Translation of Accounts

When an initial investment is made in a foreign country, transfer of funds result in an exact currency equivalent.

The foreign currency funds are then used abroad to purchase assets, and liabilities are incurred; the resulting net worth has an exact equivalent in the original currency. As business operations are undertaken, changes occur in the assets and liabilities and therefore in the net worth of the business.

The changes that occur in the foreign net worth have an effect on the value of the original investment, and they must be translated into a common currency equivalent for proper evaluation. If changes in the relative values of the currencies concerned also occur, they too must be reflected. The method used in translating the assets and liabilities affects the overall result.

At first sight, it would seem that the easiest way to translate assets and liabilities would be to translate the net worth and the underlying assets and liabilities at the current or spot rate of exchange at a moment in time. The difference between that value and the previous local currency equivalent would represent the profit or loss on the investment for the period. That might be appropriate for liquid assets or liabilities, but it is not generally appropriate for assets or liabilities that are realized over a longer period of time.

The reason is that changes in relative currency values are usually the result of inflationary forces. To protect against erosion of values, internal measures must be taken in the form of price adjustments.

To take a simple example, a machine is purchased in the United States in 1966 by a British businessman for $280,000, which is then equivalent to ₤100,000. The machine has a five-year life. In November 1967 the pound is devalued from $2.80 to $2.40 per pound. In 1971 the British businessman seeks to replace the machine, which is now fully depreciated.

He recouped the original cost of ₤100,000 through depreciation, but he now finds that sum equivalent to only $240,000. In other words, in terms of dollars he has not recovered his original cost; he has suffered a loss of $40,000 over the period. The same effect occurs when only one currency is involved, as when, because of inflation, the replacement cost in local currency is substantially higher. In either case, the businessman has suffered an economic loss.

In the lint illustration given, the businessman could have suffered a further loss if the replacement cost of the equipment in dollars had also increased owing to inflation in the United States.

In order to cope with inflation, the businessman must increase his prices sufficiently that the recovery from the customer covers the increased cost. In the example of machine replacement, the British businessman would have had to recover about ₤117,000 to equal the original $280,000 cost. He would have had to raise his prices to do so. That would have been further complicated by the additional ₤117,000 representing taxable income, some larger amount would have been -required to offset the additional taxes.