new lira U.K. pound EU euro Brazilian real Mexican pesos Hong Kong dollar Indian rupee Japanese yen Saudi Arabian riyals South African rands South Korean won 18.3840 31.6615 7.8173 1.0752 1.5295 0.6480 0.7084 1.9386 13.5955 7.7503 48.6700 93.6250 3.7504 8.0884 1265.65 1 month 3 month 18.3890 31.9015 7.8157 1.0748 1.5402 0.6086 0.7084 1.9504 13.6548 7.7483 48.7650 93.5935 3.7499 8.1393 1265.25 18.4245 32.4597 7.8126 1.0739 1.5625 0.6087 0.7084 1.9727 13.7708 7.7442 48.9475 93.5283 3.7489 8.2347 1263.35 1 year 18.5240 35.5515 7.7942 1.0673 1.6674 0.6090 0.7080 2.0668 14.2855 7.7328 49.6875 93.0020 3.7452 8.6545 1256.15 Chapter 6 Foreign Currency Translation A swap transaction involves the simultaneous spot purchase and forward sale, or spot sale and forward purchase, of a currency. Investors often use swap transactions to take advantage of higher interest rates in a foreign country while simultaneously protecting themselves against unfavorable movements in the foreign exchange rate. As an example, should interest rates in the United States exceed those in Switzerland, Swiss investors could purchase dollars in the spot market and invest them in higher yielding U.S. dollar debt instruments, say 6-month U.S. Treasury notes. In doing so, however, Swiss investors would lose this yield advantage if the U.S. dollar loses value relative to the Swiss franc in the 6-month period. To protect against this possibility, Swiss investors could simultaneously sell the dollars they expect to receive in 6 months at the guaranteed forward rate. Such swap transactions work well when the U.S./Swiss interest rate differential is greater than the discount on forward dollars (i.e., the difference between spot and 6-month forward dollars). Over time, foreign currency traders will eliminate this difference, thereby creating interest rate parity. Exhibit 6-2 defines the foreign currency translation terms used in this chapter. EXHIBIT 6-2 Glossary of Foreign Currency Translation Terms attribute. The quantifiable characteristic of an item that is measured for accounting purposes. For example, historical cost and replacement cost are attributes of an asset. conversion. The exchange of one currency for another. current rate. The exchange rate in effect at the relevant financial statement date. discount. When the forward exchange rate is below the current spot rate. exposed net asset position. The excess of assets that are measured or denominated in foreign currency and translated at the current rate over liabilities that are measured or denominated in foreign currency and translated at the current rate. foreign currency. A currency other than the currency of the country being referred to; a currency other than the reporting currency of the enterprise being referred to. foreign currency financial statements. Financial statements that employ foreign currency as the unit of measure. foreign currency transactions. Transactions (e.g., sales or purchases of goods or services or loans payable or receivable) whose terms are stated in a currency other than the entity's functional currency. foreign currency translation. The process of expressing amounts denominated or measured in one currency in terms of another currency by use of the exchange rate between the two currencies. foreign operation. An operation whose financial statements are (1) combined or consolidated with or accounted for on an equity basis in the financial statements of the reporting enterprise and (2) prepared in a currency other than the reporting currency of the reporting enterprise. forward exchange contract. An agreement to exchange currencies of different countries at a specified rate (forward rate) at a specified future date. functional currency. The primary currency in which an entity does business and generates and spends cash. It is usually the currency of the country where the entity is located and the currency in which the books of record are maintained. (continued) 171 172 Chapter 6 Foreign Currency Translation EXHIBIT 6-2 Glossary of Foreign Currency Translation Terms (Continued) historical rate. The foreign exchange rate that prevailed when a foreign currency asset or liability was first acquired or incurred. local currency. Currency of a particular country being referred to; the reporting currency of a domestic or foreign operation being referred to. monetary items. Obligations to pay or rights to receive a fixed number of currency units in the future. reporting currency. The currency in which an enterprise prepares its financial statements. settlement date. The date on which a payable is paid or a receivable is collected. spot rate. The exchange rate for immediate exchange of currencies. transaction date. The date at which a transaction (e.g., a sale or purchase of merchandise or services) is recorded in a reporting entity's accounting records. translation adjustments. Translation adjustments result from the process of translating