Question

Determine the main accounting assumptions underlying each currently used method (e.g., current rate method and temporal method). Determine the fundamental differences in balance sheet exposure from the application of each method.

Albert, CEO of XYZ, Inc., desires to expand the company’s sales through exports to three (3) foreign subsidiaries. Albert knows that the target subsidiaries are located in countries that require transactions to be denominated in the local currencies. Albert has researched foreign currency risk and knows that there is accounting exposure in accounting statements, operating exposure in future cash flows, and transaction exposure in outstanding obligations. Albert does not understand how these risks apply to XYZ, Inc. under his proposal or if there are any mitigating risk strategies available. Albert requests you, the head of the Risk Management division, to prepare a report that he can present to the Board of Directors on the potential foreign currency risk if XYZ, Inc. expands sales into these markets. XYZ, Inc.’s reporting currency is the U.S. dollar and the subsidiaries would purchase the merchandise as inventory items.

Answer 1

The current rate method is a method of foreign currency translation where most items in the financial statements are translated at the current exchange rate. When a company has operations in other countries, it may need to exchange the foreign currency earned by those foreign operations into the currency used when preparing the company's financial statements — the presentation currency. The current rate method is utilized in instances where the subsidiary isn't well integrated with the parent company, and the local currency where the subsidiary operates is the same as its functional currency.

The temporal method (also known as the historical method) is a method of foreign currency translation that uses exchange rates based on the time assets and liabilities are acquired or incurred to convert values on the books of an integrated foreign entity into the parent company's currency. The temporal method is used in instances where the local currency of the subsidiary differs from its functional currency. Differing exchange rates are used depending on the financial statement item being translated. Monetary assets and liabilities are converted using the exchange rate in effect as of the balance sheet date. Non-monetary assets and liabilities are converted using the exchange rate in effect on the date of the transaction. Gains and losses due to foreign exchange are reported in net earnings.