Translation methodology foreign currency Is functional currency

ADS

When the functional currency is the currency of the foreign unit, U.S. GAAP requires firms to use the all-current translation method. The rationale for this method is that the firm’s investment in the foreign unit is for the long term; therefore, short-term changes

in exchange rates should not affect periodic net income. Under the all-current translation method,:

•  translate revenues and expenses at the average exchange rate during the period.
• translate balance sheet items at the end-of-the-period exchange rate
•  include the resulting ‘‘translation adjustment’’ (the amount needed to balance the balance sheet) as a component of other comprehensive income rather than net income
•  recognize the cumulative amount in the translation adjustment account in net income when measuring any gain or loss in the case of a sale or disposal of a foreign unit

The ‘‘translation adjustment’’ reported by a firm can include a second component in addition to the effect of exchange rate changes on the parent’s equity investment in foreign subsidiaries or branches. Firms can hedge their investment in foreign operations using forward contracts, currency swaps, or other derivative instruments. As part of the translation adjustment, firms report the change in fair value of a derivative that qualifies as a hedge of the net investment in a foreign entity. In this sense, the foreign currency hedge is treated similar to a cash flow hedge  in that the change in the fair value of the hedge appears in other comprehensive income. The difference is that firms do not separately disclose the change in the fair value of the hedge, but rather embed it in the translation adjustment, which also captures the effect of exchange rate changes on the parent’s equity investment in the foreign entity.

Illustration—Foreign Currency Is Functional Currency
Exhibit 8.22 illustrates the all-current method for a foreign unit during its first year of operations. The exchange rate was $1.0:1FC (FC ¼ one unit of a foreign currency such as a euro or Singapore dollar) on January 1, $2.0:1FC on December 31, and $1.5:1FC on

average during the year. Thus, the foreign currency increased in value relative to the U.S. dollar during the year. The translation process is as follows:

•  The firm translates all assets and liabilities on the balance sheet at the exchange rate on December 31.
• The firm translates common stock at the exchange rate on the date of issuance.
•  The firm translates all revenues and expenses of the foreign unit at the average exchange rate. The foreign unit realized a transaction gain during the year and recorded it in current income. In addition, the translated amounts for the foreign  unit include an unrealized transaction gain arising from exposed accounts that are not yet settled.

The firm takes translated net income and dividends to determine translated retained earnings. Note (a) to Exhibit 8.22 shows the computation of translated retained earnings. The foreign unit paid the dividend on December 31. n The firm uses the translation adjustment account to reflect the cumulative effects of the exchange rate translations on this investment. The amount is determinedas shown in note (b) to Exhibit 8.22.

Note b shows the calculation of the translation adjustment. By investing $30 in the foreign unit on January 1 and allowing the $22.5 of earnings to remain in the foreign unit throughout the year while the foreign currency was increasing in value relative to the U.S. dollar, the parent has a potential exchange gain of $37.5. It reports this amount as a componentof other comprehensive income on the statement of comprehensive income

ADS