financial statements from the entity's functional currency into the reporting currency. unit of measure. The currency in which assets, liabilities, revenue, and expenses are measured. THE PROBLEM If foreign exchange rates were relatively stable, currency translation would be no more difficult than translating inches or feet to their metric equivalents. However, exchange rates are seldom stable. The currencies of most industrialized countries are free to find their own values in the currency market. For an illustration of the volatility of exchange rates of selected countries, examine the data compiled by the Federal Reserve Bank of St. Louis at www.research.stlouisfed.org/fred2. Fluctuating exchange values are particularly evident in Eastern Europe, Latin America, and certain parts of Asia. Currency fluctuations increase the number of translation rates that can be used in the translation process and create foreign exchange gains and losses. Currency movements are also closely tied to local rates of inflation, the subject of Chapter 7. FINANCIAL STATEMENT EFFECTS OF ALTERNATIVE TRANSLATION RATES The following three exchange rates can be used to translate foreign currency balances to domestic currency. First, the current rate is the exchange rate prevailing as of the financial statement date. Second, the historical rate is the prevailing exchange rate when a foreign currency asset is first acquired or a foreign currency liability first incurred. Finally, the average rate is a simple or weighted average of either current or historical exchange rates. As average rates are simply variations of current or historical rates, the following discussion focuses on the latter two. What then are the financial statement effects of using historical as opposed to current rates of exchange as foreign currency translation coefficients? Historical exchange rates generally preserve the original cost equivalent of a foreign currency Chapter 6 Foreign Currency Translation item in the domestic currency statements. Suppose that a foreign subsidiary of a U.S. parent company acquires an item of inventory for 1,000 foreign currency (FC) units when the exchange rate (indirect quote) is FC2 = $1. This asset would appear in the U.S. consolidated statements at $500. Now assume that the exchange rate changes from FC2 = $1 to FC4 = $1 by the next financial statement date and that the inventory item is still on hand. Will the U.S. dollar equivalent of the inventory now change to $250? It would not. As long as we translate the original FC1,000 cost at the rate that prevailed when the asset was acquired (historical rate), it will appear in the U.S. financial statements at $500, its historical cost expressed in U.S. dollars. Use of historical exchange rates shields financial statements from foreign currency translation gains or losses, that is, from increases or decreases in the dollar equivalents of foreign currency balances due to fluctuations in the translation rate between reporting periods. The use of current rates causes translation gains or losses. Thus, in the previous example, translating the FC1,000 piece of inventory at the current rate (FC4 = $1) would yield a translation loss of $250 [(FC1,000 , 2) - (FC1,000 , 4)]. Here we must distinguish between translation gains and losses and transaction gains and losses, both of which fall under the label exchange gains and losses. Foreign currency transactions occur whenever an enterprise purchases or sells goods for which payment is made in a foreign currency or when it borrows or lends foreign currency. Translation is necessary to maintain the accounting records in the currency of the reporting enterprise. Of the two types of transaction adjustments, the first, gains and losses on settled transactions, arises whenever the exchange rate used to book the original transaction differs from the rate used at settlement. Thus, if a U.S. parent company borrows FC1,000 when the exchange rate is FC2 = $1 and then converts the proceeds to dollars, it will receive $500 and record a $500 liability on its books. If the foreign exchange rate rises to FC1 = $1 when the loan is repaid, the U.S. company will have to pay out $1,000 to discharge its FC1,000 debt. The company has suffered a $500 conversion loss. The second type of transaction adjustment, gains or losses on unsettled transactions, arises whenever financial statements are prepared before a transaction is settled. In the preceding example, assume that the FC1,000 is borrowed during year 1 and repaid during year 2. If the exchange rate prevailing at the financial statement date (end of year 1) is FC1.5 = $1, the dollar equivalent of the FC1,000 loan will be $667, creating an exchange loss of $167. Until the foreign currency debt is actually repaid, however, this unrealized exchange loss is similar in nature to a translation loss as it results from a restatement process. Exhibit 6-3 lays out the distinction between transaction and translation gains and losses. Differences in exchange rates in effect at the various dates shown cause the various types of exchange adjustments. When considering exchange gains and losses, it is critical to distinguish between transaction gains and losses and translation gains and losses. A realized (or settled) transaction creates a real gain or loss. Accountants generally agree that such a gain or loss should be reflected immediately in income. In contrast, translation adjustments (including gains or losses on unsettled transactions) are unrealized or paper items. The appropriate accounting treatment of these gains or losses is less obvious. 