## **Learning Outcomes**

This article explains how to approach foreign currency translation and hyperinflationary accounting issues tested in the CFA Level 2 exam, enabling you to focus on what affects reported numbers and key ratios. It clarifies the distinction between functional, local, and presentation currencies and links these definitions to the choice of current rate versus temporal translation methods. You learn how foreign currency transaction exposure differs from translation exposure, and how gains and losses from each are reported in the financial statements. The article explains step‑by‑step translation procedures under both methods, highlighting which balance sheet and income statement items use current, historical, or average exchange rates. It emphasizes where translation adjustments are recorded—other comprehensive income versus net income—and how that placement drives differences in profitability, leverage, and coverage ratios. The discussion extends to subsidiaries operating in hyperinflationary economies, contrasting IFRS restatement and translation requirements with US GAAP’s immediate use of the parent’s reporting currency. You also see how inflation adjustments combine with exchange rate changes to affect equity and reported performance. Throughout, the material focuses on interpreting the economic meaning of translation exposures and common exam question traps, such as misclassifying monetary versus nonmonetary items or confusing transaction and translation effects.

## **CFA Level 2 Syllabus**

For the CFA Level 2 exam, you are expected to understand how multinational operations affect financial reporting and analysis, with a focus on the following syllabus points:

- Compare presentation, functional, and local currencies.
- Describe accounting for foreign currency transactions and translation gains/losses.
- Analyze how exchange rate changes affect consolidated financial statements.
- Distinguish between the current rate and temporal methods and their effects.
- Calculate translation results for subsidiaries operating in hyperinflationary economies.
- Assess how translation methods influence financial ratios and reporting quality.

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Which translation method is used when a subsidiary's functional currency matches the parent’s reporting currency?
2. How does the temporal method treat nonmonetary assets on the balance sheet?
3. What is the primary difference in accounting for hyperinflationary subsidiaries under IFRS versus US GAAP?
4. Where is the cumulative translation adjustment (CTA) recorded under the current rate method?

## **Introduction**

Multinational companies must report financial results across different countries, currencies, and environments. Translating foreign operations into the parent’s reporting currency can significantly affect consolidated financial statements and key ratios. The translation method selected, and whether the subsidiary operates in a hyperinflationary economy, determines the recognition and reporting of translation gains, losses, and the quality of reported results. Understanding these differences is essential for financial analysis and for the CFA Level 2 exam.

> **Key Term: Functional Currency**
> The primary currency of the economic environment in which a subsidiary conducts its major operations and generates and expends cash.
>
> **Key Term: Local Currency**
> The currency of the country where the subsidiary is physically located or operates.
>
> **Key Term: Presentation (Reporting) Currency**
> The currency in which the parent company presents its consolidated financial statements.

## Foreign Currency Transaction Exposure

Foreign currency transaction exposure arises when a company enters into transactions denominated in a currency other than its functional currency. Changes in exchange rates between the transaction date and settlement date create gains or losses that must be recognized in the income statement.

> **Key Term: Foreign Currency Transaction Exposure**
> The risk that exchange rate movements between the transaction date and settlement date will affect reported earnings and asset/liability values.

### **Worked Example 1.1**

A US company sells goods to a German customer for €100,000 when the euro is \$1.12. Payment is received 30 days later when the euro is \$1.10. How is the transaction recorded?

> **Answer:**  
> On the transaction date, revenue and receivable are recorded at \$112,000. At settlement, the company receives \$110,000, resulting in a \$2,000 foreign currency transaction loss recognized in the income statement.

### **Exam Warning**

> For CFA exam questions, always recognize that foreign currency transaction gains and losses are income statement items, not equity adjustments.

## Foreign Currency Translation Methods

The method used to translate a foreign subsidiary’s financial statements depends on its functional currency relative to the parent’s reporting currency.

> **Key Term: Current Rate Method**
> All assets and liabilities are translated at the current exchange rate. Income statement items are translated at the average rate. The functional and reporting currencies differ.
>
> **Key Term: Temporal Method**
> Monetary assets and liabilities are translated at the current rate; nonmonetary items are translated at historical rates. Used when the functional and reporting currencies are the same.

### Choosing the Appropriate Method

If the subsidiary’s functional currency is different from the parent’s reporting currency, use the current rate method. If the functional and reporting currencies are the same, use the temporal method. Determination is based on factors such as cash flows, pricing, and financing environment.

