change rate throughout the balance sheet. The temporal method provided the con-
ceptual base for the first influential translation standard, Financial Accounting Stan-
dard Board’s (FASB’s) Standard 8 (FAS 8).
The temporal method points to a more general issue: the relationship between
translation and valuation methods for accounting purposes. When methods of valua-
tion provide results that do not reflect economic reality, translation will fail to rem-
edy that deficiency, but will tend to make the distortion very apparent. To illustrate
this point: companies with estate holdings abroad financed by local currency mort-
gages found that under FAS 8 their earnings were subject to considerable translation
losses and gains. This came about because the value of their assets remained con-
stant, as they were carried on the books at historical cost and translated at historical
exchange rates, while the value of their local currency liabilities increased or de-
creased with every twitch of the exchange rate between reporting dates.
In contrast, U.S. companies whose foreign affiliates produced internationally
traded goods (e.g., minerals or oil) felt comfortable valuing their assets on a dollar
basis. Indeed, this latter category of companies was the one that did not like the tran-
sition to the current/current method at all. Here, all assets and liabilities are translated
at the exchange rate prevailing on the reporting date. They found the underlying as-
sumption that the value of all assets (denominated in the local currency of the foreign
affiliate) would change in direct proportion to the exchange rate change did not re-
flect the economic realities of their business.
In order to accommodate the conflicting requirements of companies in different
situations and still maintain a semblance of conformity and comparability, in the
early 1980s the FASB issued Standard 52, replacing Standard 8. FAS 52, as it is
commonly referred to, uses the current/current method as the basic translation rule.
At the same time, it mitigates the consequences by allowing companies to move
translation losses directly to a special subaccount in the net worth section of the bal-
ance sheet, instead of adjusting current income. This latter provision may be viewed
as a mere gimmick without much substance, providing at best a signaling function,
indicating to users of accounting information that translation gains and losses are of
a nature different from items normally found in income statements.
A more significant innovation of FAS 52 is the “functional” currency concept,
which gives a company the opportunity to identify the primary economic environ-
ment and select the appropriate (functional) currency for each of the corporation’s
foreign entities. This approach reflects the official recognition by the accounting pro-
fession that the location of an entity does not necessarily indicate the currency rele-
vant for a particular business. Thus, FAS 52 represents an attempt to take into ac-
count the fact that exchange rate changes affect different companies in different
ways, and that rigid and general rules treating different circumstances in the same
manner will provide misleading information. In order to adjust to the diversity of real
life, FAS 52 had to become quite complex. The following provides a brief road map
to the logic of that standard.
In applying FAS 52, a company and its accountants must make two decisions in
sequence. First, they must determine the functional currency of the entity whose ac-
counts are to be consolidated. For all practical purposes, the choice here is between
local currency and the U.S. dollar. In essence, there are a number of specific criteria
that provide guidelines for this determination. As usual, extreme cases are relatively
easily classified: A foreign affiliate engaged in retailing local goods and services will
have the local currency as its functional currency, while a “border plant” that receives
6 • 12 MANAGEMENT OF CORPORATE FOREIGN EXCHANGE RISK