173 174 Chapter 6 Foreign Currency Translation EXHIBIT 6-3 Types of Exchange Adjustments Exchange gain/loss Transaction gain/loss Transaction date Financial statement date Translation gain/loss Settlement date Initial financial statement date Subsequent financial statement date Unsettled transaction Settled transaction An informed reader of consolidated financial statements must understand three major issues associated with fluctuating exchange rates: 1. What exchange rate was used to translate foreign currency balances to domestic currency? 2. Which foreign currency assets and liabilities are exposed to exchange rate changes? 3. How are translation gains and losses accounted for? These issues are examined in the rest of this chapter. Foreign Currency Transactions The distinguishing feature of a foreign currency transaction is that settlement is effected in a foreign currency. Thus, foreign currency transactions occur whenever an enterprise purchases or sells goods for which payment is made in a foreign currency or when it borrows or lends foreign currency. As an example, a company purchasing inventories denominated in Saudi Arabian riyals on account suffers an exchange loss should the riyal gain in value before settlement. A foreign currency transaction may be denominated in one currency but measured in another. To understand why, consider first the notion of the functional currency. The functional currency of an entity is the primary currency in which it transacts business and generates and spends cash. If a foreign subsidiary's operation is relatively self-contained and integrated within the foreign country (i.e., one that Chapter 6 Foreign Currency Translation manufactures a product for local distribution), it will normally generate and spend its local (country-of-domicile's) currency. Hence, the local currency (e.g., euros for the Belgian subsidiary of a U.S. parent) is its functional currency. If a foreign entity keeps its accounts in a currency other than the functional currency (e.g., the Indian accounts of a U.S. subsidiary whose functional currency is really British pounds, rather than Indian rupees), its functional currency is the third-country currency (pounds). If a foreign entity is merely an extension of its parent company (e.g., a Mexican assembly operation that receives components from its U.S. parent and ships the assembled product back to the United States), its functional currency is the U.S. dollar. Exhibit 6-4 identifies circumstances justifying use of either the local or parent currency as the functional currency. To illustrate the difference between a transaction being denominated in one currency but measured in another, assume that a U.S. subsidiary in Hong Kong purchases merchandise inventory from the People's Republic of China payable in renminbi. The subsidiary's functional currency is the U.S. dollar. In this instance, the subsidiary would measure the foreign currency transactiondenominated in renminbiin U.S. dollars, the currency in which its books are kept. From the parent's point of view, the subsidiary's liability is denominated in renminbi but measured in U.S. dollars, its functional currency, for purposes of consolidation. FAS No. 52, the U.S. authoritative pronouncement on accounting for foreign currency, mandates the following treatment for foreign currency transactions: 1. At the date the transaction is recognized, each asset, liability, revenue, expense, gain, or loss arising from the transaction shall be measured and recorded in the EXHIBIT 6-4 Functional Currency Criteria Circumstances Favoring Local Currency as Functional Currency Circumstances Favoring Parent Currency as Functional Currency Cash flows Primarily in the local currency and do not impact parent's cash flows Sales price Largely irresponsive to exchange rate changes and governed primarily by local competition Largely in the host country and denominated in local currency Incurred primarily in the local environment Primarily denominated in local currency and serviced by local operations Infrequent, not extensive Directly impact parent's cash flows and are currently remittable to the parent Responsive to changes in exchange rates and determined by worldwide competition Largely in the parent country and