Application of FASB No. 52
Sterling Ltd., the British subsidiary of a U.S. company, started business and acquired fixed assets at the beginning of a year when the exchange rate for the pound sterling was £1=$1.50. The average exchange rate for the period was $1.40, the rate at the end of the period was $1.30, and the historical rate for inventory was $1.45. Refer to Exhibits 10A.2 and 10A.3 for the discussion that follows.
During the year, Sterling Ltd., has after-tax income of £20 million, which goes into retained earnings—that is, no dividends are paid. Thus, retained earnings rise from 0 to £20 million. Exhibit 10A.2 shows how the income statement would be translated into dollars under two alternatives: (1) The functional currency is the pound sterling and (2) the functional currency is the U.S. dollar.
If the functional currency is the pound sterling, Sterling Ltd. will have a translation loss of $22 million, which bypasses the income statement (because the functional currency is identical to the local currency) and appears on the balance sheet as a separate item called cumulative translation adjustment under the stockholders’ equity account. The translation loss is calculated as the number that reconciles the equity account with the remaining translated accounts to balance assets with liabilities and equity. Exhibit 10A.3 shows the balance sheet translations for Sterling Ltd. under the two alternative functional currencies.
Similarly, if the dollar is the functional currency, the foreign exchange translation gain of $108 million, which appears on Sterling Ltd.’s income statement (because the functional currency differs from the local currency), is calculated as the difference between translated income before currency gains ($23 million) and the retained earnings figure ($131 million). This amount just balances Sterling Ltd.’s books.
Sterling Ltd., the British subsidiary of a U.S. company, started business and acquired fixed assets at the beginning of a year when the exchange rate for the pound sterling was £1=$1.50. The average exchange rate for the period was $1.40, the rate at the end of the period was $1.30, and the historical rate for inventory was $1.45. Refer to Exhibits 10A.2 and 10A.3 for the discussion that follows.
During the year, Sterling Ltd., has after-tax income of £20 million, which goes into retained earnings—that is, no dividends are paid. Thus, retained earnings rise from 0 to £20 million. Exhibit 10A.2 shows how the income statement would be translated into dollars under two alternatives: (1) The functional currency is the pound sterling and (2) the functional currency is the U.S. dollar.
If the functional currency is the pound sterling, Sterling Ltd. will have a translation loss of $22 million, which bypasses the income statement (because the functional currency is identical to the local currency) and appears on the balance sheet as a separate item called cumulative translation adjustment under the stockholders’ equity account. The translation loss is calculated as the number that reconciles the equity account with the remaining translated accounts to balance assets with liabilities and equity. Exhibit 10A.3 shows the balance sheet translations for Sterling Ltd. under the two alternative functional currencies.
Similarly, if the dollar is the functional currency, the foreign exchange translation gain of $108 million, which appears on Sterling Ltd.’s income statement (because the functional currency differs from the local currency), is calculated as the difference between translated income before currency gains ($23 million) and the retained earnings figure ($131 million). This amount just balances Sterling Ltd.’s books.