Translation Methods and Financial Statement Effects
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Temporal Method & Financial Statement Effects
- Income Statement Volatility: Under the temporal method, translation gains or losses are reported directly on the income statement. Therefore exchange rate volatility can create net income volatility for companies consolidating subsidiaries with the temporal method.
- Balance Sheet Exposure: Monetary assets and liabilities are exposed to translation at current exchange rates. If exposed assets exceed exposed liabilities, then the foreign subsidiary has a net balance sheet exposure. Therefore, a translation loss will occur when the foreign currency weakens. If exposed liabilities exceed exposed assets, then a translation loss will occur when the foreign currency strengthens. It is important to be mindful of the subsidiary's balance sheet exposure and the movement of its local currency when analyzing a company that consolidates with the temporal method.
Current Rate Method & Financial Statement Effects
- Income Statement Stability: Because the current rate method applies the cumulative translation adjustment to the equity section of the parent's balance sheet, the consolidated net income will be less volatile, when compared to translation under the temporal method.
- Balance Sheet Exposure: All assets and liabilities are translated at current rates. Given that a subsidiary's assets will exceed its liabilities, a net asset balance sheet exposure is created. Therefore when the foreign currency (subsidiary's local currency) appreciates, the cumulative translation adjustment will be positive.
Translation Methods and Financial Ratios
- Because the current rate method uses largely (not entirely) the current exchange rate to translate financial items, the financial ratios in the presentation currency will more closely (but not identically) resemble the financial ratios in the local currency. The temporal rate uses multiple exchange rates, so the local currency ratios and the presentation currency ratios are much less comparable.
- Because the current rate method does not translate contributed capital at the current exchange rate, financial ratios which employ both income statement items and balance sheet items, local currency ratios and presentation currency ratios will not be identical.
- Under the temporal method, financial ratios in the local currency can be significantly different from those in the presentation currency.