How Current Rate Method and the Temporal Method Affect Financial Statements and Ratios

Both the current rate and temporal methods have a significant impact on the parent company’s financial statements and ratios. The following example demonstrates the effects under each translation method.

Example: Effects of Using the Current Rate and the Temporal Methods on the Financial Statements and Ratios

Cameco is a hypothetical Canada-based company that has the Canadian dollar as its presentation currency. Cameco established a wholly-owned subsidiary in India, Vedant, on 1 January 2012. In addition to Cameco making an equity investment in Vedant, a long-term note payable to an Indian bank was negotiated to purchase property and equipment. The subsidiary begins operations with the following balance sheet in Indian Rupees (INR). Assume that the inventory is measured at historical cost on a FIFO basis, i.e., ending inventory is assumed to be composed of the most recently acquired items.

The following exchange rate information is available for translation of Vedant’s Indian rupee financial statements into Canadian dollar for consolidation purposes:

$$ \textbf{Exchange Rate Table} $$

$$\small{\begin{array}{l|c} \textbf{Date} & \textbf{CAD per INR}\\ \hline\text{1-Jan-12} & 0.020\\ \hline\text{Average, 2012} & 0.025\\ \hline{\text{Weighted-average rate}\\ \text{when inventory was acquired}} & 0.024\\ \hline{\text{1 December 2012 when}\\ \text{dividends were declared}} & 0.028\\ \hline\text{31-Dec-12} & 0.030\\  \end{array}}$$

Vedant’s balance sheet as at Me January 2012 given in the table below:

$$ \textbf{Vedant Balance sheet, 1 January 2012} $$

$$\small{\begin{array}{l|r} \textbf{Assets} & \textbf{Amounts in INR‘000′}\\ \hline\text{Cash} & 2,000\\ \hline\text{Property and equipment} & 4,000\\ \hline\textbf{Total Assets} & \textbf{6,000}\\ \hline\textbf{Liabilities and Equity} & {}\\ \hline\text{Long-term note payable} & 4,000\\ \hline\text{Capital stock} & 2,000\\ \hline\textbf{Total liabilities and equity} & \textbf{6,000}\\ \end{array}}$$

Vedant’s balance sheet as at 31 December 2012 and the income statement for the year ended 31 December 2012 respectively are given in the tables below:

$$ \textbf{Vedant Income Statement and Statement of Retained Earnings, 2012} $$

$$\small{\begin{array}{l|r} \text{Sales} & 15,000\\ \hline\text{Cost of sales} & (10,000)\\ \hline\text{Selling expenses} & (800)\\ \hline\text{Depreciation expense} & (450)\\ \hline\text{Interest expense} & (300)\\ \hline\text{Income tax} & (500)\\ \hline\textbf{Net income} & \textbf{2,950}\\ \hline\text{Less: Dividends, 1 Dec 2012} & (400)\\ \hline\textbf{Retained earnings, 31 Dec 2012} & \textbf{2,550}\\  \end{array}}$$

$$ \textbf{Vedant Balance Sheet, 31 December 2012} $$

$$\small{\begin{array}{l|r} \textbf{Assets} & {}\\ \hline\text{Cash} & 1,000\\ \hline\text{Accounts receivable} & 1,200\\ \hline\text{Inventory} & 2,200\\ \hline\text{Property and equipment} & 5,000\\ \hline\text{Accumulated depreciation} & (350)\\ \hline\textbf{Total assets} & \textbf{9,050}\\ \hline\textbf{Liabilities and Equity} & {}\\ \hline\text{Accounts payable} & 500\\ \hline\text{Long-term notes payable} & 4,000\\ \hline\text{Capital stock} & 2,000\\ \hline\text{Retained earnings} & 2,550\\ \hline\text{Total liabilities and equity} & \textbf{9,050}\\ \end{array}}$$

