Example
What you'll learn
- LOS 9.eCalculate the translation effects and evaluate the translation of a subsidiary’s balance sheet and income statement into the parent company’s presentation currency.
Let’s look at extended examples of both translation methods.
Current Rate Method
FlexCo International is a U.S. company with a subsidiary, Vibrant, Inc., located in the country of Martonia. Vibrant was acquired by FlexCo on 12/31/2021. FlexCo reports its financial results in U.S. dollars.
The currency of Martonia is the loca (LC). Vibrant’s financial statements for 2022 are shown in the following two figures.
Vibrant December 31, 2021 and 2022 Balance Sheet
Vibrant 2022 Income Statement
The following exchange rates between the U.S. dollar and the loca were observed:
December 31, 2021: $0.50 = LC1.00. December 31, 2022: $0.4545 = LC1.00.
Average for 2022: $0.4762 = LC1.00. Historical rate for common stock: $0.50 = LC1.00. Historical rate for PP&E and depreciation: $0.4881 = LC1.00.
Historical rate for beginning and ending inventory $0.52/LC and $0.456/LC, respectively.
Purchases were made evenly throughout the year.
The majority of Vibrant’s operational, financial, and investment decisions are made locally in Martonia, although Vibrant does rely on FlexCo for information technology expertise.
Use the appropriate method to translate Vibrant’s 2022 balance sheet and income statement into U.S. dollars.
Solution
Vibrant is relatively self contained, which likely means the loca is the functional currency. Since the functional currency ≠ the parent’s presentation currency, the current rate method is used to translate Vibrant’s financial statements from the functional currency to the parent’s presentation currency. The current rate method uses the current rate for all balance sheet accounts (except common stock, which is translated at the historical rate) and the average rate for all income statement accounts.
The translation gain or loss is included in the CTA, which is reported in the equity section of the balance sheet as a part of other comprehensive income.
Vibrant’s translated 2022 income statement is shown in the following table. Notice that we translate the income statement first with the current rate method to derive net income, which we then use to calculate retained earnings on the balance sheet.
Vibrant’s 2022 Translated Income Statement Under the Current Rate Method
Vibrant’s 2022 translated balance sheet is shown in the next table.
Vibrant 2022 Translated Balance Sheet Under the Current Rate Method
Notice the change in the CTA from 2021 to 2022 is equal to −$37.9 (−$37.9 ending CTA − $0 beginning CTA). Because Vibrant was acquired at the end of 2021, the CTA was zero on that date. Thus, the depreciating loca resulted in translation loss of $37.9 for the year ended 2022.
The translation loss occurred because Vibrant had a net asset exposure (assets > liabilities) and the loca depreciated relative to the dollar.
Temporal Method
Now let’s apply the temporal method to Vibrant.
Suppose instead that the majority of Vibrant’s operational, financial, and investment decisions are made by the parent company, FlexCo. In this case, Vibrant’s functional currency and FlexCo’s presentation currency are likely the same; thus, the temporal method is used to remeasure the loca to the dollar. All other information is the same.
Use the appropriate method to translate Vibrant’s 2022 balance sheet and income statement into U.S. dollars.
Under the temporal method, we’ll start with the balance sheet.
Vibrant 2022 Remeasured Balance Sheet Under the Temporal Method
Vibrant’s remeasured income statement using the temporal method is shown in the following table. Remember the remeasurement gain or loss appears in the income statement under the temporal method.
Vibrant’s 2022 Remeasured Income Statement Under the Temporal Method
The remeasurement gain occurred because Vibrant had a net monetary liability exposure (monetary liabilities > monetary assets), and the loca depreciated relative to the dollar.
Why Do the Two Methods Report Significantly Different Results?
You should immediately notice that the two different methods report very different results, particularly related to the size and sign of the translation gain/loss, net income, and total assets. These comparisons are shown in Figure 9.4.
Figure 9.4: Vibrant Example: Current Rate vs. Temporal Method
We can make the following observations.
Income before translation gain/loss is different between the two methods. This is because COGS and depreciation are translated/remeasured at different rates under the two methods. Under the current rate method, COGS and depreciation expense are translated at the average rate thereby reflecting the depreciating local currency.
Under the temporal method, COGS and depreciation expense are remeasured at historical (actual) rates, and thus, do not reflect the depreciating local currency.
The translation gain/loss is different between the two methods; it’s not even the same sign. The current rate method results in a translation loss, while the temporal method results in a translation gain. This is NOT an unusual occurrence.
Under the current rate method, Vibrant’s net assets (assets > liabilities) are exposed to the depreciating local currency. Holding net assets in a depreciating environment results in a loss. Under the temporal method, Vibrant’s net monetary liabilities (monetary liabilities > monetary assets) are exposed.
Holding net monetary liabilities in a depreciating environment results in a gain.
Net income is different between the two methods. This is because of the different exchange rates used to translate/remeasure COGS and depreciation expense as previously discussed. In addition, the gain/loss recognized under the two methods are reported in different financial statements.
Under the current rate method, the translation loss is reported in shareholders’ equity as a part of the CTA. Under the temporal method, the remeasurement gain is reported in the income statement. Reporting the gain or loss in the income statement results in more volatile net income.
Total assets are different between the two methods because inventory and net fixed assets are different. Inventory and fixed assets are translated at the current rate under the current rate method thereby reflecting the depreciating local currency. Under the temporal method, the historical rate is used, thus, inventory and fixed assets do not reflect the depreciating local currency.
Comparing Subsidiary Results to Translated Results Under the Current Rate Method
A side by side comparison of Vibrant’s 2022 balance sheet and income statement before and after translation is presented in Figure 9.5.
Figure 9.5: Vibrant LC and Translated Balance Sheet and Income Statement