During the calculation of translation gains and losses using temporal and current rate methods can anybody give me an insight into as why the temporal method starts with balance sheet and finds the related relation to income statement as opposed to current rate method that starts with the income statement and finds the relation to balance sheet? Why the opposite directions
I’m not sure that there’s a particular reason for one direction vs. the other; perhaps Greenman72 can shed some light on that.
Nevertheless, each method had to start somewhere, because, ultimately, one number will be forced at the end to make everything balance. Frankly, I suspect that they did it in opposite directions primarily to frustrate Level II CFA candidates.
My take is that this revolves around the fact that under the Temporal method, translation gains/losses flow to the Income Statement. So, from a practical perspective, to calculate the IS impact, you need to derive the change in Retained Earnings first.
My understanding of the theory behind translation gains/losses flowing through the IS is that monetary assets and liabilities denominated in the foreign currency will generate translation gains/losses that will be realized in the near term (and therefore reflected in the IS).
Under Temporal Method , parent company’s currency is the functional currency i.e the company that controls the primary economic environment, so it has to bears the losses as well as the gains resulting from the currency movement relative to the subsidiary operating in foreign country. As such traslation starts off with balance sheet and through retained earnings , any translation loss/gain is posted in the IS. With current method, the primary economic environment and functional currency of parent and subsidiary being different i.e the foreign country’s , income statement items are translated first and cumulative translation adjustments make their way on the balance sheet , (basically a plug and chug). Overall , the only change in IS under current method is b/c items translated at current rate. are negatively exposed to currency movements when foreign currency is depreciating.
I was pondering this question this afternoon because I was scheduled to meet with a Level II candidate for tutoring this evening. I came up with this:
If the functional currency is different from the presentation currency, then the subsidiary is essentially acting autonomously; i.e., not under the control or influence of the parent. The parent doesn’t take responsibility for the subsidiary’s decisions, and the subsidiary only occasionally (i.e., yearly) passes information along to the parent so that the parent can present their financial statements. Thus, the information is translated using the current method: the parent only gets to see how the subsidiary looks at the moment the information is reported. Furthermore, the parent isn’t responsible for translation gains/losses as it is nothing more than a reporting conduit; thus, they start with the income statement (on which they do not show a gain/loss), then move to the balance sheet; the gain/loss is included in OCI but is not part of the parent’s income.
If the functional currency is different from the local currency, then the parent is taking full responsibility for the actions of the subsidiary; as soon as the subsidiary engages in any transaction, the parent owns it. Thus, the information is remeasured using the temporal method: the parent treats all transactions as if it had done them itself, at the time they occurred. Furthermore, the parent takes responsibility for any foreign currency gains/losses; thus, they start with the balance sheet, then move to the income statement; the gain/loss in included in the income statement as part of the parent’s income.
(It seems reasonable to me, anyway.)
Yeah that makes for a strong argument according to me.