LM03 Multinational Operations 2024 Level II Notes

LM03 Multinational Operations

1. Introduction ........................................................................................................................................................ 2
1.1 Foreign Currency Transactions .......................................................................................................... 2
2. Disclosures Related to Foreign Currency Transaction Gains and Losses ................................... 5
3. Translation of Foreign Currency Financial Statements ..................................................................... 5
3.1 Translation Conceptual Issues ............................................................................................................ 5
4. Translation Methods ....................................................................................................................................... 6
5. Illustration of Translation Methods ....................................................................................................... 11
6. Translation Analytical Issues .................................................................................................................... 13
7. Translation in a Hyperinflationary Economy ..................................................................................... 15
8. Using Both Translation Methods ............................................................................................................. 15
8.1 Disclosures Related to Translation Methods .............................................................................. 16
9. Multinational Operations and a Company’s Effective Tax Rate ................................................... 16
10. Additional Disclosures on the Effects of Foreign Currency ........................................................ 17
10.1 Disclosures Related to Sales Growth ........................................................................................... 17
10.2 Disclosures Related to Major Sources of Foreign Exchange Risk .................................... 17
Summary................................................................................................................................................................ 18

This document should be read in conjunction with the corresponding learning module in the 2024
Level II CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are
copyright 2023, CFA Institute. Reproduced and republished with permission from CFA Institute. All
rights reserved.

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of
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LM03 Multinational Operations 2024 Level II Notes

1. Introduction
Many companies engage in transactions outside their national borders. Exporters who will
receive foreign currency in the future carry foreign currency receivables on their books.
Similarly, importers who will pay in foreign currency in future carry foreign currency
payables on their books. As the exchange rate fluctuates over time, the value of the foreign
currency receivables and payables also fluctuates.
Also, companies may have subsidiaries in foreign countries. The subsidiaries usually keep
accounting records in the currency of the country in which they are located. In order to
prepare consolidated financial statements, the parent company is required to translate the
foreign currency financial statements of its subsidiaries into its own currency.
This reading focuses on accounting for these two scenarios: (1) foreign currency
transactions and (2) translation of foreign currency financial statements.
1.1 Foreign Currency Transactions
Before discussing foreign currency transactions, it is important to understand the following
definitions:
Presentation currency: This is the currency in which financial statement amounts are
presented. Generally, it is the currency of the country where the company is located.
Functional currency: This is the currency of the primary economic environment in which
an entity operates.
Foreign currency transaction: This is a transaction in any currency other than the
functional currency of a company.
Two types of foreign currency transactions that result in a foreign currency asset or liability
are:
• Import / Export
• Lending / Borrowing
Foreign Currency Transaction Exposure to Foreign Exchange Risk
Transaction exposure related to imports and exports can be summarized as follows:
Import Purchase: Here the importer is required to pay in foreign currency and the
settlement date falls after the purchase date. The importer is exposed to the risk that the
functional currency may weaken against the foreign currency. This will increase the amount
of the functional currency that he is required to pay. For example, consider a US company
that imports goods from Mexico and is required to pay in Mexican Pesos. The company is
exposed to the risk that the US dollar may weaken against the Mexican Peso.

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LM03 Multinational Operations 2024 Level II Notes

Export Sales: Here the exporter agrees to be paid in foreign currency and the settlement
date falls sometime after the sale date. The exporter is exposed to the risk that the functional
currency may strengthen against the foreign currency. This will decrease the amount of
functional currency that he will receive. For example, consider a US company that exports
goods to the UK and agrees to be paid in pounds. The company is exposed to the risk that the
US dollar may strengthen against the pound.
Both US GAAP and IFRS require the change in the value of foreign currency asset or liability
resulting from foreign currency transaction to be treated as a gain or loss reported on the
income statement.
If the balance sheet date falls between the transaction date and the settlement date, the
foreign currency account receivable / account payable is translated at the exchange rate at
the balance sheet date. The change in the value of account receivable / account payable is
recognized as a foreign currency transaction gain or loss in income. However, these gains
and losses are unrealized at the time they are recognized and might or might not be realized
when the transactions are settled.
Example: Accounting for Foreign Currency Transactions with Settlement before the
Balance Sheet Date
(This is based on Example 1 of the curriculum.)
FinnCo purchases goods from its Mexican supplier on 1 November 20X1; the purchase price
is 100,000 Mexican pesos. Credit terms allow payment in 45 days, and FinnCo makes
payment of 100,000 pesos on 15 December 20X1. FinnCo’s functional and presentation
currency is the euro. Spot exchange rates between the euro (EUR) and Mexican peso (MXN)
are as follows:
1 November 20X1 MXN1 = EUR0.0684
15 December 20X1 MXN1 = EUR0.0703
FinnCo’s fiscal year end is 31 December. How will FinnCo account for this foreign currency
transaction, and what effect will it have on the 20X1 financial statements?
Solution:
Amount that FinnCo could have paid for its inventory on the date of purchase, i.e., 1
November 20X1 = MXN100,000 × EUR0.0684 = EUR6,840
Amount actually paid by the company on 15 December 20X1 = MXN100,000 × EUR0.0703 =
EUR7,030
By deferring payment, the net result is a loss of EUR7,030 – EUR6,840 = EUR190

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LM03 Multinational Operations 2024 Level II Notes

Although the cash outflow to acquire the inventory is EUR7,030, the cost included in the
inventory account is only EUR6,840. The remaining EUR190 is reported as a foreign
exchange loss in net income for 20X1. This is a realized loss.

