 Hello and welcome to this session. This is Professor Farhad. In this session, we would look at translation of financial statement. And this is part one of four. In other words, I'm going to start this part, explain the concept that we need to explain the basic concepts. Then we're going to move into three other sessions, working examples to illustrate the concepts. But it's very important that you understand the concepts in this session before we proceed. This topic is covered in an advanced accounting course or international accounting course. Also, it's covered on the CPA exam and maybe on the CMA exam as well. For more lectures, you can go to my website, farhad-lectures.com, but in this session, we will focus on this specific topic. So what is the big picture here? Let's start with the big picture. What we are doing is we are translating financial statement. And for the purpose of this session, I'm going to be US-centric. In other words, I'm going to assume that my base is the United States. Therefore, what happened is this. US companies, many US companies, most US companies, Cisco, Coca-Cola, McDonald, they operate overseas. So they have operations in Mexico. They have operation in South America. They have operation in Russia. They have operation in Canada, so on and so forth. Or they might have branches or subsidiaries or they might have investments in those countries. So what's going to happen is this. When the US company, when MCD, when McDonald, when McDonald referred their numbers to the shareholders, they have to use US dollars. So what we have to do, we have to translate the financial statements from the foreign subsidiary, from the foreign branch into US dollar using US dollar. Because that's going to be the uniform, the monetary unit that we're going to be using. Okay? So that's what we're going to be doing. So US company may be involved in foreign operation through the operation of branch, subsidiary or investing company. What's going to happen is this. Accounts of the foreign activities maintained in the foreign currency must be restated into US dollars. So things will make sense. You cannot combine euros with US dollar. You cannot add the numbers. You have to restate them before you add them. You cannot add Japanese into US dollar. You have to do something about a restatement before you combine them or consolidate them in one financial statement. So that's the first thing. So what we have to do is this. We have to understand that we have a control over a subsidiary when we own directly or indirectly a controlling interest. How do we define a controlling interest? Usually more than 51%. Some exceptions when we don't intend to control or the control is temporary, then we don't have to consolidate or the control does not really rest with the company. And that could be if there's any restriction by the by the hosting government from from allowing us from not taken withdrawals out or if there's any exchange restriction. Simply put, here's another picture, another big picture. What we're doing is the conversion from one currency into the currency of the parent company. Again, we're going to be always assuming it's a US company. The process is called the translation. So basically we're translating the financial statements. So we have financial statements in euro and we're going to go ahead and translate them into US dollar. Now, what do we use when we translate them? Which exchange rate we could use the current? We could use the historical. We can use the also the average rate the way at average. So those rates, we're going to be talking a little bit more about later. There are specific rules. When do we use which rate? Now this translation process, we have two types of, we have two methods of translation, two methods of translation. One is called the remeasurement and one is called translation. That's all what I'm going to talk about today. Right now, you're going to see the slide again. Once I go over the explanation, we go back and we say, okay, this is what remeasurement is and this is what translation is. Don't worry about this. We're going to go back and cover those in details after we go through the big picture explaining when do we use remeasurement, when do we use translation. So it all depends on something called the functional currency. There is this functional currency concept. And this is what we need to spend maybe five to 10 minutes explaining or maybe a little bit more about this functional currency because depending on the functional currency, we're either going to use remeasurement or translation depending on the currency. So this is an important concept also on the CPA exam. So when you are tested on the CPA exam, they focus on, do you know what's the functional currency? Because if you know the functional currency, you would know if you would need to use remeasurement or translation. So how do we know the functional currency? How do we know what the functional currency is? The functional currency, it depends on many factors, but usually some economic indicators will tell us what the functional currency is. Well, how is our cash flow? How do we prepare our cash flow statement? How do we make payment to our suppliers? How do we receive the most of our sales? What is the sales prices? What's our sales market? What is our payment to key employees? Expenses, cost of goods sold. How do we finance our company within the local market? Okay, intercompany transactions. So all of those