Each overseas affiliate prepares its profit and loss statement and balance sheet, in its measurement currency. There are three aspects relating to translation.
Currency for Translating the Affiliates’ Financial Statements:
The functional currency of MNC affiliates is the currency of the primary economic environment of the affiliate. In some countries—such as the USA—the accounting standard relating to translation prevents affiliates from using a functional currency as the reporting currency for their financial statement when there is hyper-inflation in the country in which the affiliate is located. According FASB 52, a country is said to experience hyper-inflation when the average inflation rate over a three-year period is equal to or greater than 100%.
The presentation currency (also known as the reporting currency) is the currency in which financial statements are prepared by a company. The reporting currency of an affiliate can be the functional currency of the country in which it is located, or any other currency. Usually the functional currency is the reporting currency. A parent company usually prepares financial statements in the currency of the parent company’s country. For example, the reporting currency of Barclays (a British bank) is the pound sterling.
The reporting currency of the parent company is known as the parent currency. The parent company can choose a reporting currency which is not its functional currency. The reporting currency of Standard Chartered Bank, with headquarters in New Zealand, is the US dollar. A country may permit companies to choose any reporting currency it wants. Singapore permits companies to present their financial statements in a currency other than the Singapore dollar.
Does it make any difference whether the affiliates choose a reporting currency that has consistently depreciated or appreciated against the parent company’s reporting currency? Yes, because, the translated profits, assets and liabilities of the affiliates form part of the consolidated financial statements of the parent company. If the reporting currencies of all the affiliates have appreciated against the parent company’s reporting currency, the translated profits, assets and liabilities will improve the company’s consolidated financial statements.
If the reporting currencies of all the affiliates have depreciated against the parent company’s reporting currency, the translated profits, assets and liabilities of the affiliates are much smaller. So, a part of the parent company’s strategy is to watch the trend of currency movements, and alter the reporting currency of affiliates, provided the accounting standard in the affiliates’ countries permit such a change.
Exchange Rate for Converting the Affiliate’s Capital and Revenue Items:
At what rate should each affiliate’s opening stock and closing stock be converted? At what exchange rate should the purchases and sales made during the year be converted? Should an asset purchased in April 2000 be converted at the same exchange rate as an asset purchased in April 2007? Should all assets and liabilities be converted at the same exchange rate? When different exchange rates are used to convert items in the financial statements, the converted balance sheet will not tally.
Exchange difference is the difference resulting from reporting the same number of units of a foreign currency in the reporting currency at different exchange rates. It does not result in a cash inflow or outflow. It results in either translation gain or loss.
The translation of affiliates’ financial statements is governed by the accounting rules in force in the parent company’s home country. The accounting rules for dealing with translation gains and losses vary from country to country. Accounting standards specify the exchange rates to be used in translating items in financial statements and the treatment of exchange differences.
The translation of overseas affiliates’ financial statements is laid down in International Accounting Standard 21 (IAS 21) which was revised in 1993. It provides guidelines for translation of affiliates’ financial statements. IAS 39 specifies how to convert currency derivatives contracts such as forward exchange contracts for trading and speculation, and the treatment of exchange differences arising from currency derivatives.
Methods of Translation:
Four methods of translation were in use by American MNCs over the years: 1. The current/non-current method 2. The monetary/non-monetary method 3. The temporal method 4. The current method.
Prior to 1975, companies could use the current/non-current method and the monetary/non-monetary method. Financial Accounting Standards Board (FASB) 8, called Accounting for the Translation of Foreign Currency Transactions and
Foreign Currency Financial Statements was issued in 1975. It made it mandatory for US companies to use the temporal method, and show exchange difference in their financial statements. According to FASB 52 which was introduced in 1981, US MNCs could follow either FASB 8 or FASB 52 but the latter mandates the use of the current method. Except for the current method, the other three used different exchange rates for different items. Therefore, the use of the current/non-current method, the temporal method, and the monetary/ non-monetary method lead to exchange difference every year.
1. Current Method or Closing Rate Method:
Conversion of items in the Profit and Loss Account is at the closing rate. All balance sheet items are also converted at the closing rate.
2. Current/Non-Current Method:
Expenses relating to fixed assets are converted at the historical rate. Current assets and current liabilities are converted at the closing rate.
3. Temporal Method:
Expenses relating to fixed assets are converted at the historical rate. Current assets (except inventory) and current liabilities are converted at the closing rate. If inventory is shown at cost or average rate, it is converted at the historical rate. If shown at market price, it is converted at the closing rate. All fixed assets and long-term liabilities are converted at the historical rate.
4. Monetary /Non-Monetary Method:
Expenses relating to fixed assets are converted at the historical rate. All other revenue items are converted at the average rate. All current assets (except inventory) and current liabilities are converted at the closing rate. All fixed assets and inventory are converted at the historical rate.
