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International Accounting
CHAPTER 2
Translation of Foreign Currency Financial Statements

Declaration: The knowledge contained in this course has been acquired from:-
• Doupnik, T. S., & Perera, M. H. B. (2018). International accounting. Fifth Edition. New York:
McGraw-Hill.
• Jeter, D. C., & Chaney, P. K. (2019). Advanced accounting. Seven Edition John Wiley & Sons.

Disposition of Translation Adjustment 2

The translation of some accounts using the current exchange rate and others using the
historical exchange rate will result in an inequality between the total of the debit account
balances and the total of the credit account balances. This difference may be referred to
as a translation adjustment or translation gain or loss.
The second issue in financial statement translation relates to where the resulting
translation adjustment should be reported in the consolidated financial statements.
Current accounting standards require that the translation adjustment (gain or loss) be
reported currently in income or deferred as a component of stockholders’ equity,
depending on the method used to translate the accounts. The appropriate method is not
a free choice, but rather is dictated by the circumstances as described in SFAS No. 52 [ASC
830–30–45–12].

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Disposition of Translation Adjustment 3

There are two prevailing schools of thought with regard to this issue:
1. Translation gain or loss in net income
➢ The translation adjustment is considered to be a gain or loss analogous to the gains and
losses arise from foreign currency transaction.
➢ Should be reported in income in the period in which the fluctuation in exchange rate occurs.
2. Cumulative translation adjustment in stockholders’ equity
➢ Alternatively, the translation adjustment to be included it in stockholders’ equity as a
component of other comprehensive income.
➢ This treatment defers the gain or loss in stockholders’ equity until it is realized in some way.
➢ When a foreign operation is sold or otherwise disposed of, the cumulative translation
adjustment related to it that has been deferred in a separate component of stockholders’
equity is transferred to income as a realized gain or loss.

Functional Currency & Translation Method 4

❑ The reporting currency is the currency in which the entity prepares its financial
statements.
❑ The functional currency is the primary currency of the foreign entity’s operating
environment. It can be either the parent’s currency (US$) or a foreign currency
(generally the local currency).

Functional Currency Translation Method Translation Adjustment

Parent currency Temporal method Gain (loss) in income
Separate component of
Foreign currency Current rate method stockholders’ equity (accumulated
other comprehensive income)

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Functional Currency Indicators 5

Economic Indicators Pointing to Local Currency as Indicators Pointing to U.S. Dollar as
Indicator Functional Currency Functional Currency
Primarily in the local currency and do not Directly affect the parent’s cash flows on a current basis
Cash flows
directly affect parent’s cash flows. and are readily available for remittance to the parent.
Are not primarily responsive in the short term Are primarily responsive in the short term to exchange
Sales prices to exchange rate changes; determined rate changes; determined primarily by worldwide
primarily by local conditions. competition.
Active local market although there may be Sales are mostly in the parent country, or sales contracts
Sales market
significant amounts of exports. are denominated in parent currency.
Production costs and operating expenses Production costs and operating expenses are obtained
Expenses
are determined primarily by local conditions. primarily from parent sources.
Primarily denominated in the local currency,
Primarily from parent or other parent currency-
and foreign entity’s cash flow from
Financing denominated obligations, or parent company is
operations is sufficient to service existing and
expected to service the debt.
normally expected obligations.
Low volume of intercompany transactions
High volume of intercompany transactions; there is an
Intercompany and there is not an extensive interrelationship
extensive interrelationship between operations of the
transactions between operations of the foreign entity and
parent and those of the foreign entity.
those of the parent.

Direct & Indirect Exchange Quote 6

A direct exchange quote is one in which the exchange rate is quoted in terms of how
many units of domestic currency can be converted into one unit of foreign currency. For
example, a direct quotation of EGP for one $ is 31.52 means that EGP 31.52 could be
exchanged for one US.$.
To translate dollars into EGP, the number of $ is multiplied by the direct exchange rate expressed in x EGP
per 1 $.

Exchange rates are also often stated in terms of converting one unit of the domestic
currency into units of a foreign currency, which is called an indirect quote. In the
preceding example, one EGP could be converted into 0.032 $ (1/31.52).
To translate dollars into EGP, the number of $ could also be divided by the indirect exchange rate (x $ per
1 EGP).

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Translation Objectives 7

According to FASB ASC subtopic 830–30 The objectives of translation are to-.:
1- Provide information that is generally compatible with the exposed economic effects of
an exchange rate change on an enterprise’s cash flows and equity.
Compatibility in terms of effect on equity is achieved if, for example, an entity is in an exposed
asset position and the translation process results in an increase (decrease) in stockholders’ equity
when there is a favourable (unfavourable) change in the exchange rate.
Compatibility in terms of cash flow consequences is achieved if favourable (unfavourable) rate
changes that are reasonably expected to affect cash flows are reflected as gains (losses) in determining
net income for the period.

