Current Rate Method
Applying the Current Rate Method
The current rate method is applied using the following procedures:
All income statement accounts are translated at the rate that existed when the transaction occurred, but in practice, we typically use the average rate. All balance sheet accounts are translated at the current rate except for common stock, which is translated at the historical (actual) rate that applied when the stock was issued. Dividends are translated at the rate that applied when they were declared.
Translation gain or loss is reported in shareholders’ equity as a part of the cumulative translation adjustment (CTA).
Figure 9.2 summarizes the impact of changing exchange rates on the parent’s exposure.
Figure 9.2: Impact of Changing Exchange Rates on Exposure
Calculating the Translation/Remeasurement Gain or Loss
Recall that under the current rate method, the translation gain or loss is reported in shareholders’ equity as a part of the CTA. The CTA is simply a “plug” figure that forces the basic accounting equation (A = L + E) to balance.
Let’s try an example.
Given the following balance sheet data, calculate the ending balance of the CTA.
Solution
First, we need to calculate the ending balance of retained earnings. Given the beginning balance of retained earnings, the current period net income, and the dividends paid, we can calculate the ending balance of retained earnings as $200 ($175 beginning retained earnings + $50 net income − $25 dividends paid). Now, we can force the accounting equation to balance with a CTA of $50 ($1,000 assets − $600 liabilities − $150 common stock − $200 ending retained earnings).
It is important to understand that the CTA is an accumulated balance of all of the translation gains and losses at a point in time. In order to compute the translation gain or loss for a specific period, we need the change in the CTA for the period. Returning to our example, if the beginning balance of the CTA was $20 and the ending balance (plug) was $50, the translation gain for the period was $30.
Under the temporal method, no CTA is reported in shareholders’ equity. Instead, the remeasurement gain or loss is recognized in the income statement. The remeasurement gain or loss is also a plug figure and is simply the difference in the earnings before the gain or loss and the earnings after the gain or loss.
Let’s summarize what we have learned about the temporal and current rate methods.
Figure 9.3: Summary of Temporal Method and Current Rate Method
Exposure to Changing Exchange Rates
Before calculating the gain or loss that results from changing exchange rates, it is necessary to understand the parent’s exposure under the two methods. Under the current rate method, exposure is defined as the net asset position of the subsidiary. A firm has a net asset position when its assets exceed its liabilities.
Recall that under the current rate method, all of the assets and liabilities are translated at the current rate. Thus, it is the net assets, that is, the subsidiary’s equity, that are exposed to changing exchange rates. So, if the subsidiary has a net asset exposure and the local currency is appreciating, a gain is recognized.
Conversely, a net asset exposure in a depreciating environment will result in a loss.
Recall that under the temporal method, the nonmonetary assets and liabilities are remeasured at historical rates. Thus, only the monetary assets and liabilities are exposed to changing exchange rates. Therefore, under the temporal method, exposure is defined as the subsidiary’s net monetary asset or net monetary liability position.
A firm has net monetary assets if its monetary assets exceed its monetary liabilities. If the monetary liabilities exceed the monetary assets, the firm has a net monetary liability exposure.
Since very few assets are considered to be monetary (mainly cash and receivables), most firms have net monetary liability exposures. If the parent has a net monetary liability exposure when the foreign currency is appreciating, the result is a loss. Conversely, a net monetary liability exposure coupled with a depreciating currency will result in a gain.
Under the temporal method, firms can eliminate their exposure to changing exchange rates by balancing monetary assets and monetary liabilities. When balanced, no gain or loss is recognized. For example, imagine that a U.S. multinational firm has a net monetary liability exposure of €1 million.
In this case, a loss will occur if the euro appreciates relative to the dollar. To eliminate the exposure, the firm could sell euro denominated nonmonetary assets, such as fixed assets or inventory, and use the proceeds to reduce the monetary liabilities.
Eliminating exposure under the current rate method is more difficult because it is necessary to balance total assets and total liabilities. Balancing assets and liabilities would eliminate shareholders’ equity.