Question

When incorporating, it is important to consider whether or not the company’s business deals internationally. 1. Summarize the impact of foreign exchange rates on the company’s financial statements. What risks do foreign exchange rates pose? 2. What are the two methods used to translate financial statements and how does the functional currency play a role in determining which method is used? 3. Compose a hypothetical example to demonstrate the translation process using the two methods. Ensure all information is entered accurately.

Answer 1

1)Companies with international deals should translate the transactions from their functional currency to a single reporting currency as required by the accounting guidelines. Significant shifts in currency exchangerates can have a dramatic effect on the company’s revenue and profit trends that means fluctuation in exchange rates can affect financial statement trends.The foreign exchange gain or loss will reflect as an income or expenses in the income statement and the same will be correspondingly reflected in balance sheet as well.However the gain or loss from the exchange rate can have either a positive or negative effect depending on which currency the transaction is designated in and which direction the exchange rate moves. Foreign currency risk or Transaction risk is the risk associated with Foreign Exchange Rate.

2) Current rate method (or closingrate) and the temporal method are the two methods used to translate financial statements .Primary currency of a foreign entity’s operating environment is its functional currency. The functional currency orientation results in the following rule:

Functional currency Translation method Translation adjustment US DOLLAR Temporal method Gain(loss) in Net income Seperate component of Foreign currency Current rate method Other Comprehensive Income

3)Suppose P&G has a subsidiary in Thailad. Its subsidiary in Thailand reported the following:

(All in the local currency i.e. Thai baht): Current assets = 5,000,000. Fixed assets = 35,000,000. Total assets = 40,000,000. Current liabilities = 3,000,000. Long term debt = 12,000,000. Equity = 25,000,000. Total liability and equity = 40,000,000.

Now the current exchange rate will translate all the assets and liabilities (which are in Thai baht) to USD. The current exchange rate will be used. Current rate = 1 baht = 0.028 USD. The equity is translated using the rate applicable on the date of issuance. Suppose the rate on issuance date was 1 baht = 0.025 USD. Any balance will be shown as cumulative translation djustment (CTA).

So, current assets in USD will be = 5,000,000*0.028 = $140,000. Fixed assets = 35,000,000*0.028 = $980,000. Total assets = $1,120,000. Current liability =  3,000,000*0.028 = $84,000. Long term debt = 12,000,000*0.028 = $336,000. Equity = 25,000,000*0.025 = $625,000. Total liability and equity = $1,045,000

Difference = 1,120,000 - 1,045,000 = $75,000 (assets - liabilities). This will be shown as CTA in the balance sheet as the adjusting amount.

Assets			Liabilities
Current assets	140,000.00		Current liabilities	84,000.00
Fixed assets	980,000.00		Long term debt	336,000.00
			Equity	625,000.00
			CTA	75,000.00
Total assets	1,120,000.00		Total liability and equity	1,120,000.00

Temporal rate translation method  uses exchange rates based on the time assets and liabilities are acquired or incurred.

Current assets are translated using current exchange rate, fixed assets are translated using historical exchange rate, equity is translated using the rate at time of issuance.

Assets	in baht	Relevant rate	Description	Liabilities	in baht	Relevant rate	Description
Current assets	5,000,000.00	0.028	Current rate	Current liabilities	3,000,000.00	0.028	Current rate
Fixed assets	35,000,000.00	0.026	Historical rate	Long term debt	12,000,000.00	0.027	Historical rate
				Equity	25,000,000.00	0.025	Rate on date of issuance
Total assets	40,000,000.00			Total liability and equity	40,000,000.00

Using the given rates, conversions are done to obtain the numbers in USD:

Assets	in USD	Liabilities	in USD
Current assets	140,000.00	Current liabilities	84,000.00
Fixed assets	910,000.00	Long term debt	324,000.00
		Equity	625,000.00
		CTA	17,000.00
Total assets	1,050,000.00		1,050,000.00