Homework
PLEASE READ THE ATTACHED LECTURE NOTES AND COMPLTE THE HOMEWORK ASSIGNMENT, THAT IS HIGHLIGHTED AT THE END OF PAGE7
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Translationof Foreign Currency in Financial Statements
And
Preparation of Journal Entries
This week’s focus is on the translation of foreign currency financial statements for the purpose of preparing consolidated financials and posting journal entries.
IAS 21
The Effects of Changes in Foreign Exchange Rates is the standard that explains
· what exchange rate is applied,
· in what circumstances recorded amounts are translated again at current exchange rates, and
· how to account for any exchange differences that arise.
IAS 21 provides guidance on what exchange rates should be used to translate the financial statements and explains how to account for exchange differences.
Please note that IAS 21 does do apply to
· foreign currency derivatives.
· hedge accounting. or
· cash flows arising from transactions in a foreign currency.*
* Reference IFRS 9 Financial Instruments for the first two and IAS 7 Statement of Cash Flows for the last one for guidance.
When preparing consolidated financial statements on a worldwide basis, the foreign currency financial statements prepared by foreign operations must be translated into the parent company’s reporting currency.
Issues related to this translation:
1. Which method should be used, and
2. Where should the resulting translation adjustment be reported in the consolidated financial statements.
Translation methods differ based on which accounts are translated at the current exchange rate and which are translated at historical rates. Accounts translated at the current exchange rate are exposed to translation adjustment (balance sheet exposure).
Different translation methods give rise to different concepts of balance sheet exposure and translation adjustments of differing sign and magnitude.
There are four major methods of translating foreign currency financial statements:
1. current/noncurrent method
2. monetary/non-monetary method
3. temporal method
4. current rate
We will be focusing on the temporal and current rate methods.
CURRENT RATE METHOD
All assets and liabilities are translated at the current exchange rate giving rise to a balance sheet exposure equal to the foreign subsidiary’s net assets. Stockholders’ equity accounts are translated at historical exchange rates. Income statement items are translated at the average exchange rate for the current period.
· Appreciation of the foreign currency results in a positive translation adjustment
· Depreciation of the foreign currency results in a negative translation adjustment
Translating all assets and liabilities at the current exchange rate maintains the relationships that exist in the foreign currency financial statements.
Translating assets carried at historical cost at the current exchange rate results in amounts being reported on the parent’s consolidated balance sheet that have no economic meaning.
TEMPORAL METHOD
A method of foreign currency translation that uses exchange rates based on the time assets and liabilities are acquired or incurred. The exchange rate used also depends on the method of valuation that is used. Assets and liabilities valued at current costs use the current exchange rate and those that use historical exchange rates are valued at historical costs. Source: INVESTOPEDIA
With the temporal method assets are carried at current or future value (cash, marketable securities, receivables) and liabilities are re-measured at the current exchange rate.
· Assets carried at historical cost and stockholders’ equity accounts are re-measured at historical exchange rates.
· Expenses related to assets re-measured at historical exchange rates are re-measured using the same rates.
· Other income statements items are re-measured using the average exchange rate for the period.
· When liabilities are greater than the sum of cash, marketable securities, and receivables, a net liability balance sheet exposure exists.
· Appreciation of the foreign currency results in a re-measurement loss.
· Depreciation of the foreign currency results in a re-measurement gain.
Re-measuring assets carried at historical cost at historical exchange rates maintains the underlying valuation method used by the foreign operation in preparing its financial statements.
Re-measuring some assets at historical exchange rates and other assets at the current exchange rate distorts the relationships that exist among account balances in the foreign currency financial statements.
All of the above is determined by identifying the functional currency of a foreign operation.
· The financial statements of a foreign operation whose functional currency is different from the parent’s reporting currency are translated using the current rate method, with the resulting translation adjustment deferred in stockholders’ equity until the foreign entity is disposed of. Upon disposal of the foreign operation, the accumulated translation adjustment is recognized as a gain or loss in net income.
· The financial statements of foreign operations whose functional currency is the same as the parent’s reporting currency are re-measured using the temporal method with the resulting re-measurement gain or loss reported immediately in net income.
FASB RULES
Statement #52 Summary
Foreign Currency Translation (Issued 12/81)
Summary
Application of this Statement will affect financial reporting of most companies operating in foreign countries. The differing operating and economic characteristics of varied types of foreign operations will be distinguished in accounting for them. Adjustments for currency exchange rate changes are excluded from net income for those fluctuations that do not impact cash flows and are included for those that do. The requirements reflect these general conclusions:
The economic effects of an exchange rate change on an operation that is relatively self-contained and integrated within a foreign country relate to the net investment in that operation. Translation adjustments that arise from consolidating that foreign operation do not impact cash flows and are not included in net income.
The economic effects of an exchange rate change on a foreign operation that is an extension of the parent’s domestic operations relate to individual assets and liabilities and impact the parent’s cash flows directly. Accordingly, the exchange gains and losses in such an operation are included in net income.
Contracts, transactions, or balances that are, in fact, effective hedges of foreign exchange risk will be accounted for as hedges without regard to their form.
More specifically, this Statement replaces FASB Statement No. 8, Accounting for the Translation of Foreign Currency Transactions and Foreign Currency Financial Statements and revises the existing accounting and reporting requirements for translation of foreign currency transactions and foreign currency financial statements. It presents standards for foreign currency translation that are designed to (1) provide information that is generally compatible with the expected economic effects of a rate change on an enterprise’s cash flows and equity and (2) reflect in consolidated statements the financial results and relationships as measured in the primary currency in which each entity conducts its business (referred to as its “functional currency”).
