chapter 11 - translation of foreign financial statements ppt slides

FISCHER | TAYLOR | CHENG

Translation of Foreign Financial Statements

COPYRIGHT © 2012 South-Western/Cengage Learning 2

Learning Objectives

1. Define the functional currency, and identify factors suggesting the functional currency.

2. Explain the objectives of the translation process.

3. Apply the functional currency translation process to a trial balance, and calculate the translation adjustment.

4. Explain how the translation adjustment is accounted for and how a hedge may be employed.

5. Describe the consolidation process and the sophisticated equity method, giving particular attention to modifications due to translation.

6. Apply the remeasurement process to a trial balance, and explain how to account for the remeasurement gain or loss.

7. Differentiate between the two methods for converting functional currency to the parent/investor’s currency, and explain the circumstances under which each should be used.


Foreign Currency Translation

• The process of expressing amounts denominated or measured in foreign currencies into amounts measured in the reporting currencies of the domestic entity

• Relationships suggesting the need for translation– Home office/branch– Parent/subsidiary– Investor/investee


FASB’s Statement No. 52

• Adopted a functional currency approach• Focuses on whether the domestic reporting

entity’s cash flows will be indirectly or directly affected by changes in the exchange rates of the foreign entity’s currency


Functional Currency

• ASC §830-10-55-5• The currency of the primary economic

environment in which the entity generates and expends cash

• A number of factors must be evaluated in order to properly identify the functional currency

• These factors should be considered both individually and collectively in order to identify the functional currency


Factors Suggesting theFunctional Currency

Exhibit 11-1:


Objectives of the Translation Process

• Provide information that is generally compatible with the expected economic effects of a rate change on an enterprise’s cash flows and equity

• Reflect in consolidated statements the financial results and relationships of the individual consolidated entities as measured in their functional currencies in conformity with U.S. GAAP


Expected Economic Effects of Rate Changes:Functional Currency Is Not the Foreign Currency

• Foreign entity is a conduit for the U.S. parent’s operations• The foreign subsidiary’s translated financial statements are

identical to those statements that would have resulted had the transactions been originally recorded in the dollar functional currency

• The financial statement relationships for the translated financial statements are identical to those that would have resulted had the transactions been originally recorded in the dollar functional currency

• The transactions of the foreign entity had an immediate or potentially immediate impact on the dollar cash flows and equity; therefore, the impact was included in net income


Expected Economic Effects of Rate Changes:Functional Currency Is the Foreign Currency

• The foreign subsidiary operates independently of the U.S. parent, not as a conduit

• Rate changes are not expected to have an immediate impact on the parent’s cash flows


Expected Economic Effects of Rate Changes:Functional Currency Is the Foreign Currency

• No translation gains/losses should be included in current net income– Translation adjustments should be classified as a

separate component of other comprehensive income

IFRS

• Uses “exchange difference” rather than “translation adjustment”

• Method of translating is the same as US-GAAP

• Exchange difference is reported in other comprehensive income


The Translation Process

Start

End

Convert foreign financial statements to GAAP

Identify the “Books of Record” (BR) or local

currency and the “Functional

Currency” (FC)

Is FC an inflationarycurrency?

Yes

No

Is BR the FC?

Use functional method to translate

Yes

Noapply the

remeasure-ment process(shown later)


Current Rate / Functional Method

Account Translate Using…

Assets and Liabilities Current exchange rate

Revenues and Expenses Weighted average rate

Equity accounts (excluding RE) Historical rate on date of investment in the

subsidiary

Retained Earnings

Beginning balance translated using rate on date of investment plus translated net income less

dividends translated at rate on date of declaration

Statement of Cash Flows Components translated at rate in effect at time

of the cash flow; operations at rate used for revenues and expenses


The Cumulative Translation Adjustment

• The adjustment is NOT included in net income• The adjustment is shown as a separate

component of other comprehensive income (OCI)

• The adjustment may be recognized as a component of net income when there is a partial or complete sale/liquidation of the investment in the foreign entity


Direct Calculation of the Current-Period Translation Adjustment

1. Net assets at the beginning of the period multiplied by the change in exchange rates during the period

[0 FC ($1.05 – $1.00)] = $0

2. Change in net assets (excluding capital transactions) multiplied by the difference between the current rate and the average rate used to translate income

[39,000 FC ($1.05 – $1.03)] = $780

continued . . .


