CHF Rate* US$
Sales . . . CHF 4,000,000 0.65 A $ 2,600,000 Cost of goods sold . . . . (3,000,000) 0.65 A (1,950,000)
Gross profit . . . . 1,000,000 650,000
Depreciation expense . . . . (100,000) 0.65 A (65,000)
Amortization expense . . . . (10,000) 0.65 A (6,500)
Other expenses . . . . (220,000) 0.65 A (143,000)
Income before income taxes . . . . 670,000 435,500
Income taxes . . . . (200,000) 0.65 A (130,000) Net income . . . CHF 470,000 $ 305,500
Statement of Retained Earnings For Year Ending December 31, 2011
Translation
CHF Rate* US$
Retained earnings, 1/1/11 . . . . CHF –0– $ –0–
Net income, 2011 . . . . 470,000 Above 305,500
Dividends, 10/1/11 . . . . (150,000) 0.67 H (100,500)
Retained earnings, 12/31/11 . . . . CHF 320,000 $ 205,000
*Indicates the exchange rate used and whether the rate is the current (C), average (A), or a historical (H) rate.
Translation of Foreign Currency Financial Statements 449
To properly translate the Swiss franc financial statements into U.S. dollars, USCO must gather exchange rates between the Swiss franc and U.S. dollar at various points in time. Rele- vant exchange rates (in U.S. dollars) are as follows:
January 1, 2011 . . . $0.60 Rate when property and equipment were acquired and
long-term debt was incurred, March 15, 2011 . . . 0.61 Rate when patent was acquired, April 10, 2011 . . . 0.62 Average 2011 . . . 0.65 Rate when dividends were declared, October 1, 2011 . . . 0.67 Average fourth quarter 2011 . . . 0.68 December 31, 2011 . . . 0.70 As you can see, the Swiss franc steadily appreciated against the dollar during the year.
TRANSLATION OF FINANCIAL STATEMENTS—CURRENT RATE METHOD
The first step in translating foreign currency financial statements is to determine the func- tional currency. Assuming that the Swiss franc is the functional currency, the income statement and statement of retained earnings are translated into U.S. dollars using the current rate method as shown in Exhibit 10.4.
All revenues and expenses are translated at the exchange rate in effect at the date of ac- counting recognition. We utilize the weighted average exchange rate for 2011 here because each revenue and expense in this illustration would have been recognized evenly throughout the year. However, when an income account, such as a gain or loss, occurs at a specific point in time, the exchange rate as of that date is applied. Depreciation and amortization expenses also are translated at the average rate for the year. These expenses accrue evenly throughout the year even though the journal entry could have been delayed until year-end for convenience.
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The translated amount of net income for 2011 is brought down from the income statement into the statement of retained earnings. Dividends are translated at the exchange rate on the date of declaration.
Translation of the Balance Sheet
Looking at SWISSCO’s translated balance sheet in Exhibit 10.5, note that all assets and lia- bilities are translated at the current exchange rate. Common stock and additional paid-in cap- ital are translated at the exchange rate on the day the common stock was originally sold.
Retained earnings at December 31, 2011, is brought down from the statement of retained earn- ings. Application of these procedures results in total assets of $1,169,000 and total liabilities and equities of $1,100,000. The balance sheet is brought into balance by creating a positive translation adjustment of $69,000 that is treated as an increase in Stockholders’ Equity.
Note that the translation adjustment for 2011 is a positive$69,000 (credit balance). The sign of the translation adjustment (positive or negative) is a function of two factors: (1) the nature of the balance sheet exposure (asset or liability) and (2) the change in the exchange rate (appreciation or depreciation). In this illustration, SWISSCO has a net asset exposure (total assets translated at the current exchange rate are more than total liabilities translated at the current exchange rate), and the Swiss franc has appreciated,creating a positive translation adjustment.
The translation adjustment can be derived as the amount needed to bring the balance sheet back into balance. The translation adjustment also can be calculated by considering the impact of exchange rate changes on the beginning balance and subsequent changes in the net asset po- sition summarized as follows:
1. Translate the net asset balance of the subsidiary at the beginning of the year at the exchange rate in effect on that date (a).
