Multinational companies (MNCs) conduct operations in countries where local financial reporting regulations may be quite different from those governing parent company financial statements. They prepare financial statements that consolidate their domestic and foreign operations that are based on different sets of accounting principles and different measurement units (currencies) with fluctuation exchange rates.

Exchange rates:

• Current exchange rate = the spot rate on the balance sheet date.
• Historical exchange rate = the spot rate on the transaction date.

The general concept of exposure relates to the extent to which a company is affected by fluctuations in exchange rates. U.S. companies frequently have non-US subsidiaries that conduct their operations in the local currency. U.S. companies are required to report their operations in $US. As a result, the balance sheets and income statements of their subsidiaries must be translated into $US. Fluctuations in exchange rates, therefore, can result in unrealized gains (losses).

Effects of Exchange Rate Changes

The impact of changes in local currency sales can be disentangled from changes in the exchange rate. Let HC = Home Currency (presentation currency), LC = Local Currency (functional currency). Assume Foreign Subsidiary is 100% owned.

Parent Co. consolidated HC sales = Subsidiary Co. LC sales x (1 + LC Sales growth) x Exchange Rate (HC/LC)

Example

Assume Subsidiary Co. sales grow at 15% per year. Subsidiary is 100% owned by Parent Co.

• Exchange Rate in Year 1: LC 1 = $1.00
• Exchange Rate in Year 2: LC 1 = $1.30

Year	1	2	Cash Balance
Subsidiary			End Year 2 in LC
Revenues in LC	20,000	23,000	43,000
% change		15%
Exchange Rate	LC 1 = $1.00	LC 1 = $1.00	LC 1 = $1.30
Parent-Consolidated			End Year 2 in $ (HC)
Revenues in $ (HC)	$20,000	$29,900	$55,900
% change		49.5%

The consolidated sales figure for the parent reflects the results of sales growth in local currency and movements in the value of the local currency. It increase by 49.5% over the year as a result of:

• Subsidiary LC Sales increase 15% over the year.
• Value of LC increases 30% over the year.

The additional 24.5% revenue increase is the "flow effect" on the income statement.

The consolidated cash balance figure for the parent reflects the effects of the exchange rate on the parent's consolidated balance sheet.

• The 20,000 (LC), which was equivalent to $20,000 in year 1, now is worth $26,000 in year 2. This is called the "holding game/loss effects".

The total translation gain or loss measured in dollars (HC) is the sum of the two effects:

Translation gain/loss = flow effect + holding gain/loss effect

Example Summary

• Amount in dollars if we assume the exchange rate stayed constant: $43,000
• Exchange rate effects:
  • Flow effects: 23,000 x (1.3 - 1) = $6,900.
  • Holding game/loss effects: 20,000 x (1.3 - 1) = $6,000.

• Amount including exchange rate effect: $55,900 (43,000 + 6,900 + 6,000).

Basic Accounting Issues

Accounting for foreign operations raises three basic issues:

Issue 1. Which exchange rate to use for translation?

Should we use the historical rate (the rate at the time the transaction took place) or current rate (the rate at the balance sheet date, or the average rate for the income statement period)? Should we use different rates for different types of transactions?

Issue 2. The definition of exposure to exchange rate changes.

For example, which assets or liabilities should be adjusted for exchange rate changes?

Issue 3. How to treat translation gains / losses?

Even if the local currency data do not change, financial data recorded in the parent currency (after translation) can change as exchange rates change. Should translation gains / losses be recognized immediately or deferred (and possibly amortized)? In practice the reported translation gain / loss depends on two characteristics of the reporting period:

• The exchange rate(s) chosen for translation. (issue 1)
• The transactions selected for translation. (issue 2)

That is, the reported translation gain or loss reflects the impact of changing exchange rates on the parent's "accounting" rather than its "economic" exposure.