Example: Accounting for Foreign Currency Transaction with Intervening Balance

Sheet Date
(This is based on Example 2 of the curriculum.)
FinnCo sells goods to a customer in the United Kingdom for £10,000 on 15 November 20X1,
with payment to be received in British pounds on 15 January 20X2. FinnCo’s functional and
presentation currency is the euro. Spot exchange rates between the euro (€) and British
pound (£) are as follows:
15 November 20X1 £1 = €1.460
31 December 20X1 £1 = €1.480
15 January 20X2 £1 = €1.475
FinnCo’s fiscal year end is 31 December. How will FinnCo account for this foreign currency
transaction, and what effect will it have on the 20X1 and 20X2 financial statements?
Solution:
The change in value of the accounts receivable from the date of sale to the balance sheet
date, i.e., from 15th Nov to 31st Dec is recognized as a foreign currency transaction gain or
loss in the 20X1 income statement. So, the company will report a transaction gain of £10,000
× (€1.48 – €1.46) = €200. Note that this is an unrealized gain.
The change in value of the accounts receivable that occurs from the balance sheet date to the
settlement date, i.e., from 31st Dec to 15th Jan is recorded as a foreign currency transaction
gain or loss in the 20X2 income statement. So the company will report a transaction gain of
£10,000 × (€1.475 – €1.480) = -€50 (i.e., a transaction loss of €50).
The total change from the transaction date to the settlement date = £10,000 ×(€1.475 –
€1.460) = €150. This was accounted by showing a gain of €200 in 20X1 and a loss of €50 in
20X2.
Impact of Change in Exchange Rate
Whether a change in exchange rate results in a foreign currency gain or loss depends on:
• The nature of exposure to foreign exchange risk (asset or liability)
• The direction of change in the value of the foreign currency (strengthens or weakens)
Foreign currency
Transaction Type of Exposure Strengths Weakness
Export sale Asset (account receivable) Gain Loss

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LM03 Multinational Operations 2024 Level II Notes

Import purchase Liability (account payable) Loss Gain

Analytical Issues
Both IFRS and US GAAP require FX gains and losses to be reported in net income even if they
have not yet been realized, but neither standard indicates where on the income statement
these should be placed. The two most common placement treatments are:
• As component of other operating income/expense
• As component of non-operating income/expense, in some cases as part of financing
cost
The calculation of profit margins is affected by where the FX gains/losses are reported. As
seen in the previous example – ‘Accounting for Foreign Currency Transaction with
Intervening Balance Sheet Date’, unrealized FX gains/losses on the balance sheet date are
not reflective of the ultimate realized FX gains/losses. The ultimate realized FX gain/loss
may vary due to a change in currency exchange rates.

2. Disclosures Related to Foreign Currency Transaction Gains and Losses

IFRS requires disclosure of “the amount of exchange differences recognized in profit or loss”.
US GAAP requires disclosure of “the aggregate transaction gain or loss included in
determining net income for the period”.
If the amount involved is immaterial, a company may choose not to disclose that transaction
gain/loss.
Companies may use hedging instruments like currency forward contracts and foreign
currency options to minimize FX risk. This must be disclosed.

3. Translation of Foreign Currency Financial Statements

3.1 Translation Conceptual Issues
When a parent company creates its consolidated financial statements, it needs to translate
the foreign currency financial statements of its subsidiaries into its own presentation
currency. There are two methods of translation:
1. All assets and liabilities are translated at the current exchange rate. This is called the
current rate method.
2. Only monetary assets and liabilities are translated at current exchange rate, whereas
the non-monetary assets and liabilities are translated at the historical exchange rate.
This is called the monetary/nonmonetary method or temporal method.
If assets translated at current exchange rates are greater than liabilities translated at current
exchange rates, then the company will have a net asset balance sheet exposure. Conversely, if
liabilities translated at the current exchange rate are greater than the assets translated at

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LM03 Multinational Operations 2024 Level II Notes

current exchange rates then the company will have a net liability balance sheet exposure.
The relationship between exchange rate and balance sheet exposure can be summarized as
follows:
Balance Sheet Foreign currency (FC)
Exposure Strengthens Weakens
Net asset Positive translation adjustment Negative translation adjustment
Net liability Negative translation adjustment Positive translation adjustment