450 Chapter 10
EXHIBIT 10.5 Translation of Balance Sheet—Current Rate Method
SWISSCO Balance Sheet December 31, 2011
Translation
CHF Rate US$
Assets
Cash . . . CHF 130,000 0.70 C $ 91,000
Accounts receivable . . . . 200,000 0.70 C 140,000
Inventory . . . . 400,000 0.70 C 280,000
Total current assets . . . . 730,000 511,000
Property and equipment . . . . 1,000,000 0.70 C 700,000
Less: Accumulated depreciation . . . . (100,000) 0.70 C (70,000)
Patents, net . . . . 40,000 0.70 C 28,000 Total assets . . . CHF 1,670,000 $1,169,000 Liabilities and Equities
Accounts payable . . . CHF 600,000 0.70 C $ 420,000
Total current liabilities . . . . 600,000 420,000
Long-term debt . . . . 250,000 0.70 C 175,000
Total liabilities . . . . 850,000 595,000
Common stock . . . . 100,000 0.60 H 60,000
Additional paid-in capital . . . . 400,000 0.60 H 240,000
Retained earnings . . . . 320,000 Above 205,000
Cumulative translation adjustment . To balance 69,000
Total equity . . . . 820,000 574,000
Total liabilities and equity . . . CHF 1,670,000 $1,169,000 hoy36628_ch10_435-488.qxd 1/7/10 6:42 PM Page 450
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Translation of Foreign Currency Financial Statements 451
2. Translate individual increases and decreases in the net asset balance during the year at the rates in effect when those increases and decreases occurred (b). Only a few events, such as net income, dividends, stock issuance, and the acquisition of treasury stock, actually change net assets. Transactions such as the acquisition of equipment or the payment of a li- ability have no effect on total net assets.
3. Combine the translated beginning net asset balance (a)and the translated value of the indi- vidual changes (b)to arrive at the relative value of the net assets being held prior to the impact of any exchange rate fluctuations during the year (c).
4. Translate the ending net asset balance at the current exchange rate to determine the re- ported value after all exchange rate changes have occurred (d).
5. Compare the translated value of the net assets prior to any rate changes (c) with the ending translated value (d). The difference is the result of exchange rate changes during the period.
If (c) is higher than (d), a negative (debit) translation adjustment arises. If (d) is higher than (c), a positive (credit) translation adjustment results.
Computation of Translation Adjustment
Based on the process just described, the translation adjustment for SWISSCO in this example is calculated as follows:
Net asset balance, 1/1/11 . . . CHF 500,000 ⫻ 0.60 ⫽ $ 300,000 (a) Change in net assets:
Net income, 2011 . . . 470,000 ⫻ 0.65 ⫽ 305,500 (b) Dividends declared, 10/1/11 . . . (150,000) ⫻ 0.67 ⫽ (100,500) (b) Net asset balance, 12/31/11 . . . CHF 820,000 $ 505,000 (c) Net asset balance, 12/31/11
at current exchange rate . . . CHF 820,000 ⫻ 0.70 ⫽ 574,000 (d)
Translation adjustment, 2011 (positive). . . . $ (69,000)
The process described and demonstrated above is used to calculate the current period’s trans- lation adjustment. Because SWISSCO began operations at the beginning of the current year, the
$69,000 translation adjustment is the only amount that will be needed to keep the U.S. dollar consolidated balance sheet in balance. In subsequent years, a cumulative translation adjustment comprised of the current year’s translation adjustment plus translation adjustments from prior years will be included in stockholders’ equity on the U.S. dollar consolidated balance sheet.
Most companies report the cumulative translation adjustment in Accumulated Other Compre- hensive Income, along with unrealized foreign exchange gains and losses, gains and losses on cash flow hedges, unrealized gains and losses on available-for-sale marketable securities, and adjustments for pension accounting.
The cumulative translation adjustment is carried in accumulated other comprehensive in- come only until the foreign operation is sold or liquidated. In the period in which sale or liq- uidation occurs, the cumulative translation adjustment related to the particular entity is removed from accumulated other comprehensive income and included as part of the gain or loss on the sale of the investment. In effect, the accumulated unrealized foreign exchange gain or loss that has been deferred in accumulated other comprehensive income becomes realized when the entity is disposed of.
Translation of the Statement of Cash Flows
The current rate method requires translating all operating items in the statement of cash flows at the average-for-the-period exchange rate (see Exhibit 10.6). This is the same rate used for translating income statement items. Although the ending balances in Accounts Receivable, In- ventory, and Accounts Payable on the balance sheet are translated at the current exchange rate, the average rate is used for the changesin these accounts because those changes are caused by operating activities (such as sales and purchases) that are translated at the average rate.
Investing and financing activities are translated at the exchange rate on the day the activity took place. Although long-term debt is translated in the balance sheet at the current rate, in the statement of cash flows, it is translated at the historical rate when the debt was incurred.
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The $(4,500) “effect of exchange rate change on cash” is a part of the overall translation adjustment of $69,000. It represents that part of the translation adjustment attributable to a decrease in Cash and is derived as a balancing amount.