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FASB Statement No. 52 and Its Implications for Financial Statement Analysis
Author（s）： Thomas I. Selling and George H. Sorter
Source: Financial Analysts Journal, Vol. 39, No. 3 （May - Jun., 1983）， pp. 64-69
Published by: CFA Institute
The FinancialAccounting StandardsBoard'sStatementNo. 52 on foreign currencytranslationintroduces the concept of the “functional currency” to determine therecognition of foreign currencytranslationgains, losses and adjustments. According to the criteriaset forth in the statement, the functional currencyin the case ofa foreign subsidiarythat is an independent, cash-generatingcenterwill be the localcurrency;in most other cases, the functional currency will be the dollar.
If the functionalcurrencyis the dollar,the translationprocess under StatementNo. 52 is essentially the same as under the old Statement No. 8: The “temporal”
method is used, and gains or losses resulting from translationare included in income for the period. If the functionalcurrencyis the local currency,then the “all current” method is applied: All assets and liabilitiesare translatedat the currentrate; translationgains and losses are not recognized in the income statement, butareincluded in owners' equity as “translationadjustments”;and income statementitems are translated at the rate that prevailed when the revenue or expense wasrecognized （in general, the weighted average exchange rate for the year）。
When the local currencyis the functionalcurrency,adoption of StatementNo.
52 will lead to smallerfluctuationsin operating income and much smallerfluctuations in net incomein responseto changesin exchangerate.Thisresultshouldpleasemany critics of Statement No. 8. On the other hand, Statement No. 52 raises itsown problems. In particular,the translation at current exchange rates of localcurrency-denominatedhistoricalcost items may be considered to result in a figurethatis neithera meaningfuldescriptionof past cash flows nor a descriptionof futureflows. The statement furtherconfounds interpretationof the effects of translationby requiringthat these meaningless balancesbe consolidated with the parentcompany's accounts.
IN DECEMBER 1981,the Financial Accounting Standards Board adopted （by a one-votemargin）StatementNo. 52 dealing with foreign currencies. This new pronouncementsupersedes Statement No. 8, which was undoubtedly the mostcontroversiaalnd contentiousstatementever issued by the FASB.Its criticsobjected most stronglyto the requirementsthat alltranslationgains and losses be reflected in current income and that foreign currencyitems be translatedaccordingto the “temporalmethod,”
which resulted in the translation of differentitems at different rates.
Problems with Statement No.8.
All income statement events and balance sheetitems arequantifiedeitherin termsof past transactions （e.g., inventory, plant and equipment,common stock, depreciation,cost of goods sold）or in terms of future transactions （e.g., cash,receivables,short-termpayables）。Underthe temporal method of translating foreign financial statements, items quantified in terms of pastflows aretranslatedusing the exchangerate thatexisted when the quantifying transaction occurred, whereas items quantified in terms offuture flows are translated at the currentrate.
Thismethod preservesexistingaccountinglogic,which argues that, if it is proper to quantify anitem in terms of a past flow, it would also seemappropriateto quantifythatitem atthe exchangeratethat existed when the past flow took place.
It is hard to see how changes in exchange ratescould affectsuch past flows. Similarly,it wouldseem logicalto translateitemsquantifiedin termsof futureflows in terms of the currentexchangerate.
However, StatementNo. 8 combinedthe temporal method with the immediaterecognitioninincome of translationgains and losses, and thisresulted in reported earnings fluctuationsthat,accordingto critics of the statement, were unrelated to economicgains and losses accruing tocompanies owning foreign subsidiaries.In fact,under this standard, economic gains often resulted in accountinglosses. Forexample,the useof the temporalmethod meant that economically relateditems such as inventory and accountspayablewere translatedat differentrates（historical and current,respectively）， so that a translation gainorloss resultedeven thoughthese itemsin a sense serve as economic hedges for eachother.
