Multinational Corporate Finance Spring 2002 Professor Gordon Bodnar

Accounting for Multinational Operations The Financial Accounting Standards Board (FASB) controls accounting practices for foreign currency (FC) activities of U.S. firms. The current procedures are governed by SFAS No. 52 Foreign Currency Translation published in 1981.

Accounting for Foreign Currency Transaction Gains and Losses Transaction gains or losses arise from unhedged transactions whose FC amounts are set and agreed to, but not settled until some future date. Examples of such transactions are purchases and sales of goods and services on credit denominated in FC; and acquisition of nominal assets or liabilities (debt) denominated in FC. U.S. Generally Accepted Accounting Principles (GAAP) requires that transactions be measured in U.S. dollars. To record FC transactions in dollars, the FC price is translated into US$ using the spot exchange rate prevailing on the transaction date. When payment occurs (at some later date) the settlement typically gives rise to an exchange rate gain or loss (due to exchange rate movements) that is recorded on the settlement date. This gain or loss is also recorded on any intervening balance sheet dates. U.S. rules follow the two-transaction approach. Sales and purchases are treated as separate from the Accounts Receivable (A/R) or the Accounts Payable (A/P) they produce. The sales and purchases are recorded on the transaction date and are not revalued as exchange rates change during the credit period. The A/R or A/P opened on the transaction date produces exchange rate gains or losses when the FC payment is converted into dollars on the settlement date. Example :

US Firm sells good to UK buyer for £5000 on July 1 with payment Oct 1 Spot exchange rate on July 1 = S0 Spot exchange rate on Oct 1 = S1 (S1 > S0 $ depreciation)

U.S. Firm Accounts; July 1: Transaction Date Accounts receivable Sales U.S. Firm Accounts; Oct 1: Settlement Date 1 Cash Accounts receivable Exchange-Rate Gain

Debit 5000 S0 5000 S1

Credit 5000 S0 5000 S0 5000 (S1 - S0))

This is the record keeping for a transaction completed within the balance sheet period. The items in italics enter income immediately as their sum represents the true dollar receipts for the sale. What happens when the balance sheet date, b, intervenes between the transaction date, 0, and the settlement date, 1? The unsettled transaction must be valued and accounted for in the balance sheet. Let us assume Sb > S1 > S0 so the exchange rate appreciates to the balance sheet date and then depreciates somewhat. Also, assume the same sale for £5000, but it now occurs on Dec. 1, with a settlement date of Feb. 1, and an intervening fiscal year-end of Dec. 31.

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U.S. Firm Accounts; Dec. 1: Transaction Date Accounts receivable Sales U.S. Firm Accounts; Dec. 31: Balance Sheet Date Accounts receivable Exchange-Rate Gain U.S. Firm Accounts; Feb. 1: Settlement Date Cash Accounts receivable Exchange Rate Loss

Debit 5000 S0 5000 (Sb- S0) 5000 S1 5000 (S1 - Sb)

[Note: Exchange Rate Loss appears as a debit as it reduces owners' equity.]

Credit 5000S0 5000 (Sb - S0) 5000 Sb

More generally, transaction gains or losses will arise in connection with any items in a transaction-linked account whose contracted values are denominated in foreign currency. For transactions that are completed within a balance sheet period, the only source of transaction gains or losses is A/R or A/P. At balance sheet dates, all monetary (current values) asset and liability accounts (cash, A/R, A/P, short and long term debt) are effectively defined as transaction linked. Thus, transaction gains or losses are computed on the basis of the FC net monetary assets (FC monetary assets - FC monetary liabilities) in existence on the balance sheet date. The net gain or loss is taken into reported income for the period. (One exception is foreign-currency intercompany long-term debt with no fixed payments terms - this is viewed by GAAP as a pseudo-equity investment and its gains or losses are treated as a translation adjustment). Determining Gains/Losses on Multiple Transactions over the Reporting Period Now, consider the problem of measuring the cumulative exchange rate gain over the entire reporting period, 0 to T. Let us take the measurement interval, t, to be one day, the cumulative exchange rate gain or loss (EG) over the entire period [0,...,T] reported on date T will be T

EGT =

∑X (S t

t

− St-1)

t =1

where Xt is the amount of net foreign currency monetary assets in existence on date t and S is the appropriate exchange rate to convert the value into dollars. By adding and subtracting X0S0 in the summation, we obtain an easier expression to work with:

