Reporting of foreign currency translation
Amrhein, Denise Guithues
Although business operations in foreign countries have existed for centuries, the world has recently entered an era of unprecedented activity with worldwide production and distribution. There are many examples of the growing importance of international operations for U.S. companies. Mobile Oil, Texaco, Gulf Oil, Dow Chemical, and Coca Cola earn more than 60 percent of their total operating profits in international operations. U.S. multinational companies such as Mobile, IBM, and American Express do business with more than 50 countries around the world. U.S. exports and imports have increased more than ten times in the last two decades. U.S.-direct investments abroad have increased from $32 billion in 1960 to $600 billion in 1992. International finance has also become increasingly important as it serves world trade and foreign investment. International earning assets for the Bank of America, for example, represent more than half its total earning assets. Citibank maintains more than 250 overseas branches in over 100 countries.
The translation of foreign currency is important for many U.S. companies and banks because they ate involved in foreign currency transactions and/or foreign operations that will produce different financial results. U.S. firms that conduct business with a foreign entity must deal with a wide range of social, political, economic, and legal differences between countries. In addition, a wide disparity exists between U.S. Generally Accepted Accounting Principles (GAAP) and foreign GAAP regarding the measurement and recording of assets, liabilities, revenues, expenses, and gains and losses. As a result, the U.S. accountant must reconcile foreign financial statements with U.S. GAAP for the purpose of consolidation, combination, or equity accounting. Foreign currency translation became even more important in 1973 when the flexible exchange rate system was established.
The growing importance of foreign currency transactions and/or foreign operations has been recognized by the accounting profession and led the Financial Accounting Standards Board (FASB) to address the issue of foreign currency translation in several official pronouncements. The most recent of these pronouncements was FASB Statement No. 52, “Foreign Currency Translation,” which was issued in December 1981. This statement was reactionary and intended to solve problems–such as violent swings in reported earnings and distortions of financial statement relationships–which had proliferated in the area of foreign currency translation under the guidelines offered by its October 1975 predecessor, FASB Statement No. 8, “Accounting for the Translation of Foreign Currency Transactions and Foreign Currency Financial Statements.” As a result, instead of building a new, structurally sound, foundation, Statement No. 52 merely repaired the cracks in an unsound substructure. Statement No. 52 should have developed more flexible guidelines for foreign currency translation, which would have been in accordance with the objectives of financial reporting delineated in FASB Statement of Financial Accounting Concepts No. 1, “Objectives of Financial approach to foreign currency translation. As a result, it requires that the first step in the translation process be the determination of the functional currency, which is defined as the currency of the primary economic environment in which the entity operates. This means that, depending on the circumstances, the functional currency could be (1) the reporting currency (such as the United States dollar), (2) the currency of record (usually a foreign currency), or (3) a third currency in which the company conducts operations.
Then, based on the functional currency, the translation method is selected. If the reporting currency is deemed to be the functional currency, the temporal method of translation will be used. On the other hand, if the foreign currency is also the functional currency, the current rate method of translation will generally be used. An exception to the latter rule occurs when the foreign entity is operating in a highly inflationary environment. In such a case, the financial statements of the foreign operation will be remeasured using the temporal method of translation, regardless of which currency is determined to be the functional currency. For the purpose of this rule, the FASB defined a highly inflationary environment to be one that has experienced a three-year cumulative inflation rate of 100 percent or more. This highly complex area has been further complicated by fluctuating exchange rates which have resulted in violent swings in earnings known as the ‘yo-yo” effect. The net result of these options and uncontrollable variables makes it highly unlikely that a multinational company will be able to translate the statements of its foreign operations without some degree of distortion. Faced with this situation, there is a need for some method of informative disclosure which will minimize the distorting effects of foreign currency translation on financial information. This will allow for a more meaningful presentation.
The systems suggested by the FASB for coping with these problems have followed a pattern of crisis management–attempting to solve problems after they have reached critical stages. Furthermore, standard-setters seem to have been predisposed to seek out and apply normative (standardized) methods to dissimilar situations. Consequently, when statement issuers presented the required information, it either conflicted with economic sense or encouraged uneconomic actions. Neither is a desirable product of accounting information. What is needed is a systems approach that analyzes the problems (general and specific) and then suggests realistic measures which provide useful information to financial statement users given the particular circumstances.