Illustration:
A British company is due to receive €1,000,000 in 90 days from a French company. The current spot rate is €2.95/£, and the 90-day forward rate is €2.93/£. Interest rates in France and UK are 5.40% p.a. and 8.11% p.a. respectively. How can it use a money market hedge? Ignore currency conversion costs.
Solution:
The company borrows €1,000,000 for 90 days at 5.40% p.a.
Interest = (0.054) (90 ÷ 360) (€1,000,000) = €13,500.
Total amount repayable = €13,500 + € 1,000,000 = €1,013,500
The company converts €1,000,000 into pounds at the current spot rate.
Amount received = €1,000,000 ÷ €2.95 = £338,983
The company invests £338,983 for 90 days at 8.11 % p.a.
Interest receivable = (0.0811) (90 ÷ 360) (£ 338,983) = £6,873.
Total amount receivable = £6,873 + £338,983 = £345,856
The company enters into a 90-day forward contract to buy the interest component of its euro loan at the forward rate of €2.93/£; the outflow would be €13,500 ÷ €2.93 = £4,607.51
On day 90, the company receives €1,000,000. It receives £345,856 from its investment. It honours the forward contract, delivers £4,607.51 and collects €13,500. It repays €1,013,500 with €1,000,000 received from the French company, and €13,500 received from the forward contract. Pounds remaining = £ (345,856 – 4,607.51) = £341,248.49.
Accounting Standard for Translation in India:
Accounting Standard 11 (AS 11) deals with translation of affiliates’ financial statements into the rupee, and defines certain terms in the conversion process. It was made mandatory from April 1, 2004. It describes the method of conversion to be used as Well as the treatment of the exchange differences arising from forward contracts (to be shown in the parent company’s profit and loss account). Fair Value is the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction.
Assets and liabilities are classified as:
i. Non-Monetary Items:
They are assets and liabilities other than monetary items; examples are fixed assets, inventory and investments in equity shares.
ii. Monetary Items:
These are money held, assets and liabilities to be received or paid in fixed or determinable amounts of money; examples are cash, receivables and payables.
According to AS 11, an overseas subsidiary/associate/branch should be first classified either as an integral foreign operation, or a non-integral foreign operation. The translation method is different for each category.
An integral foreign operation is one whose operations cause an immediate impact on the cash flows of the parent Indian firm (the affiliate may only sell goods on behalf of the parent company and remit the proceeds to the parent company).
A non-integral foreign operation is one whose operations do not cause an immediate impact on the cash flows of the parent Indian firm. The affiliate has a significant degree of autonomy. It incurs expenses, earns revenues, borrows and conducts all its operations in the local currency of the country in which it is located. It may also enter into foreign currency transactions, including some transaction in the parent company’s reporting currency.
The important terms used in AS 11 are explained below:
i. The reporting currency is the currency used by the parent company in presenting its financial statements. It is also called the presentation currency.
ii. Foreign currency is a currency other than the reporting currency of an enterprise. It is the currency used for preparing overseas affiliates financial statements. It is also called measurement currency.
iii. A foreign currency transaction is a transaction that is denominated in foreign currency, or requires settlement in foreign currency.
iv. The closing rate is the exchange rate on the date that the financial statements are prepared for the parent company.
v. The historical rate is the exchange rate on the date that the transaction occurred. If the affiliate incurred a liability on December 15, 2001 then the historical rate is the exchange rate prevailing on that date. If the affiliate purchased a fixed asset on August 10, 2003 then the historical rate is the exchange rate prevailing on that date.
vi. The average rate is the arithmetic average of the exchange rates prevailing during the accounting period. It can be computed as the arithmetic average of the exchange rate on the last day of each month of the affiliate’s accounting year or the average of the exchange rate on each day of the accounting year.
Method of Translation for Integral Foreign Operation:
1. The cost and depreciation of tangible fixed assets should be translated using the exchange rate at the date of purchase of the asset. If the asset is carried at fair value, it should be translated using the exchange rate that existed on the date of such valuation.
2. The cost of inventory should be translated using the exchange rate that existed when those costs were incurred.
3. Monetary items in the balance sheet should be translated using the closing rate. Non-monetary items in the balance sheet should be translated using the exchange rate at the date of the transaction. If the non-monetary items are carried at fair value, then they should be translated using the exchange rate that existed on the date of the valuation.
4. The exchange difference should be treated as an income or expense in the Profit and Loss account of the parent firm, in the period in which it arises if the transaction was settled in the same accounting period during which it occurred. If the transaction was settled in the subsequent accounting period, then the exchange difference is recognized and shown in the Profit and Loss account of that subsequent period.
Method of Translation for Non-Integral Foreign Operation:
All monetary and non-monetary assets and liabilities of the foreign affiliate should be translated at the closing rate. All incomes and expenses of the foreign affiliate should be translated at the exchange rate at the date of each transaction. The exchange rate difference should be shown as a reserve, and should not appear in the profit and loss account of the parent company.