EGT = XT ST − X0 S0 +

T

∑ (X − t

X t-1) St-1

t =1

This means that the transaction gain or loss reported at the balance sheet date T is given by [the end of year (EOY) foreign currency net monetary assets (FCNMA) times the EOY closing exchange rate] minus [the beginning of the year (BOY) FCNMA times the BOY opening exchange rate] plus [the sum of daily changes in FCNMA each multiplied by the previous day's closing exchange rate]. Some firms’ information systems permit easy updating of daily FCNMA. For others this daily updating is a burden. Accordingly, SFAS No. 52 allows the third term to be computed less frequently, monthly, quarterly or even annually. In these cases SFAS No. 52 requires the use of "appropriately weighted" average exchange rates for the period. The exchange rate gain or loss calculation then becomes:

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EG T = XT ST − X0 S0 +

N

∑ (X

n

− X n-1) Sˆn-1

n =1

where n counts subperiods, N is the number of periods in the year ending at T and Ŝn-1 is the period average exchange rate (in practice, usually a sales-weighted exchange rate). When a single annual weighted (N = 1) or arithmetic average (equally weighted) exchange rate can be used, the formula undergoes a further simplification:

EGT = X0 (ST − S0) + ( XT − X0)(ST − Sˆ) This says that the transaction gain can be approximated under the stated conditions as (the opening FCNMA times the exchange rate change over the year) plus (the change in FCNMA over the year times the difference between the EOY and year-average exchange rates). Example: If a firm started the year with FCNMA of FC1000 and ended the year with FCNMA of FC1200 and the exchange rate (S(HC/FC)) started the year at 1.00 and ended the year at 1.20 (HC depreciation) with an average rate of 1.10, then the firm’s exchange rate gain or loss from foreign currency transactions would be:

EGT = FC1000(1.20 − 1.00) + (FC1200 − FC1000)(1.20 − 1.10) = HC220 The firm would have experienced an exchange rate gain of HC220. This would be reported on the income statement for that reporting period. This is an exchange rate gain because the firm had a net foreign current asset position and the home currency depreciated in nominal terms relative to the foreign currency. Translation of Foreign Currency Balance Sheets The other problem in accounting for foreign activities is how to report the results of subsidiary operations in different countries. U.S. GAAP requires firms to produce consolidated financial statements that include all of their incorporated subsidiaries. The financial statements of these operations must be translated into U.S. dollars before consolidated financial statements can be prepared. This process gives rise to gains or losses from exchange rate changes. Broadly speaking, four balance sheet translation methods are currently in use around the world. In order of their evolution they are: i) the current/non-current method, now used mainly in low income countries; ii) the monetary/non-monetary method, used in some industrializing and smaller industrial countries; iii) the temporal method, used by some major countries usually in combination with iv) the current rate (or closing rate) method used by the majority of large industrial countries. The methods vary with respect to the timing of the exchange rates used to translate the components of the foreign financial statements into the parent currency. The primary distinction between the rules is whether the historical exchange rates (those in effect when the item was recorded on the balance sheet) or the current exchange rates are used when converting items into the parent currency. Exhibit 2 shows which exchange rates should be used for the various balance sheet items under each of the four procedures. The exchange rate gains and losses produced by the various translation methods can differ radically. Accounts translated at the current rate are “exposed” in the accounting sense. Total exposure is the net of exposed assets minus liabilities. In all cases the exchange rate gain or loss can be calculated as:

EG = (NetFCAccountingExposure) x (ExchangeRateChange) As Exhibit 2 indicates, the amount exposed under the current rate method is the FC book value of owners' SAIS 380.761

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equity (total assets - total liabilities). Because this is typically a positive quantity, a parent currency depreciation will result in an exchange rate gain. For all other methods the FC accounting net position exposed (the basis) can be either positive or negative (depending on the difference between the amount of assets and liabilities converted at current exchange rates) resulting in either a gain or a loss from parent currency depreciation against the subsidiary currency. The other primary difference in the methods is the location for reporting resulting exchange rate gains or losses. For the monetary/non-monetary and temporal methods, the exchange rate gain/loss is reported as part of current income on the consolidated results. Under the current/non-current method, losses are recognized in income but gains are deferred to a balance sheet suspense account to offset translation losses in the future. Under the current rate method, the exchange rate gain/loss from consolidated the foreign financial statements bypasses the consolidated income statement entirely and is cumulated in a separate account (typically denoted Cumulative Translation Adjustments) in the owners' equity section. Exhibit 2: Exchange Rates Used to Translate Balance Sheet Items Balance Sheet Accounts Cash and Deposits Accounts Receivable Inventories at Cost Inventories at Market Investments at Cost Investments at Market Pre-paid Expenses Goodwill Fixed Assets Accumulated Depreciation Accounts Payable Short-Term Debt Long-Term Debt Common Stock Retained Earnings