2- Reflect in consolidated statements the financial results and relationships of the

individual consolidated entities as measured in their functional currencies in
conformity with Parent Currency generally accepted accounting principles.

Highly Inflationary Economies 8

U.S. GAAP mandates the use of the temporal method with translation gains/losses
reported in net income, For those foreign entities located in a highly inflationary
economy.
A country is defined as a highly inflationary economy if its cumulative three-year inflation
exceeds 100 percent. With compounding, this equates to an average of approximately 26 percent
per year for three years in a row.
One reason for this rule is to avoid a “disappearing plant problem” that exists when the
current rate method is used in a country with high inflation.
For Example, an Egyptian subsidiary of a U.S. parent purchased land at the end of Year 1 for 100,000 EGP when the
exchange rate was $ 0.13 per 1 EGP. Under the current rate method, Land would be reported in the parent’s
consolidated balance sheet at $12,500.
In Year 2, Egypt experienced a high percent inflation, the EGP plummeted against the U.S. dollar to a value of $0.03 at
the end of Year 2. Under the current rate method, Land now would be reported in the parent’s consolidated balance
sheet at $3,000 and a negative translation adjustment of $8,500 would result.
Using the current rate method, land has lost 76 percent of its U.S. dollar value in one year, and land is not
even a depreciable asset!

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Disclosures Related to Translation 9

❑ Accounting standards require an analysis of the change in the cumulative translation

adjustment account to be presented in the financial statements or notes thereto.
Many companies comply with this requirement by providing information on the
current year’s translation adjustment in their statement of comprehensive income and
including a column titled “Accumulated Other Comprehensive Income” (AOCI) in their
statement of changes in equity.
❑ IAS 21 also requires companies to provide information related to cumulative
translation adjustments.
❑ many companies include a description of translation procedures followed in the
“summary of significant accounting policies” in the notes to the financial statements.
In addition, they provide a description of how to hedge the foreign currencies
exchange rate risk.
You may refer to Rameda-Dec-2022-Consolidated-Financial-Statement as an example

Exercise (4) 10
❑ Jomall, Inc U.S, owns EGX Corp. a subsidiary in Egypt (Jomall-EG) which was
incorporated Jan. 1, 2020
❑ Jomall’s balance sheet items as of 12/31/2021, in EGP:
Cash 3,000 Accounts payable 2,000 Capital stock 3,000
Accounts rec. 2,000 Long-term debt 6,000 Accum. depr. 2,000
Inventory 2,500 Fixed assets 8,000 Retained earnings 1,800

❑ Jomall’s income statement items for 2021, in EGP:

Sales 20,000 Selling and administrative exp. 2,500
COGS 14,000 Interest. expenses 500
Depr. expenses 1,000 Income tax expenses 500

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Exercise (4) 11
Instructions
▪ The inventory is carried at cost.
▪ The 3,000EGP beginning inventory of 2021 was acquired evenly during the last quarter of
2020, while, the year end inventory was acquired evenly during the last quarter of 2021.
▪ The 13,500EGP purchases were made evenly throughout the year.
▪ 50% of fixed assets were acquired on January 1, 2020, and the other 50% acquired on Dec
31, 2020.
▪ the capital stock was sold on January 1, 2020.
▪ The 2020 retained earning is equal 135 US.$.
▪ Relevant exchange rates (1 EGP per x U.S. dollar):
January 1, 2020 0.10 Average for 4th quarter 2020 0.085 December 31, 2020 0.075
Average for 2021 0.095 Average for 4th quarter 2021 0.090 December 31, 2021 0.08
Required prepare the translated balance sheet and income statement using the temporal
method.
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Exercise (4) 12

COGS
Beginning inventory (cost) x Historical Exchange Rate 2020 = Beginning inventory in PC
3,000 x 0.085 = 255
+ Purchases in FC x Average ER 2021 = Purchases in PC
13,500 x 0.095 = 1,282.5
- Ending inventory (cost) x Historical Exchange Rate 2021 = Ending inventory in PC
2,500 x 0.090 = 225
COGS in PC 1,312.5

Fixed assets “Historical”= {6,000 x .5 x 0.1} + {6,000 x .5 x 0.075} = 525

Fixed assets Depr. “Historical”= {1,000 x .5 x 0.1} + {1,000 x .5 x 0.075} = 87.5

