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Institute of Chartered Financial Analysts of India (ICFAI) University 2006 Certification Finance International and Trade – I - university paper

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part C: Applied Theory

6.
There are 4 methods which guide the translation of the financial statements of a foreign entity, whether independent or integrated. These are

· Current/Non-Current method

· Monetary/Non-monetary method

· Temporal method

· Current rate method

For understanding these methods, we need to 1st understand a few terms:

Historical exchange rate: It is the rate at which a transaction was truly settled. For example, the rate which was used to convert the domestic currency into the foreign currency for settling the payment for a machinery bought by the company. In cases where no true currency conversion takes place, it is the rate prevailing at the time the original transaction took place. For example, if the machinery in the above example was bought by a foreign subsidiary, there would have been no conversion of currency. In that case, the historical rate would have been the rate prevailing when the machinery was bought.

Current or closing exchange rate: It is the rate prevailing on the date of translation of accounts.

avg. rate: It is the avg. of the rates prevailing over a certain period of time.

CURRENT/NON-CURRENT METHOD

This method is based on the premise that exposure is linked to the maturity of the asset or liability and hence, does not provide importance to its nature. It advocates the conversion of all current assets and liabilities at the closing rate, and all non-current assets and liabilities at the historical rate. All items of income and expenditure are needed to be converted at the avg. rate for the relevant period, other than those items that are related to non-current assets and liabilities. All such items (like depreciation) are to be converted at the identical rate as the related asset or liability.

As the non-current assets and liabilities are converted at the historical rate, this method outcomes in only the current assets and liabilities being exposed to exchange rate movements. Hence, when the foreign subsidiary has a positive working capital, the parent company books an exchange gain on depreciation of the domestic currency, and an exchange loss on its appreciation. Conversely, when the foreign subsidiary has a negative working capital, the parent company would book an exchange loss on depreciation of the domestic currency, and an exchange gain on its appreciation.

MONETARY/NON-MONETARY METHOD

This method emphasizes the nature of the item rather than its maturity. It classifies assets and liabilities into monetary and non-monetary. Monetary items are money held and assets and liabilities to be received or paid in fixed or determinable amounts of money. Under this method, the monetary assets and liabilities (like cash, accounts receivables, accounts payable) are translated at the closing rate, and the non-monetary items (like inventory, building are translated at the historical rate). Items of the income statement are translated at the avg. rate, other than for those related to the non-monetary items (like depreciation and cost of raw material consumed). These are translated at the rate at which the corresponding non-monetary asset or liability is translated. This differentiation ranging from the items of the income statement may lead to a few mismatches. For example, while sales are translated at the avg. rate, a part of cost of goods sold (to be specific, cost of raw materials consumed) may get reflected at the historical rate.



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