From the previous learning outcome statements, we learned how to compute the translated assets and liabilities using both the current and temporal methods. The translation worksheets for the income statement and the balance sheet respectively on 31 December 2012 are given in the tables that follow:

$$ \textbf{Vedant Income Statement and Statement of Retained Earnings, 2012} $$

$$\small{\begin{array}{l|lll|ll}  \textbf{Vedant’s Functional currency is:}&{}& \textbf{Local Currency (INR)} &{}& \textbf{Parent’s Currency (CAD)}\\\hline{} & {} &\textbf{Current Rate} & {}&\textbf{Temporal}\\ \hline {}& \text{INR} &\text{Exch. Rate} &\text{CAD} & \text{Exch. Rate} & \text{CAD}\\ \hline\text{Sales} & 15,000 & 0.025 A & 375 & \text{0.025 A} & 375\\ \hline \text{Cost of sales} & (10,000) & \text{0.025 A} & (250) & \text{0.024 H} & (240)\\ \hline\text{Selling expenses} & (800) & 0.025 A & (20) & \text{0.025 A} & (20)\\ \hline\text{Depreciation expense} & (450) & 0.025 A & (11) & \text{0.020 H} & (9)\\ \hline\text{Interest expense} & (300) & 0.025 A & (8) & \text{0.025 A} & (8)\\ \hline\text{Income tax} & (500) & \text{0.025 A} & (13) & \text{0.025 A} & (13)\\ \hline\textbf{Income before trans. gain/loss} & \textbf{2,950} & {}& \textbf{74} &{} & \textbf{86}\\ \hline\textbf{Translation gain/loss} & \textbf{N/A} &{} & \textbf{N/A} & \textbf{to balance} & \textbf{(38)}\\ \hline\textbf{Net income} & \text{2,950} &{} & \text{74} &{} & \text{48}\\ \hline\text{Less: Dividends, 1 Dec 2012} & (400) & \text{0.028 H} & (11) & \text{0.028 H} & (11)\\ \hline\textbf{Retained earnings, 31 Dec 2012} & \textbf{2,550} &{} & \text{63} & \textbf{from B/S} & \textbf{37}\\  \end{array}}$$

$$ \textbf{Vedant Balance Sheet, 31 December 2012} $$

$$\small{\begin{array}{l|lll|ll}  \textbf{Vedant’s Functional currency is:}&{}& \textbf{Local Currency (INR)} &{}& \textbf{Parent’s Currency (CAD)}\\\hline{} & {} &\textbf{Current Rate} & {}&\textbf{Temporal}\\ \hline {}& \text{INR} &\text{Exch. Rate} &\text{CAD} & \text{Exch. Rate} & \text{CAD}\\ \hline\textbf{Assets} &{} &{} &{} &{} &{}\\ \hline\text{Cash} & 1,000 & \text{0.030 C} & 30 & \text{0.030 C} & 30\\ \hline\text{Accounts receivable} & 1,200 & \text{0.030 C} & 36 & \text{0.030 C} & 36\\ \hline\text{Inventory} & 2,200 & \text{0.030 C} & 66 & \text{0.024 H} & 53\\ \hline\text{Property and equipment} & 5,000 & \text{0.030 C} & 150 & \text{0.020 H} & 100\\ \hline\text{Accumulated depreciation} & (350) & \text{0.030 C} & (11) & \text{0.020 H} & (7)\\ \hline\textbf{Total Assets} & \textbf{9,050} & {}&\text{272} & {}& \textbf{212}\\ \hline \textbf{Liabilities and Equity} & {}& {}& {}&{} &{}\\ \text{Accounts payable} & 500 & \text{0.030 C} & 15 & \text{0.030 C} & 15\\ \hline \text{Long-term notes payable} & 4,000 & \text{0.030 C} & 120 & \text{0.030 C} & 120\\ \hline\text{Capital stock} & 2,000 & \text{0.020 C} & 40 & \text{0.020 H} & 40\\ \hline \textbf{Retained earnings} & \textbf{2,550} & \textbf{from I/S} & \textbf{63} & \textbf{to balance} & \textbf{37}\\ \hline\textbf{Translation adjustment} & \textbf{N/A} & \textbf{to balance} & \textbf{97} &{} & \textbf{N/A}\\ \hline\textbf{Total liabilities and equity} & \textbf{9,050} &{} & \textbf{272} & {}& \textbf{212}\\  \end{array}}$$

