EXECUTIVE SUMMARY

Accounting for currency translation risks can be very complex. This article addresses only the basics and provides some tools to help the reader understand the issues and find resources.

Globalization has changed the old accounting rule that debits equal credits. Net income became just one part of comprehensive income, and the equity part of the accounting equation became: Equity = Stock + Other Comprehensive Income + Retained Earnings. Other comprehensive income contains items that do not flow through the income statement. The currency translation adjustment in other comprehensive income is taken into income when a disposition occurs.

Accounting risk may be hedged. One way that companies may hedge their net investment in a subsidiary is to take out a loan denominated in the foreign currency. Some firms experience natural hedging because of the distribution of their foreign currency denominated assets and liabilities. It is possible for parent companies to hedge with intercompany debt as long as the debt qualifies under the hedging rules. Others choose to enter into instruments such as foreign exchange forward contracts, foreign exchange option contracts and foreign exchange swaps. Unfortunately, FX rate changes cannot always be anticipated and hedging has risks and costs.

Susan M. Sorensen. CPA, Ph.D. has 30 years of public accounting experience and is an assistant professor of accounting, and Donald L. Kyle. CPA, Ph.D. is a professor of accounting, both at the University of Houston–Clear Lake. Their e-mail addresses are sorensen@uhcl.edu and kyle@uhcl.edu. respectively.

When corporate earnings growth was in the double digits in 2006, favorable foreign currency translation was only a small part of the earnings story. But now, in a season of lower earnings coupled with volatility in currency exchange rates, currency translation gains represent a far greater portion of the total.

Using the concept that a picture is worth a thousand words—and a worksheet even more—this article uses Excel and real-world examples to explain why multinational companies are increasingly experiencing and managing what is often referred to as accounting risk caused by foreign currency exchange rate (FX) fluctuations. The article is designed to help the reader create the worksheet shown in Exhibit 3, and then use it to see firsthand how FX fluctuations affect both the balance sheet and income statement, and how currency translation adjustments (CTAs) may be hedged.

Accounting for translation risks can be very complex. This article addresses only the basics and provides some tools to help the reader understand the issues and find additional resources.

THE BALANCE SHEET PLUG

Today “managing the balance sheet” goes far beyond watching the current asset–to–liability ratio. FX rate fluctuations may have a significant effect on assets, liabilities and equity beyond the effects that flow through the income statement. Globalization has changed the old accounting rule that debits equal credits (no plugging is permitted). Years ago, net income became just one part of comprehensive income (CI), and the equity part of the accounting equation became: Equity = Stock + Other Comprehensive Income + Retained Earnings. Other comprehensive income (OCI) contains items that do not flow through the income statement. The currency translation adjustment in other comprehensive income is taken into income when a disposition occurs.

The financial statements of many companies now contain this balance sheet plug. As shown in Exhibit 1, eBay’s currency translation adjustments (CTA) accounted for 34% of its comprehensive income booked to equity for 2006. General Electric’s CTA was a negative $4.3 billion in 2005 and a positive $3.6 billion in 2006. The CTA detail may appear as a separate line item in the equity section of the balance sheet, in the statement of shareholders’ equity or in the statement of comprehensive income.

Keeping accounting records in multiple currencies has made it more difficult to understand and interpret the financial statements. For example, an increase in property, plant and equipment (PP&E) may mean that the company invested in more PP&E or it may mean that the company has a foreign subsidiary whose functional currency strengthened against the reporting currency. This may not seem like a significant issue, but goodwill arising from the acquisition of a foreign subsidiary may be a multibillion-dollar asset that will be translated at the end-of-period FX rate.

TRANSACTION RISK VS. TRANSLATION RISK

Because the terms for these two types of risk are similar, it is important to understand the difference and have a general idea of the effect that FX fluctuations have on these risks. In very simplified terms, these risks can be thought of as follows:

Currency transaction risk . Currency transaction risk occurs because the company has transactions denominated in a foreign currency and these transactions must be restated into U.S. dollar equivalents before they can be recorded. Gains or losses are recognized when a payment is made or at any intervening balance sheet date.

