Two types of exchange rates are used in translating financial statements:
1. Historical exchange rate:the exchange rate that exists when a transaction occurs.
2. Current exchange rate: the exchange rate that exists at the balance sheet date.
Translation methods differ as to which balance sheet and income statement accounts to trans- late at historical exchange rates and which to translate at current exchange rates.
Assume that the company described in the discussion question on the next page began op- erations in Gualos on December 31, 2010, when the exchange rate was $0.20 per vilsek. When Southwestern Corporation prepared its consolidated balance sheet at December 31, 2010, it had no choice about the exchange rate used to translate the Land account into U.S. dollars. It translated the Land account carried on the foreign subsidiary’s books at 150,000 vilseks at an exchange rate of $0.20; $0.20 was both the historicaland currentexchange rate for the Land account at December 31, 2010.
Consolidated Balance Sheet: 12/31/10 Land (150,000 vilseks $0.20) . . . $30,000
During the first quarter of 2011, the vilsek appreciates relative to the U.S. dollar by 15 per- cent; the exchange rate at March 31, 2011, is $0.23 per vilsek. In preparing its balance sheet at the end of the first quarter of 2011, Southwestern must decide whether the Land account carried on the subsidiary’s balance sheet at 150,000 vilseks should be translated into dollars using the historical exchange rateof $0.20 or the current exchange rateof $0.23.
If the historical exchange rate is used at March 31, 2011, Land continues to be carried on the consolidated balance sheet at $30,000 with no change from December 31, 2010.
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If the current exchange rate is used, Land is carried on the consolidated balance sheet at
$34,500, an increase of $4,500 from December 31, 2010.
Current Rate—Consolidated Balance Sheet: 3/31/11 Land (150,000 vilseks $0.23) . . . $34,500
Discussion Question
HOW DO WE REPORT THIS?
Southwestern Corporation operates throughout Texas buying and selling widgets. To expand into more profitable markets, the company recently decided to open a small subsidiary in the nearby country of Gualos. The currency in Gualos is the vilsek. For some time, the government of that country held the exchange rate constant: 1 vilsek equaled
$0.20 (or 5 vilseks equaled $1.00). Initially, Southwestern invested cash in this new opera- tion; its $90,000 was converted into 450,000 vilseks ($90,000 5). Southwestern used one- third of this money (150,000 vilseks, or $30,000) to purchase land to hold for the possible construction of a plant, invested one-third in short-term marketable securities, and spent one-third in acquiring inventory for future resale.
Shortly thereafter, the Gualos government officially revalued the currency so that 1 vilsek was worth $0.23. Because of the strength of the local economy, the vilsek gained buying power in relation to the U.S. dollar. The vilsek then was considered more valuable than in the past. Southwestern’s accountants realized that a change had occurred; each of the assets was now worth more in U.S. dollars than the original $30,000 investment:
150,000 vilseks $0.23 $34,500. Two of the company’s top officers met to determine the appropriate method for reporting this change in currency values.
Controller: Nothing has changed. Our cost is still $30,000 for each item. That’s what we spent. Accounting uses historical cost wherever possible. Thus, we should do nothing.
Finance director: Yes, but the old rates are meaningless now. We would be foolish to re- port figures based on a rate that no longer exists. The cost is still 150,000 vilseks for each item. You are right, the cost has not changed. However, the vilsek is now worth
$0.23, so our reported value must change.
Controller: The new rate affects us only if we take money out of the country. We don’t plan to do that for many years. The rate will probably change 20 more times before we remove money from Gualos. We’ve got to stick to our $30,000 historical cost. That’s our cost and that’s good, basic accounting.
Finance director: You mean that for the next 20 years we will be translating balances for external reporting purposes using an exchange rate that has not existed for years?
That doesn’t make sense. I have a real problem using an antiquated rate for the in- vestments and inventory. They will be sold for cash when the new rate is in effect.
These balances have no remaining relation to the original exchange rate.