The two translation methods lead to very different amounts that are to be included in Cameco’s financial statements. These differences are summarized in the chart that follows:

$$\small{\begin{array}{l|l|l|l} \textbf{Vedant’s Functional Currency is:} & \textbf{Local Currency (INR)} & \textbf{Parent’s Currency (CAD)} & {}\\ \hline\text{Translation Method} & \text{Current Rate (CAD)} & \text{Temporal (CAD)} & \text{Difference}\\ \hline\text{Sales} & 375 & 375 & 0\%\\ \hline \text{Net income} & 74 & 48 & 54\%\\ \hline\text{Income from translation gain (loss)} & 74 & 86 & -14\%\\ \hline\text{Total assets} & 272 & 212 & 28\%\\ \hline\text{Total equity} & 137 & 77 & 78\%\\  \end{array}}$$

From the above table, the current rate method results in a significantly higher net income than the temporal method. This result is due to the exclusion of the translation adjustment when calculating the income under the current method. If the translation loss were excluded from net income, the temporal method would result in a significantly higher amount of net income. The total equity under the current method is higher when compared to that under the temporal method. This is because of the combination of smaller net income under the temporal method and a positive translation adjustment under the current rate method.

Total assets also are higher under the current rate method. This is because all assets are translated at the current exchange rate, which is higher than the historical exchange rates at which inventory and fixed assets are translated under the temporal method.

Moreover, IFRS and US GAAP require the translation loss to be included in net income when the temporal method is used. This results in a smaller amount of net income than when using the current rate method. The Indian rupee appreciated against the Canadian dollar. Since Vedant has a higher amount of liabilities translated at the current exchange rate (monetary liabilities) than its monetary assets, a transaction loss arises. A translation gain under the temporal method would arise if Vedant’s monetary assets exceeded monetary liabilities.

We further compute several significant ratios from the original Indian rupee financial statements and the translated (Canadian dollar) financial statements to examine the effects of translation.

$$\small{\begin{array}{l|c|c|c} {}&\textbf{Vedant’s Functional Currency is:} & \textbf{Local Currency (INR)} & \textbf{Parent’s Currency (CAD)}\\ \hline\text{Ratio} & \text{Original INR} & \text{Current Rate (CAD)} & \text{Temporal (CAD)}\\ \hline\text{Current ratio} & 8.80 & 8.80 & 7.92\\ \hline\text{Debt-to-assets ratio} & 0.44 & 0.44 & 0.57\\ \hline\text{Debt-to-equity ratio} & 0.88 & 0.88 & 1.56\\ \hline\text{Interest coverage} & 12.50 & 12.50 & 14.13\\ \hline\text{Gross profit margin} & 0.33 & 0.33 & 0.36\\ \hline\text{Operating profit margin} & 0.25 & 0.25 & 0.28\\ \hline\text{Net profit margin} & 0.20 & 0.20 & 0.13\\ \hline\text{Receivables turnover} & 12.50 & 10.42 & 10.42\\ \hline\text{Inventory turnover} & 4.55 & 3.79 & 4.55\\ \hline\text{Fixed asset turnover} & 3.23 & 2.69 & 4.03\\ \hline\text{Return on assets} & 0.33 & 0.27 & 0.23\\ \hline\text{Return on equity} & 0.65 & 0.54 & 0.63\\  \end{array}}$$

Where:

$$\text{Current ratio}=\frac{\text{Current Assets}}{\text{Current liabilities}}$$

$$\text{Debt-to-assets ratio}=\frac{\text{Total debt}}{\text{Total assets}}$$

$$\text{Debt-to-equity ratio}=\frac{\text{Total debt}}{\text{Total equity}}$$

$$\text{Interest coverage ratio}=\frac{\text{Earnings Before Interest and Tax (EBIT)}}{\text{Interest payments}}$$

$$\text{Gross profit margin}=\frac{\text{Gross profit}}{\text{Sales}}$$

$$\text{Operating profit margin}=\frac{\text{Operating profit}}{\text{Sales}}$$

$$\text{Net profit margin}=\frac{\text{Net income}}{\text{Sales}}$$

$$\text{Receivables turnover}=\frac{\text{Sales}}{\text{Accounts receivable}}$$

$$\text{Inventory turnover}=\frac{\text{Cost of goods sold}}{\text{Inventory}}$$

$$\text{Fixed asset turnover}=\frac{\text{Sales}}{\text{Property and Equipment}-\text{Accumulated depreciation}}$$

$$\text{Return on assets}=\frac{\text{Net income}}{\text{Total assets}}$$

$$\text{Return on equity}=\frac{\text{Net Income}}{\text{Total equity}}$$

From the table above, the financial ratios from Vedant’s translated financial statements in Canadian dollars differ significantly depending on the translation method used. Of the ratios presented, only the receivables turnover ratio is the same under both translation methods. It is the only ratio in which there is no difference in the type of exchange rate used to translate the sales and accounts receivable, i.e., sales are translated at the average exchange rate, and receivables are translated at the current exchange rate under both methods.

