Translation Methods

When you think of titans of industry like Nike, Pepsi, Walmart, or Exxon, you may identify them as American companies. But these multinational corporations have subsidiaries and factories around the world. And that means each corporation has multiple foreign currency financial statements under its one corporate entity. How does that make your life as an analyst harder?

Yes!

No.

What's one piece of information a company must keep for a long time when it's using the temporal method?

Right. IFRS and US GAAP also specify that companies must keep records of the exchange rates that were present when transactions involving non-monetary assets (inventory, fixed assets, intangible assets, and so forth) are acquired. So there's a need for the historical exchange rate information.

Remember that the translation adjustment that results from using the current exchange rate method will be accounted for as a line item in shareholders' equity on the balance sheet. Each period, the translation adjustment will add or subtract from the total balance, so the balance sheet amount represents a cumulative amount. Since the translation adjustment is recognized on the balance sheet, it is an unrealized gain or loss. The gain or loss will be realized only if the subsidiary is sold.

And as a result, under the temporal method, there is a translation adjustment on the _income statement_. This makes sense when you think about it. The foreign subsidiary is using the same currency, so the translation adjustments should be realized in the near future, and gains and losses should be included in net income.

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Exactly.

Not really. It would be hard to predict future exchange rates.

No. That's not always the case.

For revenues and expenses under the temporal method, those transactions are translated at the exchange rate that existed when the transaction occurred, so typically the average rate is used. But there's a catch: Expenses related to non-monetary assets, such as cost of goods sold, depreciation, and amortization, are translated with the _same exchange rate_ used to translate the related asset. So if inventory is translated using a specific historical rate, cost of goods sold will also use the same rate.

No, that's not true. Any financial statement can be translated.

First, if the parent's presentation currency is the functional currency of the subsidiary, then the monetary/non-monetary method is required. But there's a twist. Instead of referring to it as the _monetary/non-monetary method_, IFRS and US GAAP actually refer to it as the __temporal method__, which is essentially a modification of the monetary/non-monetary method. The difference is that with the temporal method, non-monetary assets and liabilities held on the balance sheet at _current value_ are also translated using the exchange rate used when the current value was determined.

To understand why IFRS and US GAAP would want non-monetary assets and liabilities held at current values to be translated at current rates, it's helpful to think about what account would be affected by such a requirement. What account do you think that might be?

So this means that some record keeping is involved when using the temporal method.

No. Accounts payable is a monetary liability.

Not quite. Accounts receivable is a monetary asset.

No. Only one main financial statement is required.

But switch gears now. Say the foreign currency is also the functional currency. In that case, IFRS and US GAAP specify that the __current exchange rate method__ be used, which means that, along with assets and liabilities at the current rate, revenues and expenses are translated at the exchange rate that existed when the transactions took place.

So typically, that means an average rate is used for revenues and expenses. Why do you think that's the case?

All of those foreign currency financial statements have to be painstakingly translated into a _single_ currency. First thing's first: identifying the company's functional currency. Among the factors specified by IFRS and US GAAP, the main priority is given to the currency that influences sale prices for goods and services, and the currency of the country the entity's located in. Once the functional currency is identified, then it's time to translate the statements. To make your life a little easier in this regard, both IFRS and US GAAP specify the use of one of two different methods: either the monetary/non-monetary method or the current exchange rate method.

Yes! IFRS and US GAAP want current-valued balance sheet accounts under the temporal method to be recorded at the current rate. Because inventory could have been purchased recently or a long time ago, the values within inventory should reflect the purchase period. Otherwise, a currency change could materially alter the value, even if the company took advantage of that currency movement by purchasing inventory.

Some statements won't translate to the parent company's currency

Every statement has to be translated to and reported in a single currency

Each country with operations requires a local financial statement to be published

Future exchange rate data

Current exchange rate data

Historical exchange rate data

Inventory

Accounts payable

Accounts receivable

Because revenues and expenses occur at one point in time

Because revenues and expenses occur throughout the year

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