denominated in parent currency Primarily related to productive factors imported from the parent company Primarily from the parent or reliance on parent company to meet debt obligations Frequent and extensive Economic Factors Sales market Expenses Financing Intercompany transactions Adapted from: Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 52, Stamford, CT: FASB, 1981, Appendix A. 175 176 Chapter 6 Foreign Currency Translation functional currency of the recording entity by use of the exchange rate in effect at that date. 2. At each balance sheet date, recorded balances that are denominated in a currency other than the functional currency of the recording entity shall be adjusted to reflect the current exchange rate. On this basis, a foreign exchange adjustment (i.e., gain or loss on a settled transaction) is necessary whenever the exchange rate changes between the transaction date and the settlement date. Should financial statements be prepared before settlement, the accounting adjustment (i.e., gain or loss on an unsettled transaction) will equal the difference between the amount originally recorded and the amount presented in the financial statements. The FASB rejected the view that a distinction should be drawn between gains and losses on settled and unsettled transactions, because such distinctions cannot be applied in practice. Two accounting treatments for transactions gains and losses are possible. Single-Transaction Perspective Under a single-transaction perspective, exchange adjustments (both settled and unsettled) are treated as an adjustment to the original transaction accounts on the premise that a transaction and its settlement are a single event. The following example illustrates this treatment. On September 1, 2011, a U.S. manufacturer sells, on account, goods to a Swedish importer for 1 million Swedish krona (SEK). The dollar/krona exchange rate is $0.12 = SEK 1, the krona receivable are due in 90 days, and the U.S. company operates on a calendar-year basis. The krona begins to depreciate before the receivable is collected. By the end of the month, the dollar/krona exchange rate is $0.11 = SEK 1; on December 1, 2011, it is $0.09 = SEK 1. (These transactions are posted in Exhibit 6-5.) EXHIBIT 6-5 U.S. Company's Record: Single-Transaction Perspective Sept. 1, 2011 Sept. 30, 2011 Dec. 1, 2011 Dec. 1, 2011 Accounts receivable Sales (To record credit sale) Sales Accounts receivable (To adjust existing accounts for initial exchange rate change: SEK 1,000,000 $0.12 minus SEK 1,000,000 $0.11) Retained earnings Accounts receivable (To adjust accounts for additional rate change: SEK 1,000,000 $0.11 minus SEK 1,000,000 $0.09) Foreign currency Accounts receivable (To record settlement of outstanding foreign currency receivables) Foreign Currency U.S. Dollar Equivalent SEK 1,000,000 SEK 1,000,000 120,000 120,000 10,000 10,000 20,000 20,000 SEK 1,000,000 SEK 1,000,000 90,000 90,000 Chapter 6 Foreign Currency Translation In this illustration, until the account is collected, the initial dollar amount recorded for both accounts receivable and sales is considered an estimate to be subsequently adjusted for changes in the dollar/krona exchange rate. Further depreciation of the krona between the financial statement date (September 1) and the settlement date (December 1) would require additional adjustments. In the Rio Tinto example at the beginning of this chapter, the effect of exchange rate changes illustrated in Exhibit 6-5 would have impacted consolidated revenues. Two-Transaction Perspective Under a two-transaction perspective, collection of the krona receivable is considered a separate event from the sale that gave rise to it. In the previous illustration, the export sale and related receivable would be recorded at the exchange rate in effect at that date. Depreciation of the krona between September 1 and December 1 would result in an exchange loss (i.e., loss on an unsettled transaction) and currency receivable on December 1, 2011, at the even lower exchange rate would result in a further exchange loss (i.e., loss on a settled transaction). See Exhibit 6-6. In the interest of uniformity, FAS No. 52 requires the two-transaction method of accounting for foreign currency transactions. Gains and losses on settled and unsettled transactions are included in the determination of income; for example, the gains and losses illustrated in Exhibit 6-6 are the foreign currency effects explained in the first exhibit of the Rio Tinto example (Earnings sensitivitiesexchange rates). Major exceptions to this requirement occur whenever (1) exchange adjustments relate to certain long-term intercompany transactions and (2) transactions are intended and effective as hedges of net investments (i.e., hedges of foreign operations' exposed net asset/liability positions) and foreign currency commitments. (The notion of an exposed asset or liability position is described shortly.) EXHIBIT 