CFA® Program Curriculum, Volume 2, pages 130 and 134 There are two methods used to remeasure or translate the financial statements of a foreign subsidiary to the parent’s presentation (reporting) currency.
Remeasurement involves converting the local currency into functional currency using the temporal method.
Translation involves converting the functional currency into the parent’s presentation (reporting) currency using the current rate method. The current rate method is also known as the all-current method.
PROFESSOR’S NOTE
The term “translation” is used in two different ways in this topic review. First, translation refers to a specific method of converting account and transaction balances to another currency. Second, translation is used to describe (without identifying a specific methodology) the general process of converting account and transaction balances from one currency to another. Thus, both the remeasurement methodology and the translation methodology result in “translation,” or the conversion of account and transaction balances to another currency. The ensuing discussion should make this distinction clear.
The translation method, current rate or temporal, is determined by the functional currency relative to the parent’s presentation currency. Since the functional currency is chosen by management, it may not be completely objective.
According to the IASB, management should consider the following factors in deciding on the functional currency:
The currency that influences sales prices for goods and services.
Currency of the country whose competitive forces and regulations mainly determine the sale price of goods and services.
The currency that influences labor, material, and other costs.
The currency from which funds are generated.
The currency in which receipts from operating activities are usually retained.
The FASB provides similar guidance.
Generally, we can use the following to determine the appropriate translation method:
If the functional currency and the parent’s presentation currency differ, the current rate method is used to translate the foreign currency financial statements. Translation usually involves self-contained, independent subsidiaries whose operating, investing, and financing activities are decentralized from the parent. See Column 1 of
Figure 15.1.
If the functional currency is the same as the parent’s presentation currency, the temporal method is used to remeasure the foreign currency financial statements.
Remeasurement usually occurs when a subsidiary is well integrated with the parent (i.e., the parent makes the operating, investing, and financing decisions). See Column 2 of Figure 15.1.
In the case where the local currency, the functional currency, and the presentation currency all differ, both the temporal method and the current rate method are used. For example, consider a U.S. firm that owns a German subsidiary whose functional
currency is the Swiss franc. In this case, the temporal method is used to remeasure from the local currency (euros) into the functional currency (Swiss francs). Then, the current rate method is used to translate from the functional currency (Swiss francs) to the presentation currency (U.S. dollar). See Column 3 of Figure 15.1.
If a subsidiary is operating in a hyperinflationary environment, the functional currency is considered to be the parent’s presentation currency, and the temporal method is used under U.S. GAAP. Under IFRS, the subsidiary’s financial statements are restated for inflation and then translated using the current exchange rate. Hyperinflation will be discussed in more detail later in this topic review.
Figure 15.1 illustrates the three ways the local currency may be remeasured and/or translated into the presentation currency of the parent. Note that the choice of the functional currency determines the method used for conversion.
Figure 15.1: Three Methods for Remeasurement/Translation of Local Currencies
Let’s look at an example.
EXAMPLE: Determining the appropriate translation method (1)
A U.S. multinational firm has a Japanese subsidiary. The subsidiary’s functional currency is the Japanese yen (¥). The subsidiary’s books and records are maintained in yen. The parent’s presentation currency is the U.S. dollar. Determine which foreign currency translation method is appropriate.
Answer:
Since the functional currency and the parent’s presentation currency differ, the current rate method is used to translate the subsidiary’s financial statements from yen to U.S. dollars.
EXAMPLE: Determining the appropriate translation method (2)
Now imagine the Japanese subsidiary’s functional currency is the U.S. dollar. Determine which foreign currency translation method is appropriate.
Answer:
Since the functional currency and the parent’s presentation currency are the same, the temporal method is used to remeasure the subsidiary’s financial statements from yen to U.S. dollars.
Before discussing the specific procedures used in applying the current rate and the temporal methods, we need to define a few exchange rates.
The current rate is the exchange rate on the balance sheet date.
The average rate is the average exchange rate over the reporting period.
The historical rate is the actual rate that was in effect when the original transaction occurred. For example, if a firm bought machinery on January 2, 2016, the historical rate for that transaction at every balance sheet date in the future would be the exchange rate on January 2, 2016.
MODULE QUIZ 15.2
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1. Which of the following is least likely a condition that requires the use of the temporal method for a U.S. parent that reports results in U.S. dollars?
A. The functional currency is the local currency.
B. The foreign subsidiary is operating in a highly inflationary economy.
C. The functional currency is some currency other than the local currency or the U.S.
dollar.
2. Mazeppa, Inc., is a multinational firm with its home office located in Toronto, Canada. Its main foreign subsidiary is located in Paris, but the primary economic environment in which the foreign subsidiary generates and expends cash is in the United States (New York).
A. The local currency is the U.S. dollar.
B. The functional currency is the euro.
C. The presentation (reporting) currency is the Canadian dollar.