deemed to be the local currency. This treatment acknowledges the parent’s (assume
for the moment a U.S. parent) interest in the local currency performance of the for-
eign affiliate since the latter is viewed as an autonomous operation; that is, a foreign
operation that happens to be owned by a U.S. parent. The temporal translation
method is prescribed when the functional currency is deemed to be the parent cur-
rency. This treatment, which recognizes both transaction and translation gains and
losses in consolidated income, acknowledges the parent company’s interest in the
dollar utility of the foreign affiliate’s activities. The affiliate is viewed as an exten-
sion of the parent company as its operations are integrally related to the latter’s; that
is, a U.S. operation that happens to be located abroad. An exception to the current rate
translation method occurs whenever a foreign subsidiary is located in a high inflation
environment. In this instance, the parent currency is deemed to be functional and the
temporal translation method employed. Being domiciled in a hard currency environ-
ment, the parent is understandably interested in seeing what operating results gener-
ated in soft currency amount to in hard currency terms.
Under the temporal translation method, monetary items are translated to parent
currency at the exchange rate prevailing at the financial statement date, nonmonetary
items at rates that preserve their original measurement bases in local currency, and
income statement items at exchange rates that correspond with the dates of the un-
derlying transactions. If revenue and expense transactions are voluminous, an aver-
age rate may be used to provide an approximation of the actual rates existing during
the period.
In high-inflation environments, financial statements prepared in conformity with
U.S. GAAP tend to distort economic reality by:
- Overstating or understating revenues and expenses
- Misstating interest income or expense
- Reporting large translation gains or losses which are difficult to interpret
- Leaving unresolved the implicit interest problem
- Distorting performance comparisons over time
As a consequence, management is generally provided with an unreliable basis
upon which to intelligently manage a business. There is often a need for parallel con-
trols in order to obtain useful management data.^3 The cost of such dual reporting sys-
tems are nontrivial, especially in today’s competitive environment.
In a world of zero inflation, enterprise income could be measured either as the dif-
ference between revenues and expenses or, utilizing the Hicksian concept of income,
as the change in owners’ equity during the period, barring any additional investments
or withdrawals by the owners. Both measures would be identical and would accurately
describe what transpired during the period. This would not be the case in a world of
changing prices. Differences between the two income measures are attributable to
gains and losses associated with holding monetary assets when performance measures
are couched in terms of local currency and/or exchange gains and losses when per-
formance measures are couched in terms of parent (hard) currency. In a high-inflation
environment, balance sheet comparisons; that is, net asset comparisons, measured on
27 • 2 FINANCIAL REPORTING IN HYPERINFLATIONARY ENVIRONMENTS(^3) Jacque and Lorange, 1984.