6-6 U.S. Company's Record: Two-Transaction Perspective Sept. 1, 2011 Accounts receivable Sales (To record credit sale at Sept. 1, 2011 exchange rate) Sept. 30, 2011 Foreign exchange loss Accounts receivable (To record effect of initial rate change) Foreign currency Foreign exchange loss Dec. 1, 2011 Accounts receivable (To record settlement of foreign currency receivable) Foreign Currency U.S. Dollar Equivalent SEK 1,000,000 SEK 1,000,000 $120,000 $120,000 10,000 10,000 SEK 1,000,000 SEK 1,000,000 90,000 20,000 110,000 177 178 Chapter 6 Foreign Currency Translation FOREIGN CURRENCY TRANSLATION Companies operating internationally use a variety of methods to express, in terms of their domestic currency, the assets, liabilities, revenues, and expenses that are stated in a foreign currency. These translation methods can be classified into two types: those that use a single translation rate to restate foreign balances to their domestic currency equivalents and those that use multiple rates. Exhibit 6-7 summarizes the treatment of specific balance sheet items under these translation methods. Single Rate Method The single rate method, long popular in Europe, applies a single exchange rate, the current or closing rate, to all foreign currency assets and liabilities. Foreign currency revenues and expenses are generally translated at exchange rates prevailing when these items are recognized. For convenience, however, revenues and expenses are typically translated by an appropriately weighted average of current exchange rates for the period. Under the single, or current, rate method, the financial statements of a foreign operation (viewed by the parent as an autonomous entity) have their own reporting domicile: the local currency environment in which the foreign affiliate does business. The consolidated statements preserve the original financial statement relationships (such as financial ratios) of the individual consolidated entities as all foreign currency financial statement items are translated by a constant. That is, consolidated results reflect the currency perspectives of each entity whose results go into the consolidated EXHIBIT 6-7 Exchange Rates Employed in Different Translation Methods for Specific Balance Sheet Items Cash Accounts receivable Inventories Cost Market Investments Cost Market Fixed assets Other assets Accounts payable Long-term debt Common stock Retained earnings Current Current Noncurrent Monetary Nonmonetary Temporal C C C C C C C C C C C C H H H C C C C C C C H * H H H H C H H * H H H H C C H * H C H H C C H * Note: C, current rate; H, historical rate; and *, residual, balancing figure representing a composite of successive current rates. Chapter 6 Foreign Currency Translation totals, not the single-currency perspective of the parent company. Some people fault this method on the ground that using multiple currency perspectives violates the basic purpose of consolidated financial statements. For accounting purposes, a foreign currency asset or liability is said to be exposed to exchange rate risk if its parent currency equivalent changes owing to a change in the exchange rate used to translate that asset or liability. Given this definition, the current rate method presumes that all local currency assets are exposed to exchange risk as the current (vs. the historical) rate changes the parent currency equivalent of all foreign currency assets every time exchange rates change. This seldom accords with economic reality as inventory and fixed asset values are generally supported by local inflation. Consider the following example. Suppose that a foreign affiliate of a U.S. multinational corporation (MNC) buys a tract of land at the beginning of the period for FC1,000,000. The exchange rate (historical rate) was FC1 = $1. Thus, the historical cost of the investment in dollars is $1,000,000 (FC1,000,000 , FC1). Due to changing prices, the land rises in value to FC1,500,000 (unrecognized under U.S. GAAP) while the exchange rate declines to FC1.4 = $1 by the end of the period. If this foreign currency asset were translated to U.S. dollars using the current rate, its original dollar value of $1,000,000 would now be recorded at $714,286 (FC1,000,000 , FC1.4) implying an exchange loss of $285,714. Yet the increase in the fair market value of the land indicates that its current value in U.S. dollars is actually $1,071,285 (FC1,500,000 , FC1.4). This suggests that translated asset values make little sense without making local price-level adjustments first. Also, translation of a historical cost number by a current market-determined exchange rate (e.g., FC1,000,000 , FC1.4 = $714,286) produces a result that resembles neither historical cost ($1,000,000) nor current market value ($1,071,285). Finally, translating all foreign currency balances by the current rate creates translation gains and losses every time exchange rates change. Reflecting such exchange adjustments