Currency translation risk . Currency translation risk occurs because the company has net assets, including equity investments, and liabilities “denominated” in a foreign currency.

Exhibit 2 provides a quick guide to the transaction and translation gain or loss effects of the U.S. dollar strengthening or weakening. GE explains its fluctuating pattern of currency translation adjustments in Note 23 of its 2006 financial statements by addressing the relative strength of the U.S. dollar against the euro, the pound sterling and the Japanese yen.

Translation risk is often referred to as “accounting risk.” This risk occurs because each “business unit” is required under FASB Statement no. 52, Foreign Currency Translation. to keep its accounting records in its functional currency and that currency may be different from the reporting currency. A business unit may be a subsidiary, but the definition does not require that a business unit be a separate legal entity. The definition includes branches and equity investments.

Functional currency is defined in Statement no. 52 as the currency of the primary economic environment in which the entity operates, which is normally the currency in which an entity primarily generates and expends cash. It is commonly the local currency of the country in which the foreign entity operates. It may, however, be the parent’s currency if the foreign operation is an integral component of the parent’s operations, or it may be another currency.

BASIC CONSOLIDATION WORKSHEET

CPAs can use Excel to create a basic consolidation worksheet like the one in Exhibit 3 that demonstrates the source of currency translation adjustments and the effects of hedging (download these worksheets here ). As this worksheet is created, the equations will produce the amounts shown in Exhibit 4. The worksheet includes lines used later, as shown in Exhibit 5. to demonstrate how a parent company can hedge translation risk by taking out a loan denominated in the functional currency of the subsidiary. The cells are color coded. Titles and general information are in yellow. Hypothetical amounts for the two trial balances and the currency exchange rates are shown in green. Equations are shown in blue.

This worksheet is based on a simple situation where a U.S. parent company acquired a foreign subsidiary for book value at the beginning of the year and used the cost method to record its investment. Advanced and international accounting textbooks contain more detailed examples. The subsidiary’s trial balance is to the left of the parent to highlight the fact that the subsidiary’s trial balance must be translated before the companies can be consolidated. The number of accounts has been kept to a minimum. Additional accounts may be added, but any change to the lines or columns will require that the equations be altered accordingly. Although the worksheets use the current rate method, they can be adapted to another translation method.

There are two steps to getting a foreign subsidiary’s trial balance ready to consolidate.

Step 1 . Convert the accounting records from foreign GAAP to U.S. GAAP.

Step 2  Translate the trial balance into U.S. dollars.

Convergence with IFRS will reduce the need for Step 1. The worksheets assume Step 1 has already been completed. The current rate method can be summarized as follows:

Net assets (assets minus liabilities) are at the exchange rates in effect on the balance sheet date.

Income statement items are at the weighted average rate in effect for the year except for material items that must be translated at the transaction date.

Stock accounts are at the historical rate.

Retained earnings and other equity items are at historical rates accumulated over time. This includes the payment of dividends.

The CTA in OCI is a plug figure to make the translated debits equal credits.

LOCATING EXCHANGE RATES

This worksheet is designed so that the reader can simulate “what if” scenarios with amounts and FX rates. FX quotes are available as both direct and indirect rates. The direct rate is the cost in U.S. dollars to buy one unit of the foreign currency. The indirect rate is the number of units of the foreign currency that can be purchased for one U.S. dollar. Current and historical FX rate information s available from Web sites such as OANDA at www.oanda.com. the Federal Reserve at www.federalreserve.gov/releases/H10/hist. or the Federal Reserve Bank of St. Louis at www.stls.frb.org/fred.

The worksheets use FX rates roughly based upon the Japanese yen-U.S. dollar relationship. The relationship between the current and historical exchange rates in Exhibits 3 and 4 indicates that the yen has strengthened against the dollar. Exhibit 4 shows a gain (credit) of $63,550 in the OCICTA account because net assets are being translated at a rate higher than the rates being used for the common stock, beginning retained earnings, and the net income from operations. The item “net income from operations” is used to draw the reader’s attention to the fact that the weighted average rate cannot be used in all situations.