The need for useful information was recognized by the FASB in Statement of Financial Accounting Concepts No. 1, “Objectives of Financial Reporting by Business Enterprises.” In broad terms, the objectives called for the presentation of information that was “useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions.” In narrower terms, SFA Concepts No. I stated, “Thus, financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise.” SFA Concepts No. I also stipulated that “Financial reporting should provide information about the economic resources of an enterprise, the claims to those resources (obligations of the enterprise to transfer resources to other entities and owners’ equity), and the effects of transactions, events and circumstances that change resources and claims to those resources.’ Most importantly, this statement specified that “Financial reporting should include explanations and interpretations to help users understand the financial information provided.” In addition, it should be pointed out that SFA Concepts No. I called for prospective as well as historical information that made economic sense, and effectively required disaggregated data (as well as consolidated) if the information was to be useful to users, such as creditors.
FOREIGN CURRENCY TRANSLATION
The combination of matrix presentation and management discussion provides for an efficient method of disclosing a significant amount of useful information. This is particularly important in a highly controversial area such as foreign currency translation, since it allows the statement users to make the adjustments that they deem necessary for their purposes. The use of three separate matrices is suggested.
The first matrix would disclose the balance sheet effects of translation along with the foreign currency transaction gains and losses (see fig. 1). (Figure 1 omitted) This matrix is based on the one suggested by Shank and Shamis. The rows represent the major currencies involved and the columns represent the various components of the exchange gain or loss. These components include:
Realized transaction gains and losses. Example: The difference between the translated amount of an account payable on the transaction date and on the settlement date.
Unrealized transaction gains and losses. Example: The difference between the translated amount of an account payable on the transaction date and the intervening balance sheet date.
Realized translation gains and losses. Example: The portion of the cumulative translation adjustment transferred to income when the related foreign investment was liquidated.
Unrealized translation gains and losses likely to be realized in the short run. Example: Where the foreign operation was a sales outlet for the parent (selling products and remitting the proceeds to the parent upon collection), the portion of the translation gain or loss likely to be realized upon remittance would be an example of an unrealized translation gain or loss likely to be realized in the short run.
Unrealized translation gains and losses likely to be realized in the long run. Example: The foreign operation was in the developmental stages and cash flows were mainly from parent to subsidiary. In the future, once the subsidiary was established, the situation would reverse and the cash flows would be from subsidiary to parent. The portion of the translation gain or loss expected to be realized when the reversal takes place would be an example of an unrealized translation gain or loss likely to be realized in the long run.
Unrealized translation gains and losses unlikely to be realized. Example: A foreign operation that was an autonomous unit and reinvested its earnings rather than making cash remittances to the parent would be an example of a situation in which translation gains and losses were unlikely to be realized. In addition to the above components, there is also a column for disclosing the method of translation used: Current rate, and Temporal. This matrix will be referred to as the “Balance Sheet Effects Matrix,” since primary emphasis is placed upon disclosures of unrealized translation differences.
Not only would this matrix break the foreign exchange gain or loss down into its real and nominal (unreal or “paper”) components, but it would further classify the nominal components in accordance with their likely disposition. Thus, the matrix could aid the statement user in weighing the relative importance of the various components presented. As the time frame prior to expected realization increased, the chance for a reversal of the gain or loss (or for other changes to take place) would also increase. This would compound the uncertainty of eventual realization.
In addition, breaking the various components of the translation differences down into the major currencies involved should highlight any portfolio effects responsible for reducing the net amount of the translation gain or loss. Based on the Markowitz-Tobin Mean Variance Model, it can be shown that the variance from a portfolio of currencies is generally less than the sum of the variance of each currency in the portfolio. A firm might have a natural portfolio of currencies as a result of the nature of its cash flows and the distribution of its assets and liabilities across currencies. The amount of diversification obtained would depend on the covariance of exchange rate changes. Changes in the portfolio of currencies or their inter-relationships could have important implications. For example, assume that Company A had a translation loss of $30,000 as a result of its investment in German marks and a translation gain of $30,000 as a result of its investment in Japanese yen. As a result, the translation gain and loss netted to zero. If these currency trends continued and the investment in marks was liquidated, Company A could expect to experience translation losses in the future. Detailing the translation gains or losses according to their components and by the major currencies involved would allow the statement user to make a more intelligent assessment of the possible impact of related changes.