For the other ratios, at least one of the items included in either the numerator or the denominator is translated at a different type of exchange rate (current, average, or historical) under the temporal method than under the current rate method. For example, inventory turnover is different because, under the current rate method, the cost of goods sold is translated at the average rate and inventory at the current exchange rate. In contrast, both the cost of goods sold and inventory are translated at the weighted average rate under the temporal method.

The current ratio, the leverage ratios (debt-to-assets and debt-to-equity ratios), the interest coverage ratio, and the profit margins (gross profit margin, operating profit margin, and net profit margin) are the same in the Indian rupee and current rate method (Canadian dollar) columns of the above table. This is because each of the ratios is calculated using information from either the balance sheet or the income statement, but not both. These ratios are referred to as pure ratios.

However, the turnover and return ratios are higher when calculated from the Indian rupee amounts than when calculated from the current rate amounts. This is because the calculation amounts from the balance sheet are compared with amounts from the income statement. The balance sheet items are translated using the current exchange rate, while revenues and expenses are translated using the average exchange rate. This leads to the underlying distortions when the current rate method is applied. The turnover and return ratios are called mixed ratios as they combine inputs from both the balance sheet and the income statement.

Translation using the temporal method distorts all the underlying relationships in the Indian rupee financial statements, except the inventory turnover. In Vedant’s case, the temporal method results in a higher gross profit margin and operating profit margin but a lower net profit margin as compared with Indian rupee calculations. Similarly, receivables turnover is lower, inventory turnover is the same, and fixed asset turnover is higher when calculated from the translated amounts.

Key Points Regarding the Original versus the Translated Financial Ratios

• Pure ratios such as the current ratio and leverage ratios will be the same.
• If the foreign currency is depreciating, translated mixed ratios such as the turnover ratio and the return ratios will be larger than the original ratios
• If the foreign currency is appreciating, translated mixed ratios such as the turnover ratio and the return ratios will be smaller than the original ratios

Question

Cameco is a hypothetical Canada-based company that has the Canadian dollar as its presentation currency. Cameco establishes a wholly-owned subsidiary in India, Vedant, on 1 January 2012. In addition to Cameco making an equity investment in Vedant, a long-term note payable to an Indian bank was negotiated to purchase property and equipment.

Assume that the inventory is measured at historical cost on a FIFO basis, i.e., ending inventory is assumed to be composed of the most recently acquired items. Also assume that Cameco applies the temporal method to translate Vedant’s assets and liabilities. Moreover, the average weight used to translate sales differs from the historical rate used to translate inventories.

Relative to the gross profit margin that Vedant reports in Indian rupee, Cameco’s consolidated gross profit margin will most likely:

    A. Not be distorted by currency translations.

    B. Be distorted if the current rate method is used.

    C. Be distorted because of the temporal translation method and FIFO inventory accounting applied.

Solution

The correct answer is C.

Since FIFO is used, ending inventory is assumed to be composed of the most recently acquired items. The inventory is therefore translated at relatively recent exchange rates. Besides, the average weight used to translate sales differs from the historical rate used to translate inventories; the gross profit margin will be distorted when translated into Canadian dollars.

A is incorrect.Since the average weight used to translate sales differs from the historical rate used to translate inventories, the gross profit margin will be distorted when translated into Canadian dollars.

B is incorrect. The gross margin will be the same if the current rate method is used. This is because the gross profit margin is calculated using purely income statement items, i.e., revenues and expenses, which are translated using the average rate. This preserves the original gross profit margin.

Reading 13: Multinational Operations

LOS 13 (f) Analyze how the current rate method and the temporal method affect financial statements and ratios.