4. Translation Methods
If the foreign subsidiary’s functional currency is different from the parent’s presentation
currency, the current rate method must be used.
If the foreign subsidiary’s functional currency is same as the parent’s presentation currency,
the temporal method must be used.
Exhibit 3 from the curriculum shows the factors that need to be considered in determining
the functional currency of subsidiary.
Exhibit 3 - Factors Considered in Determining the Functional Currency
In accordance with IFRS, the following factors should be considered in determining an
entity’s functional currency:
1. The currency that mainly influences sales prices for goods and services.
2. The currency of the country whose competitive forces and regulations mainly
determine the sales price of its goods and services.
3. The currency that mainly influences labor, material, and other costs of providing
goods and services.
4. The currency in which funds from financing activities are generated.
5. The currency in which receipts from operating activities are usually retained.
Additional factors to consider in determining whether the foreign entity’s functional
currency is the same as the parent’s functional currency are:
6. Whether the activities of the foreign operations are an extension of the parent’s or are
carried out with a significant amount of autonomy.
7. Whether transactions with the parent are a larger or a small proportion of the foreign
entity’s activities.
8. Whether cash flows generated by the foreign operations directly affect the cash flow
of the parent and are available to be remitted to the parent.
9. Whether operating cash flows generated by the foreign operation are sufficient to
service existing and normally expected debt or whether the foreign entity will need
funds from the parent to service its debt.

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LM03 Multinational Operations 2024 Level II Notes

Current Rate Method:

The foreign entity’s foreign currency financial statements are translated into the parent’s
presentation currency using the following procedures:
1. All assets and liabilities are translated at the current exchange rate at the balance
sheet date.
2. Stockholders’ equity accounts are translated at historical exchange rates.
3. Revenues and expenses are translated at the exchange rate that existed when the
transactions took place. For practical reasons, an average exchange rate is often used.
Net translation gain/loss is unrealized and is not shown on the income statement. It is
recorded in equity as part of other comprehensive income.
As indicted in point 1 above, all assets and liabilities are translated at the current exchange
rate. Hence, if the total assets are greater than the total liabilities of the foreign subsidiary,
there will be a net asset balance sheet exposure.
Temporal Method:
The foreign entity’s foreign currency financial statements are translated into the parent’s
presentation currency using the following procedures:
1. Assets and Liabilities
a. Monetary assets and liabilities are translated at the current exchange rate.
b. Non-monetary assets and liabilities measured at historical cost are translated at
historical exchange rates.
c. Non-monetary assets and liabilities measured at current value are translated at
the exchange rate at the date when the current value was determined.
2. Stockholders’ equity accounts are translated at historical exchange rates.
3. Revenue and Expenses
a. Revenues and expenses, other than those expenses related to non-monetary
assets, are translated at the exchange rate that existed when the transactions took
place.
b. Expenses related to non-monetary assets, such as cost of goods sold (inventory),
depreciation (fixed assets), and amortization (intangible assets), are translated at
the exchange rates used to translate the related assets.
Under the temporal method, companies must keep a record of the exchange rates that exist
when non-monetary assets (inventory, prepaid expenses, fixed assets, and intangible assets)
are acquired.
The historical exchange rates used to translate inventory (and cost of goods sold) under the
temporal method will differ depending on the cost flow assumption – LIFO, FIFO or average
cost. In LIFO, ending inventory is translated at older exchange rates. In FIFO, ending

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LM03 Multinational Operations 2024 Level II Notes

inventory is translated at recent exchange rates. In weighted average cost method, the
weighted average exchange rate for the year is used.
The translation adjustment needed to keep the translated balance sheet in balance is
reported as a gain or loss in net income. This is because the foreign entity’s monetary assets
are likely to be converted to the parent’s presentation currency in the near term.
If the exposed assets are greater than the exposed liabilities, then we have a net asset
balance sheet exposure. Conversely, if the exposed assets are less than exposed liabilities,
then we have a net liability balance sheet exposure.
Exhibit 4 provides a good summary of the translation rules.
Exhibit 4 - Rules for the Translation of a Foreign Subsidiary’s Foreign Currency
Financial Statements into the Parent’s Presentation Currency under IFRS and US GAAP
Current Rate Method Temporal Method
Assets
Monetary, such as cash and receivables Current rate Current rate

Non-monetary assets measured at current value (e.g., Current rate Current rate
marketable securities and inventory measured at
market value under the lower of cost or market rule)
Non-monetary assets measured at historical costs, Current rate Historical rates
(e.g., inventory measured at cost under the lower of
cost or market rule; property, plant & equipment; and
intangible assets)
Liabilities
Monetary, such as accounts payable, accrued Current rate Current rate
expenses, long-term debt, and deferred income taxes
Non-monetary liabilities measured at current value Current rate Current rate
Non-monetary liabilities not measured at current Current rate Historical rates
value, such as deferred revenue
Equity
Other than retained earnings Historical rates Historical rates
Retained earnings Beginning balance plus Beginning balance
translated net income less plus translated net
dividends translated at income less
historical rate dividends translated
at historical rate
Revenues Average rate Average rate
Expenses
Most expenses Average rate Average rate
Expenses related to assets translated at historical Average rates Historical rate
exchange rate, such as cost of goods sold,
depreciation, and amortization

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LM03 Multinational Operations 2024 Level II Notes

Treatment of the translation adjustment in the Accumulated as a separate Included as gain or

parent’s consolidated financial statements component of equity loss in net income

Example:
A U.S. company recently acquired a subsidiary in Turkey. A decision needs to be made
related to the inventory cost flow assumption (FIFO, LIFO or weighted average cost) and the
translation method (current rate or temporal). Assume rising prices in Turkey and a
depreciating Turkish lira (TL). Which combination will result in the lowest COGS?
Solution:
Given rising prices, FIFO COGS will be the lowest.
Given a depreciating foreign currency, the current rate method will result in lower COGS.

