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2024 Curriculum CFA Program Level II Financial Reporting and Analysis
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According to the World Trade Organization, merchandise exports worldwide were nearlyUS$15 trillion in 2010.The amount of worldwide merchandise exports in 2010 was more than twice the amountin 2003 (US$7.4 trillion) and more than four times the amount in 1993 (US$3.7 trillion).The top five exporting countries in 2010, in order, were China, the United States,Germany, Japan, and the Netherlands. In the United States alone, 293,131 companieswere identified as exporters in 2010, but only 2.2% of those companies were large(more than 500 employees).The vast majority of US companies with export activity were small or medium-sizedentities.
The point illustrated by these statistics is that many companies engage in transactionsthat cross national borders. The parties to these transactions must agree on the currencyin which to settle the transaction. Generally, this will be the currency of eitherthe buyer or the seller. Exporters that receive payment in foreign currency and allowthe purchaser time to pay must carry a foreign currency receivable on their books.Conversely, importers that agree to pay in foreign currency will have a foreign currencyaccount payable. To be able to include them in the total amount of accounts receivable(payable) reported on the balance sheet, these foreign currency denominated accountsreceivable (payable) must be translated into the currency in which the exporter (importer)keeps its books and presents financial statements.
The prices at which foreign currencies can be purchased or sold are called foreignexchange rates. Because foreign exchange rates fluctuate over time, the value of foreigncurrency payables and receivables also fluctuates. The major accounting issue relatedto foreign currency transactions is how to reflect the changes in value for foreigncurrency payables and receivables in the financial statements.
Many companies have operations located in foreign countries. For example, the Swiss food products company Nestlé SA reports that it has factories in 83 countries and a presence in almost every country in the world. US-based Procter & Gamble’s annual filing discloses more than 400 subsidiaries located in more than 80 countries around the world. Foreign subsidiaries are generally required to keep accounting records in the currency of the country in which they are located. To prepare consolidated financial statements, the parent company must translate the foreign currency financial statements of its foreign subsidiaries into its own currency. Nestlé, for example, must translate the assets and liabilities its various foreign subsidiaries carry in foreign currency into Swiss francs to be able to consolidate those amounts with the Swiss franc assets and liabilities located in Switzerland.
A multinational company like Nestlé is likely to have two types of foreign currency activities that require special accounting treatment. Most multinationals (1) engage in transactions that are denominated in a foreign currency and (2) invest in foreign subsidiaries that keep their books in a foreign currency. To prepare consolidated financial statements, a multinational company must translate the foreign currency amounts related to both types of international activities into the currency in which the company presents its financial statements.
This reading presents the accounting for foreign currency transactions and the translationof foreign currency financial statements. The conceptual issues related to these accountingtopics are discussed, and the specific rules embodied in International Financial ReportingStandards (IFRS) and US GAAP are demonstrated through examples. Fortunately, differencesbetween IFRS and US GAAP with respect to foreign currency translation issues are minimal.
Analysts need to understand the effects of foreign exchange rate fluctuations on thefinancial statements of a multinational company and how a company’s financial statementsreflect foreign currency gains and losses, whether realized or not.
Learning Outcomes
The member should be able to:
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distinguish among presentation (reporting) currency, functional currency, and local currency;
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describe foreign currency transaction exposure, including accounting for and disclosures about foreign currency transaction gains and losses;
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analyze how changes in exchange rates affect the translated sales of the subsidiary and parent company;
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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;
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calculate the translation effects and evaluate the translation of a subsidiary’s balance sheet and income statement into the parent company’s presentation currency;
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analyze how the current rate method and the temporal method affect financial statements and ratios;
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analyze how alternative translation methods for subsidiaries operating in hyperinflationary economies affect financial statements and ratios;
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describe how multinational operations affect a company’s effective tax rate;
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explain how changes in the components of sales affect the sustainability of sales growth;
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analyze how currency fluctuations potentially affect financial results, given a company’s countries of operation.
Summary
The translation of foreign currency amounts is an important accounting issue for companieswith multinational operations. Foreign exchange rate fluctuations cause the functionalcurrency values of foreign currency assets and liabilities resulting from foreigncurrency transactions as well as from foreign subsidiaries to change over time. Thesechanges in value give rise to foreign exchange differences that companies’ financialstatements must reflect. Determining how to measure these foreign exchange differencesand whether to include them in the calculation of net income are the major issuesin accounting for multinational operations.
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The local currency is the national currency of the country where an entity is located. The functional currency is the currency of the primary economic environment in which an entity operates. Normally, the local currency is an entity’s functional currency. For accounting purposes, any currency other than an entity’s functional currency is a foreign currency for that entity. The currency in which financial statement amounts are presented is known as the presentation currency. In most cases, the presentation currency will be the same as the local currency.
