Current Rate Method and Temporal Method of Translation

Translation refers to converting the functional currency into the parent’s presentation currency. The procedures specified by IFRS and US GAAP for translating foreign currency financial statements essentially require the use of either the current rate method or the temporal method. The suitable method for an individual foreign entity depends on the functional currency of the entity.

According to IASB, the management should take into account the following factors when deciding on the functional currency:

• The currency that impacts the sales prices of goods and services.
• The currency that influences the company’s operational costs.
• The currency from which funds are generated.
• The currency of the country whose forces and regulations mainly determine the sale price of goods.
• The currency in which receivables from operating activities are retained.

The Current Rate Method

The current rate method applies when a foreign entity has a functional currency that is different from the parent’s presentation currency. The parent translates the foreign entity’s financial statements, which are recorded in the subsidiary’s functional currency, into the parent company’s presentation currency.

Consider a Germany-based food company, ABC Ltd., that owns 10% of a Mexican company, XYZ Ltd. ABC primarily uses the euro as the presentation currency, and it does not control XYZ’s operations. XYZ is self-sustaining and much delinked from ABC. Therefore, XYZ uses its local currency, the Mexican Peso (MXN), as its functional currency. The current rate method is applicable in this case to translate XYZ’s assets and liabilities from Mexican Pesos, the functional currency, to ABC’s presentation currency, the euro.

How It Works

Each income statement element, i.e., revenues, and expenses, is translated at the average exchange rate during the reporting period. On the other hand, all balance sheet items are translated at the current exchange rate on the balance sheet date. Shareholder’s equity, mostly made up of common stock and dividends, is translated at the historical exchange rate. This will be the rate in effect when the assets are acquired.

Cumulative translation adjustment is a translation gain/loss caused by foreign currency exchange rate fluctuation. It is recognized under the shareholder’s equity on the balance sheet and is required to keep the translated balance sheet balanced. Balance sheet exposure to the foreign currency exchange rate is equal to the net asset (equity) position of the subsidiary.

$$ \text{Net assets (Equity) = Total assets – Total Liabilities = Equity} $$

If the local currency appreciates against the parent’s presentation currency, the exposure is positive and will result in a gain in the cumulative translation adjustment.

The Temporal Method

This translation method is applicable when the subsidiary’s functional currency is the same as the parent’s presentation currency. The local currency deviates from the functional and the presentation currencies. Re-measurement refers to the translation of the local currency to a foreign currency using the temporal method.

Under this method, assets and liabilities are classified as either monetary or non-monetary. Monetary assets and liabilities are items that are settled in cash, which include cash, receivables, payables, and debt. Non-monetary assets and liabilities are not settled in cash. They include inventory, fixed assets, intangible assets, and unearned revenue.

For example, Pearson is a hypothetical company based in Canada, and it uses Canadian Dollars (CAD) as its presentation currency. Pearson owns 100% of ACK, a company based in India, and so it controls ACK’s operation decisions. Since ACK is well integrated with the parent, it will use Canadian Dollars as its functional currency. As Pearson’s presentation currency is similar to ACK’s functional currency, it will use the temporal method to translate ACK’s assets and liabilities.

How It Works

Monetary assets and liabilities, such as accounts payable, cash, and accounts receivable, are translated at the current (end-of-period) rates under both the temporal and the current rate method is used. However, non-monetary assets and liabilities such as inventory, fixed assets, and intangible assets are translated at the historical exchange rate. The historical exchange rate can be taken as the rate on the date on which the assets were acquired or purchased. Common stock and dividends are also translated at the historical exchange rate.

Expenses related to non-monetary assets, such as the cost of goods and services (COGS) and depreciation, are translated at the historical exchange rate. Revenue and other expenses are translated using the average exchange rate. It is crucial to note that the historical rate differs based on the inventory costing method used.

Under US GAAP, re-measurement refers to the process of translating foreign currency financial statements of a foreign operation that has the parent’s presentation currency as its functional currency. A temporal method is applied here. Re-measurement gain/loss is reported on the income statement. If the local currency appreciates relative to the presentation currency, the result will be a re-measurement gain and vice versa.

The balance sheet exposure associated with the temporal method is equal to the foreign subsidiary’s net monetary asset position.

$$ \text{Net monetary asset position = Net monetary assets – Net monetary liabilities} $$

Example: Determining the Appropriate Translation Method in Various Scenarios

H Ltd is based in Belgium and complies with International Financial Reporting Standards (IFRS). H used EUR100 million of its cash and borrowed an equal amount to open a subsidiary in Switzerland. The funds were converted into Swiss Franc (CHF) on 31 December 2016 at an exchange rate of EUR1.00 = CHF1.10 and used to purchase CHF 90 million in fixed assets and CHF 10 million of inventories. An analyst wants to explore various scenarios to determine the potential impact on H Ltd.’s consolidated financial statements. No further information is available, and all other economic factors in Belgium are held constant. It is believed that the euro will appreciate against the Swiss Franc for the foreseeable future.

If the euro is chosen as the Switzerland subsidiary’s functional currency, H Ltd. will translate its fixed assets using the rate at which the assets were purchased. The temporal method must be used when the parent’s currency is chosen as the functional currency. Under the temporal method, the fixed assets are translated using the rate in effect at the time the assets were acquired.

If the Swiss Franc is chosen as the Switzerland subsidiary’s functional currency, H ltd will translate its inventory using the rate in effect at the end of the reporting period. The current rate method is used since the foreign currency is chosen to be the functional currency. All assets and liabilities are translated at the current (end-of-period) rate.

Assume that the euro is chosen as the Switzerland subsidiary’s functional currency. In that case, H Ltd. will translate its accounts receivable using the rate in effect at the end of the reporting period since monetary assets and liabilities such as accounts receivable are translated at current (end-of-period) rates regardless of whether the temporal or current rate method is used.

Question

Assume that the euro appreciates against the Swiss Franc. If the Swiss Franc is chosen to be the Switzerland subsidiary’s functional currency, H Ltd. will most likely report a (an):

     A. Subtraction from the cumulative translation adjustment.

     B. Addition to the cumulative translation adjustment.

     C. Translation gain/loss as a component of the net income.

Solution

The correct answer is A.

The current rate method must be used when the foreign currency is chosen as the functional currency. All gains or losses from translation are reported as a cumulative translation adjustment to shareholder equity. When the foreign currency decreases in value (weakens), the current rate method results in a negative translation adjustment in stockholders’ equity.

B is incorrect. An addition to the cumulative translation adjustment is most likely to result from the foreign currency appreciating (increasing in value).

C is incorrect. A translation gain or loss arises under the temporal method when the foreign currency appreciates/depreciates relative to the parent company’s presentation currency.

Reading 13: Multinational Operations

LOS 13 (d) Compare the current rate method and the temporal method, evaluate the effects of each on the parent company’s balance sheet and income, and determine which method is appropriate in various scenarios.