Translationresultsin an accountinggainorlossfor the period when exchange rate fluctuationsduring the period alterthe net balance of assetand liability accounts. Only those assets andliabilitiestranslatedat the currentratewill be affectedby suchfluctuations.UnderStatementNo.8, allliabilitieswere translatedatthe currentrate,whereas major asset roups financed by thoseliabilities（suchas inventory and plant and equipment） were translatedat the historical rate.Mostcompanies'foreignsubsidiarieswere thereforeina net translationliabilityposition,so thatdevaluation of the dollarresulted in translationlosses.
The rationalizationwas that more dollarswouldbe needed to pay off the foreign debt.
Criticspointedout thatthisconceptof exposurepresented a limited, and often distorted,view offoreign operationgains and losses. The translation loss would never be realized, for example,if foreignoperationsgeneratedsufficientforeigncash to retirethe debt. Indeed, a U.S. parentactuallybenefits from devaluation,since pidendpayments by the foreign subsidiaryyield largerdollaramounts. The criticspointed out that accounting gains and losses should not be recognized if there areno economic gains and losses.
Statement No. 52 was designed to overcomeboth major objections to Statement No. 8. Whether the cure is worse than the disease remains to be seen.
How Statement No. 52 Works.
StatementNo. 52 provides a set of criteriathat,when evaluated by management, allows determinationof the translationmethod to be used the temporal method or the “all-current” method. Underthe all-currentmethod, allassetsand liabilitiesare translatedat the currentrate.
The statementalsospecifiesthat,if the all-currentmethodis used, translationgainsandlosses mustbe excluded from income and accumulatedin anew component of owners' equity, and all income statementevents must be translatedat theratethatprevailedwhen the revenue or expensewas recognized. This rate can be approximatedby using the weighted averageexchangerateforthe year.
StatementNo. 52 introducesthe conceptof the“functionalcurrency”to determinethe recognition of foreigncurrencytranslationgains, lossesand adjustments. In most cases, the functionalcurrencywill be either the local currencyof theforeign subsidiary or the dollar. Managementmust designate a functional currency for eachforeign subsidiary, using the criteriasuggestedin Statement No. 52. If the functionalcurrencyis determinedto be the dollar, then the translation process is essentially the same as underStatementNo. 8-the temporalmethod is used,and gains orlosses resulting from translationareincluded in income for the period. If the functional currencyis the localcurrency,then the allcurrent method is applied; translationgains orlosses are not recognized in the income statement, but are included in owners' equity as “translation adjustments.”
In general, the criteria for choosing the functional currency establish whether or not theforeign subsidiary is an independent, cashgenerating center; if it is, then the local currencyis considered the functional currency. In comingto this determination, the following factors mustbe weighed:
（1） the degree to which cash flows related to theforeign entity's inpidual assets and liabilitiesarein the foreigncurrencyor affectthe parent'scash flows;
（2） the responsiveness of sales pricesof the foreignentity'sproductson a short-termbasisto changesin exchange rates;
（3） the existence of an active local marketfor theforeignentity'sproduct,even though theremaybe significantamounts of exports;
（4） whether labor,materialsand othercosts for theforeignentity's productsare incurredlocallyorelsewhere;
（5） the denominationof debtandthe extentto whichfunds generated by the foreign entity's operations are sufficientto service existing and normally expected debt obligations;and
（6） the volumeof intercompanytransactionsandtheextentof the interrelationshipbetweenthe operations of the foreign entity and the parentcompany.
Statement No. 52 requires, however, that thedollar be used as the functional currency of anysubsidiary operating in a “hyperinflationary” economy （i.e., where the cumulative three-yearinflation rate exceeds 100 per cent）。
A foreign subsidiary's functional currency mayturn out to be a foreign currency other than thelocal currency or the dollar. In this case, the subsidiary's statements must first be translated fromthe local currency into the functional currencybefore they are translated into dollars. In all cases,however, a few simple rules for translationmethod and income statement recognition oftranslation gains or losses can be applied.
（1） When translatinginto the functionalcurrency,use the temporalmethod.
（2） When translatingfromthe functionalcurrency,use the all-currentmethod.
（3） When translatinginto the functionalcurrency,gains and losses areincludedas partof income.
（4） When translatingfromthe functionalcurrency,show changesas partof stockholders'equitybutnot as part of income.