in current income could significantly distort reported measures of performance. Many of these gains and losses may never be fully realized, as changes in exchange rates often reverse direction. Multiple Rate Methods Multiple rate methods combine current and historical exchange rates in the translation process. CURRENT-NONCURRENT METHOD Under the current-noncurrent method, a foreign subsidiary's current assets (assets that are usually converted to cash within a year) and current liabilities (obligations that mature within a year) are translated into their parent company's reporting currency at the current rate. Noncurrent assets and liabilities are translated at historical rates. Income statement items (except for depreciation and amortization charges) are translated at average rates applicable to each month of operation or on the basis of weighted averages covering the whole period being reported. Depreciation and amortization charges are translated at the historical rates in effect when the related assets were acquired. Unfortunately, this method does not often square with reality. Using the year-end rate to translate current assets implies that all foreign currency cash, receivables, and inventories are equally exposed to exchange risk; that is, will be worth more or less in parent currency if the exchange rate changes during the year. This is simply not true. 179 180 Chapter 6 Foreign Currency Translation For example, if the local price of inventory can be increased after a devaluation, its value is protected from currency exchange risk. On the other hand, translation of longterm debt at the historical rate shifts the impact of fluctuating currencies to the year of settlement. Many consider this to be at odds with reality as analysts are always assessing the current realizable values of a firm's long-run obligations. Moreover, current and noncurrent definitions are merely a classification scheme, not a conceptual justification, of which rates to use in translation. MONETARY-NONMONETARY METHOD7 The monetary-nonmonetary method also uses a balance sheet classification scheme to determine appropriate translation rates. Monetary assets and liabilities; that is, claims to and obligations to pay a fixed amount of currency in the future are translated at the current rate. Nonmonetary itemsfixed assets, long-term investments, and inventoriesare translated at historical rates. Income statement items are translated under procedures similar to those described for the current-noncurrent framework. Unlike the current-noncurrent method, this method views monetary assets and liabilities as exposed to exchange rate risk. Since monetary items are settled in cash, use of the current rate to translate these items produces domestic currency equivalents that reflect their realizable or settlement values. It also reflects changes in the domestic currency equivalent of long-term debt in the period in which exchange rates change, producing a more timely indicator of exchange rate effects. Note, however, that the monetary-nonmonetary method also relies on a classification scheme to determine appropriate translation rates. This may lead to inappropriate results. For example, this method translates all nonmonetary assets at historical rates, which is not reasonable for assets stated at current market values (such as investment securities and inventory and fixed assets written down to market). Multiplying the current market value of a nonmonetary asset by a historical exchange rate yields an amount in the domestic currency that is neither the item's current equivalent nor its historical cost. This method also distorts profit margins by matching sales at current prices and translation rates against cost of sales measured at historical costs and translation rates. TEMPORAL METHOD8 With the temporal method, currency translation does not change the attribute of an item being measured; it only changes the unit of measure. In other words, translation of foreign balances restates the currency denomination of these items, but not their actual valuation. Under U.S. GAAP, cash is measured in terms of the amount owned at the balance sheet date. Receivables and payables are stated at amounts expected to be received or paid when due. Other assets and liabilities are measured at money prices that prevailed when the items were acquired or incurred (historical prices). Some, however, are measured at prices prevailing as of the financial statement date (current prices), such as inventories under the lower of cost or market rule. In short, a time dimension is associated with these money values. 7 This method was originally proposed in Samuel R. Hepworth, Reporting Foreign Operations, Ann Arbor: University of Michigan, 1956. 