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When an export sale (import purchase) on an account is denominated in a foreign currency, the sales revenue (inventory) and foreign currency account receivable (account payable) are translated into the seller’s (buyer’s) functional currency using the exchange rate on the transaction date. Any change in the functional currency value of the foreign currency account receivable (account payable) that occurs between the transaction date and the settlement date is recognized as a foreign currency transaction gain or loss in net income.
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If a balance sheet date falls between the transaction date and the settlement date, the foreign currency account receivable (account payable) is translated at the exchange rate at the balance sheet date. The change in the functional currency value of the foreign currency account receivable (account payable) is recognized as a foreign currency transaction gain or loss in income. Analysts should understand that these gains and losses are unrealized at the time they are recognized and might or might not be realized when the transactions are settled.
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A foreign currency transaction gain arises when an entity has a foreign currency receivable and the foreign currency strengthens or it has a foreign currency payable and the foreign currency weakens. A foreign currency transaction loss arises when an entity has a foreign currency receivable and the foreign currency weakens or it has a foreign currency payable and the foreign currency strengthens.
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Companies must disclose the net foreign currency gain or loss included in income. They may choose to report foreign currency transaction gains and losses as a component of operating income or as a component of non-operating income. If two companies choose to report foreign currency transaction gains and losses differently, operating profit and operating profit margin might not be directly comparable between the two companies.
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To prepare consolidated financial statements, foreign currency financial statements of foreign operations must be translated into the parent company’s presentation currency. The major conceptual issues related to this translation process are, What is the appropriate exchange rate for translating each financial statement item, and how should the resulting translation adjustment be reflected in the consolidated financial statements? Two different translation methods are used worldwide.
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Under the current rate method, assets and liabilities are translated at the current exchange rate, equity items are translated at historical exchange rates, and revenues and expenses are translated at the exchange rate that existed when the underlying transaction occurred. For practical reasons, an average exchange rate is often used to translate income items.
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Under the temporal method, monetary assets (and non-monetary assets measured at current value) and monetary liabilities (and non-monetary liabilities measured at current value) are translated at the current exchange rate. Non-monetary assets and liabilities not measured at current value and equity items are translated at historical exchange rates. Revenues and expenses, other than those expenses related to non-monetary assets, are translated at the exchange rate that existed when the underlying transaction occurred. Expenses related to non-monetary assets are translated at the exchange rates used for the related assets.
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Under both IFRS and US GAAP, the functional currency of a foreign operation determines the method to be used in translating its foreign currency financial statements into the parent’s presentation currency and whether the resulting translation adjustment is recognized in income or as a separate component of equity.
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The foreign currency financial statements of a foreign operation that has a foreign currency as its functional currency are translated using the current rate method, and the translation adjustment is accumulated as a separate component of equity. The cumulative translation adjustment related to a specific foreign entity is transferred to net income when that entity is sold or otherwise disposed of. The balance sheet risk exposure associated with the current rate method is equal to the foreign subsidiary’s net asset position.
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The foreign currency financial statements of a foreign operation that has the parent’s presentation currency as its functional currency are translated using the temporal method, and the translation adjustment is included as a gain or loss in income. US GAAP refer to this process as remeasurement. The balance sheet exposure associated with the temporal method is equal to the foreign subsidiary’s net monetary asset/liability position (adjusted for non-monetary items measured at current value).
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IFRS and US GAAP differ with respect to the translation of foreign currency financial statements of foreign operations located in a highly inflationary country. Under IFRS, the foreign currency statements are first restated for local inflation and then translated using the current exchange rate. Under US GAAP, the foreign currency financial statements are translated using the temporal method, with no restatement for inflation.
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Applying different translation methods for a given foreign operation can result in very different amounts reported in the parent’s consolidated financial statements.
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Companies must disclose the total amount of translation gain or loss reported in income and the amount of translation adjustment included in a separate component of stockholders’ equity. Companies are not required to separately disclose the component of translation gain or loss arising from foreign currency transactions and the component arising from application of the temporal method.
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Disclosures related to translation adjustments reported in equity can be used to include these as gains and losses in determining an adjusted amount of income following a clean-surplus approach to income measurement.
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Foreign currency translation rules are well established in both IFRS and US GAAP. Fortunately, except for the treatment of foreign operations located in highly inflationary countries, the two sets of standards have no major differences in this area. The ability to understand the impact of foreign currency translation on the financial results of a company using IFRS should apply equally well in the analysis of financial statements prepared in accordance with US GAAP.
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An analyst can obtain information about the tax impact of multinational operations from companies’ disclosure on effective tax rates.
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For a multinational company, sales growth is driven not only by changes in volume and price but also by changes in the exchange rates between the reporting currency and the currency in which sales are made. Arguably, growth in sales that comes from changes in volume or price is more sustainable than growth in sales that comes from changes in exchange rates.
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