CurrentNon Current C C C C H H C H H H C C H H R

Monetary Non-monetary C C H H H H H H H H C C C H R

Temporal Method C C H C H C H H H H C C C H R

Current or (Closing Rate) C C C C C C C C C C C C C H R

Notes: C = current rate or closing rate; H = historical rate(s); R = residual, as retained earnings are a balancing item. Market values include current selling prices, replacement values, net realizable values or fixed contract prices.

Translation Adjustments under SFAS No. 52 Although the accounting authorities advocated the use of the current/non-current method, there were no strict rules on the appropriate method prior to 1976. Under SFAS No. 8, the temporal method was the only method permitted by U.S. GAAP from 1975 - 1981. During the period 1976 - 1979 the dollar depreciated consistently. For many multinational firms with foreign currency net monetary liability positions, this resulted in negative adjustments to reported earnings. These adjustments made achieving the goal of stable and rising earnings difficult. Financial executives pressed the FASB for a new way to exclude the translation adjustment gains or losses from income. SFAS No. 52, effective December 1981, was the compromise result. Its goals were: i) to provide information that is generally compatible with the expected economic effects of an exchange rate change on an enterprise's cash flows and equity; and ii) to reflect in consolidated statements the financial results and relationships of the individual consolidated entities as measured in their functional currencies. The ability to exclude the translation gain or loss from reported income was linked to the firm's choice of functional currencies for its foreign subsidiaries. The functional currency is supposed to represent the primary currency in which the subsidiary conducts its business. The functional currency can be either the parent currency (the dollar) or a local foreign currency in which the subsidiary primarily operates. The FASB set out guidelines for a firm's choice of functional currency; however, these broad guidelines allow for substantial management discretion. However, the FASB does prescribe that firms with subsidiaries operating in highly inflationary environments (more than 100% over three years) must choose the dollar as functional currency. Once chosen, the functional currency cannot be switched unless economic conditions arise which clearly indicate that the appropriate functional currency SAIS 380.761

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has changed. U.S. firms choosing the dollar as functional currency use the temporal method to translate foreign subsidiaries' financial statements into dollars (just as under the previous accounting standard SFAS No. 8). Firms choosing the foreign currency as their functional currency for foreign operations use the current rate method for translating foreign subsidiaries' financial statements into dollars. Firms are allowed to mix the choice across subsidiaries. Translation with the Dollar as Functional Currency (Temporal Method) When the U.S. dollar is chosen as a foreign entity's functional currency, its foreign currency financial statements are remeasured (translated) into dollars using the temporal method. Since the functional currency of the subsidiary is the dollar, the firm need only “remeasure” the non-dollar activities of the subsidiary, just as it does any foreign currency denominated activities of the parent operations. The temporal method is often said to embody a parent company perspective because it restates the subsidiaries activities as if they had been carried out by the parent. Under the temporal method the exchange rate gain/loss calculated from the consolidation process is the same as the exchange rate gain/loss that would be measured if the parent operation had carried out all of the transactions itself—it is identical to the measurement of the exchange rate exposure in the previous section. The rules for the application of the temporal rate method applied to a foreign subsidiary account are:

