Companies with international operations will have assets and liabilities, income and expenses in foreign currency. However, since the investors of the country of origin and the entire financial community are interested in the value of the state currency (HC), the foreign currency balance sheet account and the income statement must be assigned an HC value. In particular, the financial statements of MNC overseas subsidiaries must be spelled out from local currency to domestic currency before being consolidated with the parent’s financial statements.
If the value of the currency changes, foreign exchange translation gains or losses may occur. Assets and liabilities spelled out at the current exchange rate (post-change) are considered exposed; translatable at the historical exchange rate (before the change) will retain its historical HC value and, accordingly, be considered unexposed.
Translational exposure is simply the difference between an exposed asset and an exposed liability. Controversy among accountants centers on where assets and liabilities are exposed and when the exchange rate difference gains and losses obtained by accounting should be recognized (reported in the income statement). An important point to be aware of in putting this controversy in perspective is that the gains or losses are accounting—that is, there is no cash flow involved.
Four main translation methods are available: current/non-current method, monetary/nonmoneter method, temporal method, and current rate method. In practice there are also variations of each method.
Current/Non-Current Method
At one time, the current/non-current method, whose basic theoretical foundation was maturity, was used by almost all U.S. multinationals. With this method, all current assets and liabilities of foreign subsidiaries are spelled out into domestic currency at the current rate. Any non-current asset or liability is spelled out at its historical rate—that is, at the rate in effect at the time the asset was acquired or the liability occurred. Therefore, foreign subsidiaries with positive local currency working capital will incur translational losses (profits) from devaluation (revaluation) by the current/non-current method, and vice versa if the working capital is negative.
The income statement is spelled out at the average rate of the period, except for the heading of income and expenses related to non-current assets or liabilities. The last posts, such as depreciation expense, are translatable at the same rate as the balance sheet posts in question. Thus, it is possible to see different headings of income and expenses of the same maturity transliterated at different rates.
Monetary/Nonmoneter Method
Monetary/nonmoneter methods distinguish between monetary assets and liabilities—that is, posts representing a claim to receive, or an obligation to pay, a fixed number of foreign currency units—and nonmoneter, or physical, assets and liabilities. Monetary items (for example, cash, payables and receivables, and long-term debts) are spelled out at the current rate; Nonmoneter items (for example, inventories, fixed assets and long-term investments) are spelled out at historical rates.
The posts of the income statement are spelled out at the average rate during the period, except for the posts of income and expenses related to nonmonetary assets and liabilities. The last posts, especially depreciation expense and cost of goods sold, are transliterated at the same level as the balance sheet posts in question. As a result, cost of goods sold can be translated at a different rate than the one used to translate sales.
Source:
- Shapiro, A. C., & Hanouna, P. (2019).Multinational financial management. John Wiley & Sons.
- Kuo, W. (2019). International financial management.
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