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Temporal Vs Current Method Essay

2404 words - 10 pages

Accounting Exposure

Eiteman et al., Chapter 10

Winter 2004

Accounting Exposure
Accounting exposure, also called translation exposure, results from the need to restate foreign subsidiaries’ financial statements, usually stated in foreign currency, into the parent’s reporting currency when preparing the consolidated financial statements. Restating financial statements may lead to changes in the parent’s net worth or net income.

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Translation Exposure
When converting financial statement items (transactions) denominated in currencies other than the parent currency, two choices of exchange rate are possible: • The historical rate, the exchange rate prevailing at the time of the ...view middle of the document...

• Subsidiaries operating in highly inflationary economies. The use of the parent’s currency as the functional currency is required in this case.

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Translation Exposure
• If the foreign entity’s functional currency is the local currency, financial statements are translated using the current rate method. • If the foreign entity’s functional currency is the parent’s currency, financial statements are remeasured using the temporal method.

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Translation Exposure
If the functional currency of a foreign subsidiary is not the local currency, then the subsidiary’s financial statements are 1. Remeasured in the subsidiary’s functional currency using the temporal method; 2. Translated from functional to parent’s currency using the current rate method.

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The Current Rate Method
• All assets and liabilities are translated at the rate in effect on the balance sheet date. • All items on the income statement are translated at an appropriate average exchange rate or at the rate prevailing when the various revenues, expenses, gains and losses were incurred (historical rate). • Dividends paid are translated at the rate in effect on the payment date. • Common stock, paid-in capital and retained earnings are translated at historical rates.

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The Current Rate Method
When the current rate method is used, gains and losses from translation are reported in a separate equity account called cumulative translation adjustment (CTA). Gains and losses do not appear in the income statement when the current rate method is used.

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The Current Rate Method
Advantages of CTA
• Eliminates the variability of net earnings due to translation gains or losses. • The relative proportions of individual balance sheet accounts remain the same (debt-to-equity ratio, for example).

Main disadvantage of CTA
• Violates the accounting principle of carrying balance sheet accounts at historical cost.

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The Current Rate Method
Under the current rate method, translation exposure is Assets(A) − Liabilities(L) = stockholders’ equity(SE). Common stock and retained earnings, for example, are part of SE. If common stock is issued at some point in time, then the value of the issue in the parent’s currency is determined by the exchange rate prevailing when the shares were issued.

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The Current Rate Method
Similarly, the value of the earnings retained during a year in the parent’s currency is based on the exchange rate used to translate the income statement in that year. When the exchange rate changes, the value of A − L in the parent’s currency varies but the value of SE in the parent’s currency stays the same or, at least, changes according to a different rate. The CTA account is needed for the balance sheet to balance.

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The Current Rate Method: An Example
Foreign Subsidiary, Inc., (FSI) has been acquired on December 31, 2000 when the exchange rate was LC1.25/$ (LC stands for FSI’s local currency). On December 31, 2001, the exchange rate was...

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