Controller: You misunderstand the impact of an exchange rate fluctuation. Within Gualos, no impact occurs. One vilsek is still one vilsek. The effect is realized only when an actual conversion takes place into U.S. dollars at a new rate. At that point, we will properly measure and report the gain or loss. That is when realization takes place. Until then our cost has not changed.
Finance director: I simply see no value at all in producing financial information based en- tirely on an exchange rate that does not exist. I don’t care when realization takes place.
Controller: You’ve got to stick with historical cost, believe me. The exchange rate today isn’t important unless we actually convert vilseks to dollars.
How should Southwestern report each of these three assets on its current balance sheet?
Does the company have a gain because the value of the vilsek has increased relative to the U.S. dollar?
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Translation Adjustments
To keep the accounting equation (A L OE) in balance, the increase of $4,500 on the asset (A) side of the consolidated balance sheet when the current exchange rate is used must be offset by an equal $4,500 increasein owners’ equity (OE) on the other side of the balance sheet. The increase in owners’ equity is called a positive translation adjustment.It has a creditbalance.
The increase in dollar value of the Land due to the vilsek’s appreciation creates a positive translation adjustment. This is true for any asset on the Gualos subsidiary’s balance sheet that is translated at the currentexchange rate. Assets translated at the current exchange rate when the foreign currency has appreciated generate a positive (credit) translation adjustment.
Liabilities on the Gualos subsidiary’s balance sheet that are translated at the current ex- change rate also increase in dollar value when the vilsek appreciates. For example, South- western would report Notes Payable of 10,000 vilseks at $2,000 on the December 31, 2010, balance sheet and at $2,300 on the March 31, 2011, balance sheet. To keep the accounting equation in balance, the increase in liabilities (L) must be offset by a decreasein owners’ eq- uity (OE), giving rise to a negative translation adjustment.This has a debitbalance. Liabilities translated at the current exchange rate when the foreign currency has appreciated generate a negative (debit) translation adjustment.
Balance Sheet Exposure
Balance sheet items (assets and liabilities) translated at the currentexchange rate change in dollar value from balance sheet to balance sheet as a result of the change in exchange rate.
These items are exposedto translation adjustment. Balance sheet items translated at histori- calexchange rates do not change in dollar value from one balance sheet to the next. These items are not exposed to translation adjustment. Exposure to translation adjustment is referred to as balance sheet, translation, or accounting exposure. Balance sheet exposurecan be contrasted with the transaction exposurediscussed in Chapter 9 that arises when a com- pany has foreign currency receivables and payables in the following way: Transaction expo- sure gives rise to foreign exchange gains and losses that are ultimately realized in cash;
translation adjustments arising from balance sheet exposure do not directly result in cash inflows or outflows.
Each item translated at the current exchange rate is exposed to translation adjustment. In effect, a separate translation adjustment exists for each of these exposed items. However, neg- ative translation adjustments on liabilities offset positive translation adjustments on assets when the foreign currency appreciates. If total exposed assets equal total exposed liabilities throughout the year, the translation adjustments (although perhaps significant on an individ- ual basis) net to a zero balance. The nettranslation adjustment needed to keep the consolidated balance sheet in balance is based solely on the net assetor net liabilityexposure.
A foreign operation has a net asset balance sheet exposurewhen assets translated at the current exchange rate are higher in amount than liabilities translated at the current exchange rate. A net liability balance sheet exposureexists when liabilities translated at the current exchange rate are higher than assets translated at the current exchange rate. The following summarizes the relationship between exchange rate fluctuations, balance sheet exposure, and translation adjustments:
Balance Sheet Foreign Currency (FC)
Exposure Appreciates Depreciates
Net asset Positive translation adjustment Negative translation adjustment Net liability Negative translation adjustment Positive translation adjustment
Exactly how to handle the translation adjustment in the consolidated financial statements is a matter of some debate. The major issue is whether the translation adjustment should be treated as a translation gain or loss reported in net incomeor whether the translation adjust- ment should be treated as a direct adjustment to owners’ equity without affecting net income.
We consider this issue in more detail later after examining methods of translation.
438 Chapter 10
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Translation of Foreign Currency Financial Statements 439