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Exercise (4) 13
Income statement - 2021
Sales 20,000 X 0.095 1,900
COGS 14,000 His. 1,312.5
Gross profit 587.5
Selling and administrative exp. 2,500 X 0.095 237.5
Depr. expenses 1,000 His. 87.5
Interest. expenses 500 X 0.095 47.5
372.5
Net Income before tax 215
Income tax expenses 500 X 0.095 47.5
Remeasurement loss (92.5) 167.5
Net Income* 75

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Exercise (4) 14
Balance Sheet – December 31, 2021

Assets Liabilities & Equity

Cash 3,000 X 0.08* 240 Accounts payable 2,000 X 0.08 160
Accounts rec. 2,000 X 0.08 160 Long-term debt 6,000 X 0.08 480
Inventory 2,500 X 0.09 225 Capital stock 3,000 X 0.1** 300
Net Fixed assets 6,000 His. 525 Retained earnings 1,800 To 210
(8,000 – 2,000) Balance

Total Assets 1,150 Total Liabilities & Equity 1,150

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Exercise (5) 15
Jomall, Inc U.S, owns EGX Corp. a subsidiary in Egypt (Jomall-EG) which was incorporated
Jan. 1, 2020
❑ Jomall’s balance sheet items as of 12/31/2021, in EGP:
Cash 3,000 Accounts payable 2,000 Capital stock 3,000
Accounts rec. 2,000 Long-term debt 6,000 Accum. depr. 2,000
Inventory 2,500 Fixed assets 8,000 Retained earnings 1,800

❑ Jomall’s income statement items for 2021, in EGP:

Sales 20,000 Selling and administrative exp. 2,500
COGS 14,000 Interest. expenses 500
Depr. expenses 1,000 Income tax expenses 500

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Exercise (5) 16
Instructions
▪ The inventory is carried at cost.
▪ The 3,000EGP beginning inventory of 2021 was acquired evenly during the last quarter of
2020, while, the year end inventory was acquired evenly during the last quarter of 2021.
▪ The 13,500EGP purchases were made evenly throughout the year.
▪ 50% of fixed assets were acquired on January 1, 2020, and the other 50% acquired on Dec
31, 2020.
▪ the capital stock was sold on January 1, 2020.
▪ The 2020 retained earning is equal 135 US.$.
▪ Relevant exchange rates (1 EGP per x U.S. dollar):
January 1, 2020 0.10 Average for 4th quarter 2020 0.085 December 31, 2020 0.075
Average for 2021 0.095 Average for 4th quarter 2021 0.090 December 31, 2021 0.08
Required prepare the translated balance sheet and income statement using the current rate
method.
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Exercise (5) 17
Income statement - 2021
Sales 20,000 X 0.095 1,900
COGS 14,000 X 0.095 1,330
Gross profit 570
Selling and administrative exp. 2,000 X 0.095 237.5
Depr. expenses 1,000 X 0.095 95
Interest. expenses 500 X 0.095 47.5
380
Net Income before tax 190
Income tax expenses 500 X 0.095 47.5
Net Income* 142.5

*An average-for-the-period exchange rate is used to translate all income statement’s items.
* Net Income will be added to RE in the Balance Sheet

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Exercise (5) 18
Balance Sheet – December 31, 2021

Assets Liabilities & Equity

Cash 3,000 X 0.08* 240 Accounts payable 2,000 X 0.08 160
Accounts rec. 2,000 X 0.08 160 Long-term debt 6,000 X 0.08 480
Inventory 2,500 X 0.08 200 Capital stock 3,000 X 0.1** 300
Net Fixed assets 6,000 X 0.08 480 Retained earnings 1,800 277.5
(8,000 – 2,000)
Cumulative translation adj To Balance (137.5)
Total Assets 1,080 Total Liabilities & Equity 1,080
1,080 1,217.5

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Exercise (2) 19

Translation of Retained Earnings

The translated retained earnings in Year 2 (and subsequent years)
Beginning R/E in FC [from the last year’s translation] = Beginning R/E in PC 135
[Translated per method used to
Net income in FC = + Net income in PC 142.5
translate income statement items]
Dividends in FC Historical exchange rate when declared = - Dividends in PC 0

Ending R/E in FC Ending R/E in PC = 277.5

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Comparison of the Results From Applying the Two 20

Different Methods
❑ The use of different translation methods can have a significant impact on Jomall’s
consolidated financial statements. The chart below shows differences for EGX
(subsidiary) in several key items under the two different translation methods:

Translation Method
Item Difference
Current Rate Temporal
Net income 142.5 75 -47.37%
Total assets 1,080 1,150 6.48%
Total Liabilities 640 640 0.00%
Total equity 440 510 15.91%
Return on equity 32.39% 14.71% -54.58%

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Hedging Balance Sheet Exposure 21

Companies can hedge against gains and losses by using foreign currency
forward contracts, options, and borrowings.

(To be continued)
With a new chapter

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