1. Monetary assets and liabilities not recorded on the subsidiary’s financial statement in parent currency are “remeasured” using the rate prevailing on the date of the financial statements (the current exchange rate). Non-monetary items including capital accounts are converted into parent currency at their corresponding historical rates. 2. Income statement events that are related to non-monetary accounts (like cost of goods sold and depreciation) are converted into parent currency at the appropriate historical rates. Otherwise, revenues and expenses are converted into parent currency using the average exchange rate for the period. 3. Exchange rate gains or losses are computed on the basis of foreign currency net monetary assets (FCNMA) and changes therein. These gains/losses are included when determining the subsidiary’s parent currency income and retained earnings for the period. Adjustments related to the valuation of inventories or investments (at the lower of market or cost) affect operating income via the cost of goods sold or the investment account, but do not enter the calculation of exchange rate gain/loss. Determination of Parent Cost of Goods Sold for the Subsidiary $ Cost of Goods Sold = $ BOY Inventories + $ Purchases - $ EOY Inventories To determine the parent currency value of cost of goods sold, the beginning of year inventories measured in parent currency must be calculated. To this is added the parent currency value of all purchased inputs (inventories, labor, etc.) over the year. This value is calculated as the FC value of purchases times the period average exchange rate. From this amount is subtracted the parent currency value of inventories remaining at the end of the year. Remember that the parent currency value of inventories is always measured as the lower of either the parent currency value at the historical exchange rate or the end of period (current) exchange rate. This parent currency cost of goods sold is then used in the subsidiary’s parent currency restated income statement. Translation with the Foreign Currency Used as Functional Currency (Current Rate Method) When the foreign currency (or local currency) is chosen as a foreign entity's functional currency, its foreign currency financial statements are translated into parent currency using the current rate method. This method views the subsidiary essentially as a separate stand-alone enterprise. The current rate method is often said to maintain a subsidiary perspective as it converts all the subsidiary’s assets and liabilities at the same rate yielding similar SAIS 380.761

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operating and financial ratios for the subsidiary whether measured in subsidiary or parent currency. The steps for translating the subsidiary’s foreign currency as functional currency financial statements in to parent currency are: 1. All non-functional currency monetary assets and liabilities are first remeasured into the functional currency at the current exchange rate (the temporal method is applied at the level of the subsidiary to “remeasure” all non-functional currency items into the functional currency). Once the foreign subsidiaries’ books are completely remeasured into the functional currency (a non-dollar currency in this case) all assets and liabilities are translated into dollars using the exchange rate prevailing as of the financial statements date. Capital accounts (i.e., common equity) are translated at the corresponding historical rates. 2. Revenues and expenses are translated using the exchange rate prevailing on the financial statement date, although period average rates more are commonly used for expediency. 3. Translation gains or losses are reported in a separate component of consolidated owners' equity. These adjustments by-pass the income statement until the foreign operation is sold or the investment is perceived to have suffered a permanent diminution in value.

Numerical Example Universal S.A. is a wholly owned foreign subsidiary of USA Inc. Exhibit 3 presents the transaction analysis spreadsheet for Universal's activities for the year ending December 31, 2001. The relevant exchange rates for the period are as follows: Exchange Rate ($/FC) Date of Period January 1, 2001 0.15 December 31, 2001 0.25 Average for 2001 0.20 Average: Q:IV 2000 0.12 Average: Q:IV 2001 0.26 Common stock was issued and initial investment in fixed assets occurred when the exchange rate was FC1 = $0.30. Additional plant and equipment financed by long-term debt of FC 2000 was added during 2001: installation occurred evenly throughout the year and was completed by 12/31/01. Inventories are purchased one quarter ahead. For convenience, assume that sales, purchases, other expenses (including interest, taxes, payments to suppliers and dividends) are spread evenly over the year. Depreciation was charged only on old equipment, not the new equipment that remains non-operational during the year.

Exhibit 3: Universal S.A. 2001 Transaction Analysis Spreadsheet (all entries in FC) Items 1/1/01 Balance Sales/Collections Purchases: Inv Purchases: F.A. Cost of Goods Sold Depreciation Other Expenses Income taxes Payments Dividends

SAIS 380.761

Cash and A/R 2,800 15,000

Invent 1,600

Fixed Assets 5,000

9,500

Current Liabilities 2,500

4,400

Common Stock 2,000

Retained Earnings 500 15,000

9,500 2,000

2,000

(9,000) (1,000) 2,000 (1,500) (11,000) (500)

Debt

(9,000) (1,000) (2,000) (1,500)

(11,000) (500)

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12/31/01 Balance

4,800

2,100

6,000

3,000

6,400

1,500

2,000

Using the Temporal Method Exhibit 4 portrays Universal's financial statements when the dollar is used as the functional currency. Notice that the dollar value of inventories is recorded on the balance sheet at the lower of cost or market. Inventory translation does not affect the exchange rate adjustment that arises in this case. As we see in the determination of cost of goods sold (COGS), purchases are the only component that affects any monetary account. Changing inventory values may cause unwelcome variations in COGS, but will leave the exchange gain/loss untouched under the temporal rate method. This method results in a translation induced exchange loss of $435 for the period as a result of the appreciation of the foreign currency. Subsequently, Universal reports a dollar net income of $(2). Exhibit 4: Universal S.A. Financial Statements Translated by the Temporal Rate Method (US$ as Functional Currency) Balance Sheet

January 1, 2001

December 31, 2001

Cash and A/R Inventory Fixed Assets

FC 2,800 1,600 5,000

Ex- Rate 0.15 0.12 0.30

US$ 420 192 1,500

FC 4,800 2,100 6,000

Ex-Rate 0.25 0.25a Avg.b

US$ 1,200 525 1,600

Total Assets

9,400

Avg.