Example: Foreign Currency Translation in a Highly Inflationary Economy

(This is Example 4 of the curriculum.)
Turkey was one of the few remaining highly inflationary countries at the beginning of the
21st century. Annual inflation rates and selected exchange rates between the Turkish lira
(TL) and US dollar during the 2000–2002 period were as follows:
Date Exchange Rates Year Inflation Rate (%)
01 Jan 2000 TL542,700 = US$1
31 Dec 2000 TL670,800 = US$1 2000 38
31 Dec 2001 TL1,474,525 = US$1 2001 69
31 Dec 2002 TL1,669,000 = US$1 2002 45
Assume that a US-based company established a subsidiary in Turkey on 1 January 2000. The
US parent sent the subsidiary US$1,000 on 1 January 2000 to purchase a piece of land at a
cost of TL542,700,000 (TL542,700/US$ × US$1,000 = TL542,700,000). Assuming no other
assets or liabilities, what are the annual and cumulative translation gains or losses that
would be reported under each of three possible translation approaches?
Solution:
Approach 1: Translate Using the Current Rate Method
The historical cost of the land is translated at the current exchange rate, which results in a
new translated amount at each balance sheet date.
Date Carrying Value Current Translated Annual Cumulative
Exchange Amount in US$ Translation Translation
Rate Gain (Loss) Gain (Loss)
01 Jan 2000 TL542,700,000 542,700 $1,000 N/A N/A
31 Dec 2000 542,700,000 670,800 809 ($191) ($191)
31 Dec 2001 542,700,000 1,474,525 368 (441) (632)
31 Dec 2002 542,700,000 1,669,000 325 (43) (675)
At the end of three years, land that was originally purchased with US$1,000 would be

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LM03 Multinational Operations 2024 Level II Notes

reflected on the parent’s consolidated balance sheet at US$325 (and remember that land is
not a depreciable asset). A cumulative translation loss of US$675 would be reported as a
separate component of stockholders’ equity on 31 December 2002. Because this method
accounts for adjustments in exchange rates but does not account for likely changes in the
local currency values of assets, it does a poor job of accurately reflecting the economic reality
of situations such as the one in our example. That is the major reason this approach is not
acceptable under either IFRS or US GAAP.
Approach 2: Translate Using the Temporal Method (US GAAP ASC 830)
The historical cost of land is translated using the historical exchange rate, which results in
the same translated amount at each balance sheet date.
Date Carrying Value Historical Translated Annual Cumulative
Exchange Amount in Translation Translation
Rate US$ Gain (Loss) Gain (Loss)
01 Jan 2000 TL542,700,000 542,700 $1,000 N/A N/A
31 Dec 2000 542,700,000 542,700 1,000 N/A N/A
31 Dec 2001 542,700,000 542,700 1,000 N/A N/A
31 Dec 2002 542,700,000 542,700 1,000 N/A N/A
Under this approach, land continues to be reported on the parent’s consolidated balance
sheet at its original cost of US$1,000 each year. There is no translation gain or loss related to
balance sheet items translated at historical exchange rates. This approach is required by US
GAAP and ensures that non-monetary assets do not disappear from the translated balance
sheet.
Approach 3: Restate for Inflation/Translate Using Current Exchange Rate (IAS 21)
The historical cost of the land is restated for inflation, and then the inflation-adjusted
historical cost is translated using the current exchange rate.
Date Inflati Restated Current Translated Annual Cumulative
on Carrying Value Exchange Amount in Translation Translation
Rate Rate US$ Gain (Loss) Gain (Loss)
(%)
01 Jan 00 TL542,700,000 542,700 $1,000 N/A N/A
31 Dec 00 38 748,926,000 670,800 1,116 $116 $116
31 Dec 01 69 1,265,684,940 1,474,525 858 (258) (142)
31 Dec 02 45 1,835,243,163 1,669,000 1,100 242 100
Under this approach, land is reported on the parent’s 31 December 2002 consolidated
balance sheet at US$1,100 with a cumulative, unrealized gain of US$100. Although the
cumulative translation gain on 31 December 2002 is unrealized, it could have been realized
if (1) the land had appreciated in TL value by the rate of local inflation, (2) the Turkish
subsidiary sold the land for TL1,835,243,163, and (3) the sale proceeds were converted into
US$1,100 at the current exchange rate on 31 December 2002.