will help us determine what's the functional currency. So if we're reporting in Canada and if they are using Canadian dollar to run their transaction, then the functional currency is a Canadian dollar. If we are working in Mexico, if the subsidiary in Mexico and they pay their employees with Mexican pesos, they receive money from the customers in Mexican pesos. They do their banking in Mexican pesos. Therefore, it's the functional currency. Okay, so, but here's what's going to happen. The functional currency, generally speaking, not generally speaking, it may be the local currency of the foreign entity. But it could be something else. It could be the US dollar or it could be the currency of a third country. So I'm going to go over three, those three scenarios, use it a Canadian example. So let's start with the first, the most normal scenario. Okay, and what's the first normal scenario? It's something like this. Here's the first scenario. We have a subsidiary or a branch that's operating in Canada in Alberta. It's operating right here. It's a US branch. Okay, it's a US branch. But guess what? What they do is they process all their transaction, their payment, their receipts, their banking, all in Canadian dollar. So if I ask you, what's the functional currency of this US branch? And this is a McDonald. Okay, what is the currency? Well, the currency is the functional currency is the Canadian dollar. So the local currency is the functional currency. So here's what's going to happen. So what I'm going to do, I'm going to be drawing a graph here. Okay. So first, we're going to need to determine the functional currency. So what is the determine the functional currencies? There we go. So I'm going to start to draw some graph here. Determine the functional currency, FC. Okay, so now what we did is we determined the functional currency. What did we say the functional currency is? We say the functional currency is the local. Now I'm going to call it the foreign. I'm going to call it the local currency. The functional currency here is the local currency, local currency. Well, so determine the functional currency. The functional currency is the local currency. What do we do if the functional currency, this is so determine the functional currency, and it happens to be it's the local currency. Then under those circumstances, what we do. We use the method called translation. We use the translation method. We use the translation method. The translation method. I'm going to add some notes here uses the current rate method. Just write these down current rate method. And I want you to write one more thing. When we make the adjustment, it goes on the balance sheet. So it may not make a lot of sense to you, but just write this stuff down. So if we happen to have this company, this branch of McDonald operating in Alberta, what's going to happen when we do the translation? We're going to be using, since the functional currency is the local currency, we're going to be using the translation method. Remember, we have two methods of translation. This is one and this is two. We're going to be using this translation method. And this translation method, translation, it uses the current rate method and the adjustment goes to the balance sheet. That's all you have to know for now. We'll see what it means later. So this is one scenario. And this is mostly, I would say this is the normal scenario. It doesn't have to be normal, but I'm just going to call it normal and sense that if you're operating in a foreign country, most of the time, the functional currency, most of the time it's in the local currency. That's fine. Now, what could be another scenario? So this is one scenario. So here, the currency is US dollar. Let's assume now another scenario again between the US and Canada, which is the US is the parent company and Canada is the foreign country. But here's what's going to happen. I'm going to make this a little bit interesting. Let's assume we are operating a McDonald. I believe Niagara Falls, if my geography is good, falls right here. Falls right here in this red dot. So this is Niagara Falls. So we have a McDonald here and Niagara Falls. I think it's right here, someplace here. Please don't grade me on geography. Okay. So we have this McDonald's is operating right on the border, the Niagara Falls, the Canadian side. And guess what? This McDonald get older supplies from the state of New York. Okay. So they pay their supplies or their employees are US employees. So they want to pay, they want to be paid in US dollar order management is US management. And what else? The financing comes from the US. The sales is they only accept US dollar. Okay. So just making this example up. So here's what's going to happen. What's going to happen here is we are operating in Canada. But the functional currency is the US dollar, not the Canadian dollar for this McDonald. So let's go back to this map. Okay. Now determine the foreign currency. In this situation, the answer is, it's not the local currency. So it's not the local currency. No. So the foreign currency is not. Okay. So we said, yes. Now the foreign currency is not. So the foreign currency, the local currency is not the functional currency here. So what is the, what is the currency then? Well, the functional currency here, well, obviously, you know it, the functional currency here is the US dollar, the US dollar. Okay, because it's not the local currency. What happened if the functional currency