If the exchange rates had not changed during the year, the net assets would have translated to only $550,000 instead of $618,750—an increase of $68,750. The net income of the foreign subsidiary would have been only $57,200 (6,500,000 * 0.0088). Reported translated net income was $5,200 higher than it would have been if FX rates had stayed at 0.0088 versus the weighted average of 0.0096. The change in the FX rates increased the subsidiary’s net income by 9%.

The CTA of $63,550 in this simplified example can be broken down into two pieces:

Net assets at BOY *(FX at EOY – FX at BOY) = 56,000,000FC * (0.0099 – 0.0088) = $61,600

Net income * (FX at EOY – FX at w/AVG) = 6,500,000FC *(0.0099 – 0.0096) = $1,950

The specific effects of translation are often addressed in the Management section of the Annual Report or in the notes to the financial statements.

CURRENCY TRANSLATION HEDGING

Accounting risks may be hedged. One way that companies may hedge their net investment in a subsidiary is to take out a loan denominated in the foreign currency. If companies choose to hedge this type of risk, the change in the value of the hedge is reported along with the CTA in OCI. Exhibit 5 demonstrates the situation where the parent company took out a foreign currency denominated loan at the date of acquisition in an amount equal to its original investment in the subsidiary. The loan amount is converted into U.S. dollars at the date of the transaction, and it is then adjusted under FASB Statement no. 133, Accounting for Derivative Instruments and Hedging Activities. on the parent’s books at the ending balance sheet rate.

Since the U.S. dollar has strengthened, the amount of U.S. dollars required to pay off the debt has decreased by $61,600. This decrease does not offset all of the CTA since there is an effect on CTA since net income is translated at the weighted average exchange rate.

Hedging is a complex topic, and only one basic way to hedge is demonstrated. Some firms experience natural hedging because of the distribution of their foreign currency denominated assets and liabilities. It is possible for parent companies to hedge with intercompany debt as long as the debt qualifies under the hedging rules. Others choose to enter into instruments such as the following:

Foreign exchange forward contracts

Foreign exchange option contracts

Foreign exchange swaps

Unfortunately, FX rate changes cannot always be anticipated and hedging has risks and costs. One of the risks can be observed by typing in 56,000,000 in the loan payable cell (H19) in Exhibit 4 and changing the Date of Loan FX rate (B23) to 0.0088 to match the historical FX rate at the date of the loan. Since the U.S. dollar weakened, the company’s CTA gain of $63,550 is reduced by $61,600, and the company must use more U.S. dollars to repay the foreign currency denominated loan. This can be contrasted with the Exhibit 5 example, where the company benefited from the reduced cost in U.S. dollars to repay the loan as well as recognizing the hedge in OCI that helped offset the CTA loss. 

Relevant GAAP

Statement no. 161, Disclosures about Derivative Instruments and Hedging Activities—an amendment of FASB Statement No. 133

Statement no. 159, The Fair Value Option for Financial Assets and Financial Liabilities— Including an amendment of FASB Statement No. 115

Statement no. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities

Statement no. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities—an amendment of FASB Statement No. 133

Statement no. 137, Accounting for Derivative Instruments and Hedging Activities—Deferral of the Effective Date of FASB Statement No. 133—an amendment of FASB Statement No. 133

Statement no. 133, Accounting for Derivative Instruments and Hedging Activities

Statement no. 130, Reporting Comprehensive Income

Statement no. 52, Foreign Currency Translation

Comparison to IFRS

Currency translation adjustments also appear on financial statements prepared under IFRS. The treatment of currency translation is similar but not identical between IFRS and U.S. GAAP. Information on presentation in the financial statements may be obtained from sources such as Deloitte’s IAS Plus guide on IFRS model financial statements at www.iasplus.com/fs/2007modelfs.pdf.