Chapter 11

Translation of

ForeignFinancial

Statements

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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

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FASB’s Statement No. 52 Adopted a functional currency approach The previous standard (SFAS No. 8)

employed the temporal method

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Functional currency 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

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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

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Expected economic effects of a rate changeThe foreign entity is a conduit: Cash inflows/outflows are affected Translation gains/losses should be included in net income

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Expected economic effects of a rate change (con’t)The foreign entity is not a conduit: Cash inflows/outflows are not affected No translation gains/losses should be included in net income

(include as a component of other comprehensive income)

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Reflect financial results and relationships in conformity with U.S. GAAP If not affected by rate changes, the relationship between accounts (e.g., current ratio,

debt / equity ratio) should be the same after translation as they were before If affected by rate changes, relationships between accounts are different than they

were prior to translation, therefore, reflecting the economic effect of rate changes Foreign financial statements should be restated into U.S. GAAP before translation

begins

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The translation process

Start

End

Convert foreign financial statements to GAAP

Identify the “Books of Record” (BR) currency and the

“Functional Currency” (FC)

Is FC the inflationarycurrency? Yes

No

Is BR = FC?

Use functional method to get FC into

$’s

No

Noapply the remeasurement process (shown later)

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The translation of financial statement accounts

Account Functional MethodAssets & Liabilities:

At current values or monetary items(defined next slide) Current

Not as current values of nonmonetaryitems (defined next slide) Current

Revenues and Expenses:Representing amoritzation of historicalamounts Weighted Average

Not representing amoritzation ofhistorical amounts Weighted Average

Equity accounts (excluding RE) Historical

Retained EarningsBeginning balance plus

translated net income lesstranslated dividends

Translation adjustment recorded as acomponent of Other Comprehensive Income

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The translation of financial statement accounts (con’t)Monetary items: rights to receive or pay an amount of money which is:

(a) fixed or

(b) determinable without reference to future prices of specific goods/services; that is, its value does not change according to changes in price levels.

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Accounting for the 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

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Reconciliation of the annual translation adjustmentNet assets at the beginning of the period

multiplied by the change in exchange rates during the period

[100,000 FC ($1.05 - $1.00)] = $5,000 Increase in net assets (excluding capital

transactions) multiplied by the difference between the current rate and the average rate used to translate income

[50,000 FC ($1.05 - $1.03)] = $1,000continued . . .

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Increase 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

[60,000 FC ($1.05 - $1.00)] = 3,000

Translation adjustment (credit) = $9,000

Reconciliation of the annual translation adjustment (con’t)

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OCI gains and losses Attributable to foreign currency transactions

that are designated and effective as economic hedges of a net investment in a foreign entity, commencing as of the designation date.

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OCI gains and losses (con’t) Attributable to intercompany foreign currency

transactions that are of a long-term investment nature (i.e., settlement is not planned nor anticipated in the foreseeable future) when the entities to the transaction are consolidated, combined, or accounted for by the equity method in the reporting enterprise’s financial statements.

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Special issues related to consolidating the foreign subsidiary The translation adjustment is allocated between

the controlling and noncontrolling interests Any excess of cost over book value is

translated at the end of the period exchange rate Any amortization of excess is translated at the

average exchange rate for the period

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Special issues related to consolidating the foreign subsidiary (con’t) Unrealized intercompany profits must be

eliminated using the rate of exchange which existed at the date of the intercompany transaction

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Special issues related to the sophisticated equity method

The investor’s share of the investee’s translated net income

Amortization of any excess of cost over book value

The investor’s share of the cumulative translation adjustment

The investment account includes:

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Remeasured financial statements 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

Remeasurement is based on the temporal method

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Remeasurement is necessary when The foreign entity’s financial statements are prepared in a currency that is not

the functional currency. The functional currency may be– another foreign currency– the U.S.dollar

The foreign entity’s functional currency is that of a highly inflationary economy

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The remeasurement process

Start

A

Convert foreign financial statements to

GAAP

Identify the “Books of Record” (BR) currency

and the “Functional Currency” (FC)

Is BR =

FC?

Is FC = inflationar

y currency?

Use Temporal method

Is FC = $?

A

Use Temporal method

End

Use Temporal method to get into

functional currencyEnd

Yes

No

Yes No

Yes

A apply the translation process shown earlier

No

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Remeasurement of financial statement accounts

Account Temporal MethodAssets & Liabilities:

At current values or monetary items CurrentNot as current values or nonmonetaryitems Historical

Revenues and Expenses:Representing amoritzation of historicalamounts Historical

Not representing amoritzation ofhistorical amounts Weighted Average

Equity accounts (excluding RE) Historical

Retained EarningsBeginning balance plus

remeasured net income lessremeasured dividends

Translation adjustment recorded as acomponent of Net Income

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Special remeasurement issues Application of lower of cost or market for inventory Historical exchange rates for purchase accounting Remeasured financial statements may still need to be translated Equity method of accounting for an investment should include the

appropriate share of remeasurement gains or losses

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Tax allocation implications Interperiod tax allocation: appropriate if translation/remeasurement

adjustments are included in income in a different period for tax purposes versus accounting purposes

Intraperiod tax allocation: appropriate if translation adjustments are included in other comprehensive income rather than operating net income

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Disclosure requirements

Beginning and ending amount of cumulative translation adjustments

The aggregate adjustment for the period resulting from translation adjustments and gains and losses from certain hedges and intercompany balances

An analysis of the cumulative translation adjustment including:

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Disclosure requirements (con’t) The amount of income taxes for the period allocated to translation adjustments The amounts transferred from cumulative translation adjustments in OCI and

included in determining net income for the period as a result of the sale or complete or substantially complete liquidation of an investment in a foreign entity