Multinationals Operations - How to translate and report financials of a subsidiary to it's parent

CFA Level 2 – Financial Reporting & Analysis; Study Session 6, Reading 25 in 2011 textbook/Reading 23 in 2010 textbook.

This is okay material… interesting but very mechanical and process oriented

Terminology & Formulae

1. I/S = Income Statement, B/S = Balance Sheet, C/F = Statement of Cash Flows
2. R/E = Retained Earnings, SH Equity = Stockholders/Shareholders Equity,
3. FX = Foreign Exchange, LC = Local Currency, FC = Foreign Currency
4. COGS = Beg. Inventory + Purchases – Ending Inventory
5. Opening R/E + Net Income (plug) – Dividends = Closing R/E or
6. Net Income (plug) = Closing R/E + Dividends – Opening R/E

Methods of FX Translation

• Functional Currency = Reporting Currency, use Temporal/Remeasurement Method to Convert Local Currency to Reporting Currency
  • subsidiary is well integrated with the parent company
• Functional Currency ≠ Reporting Currency, use Translation/All Current Rate Method to Convert Local/Functional Currency to Reporting Currency
  • subsidiary is relatively independent of the parent company

Temporal Method

These are the steps for converting subsidiary balance sheet from local currency to reporting currency

A. Steps to convert Balance Sheet

1. Convert monetary assets (cash & accounts receivables) at current rate, inventories at provided rate or historical rate and PP&E at historical rate to get Total Assets
2. Convert monetary liabilities (accounts payable & debt) at current rate & common stock at historical rate
3. Use law of Balance Sheet to calculate ending Retained Earnings as:
   • Retained Earnings = Assets – Liabilities – Common Stock

B: Reconciliation of Retained Earnings (R/E) to calculate Net Income

Calculate Net Income using formula 6 above:

Net Income = Closing R/E

+ Dividends

– Opening R/E

If there is no FX gain/loss, then the above Net Income figure will match the Net Income on the I/S as calculated below. However, if there is an FX gain/loss, then the two won’t match and the above Net Income figure will be used to calculated a ‘plug’ figure which will be the FX gain/loss to ‘balance’ the I/S

C: Steps to convert Income Statement

1. Convert everything except at COGS & depreciation at current rate
2. Convert depreciation at historical rate
3. Calculate COGS with mixed rate (see formula 4 above):
   • COGS = Beg. Inventory (historic rate)  + Purchases (average rate) – Ending Inventory (current rate)
4. Plug Net Income from Step 4 above and calculate FX Gain/Loss

All Current Method

Apply above steps in reverse order… literally

1. Calculate Net Income from Income Statement, all items at average rate
2. Calculate ending Retained Earnings using formula 5 above
   • Closing R/E = Opening R/E (historic rate) + Net Income (from step 1) – Dividends (historic rate)
3. Convert all B/S assets & liabilities at current rate and common stock at historical rate
4. Use Closing R/E from step 2 to force the B/S to balance (A = L + E) by including FX gain/loss as Cumulative Translation Adjustment (CTA) in the shareholder’s equity section
   • CTA = Assets – Liabilities – Retained Earnings

 

Comparison of Temporal vs. All-Current Methods

(Recall that, if EUR is the local/base currency & USD is the foreign currency, then when LC appreciates, USD/EUR increases)

• LC Appreciation (quoted as FC/LC):

End Rate > Average Rate > Beg Rate
1.7 $/€ > 1.6 $/€ > 1.5 $/€

• LC Depreciating (quoted as FC/LC):

End Rate < Average Rate < Beg Rate
1.5 $/€ < 1.6 $/€ < 1.7 $/€

 

Effects of Currency Fluctuation on Transaction Exposure

Effects of Currency Fluctuation on Parent Company’s Balance Sheet

(This is different from the effects of currency fluctuation on transaction exposure above)

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