Currency Translation

Foreign subsidiaries of multinational firms normally keep their accounting records and prepare their financial statements in the currency of the country in which they are located. Thus, the Japanese subsidiary of a US firm will prepare its accounts in yen, a Brazilian subsidiary in real, a Korean subsidiary in won, and so on. When a multinational prepares consolidated accounts, it must convert all these financial statements into the currency of its home country. As we saw in Chapter 9, however, exchange rates vary in response to changes in economic circumstances. Companies can use two main methods to determine what exchange rate should be used when translating financial statement currencies--the current rate method and the temporal method.

The Current Rate Method

Under the current rate method, the exchange rate at the balance sheet date is used to translate the financial statements of a foreign subsidiary into the home currency of the multinational firm. Although this may seem logical, it is incompatible with the historic cost principle, which, as we saw earlier, is a generally accepted accounting principle in many countries, including the United States. Consider the case of a US firm that invests $100,000 in a Malaysian subsidiary. Assume the exchange rate at the time is $1 = 5 Malaysian ringgit. The subsidiary converts the $100,000 into ringgit, which gives it 500,000 ringgit. It then purchases land with this money. Subsequently, the dollar depreciates against the ringgit, so that by year-end, $1 = 4 ringgit. If this exchange rate is used to convert the value of the land back into US dollars for preparing consolidated accounts, the land will be valued at $125,000. The piece of land would appear to have increased in value by $25,000, although in reality the increase would be simply a function of an exchange rate change. Thus, the consolidated accounts would present a somewhat misleading picture.

The Temporal Method

One way to avoid this problem is to use the temporal method to translate the accounts of a foreign subsidiary. The temporal method translates assets valued in a foreign currency into the home-country currency using the exchange rate that exists when the assets are purchased. Referring to our example, the exchange rate of $1 = 5 ringgit, the rate on the day the Malaysian subsidiary purchased the land, would be used to convert the value of the land back into US dollars at year-end. However, although the temporal method will ensure the dollar value of the land does not fluctuate due to exchange rate changes, it has its own serious problem. Because the various assets of a foreign subsidiary will in all probability be acquired at different times and because exchange rates seldom remain stable for long, different exchange rates will probably have to be used to translate those foreign assets into the multinational's home currency. Consequently, the multinational's balance sheet may not balance!

Consider the case of a US firm that on January 1, 1999, invests $100,000 in a new Japanese subsidiary. The exchange rate at that time is $1 = ¥100. The initial investment is therefore ¥10 million, and the Japanese subsidiary's balance sheet looks like this on January 1, 1999: 

	Yen	Exchange Rate	US Dollars
Cash	10,000,000	($1 = ¥100)	100,000
Owners' equity	10,000,000	($1 = ¥100)	100,000

Assume that on January 31, when the exchange rate is $1 = ¥95, the Japanese subsidiary invests ¥5 million in a factory (i.e., fixed assets). Then on February 15, when the exchange rate is $1 = ¥90, the subsidiary purchases ¥5 million of inventory. The balance sheet of the subsidiary will look like this on March 1, 1999: 

		Yen	Exchange Rate	US Dollars
Fixed assets	5,000,000		($1 = ¥95)		52,632
Inventory	5,000,000		($1 = ¥90)		55,556
Total	10,000,000				108,187
Owners' equity	10,000,000		($1 = ¥100)		100,000

Although the balance sheet balances in yen, it does not balance when the temporal method is used to translate the yen-denominated balance sheet figures back into dollars. In translation, the balance sheet debits exceed the credits by $8,187. The accounting profession has yet to adopt a satisfactory solution to the gap between debits and credits. The practice currently used in the United States is explained next.