Comparing the Statements.
The differences between the old and new pro.
nouncementsin termsof theireffectson reportedearningsandfinancialpositionarehighlightedbyconsideringan examplewherethe functionalcurrency of the foreignsubsidiaryis identifiedas thelocal currency.We'll call this local currency theGrabule,and assume for simplicity,and with noloss in generality,that the exchangerateis fixedat $1:?1 until 111/Xl,the beginning of the current accounting period, and that the dollardevalues during 19X1so that the exchange ratebecomes $2:G1 by the end of the period,121311X1.
Balance Sheet Results.
Table I illustrates the differences in balancesheet amounts. Only monetaryitems （cash andpayables,in this case） aretranslatedat the samerate under both statements. Statement No. 52calls for the translationof inventory and equipment at the currentrate,whereas StatementNo.8 requires historical rates. Because the cost ofgoods sold equals the beginning inventorybalance（see TableII），the ending inventoryvaluemust consist of 100per cent of the period's purchases. The appropriatehistoricalratefor inventories valued using FIFOis the average rate forthe period （1.5）， assuming the purchases tookplace at a constant rate over the period. The retained earnings balances under both methodsare, for now, “plugs,” hence we will ignore thetranslation adjustment disclosure required byStatement No. 52.
The applicationof StatementNo. 52 will resultin higher （lower） values for assets （hence networth） if the dollar devalues （revalues）againsta foreign currency.The effect of this change onconventional financial ratios may cause somefirms to be in technicaldefault of certaininden-tureprovisions,whereasotherfirmsmayactuallyshow an improvementin their“paper”financialpositions. The pidend-paying abilityof a firmmay or may not be affected, depending uponwhether applicablestate law considers the newstockholders' equity account available forpidends.
The balancesheet （and income） numberspro-vided under Statement No. 52 may be difficultto interpret.Under StatementNo. 8, a historicalcost in Grabuleswould be multipliedby the exchange rateprevailingat the time of the transaction to yield a dollar-denominatedamount thatis easy to interpret:It is simply a description ofthe actualcash flow thatoccurredin orderto acquirethe asset, translated at the dollarequivalent of that time period. The same local-currency-denominated historical costmultiplied by the current exchangerate（perStatementNo. 52） yields a number that defies interpretation:It is not a meaningfuldescriptionof past cash flows, norisit a descriptionof futureflows. Becausechangesin exchange rates are criticallyaffectedby comparative changes in prices,fluctuationsin the exchange rateprobablyreflectsome change in theunderlyingstructureof assetprices.This,in turn,probably means that the mix and quantity ofassets held has changed.
StatementNo. 52 further confoundsinterpretation of the effectsof translationby requiringthatthese meaninglessbalancesbe consolidatedwiththe accountsof the parentcompany. The resultis an aggregation of parent company figuresrepresenting a history of the cash flows with anumber that is neither fish nor fowl.
Income Statement Results.
Table II shows how reported net incomechanges significantly under Statement No. 52because of the deferralof translationgains andlosses, as well as otherfactors.Under StatementNo. 8, cost of goods sold （FIFO）and deprecia-tion are translated at historical rates, whereassales and other items are translatedat the cur-rentrate.Theleverageprovidedby the fixedele-ment of expense createssubstantialvariationinincome-200 per cent in our example, comparedwith the actualaverageforeigncurrencyfluctua-tion for the period of 50 per cent.
Under Statement No. 52, on the other hand,all income statement items, including deprecia-tion and cost of goods sold, aretranslatedat theaverage currentrate. The fluctuationin incomedue to translationis thus 50 per cent. The fluc-tuationof operatingincomedue to changesin the exchange rate will always be less under State-ment No. 52 than under Statement No. 8.
As TableIIIindicates, the total translationad-justment under StatementNo. 52 is significant-ly largerthan and in the opposite directionof thetranslationgain or loss under StatementNo. 8.
The fluctuation in income is significantly lessunder the new statementbecause （1）fluctuationof operating income is reduced （as describedabove）and （2）translationgainsandlosses arenotreflected in income.
