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