8 This method was originally proposed in Leonard Lorensen, \"Reporting Foreign Operations of U.S. Companies in U.S. Dollars,\" Accounting Research Study No. 12, New York: American Institute of Certified Public Accountants, 1972. Chapter 6 Foreign Currency Translation In the temporal method, monetary items such as cash, receivables, and payables are translated at the current rate. Nonmonetary items are translated at rates that preserve their original measurement bases. Specifically, assets carried on the foreign currency statements at historical cost are translated at the historical rate. Why? Because historical cost in foreign currency translated by a historical exchange rate yields historical cost in domestic currency. Similarly, nonmonetary items carried abroad at current values are translated at the current rate because current value in foreign currency translated by a current exchange rate produces current value in domestic currency. Revenue and expense items are translated at rates that prevailed when the underlying transactions took place, although average rates are suggested when revenue or expense transactions are voluminous. When nonmonetary items abroad are valued at historical cost, the translation procedures resulting from the temporal method are virtually identical to those produced by the monetary-nonmonetary method. The two translation methods differ only if other asset valuation bases are employed, such as replacement cost, market values, or discounted cash flows. Because it is similar to the monetary-nonmonetary method, the temporal method shares most of its advantages and disadvantages. In deliberately ignoring local inflation, this method shares a limitation with the other translation methods discussed. (Of course, historical cost accounting ignores inflation as well!). All four methods just described have been used in the United States at one time or another and can be found today in various countries. In general, they produce noticeably different foreign currency translation results. The first three methods (i.e., the current rate, current-noncurrent, and monetary-nonmonetary) are predicated on identifying which assets and liabilities are exposed to, or sheltered from, currency exchange risk. The translation methodology is then applied consistent with this distinction. The current rate method presumes that the entire foreign operation is exposed to exchange rate risk since all assets and liabilities are translated at the year-end exchange rate. The current-noncurrent rate method presumes that only the current assets and liabilities are so exposed, while the monetary-nonmonetary method presumes that monetary assets and liabilities are exposed. In contrast, the temporal method is designed to preserve the underlying theoretical basis of accounting measurement used in preparing the financial statements being translated. See Chapter 11 for a further discussion of exposure. Financial Statement Effects Exhibits 6-8 and 6-9 highlight the financial statement effects of the major translation methods described. The balance sheet of a hypothetical Mexican subsidiary of a U.S.-based multinational enterprise appears in pesos in the first column of Exhibit 6-9. The second column depicts the U.S. dollar equivalents of the Mexican peso(MXN) balances when the exchange rate was MXN1 = $0.13. Should the peso depreciate to MXN1 = $0.11, several different accounting results are possible. Under the current rate method, exchange rate changes affect the dollar equivalents of the Mexican subsidiary's total foreign currency assets (TA) and liabilities (TL) in the current period. Since their dollar values are affected by changes in the current rate, they are said to be exposed (in an accounting sense) to foreign exchange risk. Accordingly, under the current rate method, an exposed net asset position (TA > TL) results in a 181 182 Chapter 6 Foreign Currency Translation EXHIBIT 6-8 Mexican Subsidiary Balance Sheet U. S. Dollars before Peso Devaluation Pesos Current Rate Current- Noncurrent Monetary- Nonmonetary $ 390 780 1,170 2,340 $4,680 $ 330 660 990 1,980 $3,960 $ 330 660 990 2,340 $4,320 $ 330 660 1,170 2,340 $4,500 990a 2,340 $4,320 $1,170 1,560 1,950 $4,680 $ 990 1,320 1,650 $3,960 15,000 (300) $ 990 1,560 1,770 $4,320 9,000 (180) $ 990 1,320 2,190 $4,500 (12,000) 240 $ 990 1,320 2,010 $4,320 (3,000) 60 ($ 0.13 = MXN1) Assets Cash 3,000 A/R 6,000 Inventories 9,000 F/A (net) 18,000 Total 36,000 Liabilities and Owners' Equity S-T payables 9,000 L-T debt 12,000 O/E 15,000 Total 36,000 Accounting exposure (MXN) Translation gain (loss) ($) U. S. Dollars after Peso Depreciation ($ 0.11 = MXN1) Temporal $ 330 660 Note: If the exchange rate remained unchanged over time, the translated statements would be the same under all translation methods. a Assume inventories are carried at lower of cost or market. If they were carried at historical cost, the temporal balance sheet would be identical to the monetary-nonmonetary method. translation loss if the Mexican peso loses value, and an exchange gain if the peso gains value. An exposed peso net liability position (TA