is the US dollar? If the functional currency is the US dollar, what's going to happen is we need to use the remeasurement, remeasurement method. And don't worry what remeasurement is for now. And the reason is because we're going to see what it means later. Okay, we're going to be using the remeasurement, remeasurement method. And the remeasurement method, just write this down, it uses the temporal method. And don't worry about that. Okay, it's called the remeasurement method. It uses the temporal method and any adjustment goes to the income statement. So this is our kind of basically second scenario. Okay. So now the functional currency is the US dollar, but we're operating in Canada. Therefore, we cannot use the translation. We have to use the remeasurement. What is remeasurement? Don't worry. We'll talk about remeasurement shortly. How do we do the remeasurement? Okay. So are these the only two scenarios? Not at all. Not at all. Let's go back to the map and let's go back to the map and draw another scenario. Now, third scenario could be is this. Here's what the third scenario is. McDonald's operating in Canada and they're operating in Quebec specifically in Montreal. And if you know anything about that in Quebec city, actually Montreal, they're okay with their little bit more. They're not as radical as the Quebec city. They're operating in Quebec city. So it's so it's in McDonald's. It's a US company operating in Canada. But since and since Quebec city, they're very French oriented and making up this example to illustrate the point. Okay. And they are very, you know, they're very French. All the signs are in French. If you ever visited Quebec city, guess what? All the transactions. So in that city, in Quebec city, McDonald's, the exchange is in Europe because they want to follow the France. So here we go. So this is so it's a US company operating in Canada. But the currency is not the Canadian dollar. The currency is a euro. So the currency basically is a third country, the currency of a third country. Okay. A currency. Again, I made this example up. Now, when would that happen? It in the real world. This would happen if you're operating in a third world country and the currency is not very stable. And therefore what you would do is you would use another currency to operate. Okay. But I'm just giving you this example so you would understand it. So you would understand it. So the third scenario is this. And this is like kind of, it requires most of the work. So now what's going to happen is this. The functional currency is not US dollar. So it's not the local currency and it's not the US dollar. So it's a third currency. So there we go. So now we have a third currency. So the functional currency here, it's not the local currency. So no for local currency. No for this. It's not the local currency. No for US dollar. It's a third country. A third country, foreign currency. It's the euro. So what do we have to do if that's the case? Here's what we have to do. That's a third country. Then we have to do two things. First, we have to re-measure the functional currency. Now we have two steps. We have to re-measure. Two, functional currency. Okay. Using the temporal method. Okay. So first we have to re-measure to the functional currency. Then from the functional currency, we have to translate to US dollar. Using the current rate method. So here we are going through two steps. First, we re-measure the functional currency using the temporal method. Then from the functional currency, we translate to the US dollar. Wow. Are we going to work an example? Sure. Just those are the methods. So here we're using kind of both methods. We're using both methods. So let's recap basically what we just said. The functional currency could be the local currency of the foreign entity, which is that's the most normal scenario. McDonnell operating in Canada. Every older cash flow is in Canadian dollar or their sales in Canadian dollar or their cost of goods holding Canadian dollar. Or they are operating right on the border. And they don't have to be operating on the border, but I'm just making this up to make it kind of easy for you to relate to. They're operating in Niagara Falls. The US dollar dominate their transaction because most of their customers are US. Or they're operating in Canada, but the subsidiary or the investee is using a third country currency, the euro in that situation. Now let's go back and actually I'm going to add one more scenario here, which is we did not talk about. Foreign entity operate in a highly inflationary economy. So here we go. So let's go back to the drawing board here. And now I'm going to draw a kind of a third scenario if you would like to. If if here's what's going to happen now, we were okay with this. So I'm going to just draw a line here. So I'm going to draw a line right here. Okay, now if the foreign economy is highly inflate inflationary. So let's assume the foreign economy is inflationary and highly inflationary, highly inflationary, which is highly I'm going to put highly. And how do we find it's highly inflationary? If in the past three years, the cumulative inflation is more than 100%. Simply put, in year one, they had 30% inflation in year two, it went up to 60%. And in year three, now it's 110%. So in the past three years, the inflation exceeds 100%. At this point, at this point, guess what? We consider the functional currency as the US dollar. The functional currency is the US