 # Translation Effects of a Subsidiary’s Balance Sheet and Income Statement

Recall from the previous LOS that there are two translation methods: the current rate and the temporal methods. To demonstrate the translation effects of a subsidiary’s financial statements into the parent company’s presentation currency, we will look at the following extended examples for both methods:

#### Example: Translation Methods and Translation Effects

Assume that Agrana is an Austria-based company that has the euro as its presentation currency. Agrana wholly owns a subsidiary in Canada, ABC Ltd. The subsidiary’s balance sheet in Canadian dollars (C\$) as of March 31 2016 and March 31, 2017. The following hypothetical exchange rate information is available:

$$\small{\begin{array}{l|c} \textbf{Date} & \textbf{€ per C\}\\ \hline\text{March 16, 2016} & 0.68\\ \hline\text{March 17, 2017} & 0.80\\ \hline\text{2017 average exchange rate} & 0.75\\ \hline\text{Weighted-average rate}\\ \text{when inventory was acquired} & 0.74\\ \end{array}}$$

From the exchange rate table, the Canadian dollar appreciated steadily against the euro, from the exchange rate of €0.68 at the start of the year to €0.80 at year-end.

To translate ABC’s Canadian dollar financial statements into euro for consolidation purposes, Agrana needs to come up with translation worksheets for the balance sheet and the income statement. The tables that follow show the translation worksheets for ABC’s balance sheet and income statement, respectively, as of 31 March 2017.

$$\textbf{ABC’s Balance Sheet}$$

$$\small{\begin{array}{l|r|r|r|r|r|r} {}& {\textbf{As at}\\ \textbf{March 31, 2016}} & {\textbf{As at}\\ \textbf{March 31, 2017}} & \textbf{Current Rate Method} & \textbf{€ per C\} & \textbf{Temporal Method} & {}\\ \hline \text{Cash} & 200 & 800 & 640 & \text{0.80 C} & 640 & \text{0.80 C}\\ \hline\text{Accounts}\\ \text{receivable} & 1,000 & 2,600 & 2,080 & \text{0.80 C} & 2,080 & \text{0.80 C}\\ \hline \text{Inventory} & 4,000 & 3,600 & 2,880 & \text{0.80 C} & 2,664 & \text{0.74 H}\\ \hline\textbf{Current assets} & \textbf{5,200} & \textbf{7,000} & \textbf{5,600} & {}& \textbf{5,384} & {}\\ \hline \text{Fixed assets} & 2,400 & 6,400 & 5,120 & \text{0.80 C} & 4,352 & \text{0.68 H}\\ \hline\text{Depreciation} & 100 & 700 & 476 & \text{0.68 H} & 476 & \text{0.68 H}\\ \hline\textbf{Net fixed}\\ \textbf{assets} & \textbf{2,300} & \textbf{5,700} & \textbf{4,644} & \textbf{0.80 C} & \textbf{3,876} &{}\\ \hline\textbf{Total assets} & \textbf{7,500} & \textbf{12,700} & \textbf{10,244} & {} & \textbf{9,260} & {}\\ \hline \text{Accounts}\\ \text{payable} & 800 & 2,000 & 1,600 & \text{0.80 C} & 1,600 & \text{0.80 C}\\ \hline\text{Short-term debt} & 600 & 400 & 320 & \text{0.80 C} & 320 & \text{0.80 C}\\ \hline\text{long term debt} & 2,200 & 3,750 & 3,000 & \text{0.80 C} & 3,000 & \text{0.80 C}\\ \hline \text{Common stock} & 3,200 & 3,200 & 2,176 & \text{0.68} H & 2,176 & \text{0.68 H}\\ \hline \text{Retained}\\ \text{earnings} & 700 & 3,350 & 2,464 &{} & 2,164 & \text{0.68 H}\\ \hline\textbf{Total equity} & \textbf{3,900} & \textbf{6,550} &{} & {}&{} &{}\\ \hline\textbf{Cumulative}\\ \textbf{translation}\\ \textbf{adjustment} &{} &{} &\textbf{ 685} &{} &{} &{}\\ \hline\textbf{Total}\\ \textbf{liabilities}\\ \textbf{and equity} & \textbf{7,500} & \textbf{12,700} & \textbf{10,244} &{} & \textbf{9,260} &{}\\ \end{array}}$$

Where: C = Current exchange rate; A = Average-for-the-year exchange rate; H = Historical exchange rate

$$\textbf{ABC’s Income Statement for the Year Ended 31 March 2017}$$

$$\small{\begin{array}{l|r|r|r|r|r} {}&{} & \textbf{Current Rate Method} & {} & \textbf{Temporal Method} & {}\\ \hline\text{Revenue} & 19,050 & 14,288 & \text{0.75 A} & 14,288 & \text{0.75 A}\\ \hline\text{Cost of goods}\\ \text{and services} & 12,600 & 9,450 & \text{0.75 A} & 9,324 & \text{0.74 H}\\ \hline \text{Gross margin} & 6,450 & 4,838 & \text{0.75 A} & \text{4,964} &{}\\ \hline\text{Depreciation} & 600 & 450 & \text{0.75 A} & 408 & \text{0.68 H}\\ \hline\text{Other Expenses} & 3,200 & 2,400 & \text{0.75 A} & 2,400 & \text{0.75 A}\\ \hline \text{Net income} & 2,650 & 1,988 & \text{0.75 A} & 2,156 & {}\\ \hline \text{Remeasurement}\\ \text{gain/loss} &{} & {}&{} & (468) & {}\\ \hline \text{Increase in the}\\ \text{retained}\\ \text{earnings} & {}&{} & {}& 1,688 & \text{0.68 H}\\ \end{array}}$$