2,112

12,900

Avg.

3,325

A/P L.T. Debt Capital Stock Ret. Earn

2,500 4,400 2,000 500

0.15 0.15 0.30 balance

375 660 600 477

3,000 6,400 2,000 1,500

0.25 0.25 0.30 Avg

750 1,600 600 375

Total L + E

9,400

Avg.

2,112

12,900

Avg.

3,325

a

Inventories valued at lower of cost (0.26) or market (0.25). This value is derived as follows: FC4000 assets at their historical rate of .30 = $1200 and FC2,000 of new assets at their "historical" rate (I assume the average over current period) of .20 = $400. Total = $1,600 b

Calculation of specific items for the temporal method: Cost of Goods Sold

= $ BOY Inventories + $ Purchases - $ EOY Inventories = 1,600 x 0.12 + 9500 x 0.20 - 2,100 x 0.25 = $1567

Exchange Rate Gain/Loss = (BOY FCNMA)(ST - S0) + (Change in FCNMA)(ST - S _) = $ (-4,100) x (0.25 - 0.15) + $[-4,600 - (-4,100)] x (0.25 - 0.20) = -$435 2001 Income Statement Sales Cost of Goods Sold Depreciation Other Expenses Exchange Rate Gain/Loss Income Tax

SAIS 380.761

FC

Exchange Rate

US$

15,000 (9,000) (1,000) (2,000) 0 (1,500)

0.20 see below 0.30 0.20 see below 0.20

3,000 (1,567) (300) (400) (435) (300)

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Net Income

1,500

Retained Earnings 12/31/00 Dividends Retained Earnings 12/31/01

500 (500) 1,500

(2) 477 (100) 375

0.20

Using the Current Rate Method Exhibit 5 displays Universal's financial statements when its local currency, the foreign currency, is the functional currency. The beginning owner's equity accounts are inherited from the previous year's statements prepared under the same method. Keep in mind that retained earnings and Cumulative Translation Adjustment accounts are both cumulative. Exhibit 5: Universal S.A. Financial Statements Translated by the Current Rate Method (FC as Functional Currency) Balance Sheet Cash and A/R Inventory Fixed Assets

January 1, 2001

December 31, 2001

FC

Ex- Rate

US$

FC

Ex-Rate

US$

2,800 1,600 5,000

0.15 0.15 0.15

420 240 750

4,800 2,100 6,000

0.25 0.25 0.25

1,200 525 1,500

Total Assets

9,400

0.15

1,410

12,900

0.25

3,225

A/P L.T. Debt Capital Stock Ret. Earnings Translation Acct

2,500 4,400 2,000 500 0

0.15 0.15 0.30 Avg.

375 660 600 140a (365)a

3,000 6,400 2,000 1,500 0

0.25 0.25 0.30 Avg.

750 1,600 600 340 (65)

Total L + E

9,400

Avg.

1,410

12,900

Avg.

3,225

2001Income Statement

FC

Exchange Rate

US$

15,000 (9,000) (1,000) (2,000) (1,500)

0.20 0.20 0.20 0.20 0.20

3,000 (1,800) (200) (400) (300)

Net Income

1,500

0.20

300

Retained Earnings 12/31/00 Dividends Retained Earnings 12/31/01

500 (500) 1,500

Avg. 0.20

140 (100) 340

Sales Cost of Goods Sold Depreciation Other Expenses Income Tax

a

Note that the retained earnings and translation accounts are cumulative. Beginning of year owners' equity accounts are inherited from the previous year's statements that were prepared by the same method.