dollar. Therefore, if the functional currency is the US dollar, we use the remeasurement method. The remeasurement method, which is the temporal method. Okay, so if it's highly inflationary, we use the remeasurement method. And nowadays, only like maybe few countries are highly inflationary countries. Venezuela could be one of them. Some countries in central Africa, they have high inflation. At some point in time, Argentina was highly inflationary country. So the board believes, gap believe, that the currency of a country that has highly inflationary economy has lost its utility as a store of value and cannot be a functional measuring unit. So what we have to do, we consider the US dollar as a functional currency. And again, we're not going to work an example with this, just know this. And we use the remeasurement method. Just to tell you how extreme inflation can be in certain countries. At some point, I don't believe it was in the 80s or 90s. I don't know when in Argentina, you would order a meal and they will not guarantee the price by the end of the meal. Because by the end of the meals, all the ingredient has, you know, the prices of the ingredients. So you ordered a salad. I'm being extreme here to make the point. And they don't tell you what the price is because they don't know what the price is because they did not receive the prices for today. So their supplier did not show up. OK, so that's how there's inflation prices are not stable. Therefore, you cannot use, you have to use the parent company, the US dollar as the currency. This means the foreign financial statement should be translated using the temporal method, which is using the remeasurement method. Remember, once you see the word temporal, it means the remeasurement. So connect those two together, connect those two together, temporal and remeasurement. OK, so let's go back through the scenario. So accounted, stated and local currency of a foreign entity. If the economy is highly inflationary, the functional currency is the US dollar. So we ignore the currency that they're working with. We consider the functional currency is the US dollar. And we remeasure using the US dollar using the temporal method. And any adjustment goes to the income statement. If the economy is not inflationary, which is most of the time, what's going to happen? We need to determine the functional currency for the economic indicators by knowing what's the majority of their transaction with their main transaction, like sales, cost of goods, soul payment to the two key employees. If the functional currency is the local currency, as I said, like you are operating in Canada and everything is in Canadian dollar. Then you translate the US dollar using the current rate and all adjustments goes to the balance sheet into OCI. If they're not using the local currency, if they're using the US dollar like a McDonald operating in Niagara Falls, then what's going to happen? What's going to happen is we remeasure to US dollar using the temporal method. If they are not using the US dollar, if they're using now a third currency, here is they're using a third country currency. And this scenario is McDonald operating in Quebec City. And Quebec City wants to follow the French. The French are using the euros. They only accept and they make payments in euros. Then what's going to happen? You have, you remeasure the functional currency using the temporal method. Then you translate the US dollar to the parent company using the current method. So here you have basically two steps. Okay, so now let's go back to translation and remeasurement. What is translation? Okay, the two method. Accounts measured in the functional currency are translated into the reporting currency using the current rate method. Again, we did not talk about the current rate. So basically taking the, basically translating the language from French to English, you're translating the currency from their currency to the parent company currency using the current method. Now, what is the current method? You're going to see what the current method is. We have specific rules about the current method, but basically translation. When you use remeasurement, if a foreign entity does not maintain its record in the functional currency, basically the local currency or the US dollar, the local currency accounts are remeasured into the functional currency using the temporal method. Remeasurement is the process of translating the account of a foreign entity into the functional currency when they are stated in another currency. And we're going to see this once we do the remeasurement. So remeasurement, sometimes it takes two steps. Every time you hear the word translation, you're going to be using the current method and the adjustment goes on the balance sheet. Every time we said we're going to be doing remeasurement, we're going to be using the temporal method and the adjustment goes on the income statement. So basically we only use the current method only when that's kind of the normal method, the normal in a business sense where you're operating in a foreign country and the local currency of that foreign country is the functional currency. Otherwise, if it's the US dollar, you remeasure. If it's something other than the US dollar and other than the functional currency, you have to remeasure, then you have to translate. You have two steps. Are we going to work examples? Yes, we will. So don't worry about this. Just understand when do we use