We can predictthat the adoptionof StatementNo. 52 will lead to smaller fluctuations inoperatingincome and much smallerfluctuationsin net incomein responseto changesin exchangerates,butmuchgreaterchangesin equitybecauseof “translationadjustments.”Allwho use finan-cialratiosandincomeandequitynumbersshouldbe aware of these effects of Statement No. 52.
Systematic Ratio Effects.
Table IV summarizes how significant financialratioswill be affectedby the applicationof State-ment No. 52, given devaluationsor revaluationsof the dollar.Itassumes use of a FIFOinventorycost flow; LIFO, which is not prevalent forforeign subsidiaries,would resultin smallerdif-ferences between Statement No. 52 and State-ment No. 8 results.
Nearly all the ratios are affectedin some wayby the change in accountingprinciples, but thedirectionof the change cannot always be deter-mined. Forexample,with devaluation,operatingincomeusing the all-currenmtethodof StatementNo. 52 will be smaller than operating income under StatementNo. 8 because all the expensestranslated at the current rate are larger. （Ifrevaluation occurs, the opposite result will beproduced.） Net income differences, includingtranslationgains and losses, cannotbe predicted,however. Although operating income underStatement No. 52 is smaller, a translationlosswould probablyresultunder StatementNo. 8 if,as is likely, the firmis in a net translationliabili-ty position. Thechangein net income, therefore,will depend upon the relativemagnitude of thedecrease in operating income under StatementNo. 52 comparedwith the translationloss underStatement No. 8.
All assetcategoriesand net worthwillbe largerunder StatementNo. 52, which provides for thetranslationof all assets at the currentdevaluedrate,thanunderStatementNo. 8, whichrequiredthatonly some of these assetsbe translatedatthecurrent rate. All liability and debt items aretranslated at the same rate under bothstatements, hence there will be no change inliabilitiesand debt. The translationof sales willalso be unaffected by the change in accountingprinciples.
Theimpacton cashflow will dependupon howcash flows are measured. Obviously, cashreceiptsminus cash disbursementswill be unaf-fected, since the cash balanceis translatedat thecurrentrateunderbothfinancialaccountingstan-dards.However, cashflow is typicallycalculatedin terms of income plus addback of non-cashexpenses.
If operating income is used as the startingpoint, then the derived cash flow under State-ment No. 52 will be smaller. Operatingincomeunder this statement will be smaller becausedepreciationand cost of goods sold are greaterthan they would be under Statement No. 8.
Although the decrease due to depreciationwillbe exactlyoffset by the increasein the deprecia-tion addback,cost of goods sold is not an add-backitem;the decreasein operatingincome dueto cost of goods sold will thereforecarryover asa decrease in the calculatedcash flow number.
Ifnet income is used as the startingpoint for thecash flow calculation, the impact of StatementNo. 52will not be predictablebecauseof the con-flictingeffectson net incomeof operatingincomeand the translationadjustment.
Is Statement No. 52 Better?
Does Statement No. 52 represent an improve-ment over Statement No. 8? In our opinion, itdoes not represent a theoretically sound orpreferableway of dealing with foreign currencytranslation.Forforeign subsidiariesthat are in-dependent cash generators,hence use the localcurrencyas the functionalcurrencyand applytheall-currentmethod for translation,no method sofarsuggested adequatelydescribesthe riskorex-posuredue to foreigncurrencyfluctuations.Sincethese companies are independent cashgenerators,actualgains or losses attributabletoforeign currencyfluctuationswill depend uponthe exchange rates in existence at the time cashtransfersto or from the subsidiarytake place.
StatementNo. 52contaminatesthe existingac-counting model, which provides for a historicalrecordof cash flows, with a translatednumberthat defies logicalinterpretationin termsof cashflows. Webelievethe FASBwould havebeenbet-teradvisedto silencethe criticsof StatementNo.
8 by retainingthe temporalmethodbut allowingtranslationgains and losses to be excluded fromincome. In addition, we believe that a record ofthe volatilityof the foreign currencyfluctuationforsignificantforeignsubsidiariesshould be pro-vided so that users of financial statements canassess the inherent risk.
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