### Translation Procedures and Effects

- **Current Rate Method:**
  - All assets and liabilities are translated at the closing (current) rate.
  - Equity accounts (common stock, opening retained earnings) are translated at historical rates.
  - Income statement items are translated at the average rate for the period.
  - The translation gain or loss (cumulative translation adjustment, CTA) is reported in equity (not in net income).
- **Temporal Method:**
  - Monetary assets and liabilities: current rate.
  - Nonmonetary assets and liabilities (e.g., inventory, fixed assets): historical rates.
  - Income statement items related to nonmonetary assets (e.g., COGS, depreciation): historical rates.
  - All other income and expenses: average rate.
  - Translation gain or loss is recognized in net income.

### **Worked Example 1.2**

A UK parent owns a Canadian subsidiary. The subsidiary’s functional currency is CAD. For the year, average exchange rate is £0.60/CAD, closing rate is £0.62/CAD, and historical rates for fixed assets and inventory are £0.58/CAD and £0.56/CAD, respectively. Under the current rate method, at what rates are assets and liabilities translated?

> **Answer:**  
> All assets and liabilities are translated at the closing rate (£0.62/CAD). Income and expense items use the average rate. Equity accounts use historical rates.

## Translation Effects on Financial Ratios

The translation method chosen alters reported assets, liabilities, equity, and profits, and can significantly impact key financial ratios (such as gearing, margins, and turnover). For example, translation losses recorded in equity under the current rate method do not affect profit margins or net income, but translation losses recognized in income under the temporal method reduce net income and profitability ratios.

### **Worked Example 1.3**

If a subsidiary’s net assets are positive and its local currency depreciates, what is the impact under the current rate method?

> **Answer:**  
> A net asset exposure with local currency depreciation leads to a translation loss. The cumulative translation adjustment decreases equity but does not affect net income.

### **Revision Tip**

> For exam scenarios, always check if the translation gain or loss is recognized in equity (current rate) or income (temporal). This almost always determines the effect on key ratios.

## Accounting for Hyperinflation

Hyperinflation significantly distorts local currency financial statements. IFRS and US GAAP differ in handling subsidiaries operating in hyperinflationary economies.

> **Key Term: Hyperinflation**
> A situation where a country’s cumulative inflation exceeds 100% over three years, or price levels rise rapidly and unpredictably, rendering local financial statements unreliable.

### Hyperinflationary Environments

- **US GAAP:**
  - The functional currency is deemed to be the parent’s reporting currency.
  - Temporal method is applied immediately, even if the local currency was previously the functional currency.
- **IFRS:**
  - First, restate local financial statements for inflation using a general price index.
  - Then, translate adjusted statements using the current rate method.
  - The translation gain or loss is reported in equity.

### **Worked Example 1.4**

A Brazilian subsidiary operates in a hyperinflationary economy. Over the year, cumulative inflation is 120%. Under IFRS, what is the translation process?

> **Answer:**  
> First, restate financial statement values for inflation up to the balance sheet date. Next, translate all assets, liabilities, and income at the closing rate. The CTA reflects inflation and currency effects combined and is recognized in equity.

### **Exam Warning (Hyperinflation)**

> On exam questions, do not confuse first-differencing (restatement for inflation) with translation for exchange rates. Under IFRS, restatement is done before currency translation in hyperinflationary contexts.

## **Summary**

Translating foreign subsidiary results for consolidated reporting can materially affect reported income, equity, and ratios. The translation method depends on the relationship between functional and reporting currencies, while hyperinflationary conditions require further adjustment to preserve reporting quality. Understanding the correct method, the impact of translation gains/losses, and their location in financial statements is essential for analyzing multinational operations.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Distinguish between functional, local, and reporting currencies.
- Identify when to use the current rate versus temporal translation methods.
- Understand how each method affects income, equity, and ratios.
- Explain where translation adjustments are recorded under each method.
- Apply appropriate procedures for subsidiaries in hyperinflationary economies.

## **Key Terms and Concepts**

- Functional Currency
- Local Currency
- Presentation (Reporting) Currency
- Foreign Currency Transaction Exposure
- Current Rate Method
- Temporal Method
- Hyperinflation

Multinational operations and reporting quality - Foreign currency translation and hyperinflation