what? Because on the CPA exam, they're going to test you about this. Now, let's talk a little bit more about the translation method, the current method. Remember, every time we said we're using the translation method, it means we're going to be using the current method and the adjustment goes on the balance sheet into OCI. So how do we translate using the translation method? So this is the method. So when we convert current assets and current liability, which exchange rate do we use? We use current exchange rate. When we convert paid in capital, we use historical rate. When we convert beginning retained earnings, something you have to memorize, we will use the ending balance of the prior year. That's the beginning retained earning dividend. Yes, we have to use historical rate when dividend is declared. Revenues and expenses. We have to use the average exchange rate. Why? Because sales are taken place throughout the year. The cumulative translation adjustment goes into the balance sheet. It goes into the balance sheet. When we make the adjustment at the end, and you will see when we work the example, it goes on the balance sheet. Current year translation adjustment, it goes into other comprehensive income on the balance sheet. Now, if you are using the temporal method, or which is the translation method, which is the remeasurement method, I'm sorry, the remeasurement translation method, use the temporal method, and the adjustment goes on the income statement. Here, when you convert monetary assets and liability, which is cash, account receivable, accounts payable, investments, anything that's monetary asset and liabilities, investments, you would use the current exchange rate. Assets and liabilities carried at historical cost, you would use the historical exchange rate. Assets and liabilities carried at current values, if you have anything at current values, then you have to use the current exchange rate. Revenues and expenses related to assets and liabilities translated at historical rate, like if you have a long-term asset, you're going to have depreciation, which is revenues and expenses. Depreciation expense is an expense related to a historical asset. Therefore, you would use the historical rate. Other revenues and expenses other than those related to the historical rate, they are exchanged using the transaction date. And what's going to happen, since you may not be able to keep track of the transaction date, you would use an average rate. So this is what we mean by temporal method. How do you do the translation? Which exchange rate do you use? And this is the current rate method. Which current, which exchange rate do you use when you actually do the translation? So this is basically the starting point, the starting point of things. Things are going to get a little bit more involved to do the actual translation. But the point here is when do we use the temporal method and when do you use the current rate method? So when do we use the remeasurement and when do we use the translation method? When do we use those two methods? Again, so don't confuse them. When you think of translation method, you use the current method. When you think of remeasurement method, you would think of the temporal method. Sometimes you have to use both at the same time when situation is a little bit involved. So let's take a look at this example just to see how it works. Indicator that the local currency is also the functional currency including all the following except. So there's three good answers and one wrong answer. The majority of cash flow are in the local currency. Is this a determination of the functional currency? Of course it is. So that's out. Sales prices are determined by local market conditions. For example, your sales is based on the local market. That's going to tell you what your functional currency is. Financing is generally from the parent company or guaranteed by the parent company. Well, if they're going to be sending you money, you're going to exchange them. And if it's only guaranteed in the money, it doesn't make a difference if it's the functional currency or not. So this is our hold on this. Production costs and expenses are determined by the local condition. Well, that's going to tell you this is one of the main factors or not. But financing, it says it generally, generally from the parent company. So sometime it comes from the parent company or guaranteed. Guaranteed doesn't mean anything if they don't send you the money. Okay? But financing will definitely is the weakest one. So all the following will help you determine the functional currency, but financing doesn't really, doesn't really. Obviously in the next session, we have to work examples. We have to show you how the current method work. We have to show you how the temporal method work, which is the remeasurement and translation using actual numbers. Specifically, we're going to be focusing the most important part of it. Because if you notice here, kind of basically take one number multiplied by the exchange rate as long as you have this list. We're going to also talk about how do we reconcile retained earning. And it's going to be the most interesting part on when we work the example. If you have any questions, any comments by all means, email me if you want more lectures, please visit my website. And if you do so, please consider donating. Thank you very much. And if you're studying for your CPA exam, as always, study hard. It's worth it.