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LM03 Multinational Operations 2024 Level II Notes

This approach is required by IAS 21. It is the approach that, apart from doing an appraisal,
perhaps best represents economic reality, in the sense that it reflects both the likely change
in the local currency value of the land as well as the actual change in the exchange rate.

5. Illustration of Translation Methods

Let’s look at the following example from the curriculum to demonstrate the procedures
required in translation methods.
Example: Interco is a European company that has the euro as its presentation currency. On 1
January 20X1, Interco establishes a wholly owned subsidiary in Canada, Canadaco. In
addition to Interco making an equity investment in Canadaco, a long-term note payable to a
Canadian bank was negotiated to purchase property and equipment. Translate Canadaco’s
financial statements into euro using the current rate and temporal methods.
The subsidary begins operations with the following balance sheet:
Canadaco Balance Sheet, 1 January 20X1
Assets
Cash C$1,500,000
Property and eequipment 3,000,000
C$4,500,000
Liabilites and Equity
Long-term note payable C$3,000,000
Capital stock 1,500,000
C$4,500,000

The company’s income statement and statement of retained earnings for 20X1 and balance
sheet as of 31st December 20X1 are as follows:
Sales C$12,000,000
Cost of sales (9,000,000)
Selling expense (750,000)
Depreciation expense (300,000)
Interest expense (270,000)
Income tax (500,000)
Net income C$180,000
Less Dividends 1 Dec, 20X1 (350,000)
Retained earnings 31 Dec, 20X1 C$830,000

Assets Liabilities and Equity

Cash C$980,000 Accounts payable C$450,000
Accounts receivable 900,000 Total current liabilites 450,000
Inventory 1,200,000 Long-term notes payable 3,000,000
Total current assets C$3,080,000 Total liabilities C$3,450,000
Property and equipment 3,000,000 Capital stock 1,500,000

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 LM03 Multinational Operations 2024 Level II Notes

Less: Accumulated (300,000) Retained earnings $30,000

depreciation
Total C$5,780,000 Total C$5,780,000

The company measures its inventory using FIFO.

The following exchange rate information was gathered for translation purposes.
Date € per C$
1 January 20X1 0.70
Average, 20X1 0.75
Weighted-average rate when inventory was acquired 0.74
1 December 20X1 when dividends were declared 0.78
31 December 20X1 0.80

The following worksheets show Canadaco’s translated financial statements under each of the
two translation methods – Current rate and Temporal method.
Canadaco’s Income Statement and Statement of Retained Earnings, 20X1
Canadaco’s Functional Currency Is: Local Currency (C$) Parent’s Company (€)
Current Rate Temporal
C$ Exch. Rate € Exch. Rate €
Sales 12,000,000 0.75 A 9,000,000 0.75 A 9,000,000
Cost of goods sold (9,000,000) 0.75 A (6,750,000) 0.74 H (6,660,000)
Selling expenses (750,000) 0.75 A (562,500) 0.75 A (562,500)
Depreciation expense (300,000) 0.75 A (225,000) 0.70 H (210,000)
Interest expense (270,000) 0.75 A (202,500) 0.75 A (202,500)
Income tax (500,000) 0.75 A (375,000) 0.75 A (375,000)
Income before trans. Gain (loss) 1,180,000 885,000 990,000
Translation gain (loss) N/A N/A To balance (245,000)
Net income 1,180,000 885,000 745,000
Less: Dividends 12/1/20X1 (350,000) 0.78 H (273,000) 0.78 H (273,000)
Retained earnings 12/31/20X1 830,000 612,000 From B.S 472,000

Note C = Current exchange rate A = average-for-the-year exchange rate H = historical

exchange rate
Canadaco’s Functional Currency Is: Local Currency (C$) Parent’s Company (€)
Current Rate Temporal
C$ Exch. Rate € Exch. Rate €
Assets
Cash 980,000 0.80 C 784,000 0.80 C 784,000
Accounts receivable 900,000 0.80 C 720,00 0.80 C 720,00
Inventory 1,200,000 0.80 C 960,000 0.74 H 888,000
Total current assets 3,080,000 2,464,000 2,392,000
Property and equipment 3,000,000 0.80 C 2,400,000 0.70 H 2,100,000
Less: Accumulated depreciation (300,000) 0.80 C (240,000) 0.70 H (210,000)

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Total Assets 5,780,000 4,624,000 4,282,000

Liabilities and Equity
Accounts payable 450,000 0.80 C 360,000 0.80 C 360,000
Total current liabilities 450,000 360,000 360,000
Long-term notes payable 3,000,000 0.80 C 2,400,000 0.80 C 2,400,000
Total liabilities 3,450,000 2,760,000 2,760,000
Capital stock 1,500,000 0.70 H 1,050,000 0.70 H 1,050,000
Retained earnings 830,000 From I/S 612,000 To balance 472,000
Translation Adjustment N/A To balance 202,000 N/A
Total 5,780,000 4,624,000 4,282,000