The second matrix would facilitate the presentation of the major income statement effects of foreign currency translation (see fig. 2). (Figure 2 omitted) The importance of such disclosures has been noted by several authors, including Shank and Shamis and Norby. The rows would present the major currencies involved. The first column would indicate the translation method that was used: temporal or current rate. The remaining columns would be used to disclose the various income statement effects of foreign currency translation. These effects include:
General effect–the translation gain or loss resulting from translating this year’s income statement at a different rate than last year’s income statement.
Cost of goods sold effect–the realized exchange gain or loss included in cost of goods sold which resulted from translating inventory and depreciation at historical exchange rates under the temporal method of translation while other income statement items, such as sales, were translated at the average current exchange rate.
Interest expense effect–the dollar equivalent change in interest expense on foreign debt resulting from changes in the exchange rate when interest expense is translated at the average current exchange rate.
Income tax effects–the tax impact of items included in the overall exchange gain or loss (an alternative would be to show the items on both a before- and after-tax basis).
Investment income effects–the proportion of investment income that is attributable to foreign exchange gains and losses rather than to operations of the twenty-percent to fifty-percent owned affiliates accounted for on an equity basis.
Other–any other important income statement effects not yet disclosed (for example, contractual commitments denominated in the foreign currency).
The above disclosures were considered important for a number of reasons. First of all, they would highlight the fact that there were a number of items in the income statement affected by foreign currency translation. Without such disclosure, this fact could be obscured–giving the erroneous impression that only balance sheet items were affected. The disclosures also would make a more comprehensive analysis possible. Neglecting to disclose the income statement effects would be to ignore a possibly significant aspect of translation.
The disclosure of the general effect should help to clarify the change in income resulting solely from the change in the average current rate used to translate the income statement. Disclosing the cost of goods sold effects should assist the statement user in identifying the resulting distortion on profit margins and net income. It would also allow the user to make any adjustments that he deemed necessary to his analysis. The disclosure of interest expense, income tax, investment income, and other important effects of translation would further highlight the fact that the various income statement items were affected. It would be a move away from concentrating on the “bottom line’ (net income) to the exclusion of other factors. Income tax effect disclosures could also help to clarify a confusing area. In some cases, the income tax effects can reverse the effect of translation. A before-tax gain can become an after-tax loss and vice versa. With this broader disclosure, the statement users would be provided with the information necessary to direct their attention to the complexities of translation. No longer would the statement user be forced to settle for aggregate information that obscured important details.
A third matrix would disclose the effects of foreign currency translation on earnings per share (EPS) (see fig. 3). (Figure 3 omitted) An example of such a matrix was given in Fortune as part of a discussion on the effects of FASB Statement No. 8. As in the matrices in Figures 1 and 2, the rows would represent the major currencies involved and the first column would indicate the method of translation used. The remaining columns would furnish information on earnings per share and the relevant changes. This information will include:
1. Last year’s earnings per share, as reported.
2. This year’s earnings per share, as reported.
3. This year’s earnings per share, assuming that the exchange rate did not change. This would allow a comparison of the current year’s earnings per share and last year’s earnings without the distorting effects of translation.
4. The total effect on earnings per share of exchange rate adjustments. This would highlight the effect of translation on earnings per share.
5. The portion of the effect on earnings per share resulting from exchange rate adjustments to balance sheet items. This would identify the effect that translating foreign balance sheets had on the consolidated earnings per share of the company.