Calculation of specific items for the current rate method: Exchange Rate Gain/Loss = (BOY FCOE) (ST - S0) + (Change in FCOE) (ST - S _) = $ (2,500) (0.25 - 0.15) + $(1,0000) (0.25 - 0.20) = $ 300 = Change in Cumulative Translation Account = (-$65) - (-$365) = $300 SAIS 380.761

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In the U.S. $ statements, net income minus dividends ($300 - $100 = $200) equals the change in retained earnings ($340 - $140 = $200). The translation adjustment for the year, computed on the basis of FC owner's equity (FCOE) under the current rate method is $300. This when added to the existing total in the Cumulative Translation Adjustment account brings the balance to -$65 = (-$365) + $300. In this case the translation adjustment for the year is positive, as the current rate method (almost) always produces a gain when the FC appreciates. The current rate method results in a parent currency net income of $300. Comparing Reported Results and Reality A comparison of the two results reveals the source of management's discomfort with the temporal method. The economic reality for this period is that Universal produced a foreign currency net cash flow of FC 1,500. After dividends were paid, the additional retained earnings were FC 1,000, which have a value of $250 at the end of the year exchange rate. Adding the value of the dividend, FC500 @$.20/FC = $100, the $ value of wealth created by Universal is around $350, which is greater than the net income reported under either method. The different approaches also result in significant differences in the reported $ value of the assets. Under the temporal method, the assets at the beginning of the period are $2112 and at the end of the period are $3325. Under the current rate method, the assets at the beginning of the period are $1410 and at the end of the period are $3225. The apparent growth rate of assets for Universal would vary dramatically depending on the measurement technique used. This can give rise to inappropriate conclusions about affiliate growth and asset based ratios. The combined differences in reported incomes and assets render the interpretation of return on assets (ROA) for foreign operations a hazardous activity. In foreign currency terms, the ROA (defined as net income over beginning assets) is FC1500/FC9400 = 16%. In dollar terms, the ROA under the temporal method is $(2)/$2112 = 0%, but the ROA under the current rate method is $300/$1410 = 21%. Generally speaking, foreign subsidiary financial ratios measured in $ will reflect most closely the foreign currency performance when the current rate method is used. However, sudden shifts in the exchange rates, especially late in the year have a much more significant impact on assets than they do income (because of the measurement methods), and may result in significantly distorted ratios compared the those for domestic operations. Summary and Perspective Under SFAS No. 52, two translation techniques coexist. The mixture of methods introduces consistency problems that make consolidated statements (the results of concern to investors) hard to interpret. In particular, the implementation of the current rate method in conjunction with the selection of a functional currency other than the US$ is plagued with logical problems. Choosing the FC as functional currency is basically the price one must pay in order to be able to remove translation gains or losses from the income statement. As a matter of presentation, this removal could be allowed under any set of translation rules. The best solution, from an economic point of view would be to move towards current-cost accounting in foreign currency. Then, the matching of contemporaneous values under the temporal rate method would produce both current-rate translation and the preservation of the subsidiaries’ financial ratios. The subsidiary’s accounting exposure would be owners' equity, in conformity with the "net-investment" doctrine. The construct of picking a foreign functional currency for selecting the closing rate method would then clearly be redundant. Exchange rate gains/losses would flow through the income statements if reported income and changes in owner's equity were to match. The inconsistencies under SFAS No. 52 arise technically from two sources. The first is the temporal rate mismatching that arises when the current rate method is applied to historical-cost FC balance sheets and an average rate method is applied to FC income statements. Translated depreciation expense no longer equals the change in the dollar book value of assets. The dollar cost of sales is not the difference between beginning and ending dollar inventories plus purchases. The second inconsistency is that current rate translation, applied under the aegis of the functional currency concept, produces dollar accounts that are not independent of the choice of the currency in which the transactions and positions are originally measured. Consider an example. A British subsidiary with export to the parent may have U.S. $ receivables while a German affiliate has an equal amount of U.S. payables to the parent, with the same short-term maturities. From a consolidated point of view these should cancel out; SAIS 380.761

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however, if their domestic currencies are their functional currencies, their US$ exposures do not necessarily wash in consolidation. Each may report a transaction gain or loss on its average U.S. $ balances that must be translated into dollar income at the average US$/UK£ or US$/DM rate for the period. Owing to such inconsistencies, the effects of exchange rate changes are hard to decode. Under SFAS No. 52, they appear in two places: as exchange gains or losses in the income statement, where they are an amalgam of the transaction gains or losses associated with monetary items in various functional currencies (including the dollar), and in the balance sheet Cumulative Translation Adjustment account, which aggregates incommensurate translation adjustments based upon net assets. The result is a mish-mash that is of little direct help to investors, analysts, or other users of financial reports. However, in the never ending attempt to make comparisons across firms, which may report foreign operations results under different methods or different combinations of methods, it is important to understand the potential impact these variables can have so that if necessary, an analyst can “reverse-engineer” the foreign portion of the consolidated financial statement to convert the reported figures into interpretable figures.

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