Note: With the temporal method, the balance sheet is translated first with 472,000
determined as the retained earnings needed to keep the balance sheet in balance. Hence
(245,000) is a ‘plug’.
Exhibit 5 from the curriculum summarizes the effect of currency exchange rate movement
on financial statements.
Temporal Method, Net Temporal Method Net
Current Rate Method
Monetary Liability Exposure Monetary Asset Exposure
Foreign ↑Revenues ↑Revenues ↑Revenues
currency ↑Assets ↑Assets ↑Assets
strengthens ↑Liabilities ↑Liabilities ↑Liabilities
relative to ↓Net income ↑Net income ↑Net income
parent’s ↓Shareholder’s equity ↑Shareholder’s equity ↑Shareholder’s equity
presentation Translation loss Translation gain Positive translation
currency adjustment

Foreign ↓Revenues ↓Revenues ↓Revenues

currency ↓Assts ↓Assets ↓Assets
weakens ↓Liabilities ↓Liabilities ↓Liabilities
relative to ↑Net income ↓Net income ↓Net income
parent’s ↑Shareholder’s equity ↓Shareholder’s equity ↓Shareholder’s equity
presentation Translation gain Translation loss Negative translation
currency adjustment

6. Translation Analytical Issues

An important point to note is that the impact of different translation methods can be
substantial. To illustrate this, we continue with the Canadaco example. The chart below
summarizes some of the differences of the two methods.
Canadaco’s Functional Currency Is: Local Currency (C$) Parent’s Currency (€)

Translation Method
Item Current Rate (€) Temporal (€) Difference (%)

Sales 900,000 900,000 0.0

Net Income 885,000 745,000 +18.8
Income before translation gain (loss) 885,000 990,000 -10.6
Total assets 4,624,000 4,282,000 +8.0

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 LM03 Multinational Operations 2024 Level II Notes

Total equity 1,864,000 1,522,000 +22.5

In this example, the NI under the current rate method is significantly high. This is because in
the current rate method we do not show the translation loss on the income statement. If we
remove the translation loss of 245,000 from the temporal net income, then we will get a
higher number.
To study the effects of translation, several significant ratios are calculated and presented in
the table below.
Canadaco’s Functional Local Currency Parent’s Currency
Currency Is: (C$) (€)
C$ Current Rate (€) Temporal (€)
Current ratio 6.84 6.84 6.64
Current assets 3,080,000 2,464,000 2,392,000
Current Liabilities 450,000 360,000 360,000
Debt-to-assets ratio 0.52 0.52 0.56
Total debt 3,000,000 2,400,000 2,400,000
Total assets 5,780,000 4,624,000 4,282,000
Debt-to-equity ratio 1.29 1.29 1.58
Total debt 3,000,000 2,400,000 2,400,000
Total equity 2,330,000 1,864,000 1,522,000
Interest coverage 7.22 7.22 7.74
EBIT 1,950,000 1,462,500 1,567,500
Interest payments 270,000 202,500 202,500
Gross profit margin 0.25 0.25 0.26
Gross profit 3,000,000 2,250,000 2,340,000
Sales 12,000,000 9,000,000 9,000,000
Operating profit margin 0.16 0.16 0.17
Operating profit 1,950,000 1,462,500 1,567,500
Sales 12,000,000 9,000,000 9,000,000
Net profit margin 0.10 0.10 0.08
Net income 1,180,000 885,000 745,000
Sales 12,000,000 9,000,000 9,000,000
Receivables turnover 13.33 12.50 12.50
Sales 12,000,000 9,000,000 9,000,000
Accounts receivable 900,000 720,000 720,000
Inventory turnover 7.50 7.03 7.50
Cost of goods sold 9,000,000 6,750,000 6,660,000
Inventory 1,200,000 960,000 888,000
Fixed asset turnover 4.44 4.17 4.76
Sales 12,000,000 9,000,000 9,000,000
Property and equipment (net) 2,700,000 2,160,000 1,890,000
Return on assets 0.20 0.19 0.17
Net income 1,180,000 885,000 745,000
Total assets 5,780,000 4,624,000 4,282,000
Return on equity 0.51 0.47 0.49
Net income 1,180,000 885,000 745,000
Total equity 2,330,000 1,864,000 1,522,000

We can observe that many of the ratios of Canadaco’s Canadian dollar financial statements
are preserved when the current rate method is used for translation. On the other hand, if we

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use the temporal method for translating, then most of these ratios are distorted.
Also note, NI with temporal method is low but EBIT is high because translation loss is not
included in EBIT.