Where: C = Current exchange rate; A = Average-for-the-year exchange rate; H = Historical exchange rate

The translation worksheets above show the two approaches used to translate ABC’s financial statements under different scenarios. First, assume that ABC’s functional currency is the Canadian dollar. The current rate method must be used. The items of the 2017 income statement are translated at the average exchange rate, which is (€0.75). The closing balance in retained earnings as of 31 March 2017 of €2,464 is transferred to the Canadian dollar balance sheet. Assets and liabilities are then translated at the current exchange rate (€0.80) on the balance sheet date of 31 March 2017, and the common stock account is translated at the historical exchange rate (€0.68).

A positive cumulative translation adjustment of €685 is needed as a balancing amount, which is reported in the stockholders’ equity section.

On the other hand, if Agrana determines that ABC’s functional currency is the euro, the temporal method is applicable. In this method, inventory, fixed assets, accumulated depreciation, cost of goods and services, and depreciation are translated at the historical exchange rate, i.e., €0.68 in the case of fixed assets, and €0.74 for inventory.

An amount equal to €2,164 is determined as the amount of retained earnings needed to keep the balance sheet in balance. The amount is transferred to the income statement as of 31 March 2017. Items on the income statement are then translated. The cost of goods and services and depreciation are translated at historical exchange rates. A negative translation adjustment of €468 is determined as the amount needed to arrive at the closing balance in retained earnings of €2,164. The adjustment is reported as a translation loss on the income statement.

Under the current rate method, the positive translation adjustment is explained by the fact that ABC has a net asset balance sheet exposure. Recall that:

$$\text{Net asset balance sheet exposure = Total assets + Total liabilities}$$

So ABC’s total assets exceeded the total liabilities in 2017, and the Canadian dollar appreciated relative to the euro.

Moreover, under the temporal method, ABC has a net liability balance sheet exposure. This is because the amount of exposed liabilities [accounts payable plus notes payable] exceeds that of exposed assets [cash plus receivables]. The result is called a negative translation adjustment (translation loss) when the Canadian dollar appreciates against the euro.

## Question

Impact Inc. is a US-based multinational with subsidiaries around the world. XYZ is one of the subsidiaries which operates in Singapore. XYZ was acquired in 2014 and has never paid a dividend. The financial data for XYZ for the year ended December 31, 2017 is given in the table below:

$$\textbf{XYZ’s Balance Sheet as at December 31, 2014}$$

$$\small{\begin{array}{l|c} \text{Cash} & \text{SGD 130}\\ \hline\text{Accounts receivable} & 220\\ \hline\text{Inventory} & 400\\ \hline\text{Fixed assets} & 1,500 \\ \hline\text{Accumulated depreciation} & (200)\\ \hline\text{Total assets} & \text{SGD 2,050}\\ \hline \text{Accounts payable} & 170\\ \hline\text{Long-term debt} & 220\\ \hline\text{Common stock} & 600\\ \hline \text{Retained earnings} & 1,060\\ \hline \text{Total liabilities and equity} & \text{SGD 2,050}\\ \hline \text{Total revenues} & \text{SGD 4,000}\\ \hline\text{Net income} & \text{SGD 500}\\ \end{array}}$$

The exchange rates applicable to XYZ are as given in the table below:

$$\begin{array}{l|c} \textbf{Date} & \textbf{US\ per SG\}\\ \hline\text{31 December 2014} & 0.670\\ \hline\text{Average rate in 2014} & 0.664\\ \hline\text{Weighted-average rate when inventory was acquired} & 0.653\\ \hline\text{31 December 2013} & 0.651\\ \hline\text{Rate when long-term and short-term}\\ \text{debt was issued} & 0.587\\ \hline\text{Rate when fixed assets were acquired} & 0.567\\ \end{array}$$

If the US dollar were chosen as the functional currency for XYZ in 2014, Impact Inc. could reduce its balance sheet exposure to exchange rates by:

A. Issuing SGD40 million of long-term debt to buy fixed assets.

B. Issuing SGD40 million in short-term debt to purchase marketable securities.

C. Selling SGD40 million of fixed assets for a case.

#### Solution

Since the US dollar is used as the functional currency, the temporal method must be applied. Balance sheet exposure will be the net monetary assets of $$130+220-170-220 = -40$$ or a net monetary liability of SGD40 million. This net monetary liability would be eliminated if the non-monetary assets, i.e., fixed assets, were sold to increase cash.

A and B are incorrect. Issuing short-term or long-term debt would increase the net monetary liability, thus increasing the balance sheet exposure to exchange rates.

LOS 13 (e) Calculate the translation effects and evaluate the translation of a subsidiary’s balance sheet and income statement into the parent company’s presentation currency.

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