6. The portion of the effect on earnings per share resulting from exchange rate adjustments to income statement items. This would identify the effect that translating foreign income statements had on the consolidated earnings per share of the company. This matrix could be designated the “EPS Effects Matrix. “
The information in this matrix would be useful to the financial statement user in his analysis of earnings per share. It would also be in keeping with the objectives of Accounting Principles Board Opinion No. 15, “Earnings per Share,” which stated, “Earnings per share data are used in evaluating the past operating performance of a business in forming an opinion as to its potential and in making investment decisions. …In view of the widespread use of earnings per share data, it is important that such data be computed on a consistent basis and presented in the most meaningful manner.” Therefore, where changes in earnings per share result solely from translation, that fact should be disclosed. The EPS Effects Matrix could accomplish this task.
While the matrices can do an excellent job of quantifying the impact of translation on the financial statements, there is still need for additional disclosure. Some items are very difficult, if not impossible, to quantify. For this reason, it is recommended that management discussion be used in conjunction with the matrices in order to provide as complete a picture as possible to the financial statement user. The function of management discussion would be twofold. First, it would clarify the information presented in the matrices where necessary. Secondly, it would provide additional information concerning foreign currency translation that was deemed useful to the financial statement user. Clarifying the information already presented in the matrices would usually involve answering questions, such as what type of transactions or activities led to the effects, and is this trend likely to continue? For example, a portion of the transaction losses may have resulted from the purchase of merchandise from certain sources that are no longer used. Clarification would not be necessary in every case. However, where it could provide useful, significant information, it should be done.
Another aspect of management discussion involves the presentation of additional information. The type of information presented in this section will vary depending on the circumstances. In each instance, it would be necessary to determine what information has not yet been disclosed but would be useful for decision making purposes. Possible topics might well include:
Management’s response to the effects of translation and to changes in the exchange rate
–The type and extent of hedging activities currently engaged in and those planned for the future.
–Changes in sales prices which have been instituted and any restrictions on future changes.
–Estimate of the effects of changes in the exchange rates on sales volume.
–Estimate of the effects of changes in the exchange rates on expense levels.
–Resulting economic effects of possible volume, price, and expense-level changes.
–Special advantages or disadvantages of the foreign operating environments
–Management’s outlook for the future in this area. In addition, the analysis of changes during the period in the separate component of equity for cumulative translation adjustments could be presented here along with an explanation of those changes. Other types of information considered to be useful could also be presented here.
Together, the matrix information and management discussion would provide a solid base for decision making purposes. While all aspects of this model would not apply to every situation, it would simply be necessary to apply those aspects of the model which were relevant to that particular company. Thus, the model is not designed to be a rigid framework for reporting, but, rather, it would serve as a flexible reporting framework as an aid to be used in disclosing all relevant information in the area.
In essence, the model would; provide a more definitive approach to the disclosure of the effects of foreign currency translation, present information that would enable a more critical financial analysis of the positive and negative aspects of the major international markets being served, and be flexible enough to accommodate a wide variety of situations and changing circumstances. In addition, significant advantages would accrue to prudent managements who recognize that the benefits of management discussions facilitate an understanding of the company’s past performance and future possibilities.
Accounting Principles Board Opinion No. 15, “Earnings per Share” (New York: AICPA, 1969).
Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 1, “Objectives of Financial Reporting by Business Enterprises” (Stamford, Conn.: FASB, 1981).
Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 8, “Accounting for the Translation of Foreign Currency Transactions and Foreign Currency Financial Statements” (Stamford, Conn.: FASB, 1975).
Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 52, “Foreign Currency Translation” (Stamford, Conn.: FASB, 1981).
Curran, John J., “Making Economic Sense of Foreign Earnings,” Fortune, November 2, 2982.
Norby, William C. “FASB Review Program,” (Accounting for Financial Analysis). Financial Analysts Journal 34 (September/October, 1978): 18-20.
Phillips, Herbert E., and John C. Ritchie. Investment Analysis and Portfolio Selection. Cincinnati, Ohio: South-Western Publishing Co., 1983.
Shank, John K. and Gary S. Shamis. “Reporting Foreign Currency Adjustments: A Disclosure Perspective.” Journal of Accountancy 147 (April, 1979): 59-65.
Copyright College of Business Administration. University of Detroit Mercy Spring 1994
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