7. Translation in a Hyperinflationary Economy

IFRS and US GAAP differ substantially in their approach to translating the foreign currency
financial statements of a subsidiary in a hyperinflationary economy.
US GAAP requires that the financial statements be translated using the temporal method.
IFRS require financial statements to be first restated for inflation and then inflation adjusted
financial statements be translated at the current exchange rate. See approach 3 in the
example – ‘Foreign Currency Translation in a Highly Inflationary Economy’.
The following procedures should be followed while adjusting the financial statements for
inflation:
• Monetary assets and liabilities are not restated.
• Nonmonetary assets and liabilities are adjusted for inflation.
o Restated costs are determined by applying the change in general price index to
the historical costs.
o If items are carried at revalued amounts (e.g., PP&E), these are restated from
the date of revaluation.
• All components of stockholders’ equity are restated by applying the change in general
price index from the beginning of the period or from the date of contribution to the
balance sheet.
• All income statement items are restated by applying the change in the general price
index from the dates when the items were originally recorded.
• Purchasing power gains/losses that arises from holding monetary assets and
monetary liabilities are included in net income (net monetary assets result in
purchasing power loss; net monetary liabilities result in purchasing power gain).
Requiring the temporal method ensures that companies avoid a “disappearing plant
problem” that exists when the current rate method is used in a country with high inflation. In
a highly inflationary economy, as the local currency loses purchasing power within the
country, it also tends to weaken in value in relation to other currencies. Translating the
historical cost of assets such as land and buildings at progressively weaker exchange rates
causes these assets to slowly disappear from the parent company’s consolidated financial
statements.

8. Using Both Translation Methods

Under both IFRS and US GAAP, a multinational corporation may need to use both the current

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rate and the temporal methods of translation at a single point in time. This situation will
apply when some foreign subsidiaries have a foreign currency as their functional currency
(and therefore are translated using the current rate method) and other foreign subsidiaries
have the parent’s currency as their functional currency (and therefore are translated using
the temporal method).
As a result, a multinational corporation’s consolidated financial statements can reflect
simultaneously both a net translation gain or loss that is included in the determination of net
income (from foreign subsidiaries translated using the temporal method) and a separate
cumulative translation adjustment reported on the balance sheet in stockholders’ equity
(from foreign subsidiaries translated using the current rate method).
8.1 Disclosures Related to Translation Methods
Both IFRS and US GAAP require two types of disclosures related to foreign currency
translation:
1. The amount of exchange differences recognized in net income, and
2. The amount of cumulative translation adjustment classified in a separate component
of equity, along with a reconciliation of the amount of cumulative translation
adjustment at the beginning and end of the period.

9. Multinational Operations and a Company’s Effective Tax Rate

Generally multinational companies have to pay income taxes in the country in which the
profit is earned. Transfer prices (prices charged on intercompany transactions) affect the
allocation of profits between companies.
An entity with operations in multiple countries with different tax rates could aim to set
transfer prices such that a higher portion of its profit is allocated to lower tax rate
jurisdictions. To prevent this, countries have established various laws and practices to
prevent aggressive transfer pricing practices.
Whether and when a company also pays income taxes in its home country depends on the
specific tax regime.
An analyst can obtain information about the tax impact of multinational operations from
companies’ disclosure on effective tax rates.
Refer to Example 10 in the curriculum for the effective tax rate calculations of two
companies – Heineken N.V., a Dutch brewer and Colgate Palmolive, a U.S. consumer products
company. The example demonstrates the effective tax rate for Heineken has gone up because
it expanded in markets with higher tax rates, whereas, the effective tax rate for Colgate
Palmolive has gone down because it expanded in markets with lower tax rates.

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10. Additional Disclosures on the Effects of Foreign Currency

This section discusses how to use multinational company disclosures to better understand
the effects of foreign currency.
10.1 Disclosures Related to Sales Growth
For multinational companies, the sales growth is driven by changes in volume, prices and
exchange rates. Growth in sales from changes in volume and prices is more sustainable
compared to growth due to exchange rate movement. Also, the management has more
control over volume and prices. Companies often disclose this information in the MD&A
section.
Refer to Example 11 in the curriculum for information disclosed by Procter & Gamble. This
company presents ‘organic sales growth’ to show growth achieved due to changes in volume
and prices and removes the impact of FX rates.
10.2 Disclosures Related to Major Sources of Foreign Exchange Risk
Multinational companies disclose major sources of foreign exchange risk. Disclosures about
the effects of currency fluctuations often include sensitivity analyses. For example, a
company might describe the major sources of foreign exchange risk given its countries of
operations and then disclose the profit impact of a given change in exchange rates.
Refer to Exhibit 7 from the curriculum for two excerpts from the 2011 BMW AG annual
report. The first excerpt describes the sources of the company’s currency risks and its
approach to managing those risks. The second excerpt presents the results of the company’s
sensitivity analysis.

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LM03 Multinational Operations 2024 Level II Notes