Direct Calculation of the Current-Period Translation Adjustment (continued)

• Change in net assets due to capital transactions (including investments by the domestic investor) multiplied by the difference between the current rate and the rate at the time of the capital transaction

[100,000 FC ($1.05 – $1.00)] = 5,000

Current-period translation adjustment = $5,780


Consolidating the Foreign Subsidiary

• Determination of excess is calculated in foreign currency

• All intercompany balances, except for intercompany profits and losses, should be translated at the rates used for all other accounts

• Profits and losses are translated at average rates or approximations


Elimination Entries to ConsolidateTranslated Foreign Subsidiary

• Date alignment and EL eliminations follow usual procedures

• CT elimination allocates P% of Cumulative Translation Adjustment to controlling interest

• D and A eliminations generate CTA amounts:D Markup (markdown) of accounts translated at current rateD Investment in Sub account charged at historical rateD Sub Retained Earnings charged at historical rate

Difference is CTA amount; allocated to Parent and SubA Depreciation/Amortization Expense translated at average rateA Contra accounts charged at current rate

Difference is CTA amount; allocated to Parent and Sub

continued . . .


Elimination Entries to ConsolidateTranslated Foreign Subsidiary

• IA and IS follow usual procedures• Intercompany profit where foreign entity

currency is the functional currency– Use exchange rate at date of original transaction to

determine the amount of unrealized profit to eliminate


Gains and Losses Excluded from Income

• Cumulative translation adjustment• Gains and losses attributable to foreign currency

transactions that are designated and effective as economic hedges of a net investment in a foreign entity

• Intercompany foreign currency transactions that are long-term investments in nature


Unconsolidated Foreign Investments

• Cost method– If investment was in foreign currency, translate

investment using rate from date of acquisition– Investment income (dividends) translated at rate from

date of declaration

• Sophisticated equity method– Record the amortization of the excess of cost over

book value (average rate)– Record share of the current year’s translation

adjustment


Historical Rate / Temporal Method

• Remeasurement is necessary when– Foreign entity financial statements are prepared in a currency

that is not the functional currency• Functional currency is another foreign currency• Functional currency is the U.S. dollar

– The functional currency is that of a highly inflationary economy

IFRS

When an entity's functional currency is the currency of a hyperinflationary economy, restatement of financial statement amounts requires applying changes in general price levels (i.e., the inflation-adjusted approach).



• Remeasure into functional currency before translating into parent’s domestic currency

• The remeasurement process is intended to produce financial statements that are the same as if the entity’s transactions had been originally recorded in the functional currency

• The resulting remeasurement gain or loss is included as a component of net income.


The Remeasurement Process

Use historical rate/temporal

method to remeasure

into functional currency

Start

Convert foreign financial

statements to GAAP

Identify the Books of Record (BR) currency

and the Functional Currency (FC)

Is BR = FC?

Is FC an inflationary currency?

Is FC = $?

End

End

Yes

No

Yes No

Yes

No

Use current rate/function-al method to get FC into $

Use historical

rate/ temporal method

Use historical

rate/ temporal method



Account Remeasure Using…

Assets and Liabilities: Monetary items or measured at current values

Current exchange rate

Not monetary items and not measured at current values

Historical exchange rate

Revenues and Expenses:

Representing amortization of historical amounts

Historical exchange rate

Other income and expense items Weighted average exchange rate for the

period

Equity accounts (excluding RE) Historical exchange rates

Retained Earnings

Beginning remeasured balance plus (minus) remeasured net income (loss) less dividends remeasured at historical

rates

Remeasurement gain or loss Component of current period net income


Historical Rate / Temporal Method (continued)

Monetary items: Rights to receive or pay an amount of money which is:

– Fixed in amount or– Determinable without reference to future prices of

specific goods/services; that is, its value does not change according to changes in price levels

chapter 11 - translation of foreign financial statements ppt slides

Documents

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functional currencyasc

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parentinvestors currency

translation adjustment

foreign currencyforeign

remeasurement process