Multinational Operations Analysis

  1. INTRODUCTION

A company with multinational operations has unique accounting issues which arise from business transactions conducted in multiple currencies.  As the economy becomes more globally integrated, more and more companies transact in foreign jurisdictions, either directly or through a foreign operating subsidiary.  Companies, however, must report their consolidated financial statements in a single currency and so must deal with the currency translations in a systematic manner.  The current U.S. GAAP and IFRS rules for currency translations are nearly identical, so I will not provide a separate section for IFRS as I have in prior articles[1].

The currency a company uses in the preparation of its financial statements is known as the reporting currency (also called the presentation currency).  Another important concept in translation accounting is the functional currency which is the currency of the jurisdiction in which an entity primarily operates.

  1. ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS

Companies may directly transact (meaning not through a foreign operating subsidiary) in a foreign currency.

For example, suppose company A is a U.S. company which purchases inventory from company B, which is a Mexican company.  The inventory is purchased for 18,000 pesos, and company B gives company A 45 days to settle the transaction.  The exchange rate at the time of the transaction 18 pesos per 1 U.S. dollar.  At the time of the transaction, company A (which reports in U.S. dollars) would recognize an increase in inventory with a corresponding payable for $1,000[2].  In 45 days, company A must submit payment on the payable based on the exchange rate at that time.  The exchange rate is now 17 pesos per 1 dollar (peso strengthened relative to the dollar).  At this rate, the $1,000 payable converts to 17,000 pesos or 1,000 pesos short of the number of pesos company A must pay company B.  The number of additional dollars which company A must pay is 1,000 / 17 = 58.82.  Company A would report this increase in the liability due to the change in exchange rates as a translation loss in the income statement.

In the above example, company A’s payable (to company B) is referred to as a monetary liability, because the settlement of the liability will occur in a specified currency.  Likewise, company B’s receivable (from company A) is referred to as a monetary asset, since the benefit will be received in a specified currency.  For monetary assets and liabilities, a company would record the transaction at the time the transaction occurs.  At the financial statement date, a company would recognize the gain or loss on the monetary assets or liabilities based on the exchange rate on the financial reporting date, regardless of if a gain or loss is realized.  A company recognizes this gain or loss in the income statement, generally as part of normal operations.

A company may also have nonmonetary assets, whose value is not derived from a right to receive cash in a specified currency.  Examples of nonmonetary assets are inventory, and property, plant, and equipment.  For nonmonetary assets, a company only records the value in the functional currency at the time of the transaction.  A company does not revalue nonmonetary assets on subsequent dates.

  1. ACCOUNTING FOR FOREIGN SUBSIDIARIES

Most companies operate in foreign countries through a subsidiary based in that country.  These subsidiaries will keep independent accounting records which will then be consolidated with the parent.  However, when the functional currency for these operations is different from the presentation currency of the parent company, the parent company must translate the financials of the subsidiary to the presentation currency.  Current accounting guidance provides for two methods: the temporal method or the currency rate method.  The method a company must use depends on the extent to which the subsidiary is independent of the parent[3].

3.1.  The Temporal Method

The temporal method is used when the subsidiary is considered an extension of the parent rather than a freestanding entity.  Under this method, the parent revalues monetary assets and liabilities at the exchange rate on the financial reporting date, but nonmonetary assets are carried at their historical exchange rate and not revalued on subsequent reporting dates.  Under the temporal method, the translation gains or losses on monetary assets are reported in the income statement.

With the temporal method, the subsidiary’s functional currency is the same as the parent’s.  The temporal method treats the operations of the subsidiary as a series of foreign currency transactions (as if the parent had engaged in the transactions directly).  Generally, revenue and expense items are recognized using the exchange rate at the transaction date, or the weighted-average exchange rates over the reporting period.  However, a revenue or expense item arising from a nonmonetary transaction (such as cost of goods sold, since inventory is a nonmonetary asset), will be a function of the historical rate.

3.2.  The Current Rate Method

The current rate method is used when the foreign subsidiary has independent operations and is considered a freestanding entity.  The subsidiary’s functional currency is independent of the parent’s functional currency.  Under the current rate method, all assets and liabilities are translated at the exchange rate on the financial reporting date.

The current rate method requires all revenue and expense items be translated at the exchange rate at the time of transaction.  The weighted average exchange rate for the period can be used for most transactions.  However, isolated material transactions must be translated at the rate on the transaction date.

Under the current rate method, translation gains or losses are not included in the income statement, but rather recognized in shareholder’s equity as part of other comprehensive income.

 

SOURCES

Revsine, Lawrence, Daniel W. Collins, W. Bruce Johnson, H. Fred Mittelstaedt, Leonard C. Soffer. Financial Reporting & Analysis, 6th ed.  New York:  McGraw-Hill, 2015.

Robinson, Thomas R., Elaine Henry, Wendy L. Pirie, and Michael A. Broihahn.  International Financial Statement Analysis, 3rd ed.  Hoboken: Wiley, 2015.

 

[1] Current guidance for foreign currency translations are found in ASC Topic 830 (U.S. GAAP) and IAS 21 (IFRS)

[2] At this exchange rate, each dollar “buys” 18 pesos.  Thus 18,000 pesos will be 1,000 dollars.  Likewise, each peso “buys” 1/18 = .056 dollars.

[3] Companies operating in highly inflationary economies are required to use the temporal method, regardless of other considerations.

 

About the Author:

Matthew DePaola is a long-time practitioner of the deep value investing approach. He cofounded Tortuga Capital after having concluded that few institutional money managers follow a true value investing approach. Matthew has broad experience in business finance and asset valuation, and has engineered the leveraged purchase and recapitalization of several small businesses. Matthew has also spent several years as a financial analyst in the residential real estate development field. He earned his MBA from the University of Florida’s Hough Graduate School of Business and holds a BS in Finance from Florida Gulf Coast University.

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