Summary
LO: Compare and contrast presentation in (reporting) currency, functional currency,
and local currency.
Presentation currency: The currency in which financial statement amounts are presented.
Functional currency: The currency of the primary economic environment in which an entity
operates.
Local currency: The currency of the country where a particular subsidiary is located.
LO: Describe foreign currency transaction exposure, including accounting for and
disclosures about foreign currency transaction gains and losses.
Transaction exposure related to imports and exports can be summarized as follows:
Import purchase: Here the importer is required to pay in foreign currency and the
settlement date falls after the purchase date. The importer is exposed to FX risk that the
functional currency may weaken against the foreign currency. This will increase the amount
the functional currency that the importer is required to pay.
Export sales: Here the exporter agrees to be paid in foreign currency and the settlement date
falls sometime after the sale date. The exporter is exposed to FX risk as the functional
currency may strengthen against the foreign currency. This will decrease the amount of
functional currency that the exporter will receive.
Both US GAAP and IFRS require the change in the value of foreign currency asset or liability
resulting from foreign currency transaction to be treated as a gain or loss reported on the
income statement.
If a balance sheet date falls between the transaction date and the settlement date, the foreign
currency account receivable / account payable is translated at the exchange rate at the
balance sheet date. The change in the value of account receivable / account payable is
recognized as a foreign currency transaction gain or loss in income. However, these gains
and losses are unrealized at the time they are recognized and might or might not be realized
when the transactions are settled.
LO: Analyze how changes in exchange rates affect the translated sales of the
subsidiary and parent company.
To prepare consolidated financial statements, parent companies must translate the foreign
currency financial statements into the parent’s presentation currency.
If during the course of a given year, the foreign currency appreciates as compared to the
presentation currency, the translated amounts will be higher. If the foreign currency
depreciates, the translated amount will be lower.

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LO: Compare the current rate method and the temporal method, evaluate how each
affects the parent company’s balance sheet and income statement, and determine
which method is appropriate in various scenarios.
Current rate method:
If the foreign subsidiary’s functional currency is different from the parent’s presentation
currency, the current rate method must be used. Under this method, the foreign entity’s
foreign currency financial statements are translated into the parent’s presentation currency
using the following procedures:
1. All assets and liabilities are translated at the current exchange rate at the balance
sheet date.
2. Stockholders’ equity accounts are translated at historical exchange rates.
3. Revenues and expenses are translated at the exchange rate that existed when the
transactions took place. (For practical reasons, a rate that approximates the exchange
rates at the dates of the transactions, such as an average exchange rate, may be used.)
Net translation gain/loss is unrealized (will be realized when the entity is sold) and is not
shown on the income statement. Translation adjustment is reflected in equity.
If the total assets are greater than the total liabilities, then we have a net asset balance sheet
exposure.
Temporal method:
If the foreign subsidiary’s functional currency is same as the parent’s presentation currency,
the temporal method must be used. Under this method, the foreign entity’s foreign currency
financial statements are translated into the parent’s presentation currency using the
following procedures:
1. Assets and Liabilities
a. Monetary assets and liabilities are translated at the current exchange rate.
b. Non-monetary assets and liabilities measured at historical cost are translated at
historical exchange rates.
c. Non-monetary assets and liabilities measured at current value are translated at
the exchange rate at the date when the current value was determined.
2. Stockholders’ equity accounts are translated at historical exchange rates.
3. Revenue and Expenses
a. Revenues and expenses, other than those expenses related to non-monetary
assets, are translated at the exchange rate that existed when the transactions took
place.

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LM03 Multinational Operations 2024 Level II Notes

b. Expenses related to non-monetary assets, such as cost of goods sold (inventory),

depreciation (fixed assets), and amortization (intangible assets), are translated at
the exchange rates used to translate the related assets.
LO: Calculate the translation effects and evaluate the translation of a subsidiary’s
balance sheet and income statement into the parent company’s presentation
currency.
Refer to section 3.3 for an example that demonstrates the two translation effects.
LO: Analyze how the current rate method and the temporal method affect financial
statements and ratios.
When current rate method is used for translation, most of the financial statement
relationships and ratios are preserved.
When temporal method is used for translation, most of the financial statement relationships
and ratios are distorted.
LO: Analyze how alternative translation methods for subsidiaries operating in
hyperinflationary economies affect financial statements and ratios.
IFRS and US GAAP differ substantially in their approach to translating the foreign currency
financial statements of a subsidiary in a hyperinflationary economy.
US GAAP requires that the financial statements be translated using the temporal method.
IFRS require financial statements to be first restated for inflation and then inflation adjusted
financial statements be translated at the current exchange rate.
LO: Describe how multinational operations affect a company’s effective tax rate.
Generally multinational companies have to pay income taxes in the country in which the
profit is earned. Transfer prices (prices charged on intercompany transactions) affect the
allocation of profits between companies. An entity with operations in multiple countries
with different tax rates could aim to set transfer prices such that a higher portion of its profit
is allocated to lower tax rate jurisdictions. Thus, multinational operations affect a company’s
effective tax rate.
LO: Explain how changes in the components of sales affect the sustainability of sales
growth.
For a multinational company, sales growth is driven not only by changes in volume and price
but also by changes in the exchange rates. Growth in sales that comes from changes in
volume or price is more sustainable than growth in sales that comes from changes in
exchange rates.

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LM03 Multinational Operations 2024 Level II Notes

LO: Analyze how currency fluctuations potentially affect financial results, given a
company’s countries of operation.
The effect of currency fluctuations on financial results can be studied using sensitivity
analysis. For example, a company might describe the major sources of foreign exchange risk
given its countries of operations and then disclose the profit impact of a given change in
exchange rates. An analyst can use sensitivity analysis disclosures in conjunction with his or
her own forecast of exchange rates when developing forecasts of profit and cash flow.

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