An entity’s functional currency is the currency of the primary economic environment in which that entity operates. The functional currency can be the dollar or a foreign currency depending on the facts. Normally, it will be the currency of the economic environment in which cash is generated and expended by the entity. An entity can be any form of operation, including a subsidiary, division, branch, or joint venture. The Statement provides guidance for this key determination in which management’s judgment is essential in assessing the facts.
A currency in a highly inflationary environment (3-year inflation rate of approximately 100 percent or more) is not considered stable enough to serve as a functional currency and the more stable currency of the reporting parent is to be used instead.
The functional currency translation approach adopted in this Statement encompasses:
a. Identifying the functional currency of the entity’s economic environment
b. Measuring all elements of the financial statements in the functional currency
c. Using the current exchange rate for translation from the functional currency to the reporting currency, if they are different
d. Distinguishing the economic impact of changes in exchange rates on a net investment from the impact of such changes on individual assets and liabilities that are receivable or payable in currencies other than the functional currency
Translation adjustments are an inherent result of the process of translating a foreign entity’s financial statements from the functional currency to U.S. dollars. Translation adjustments are not included in determining net income for the period but are disclosed and accumulated in a separate component of consolidated equity until sale or until complete or substantially complete liquidation of the net investment in the foreign entity takes place.
Transaction gains and losses are a result of the effect of exchange rate changes on transactions denominated in currencies other than the functional currency (for example, a U.S. company may borrow Swiss francs or a French subsidiary may have a receivable denominated in kroner from a Danish customer). Gains and losses on those foreign currency transactions are generally included in determining net income for the period in which exchange rates change unless the transaction hedges a foreign currency commitment or a net investment in a foreign entity. Intercompany transactions of a long-term investment nature are considered part of a parent’s net investment and hence do not give rise to gains or losses.
SOURCE: fasb.org
IFRS RULES
IAS 21
An entity may carry on foreign activities in two ways. It may have transactions in foreign currencies or it may have foreign operations. In addition, an entity may present its financial statements in a foreign currency. The objective of this Standard is to prescribe how to include foreign currency transactions and foreign operations in the financial statements of an entity and how to translate financial statements into a presentation currency. The principal issues are which exchange rate(s) to use and how to report the effects of changes in exchange rates in the financial statements.
This Standard does not apply to hedge accounting for foreign currency items, including the hedging of a net investment in a foreign operation. IAS 39 applies to hedge accounting.
This Standard does not apply to the presentation in a statement of cash flows of the cash flows arising from transactions in a foreign currency, or to the translation of cash flows of a foreign operation (see IAS 7 Statement of Cash Flows).
Functional currency
Functional currency is the currency of the primary economic environment in which the entity operates. The primary economic environment in which an entity operates is normally the one in which it primarily generates and expends cash. An entity considers the following factors in determining its functional currency:
(a) the currency:
(i) that mainly influences sales prices for goods and services (this will often be the currency in which sales prices for its goods and services are denominated and settled); and
(ii) of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services.
(b) the currency that mainly influences labor, material and other costs of providing goods or services (this will often be the currency in which such costs are denominated and settled).
Reporting foreign currency transactions in the functional currency
Foreign currency is a currency other than the functional currency of the entity.
Spot exchange rate is the exchange rate for immediate delivery.
Exchange difference is the difference resulting from translating a given number of units of one currency into another currency at different exchange rates.
Net investment in a foreign operation is the amount of the reporting entity’s interest in the net assets of that operation.
A foreign currency transaction shall be recorded, on initial recognition in the functional currency, by applying to the foreign currency amount the spot exchange rate between the functional currency and the foreign currency at the date of the transaction.
At the end of each reporting period:
(a) foreign currency monetary items shall be translated using the closing rate;
(b) non-monetary items that are measured in terms of historical cost in a foreign currency shall be translated using the exchange rate at the date of the transaction; and
(c) non-monetary items that are measured at fair value in a foreign currency shall be translated using the exchange rates at the date when the fair value was measured.
Exchange differences arising on the settlement of monetary items or on translating monetary items at rates different from those at which they were translated on initial recognition during the period or in previous financial statements shall be recognized in profit or loss in the period in which they arise.
However, exchange differences arising on a monetary item that forms part of a reporting entity’s net investment in a foreign operation shall be recognized in profit or loss in the separate financial statements of the reporting entity or the individual financial statements of the foreign operation, as appropriate. In the financial statements that include the foreign operation and the reporting entity (e.g. consolidated financial statements when the foreign operation is a subsidiary), such exchange differences shall be recognized initially in other comprehensive income and reclassified from equity to profit or loss on disposal of the net investment.
Furthermore, when a gain or loss on a non-monetary item is recognized in other comprehensive income, any exchange component of that gain or loss shall be recognized in other comprehensive income. Conversely, when a gain or loss on a non-monetary item is recognized in profit or loss, any exchange component of that gain or loss shall be recognized in profit or loss
Translation to the presentation currency/Translation of a foreign operation
The Standard permits an entity to present its financial statements in any currency (or currencies). For this purpose, an entity could be a stand-alone entity, a parent preparing consolidated financial statements or a parent, an investor or a venturer preparing separate financial statements in accordance with IAS 27 Consolidated and Separate Financial Statements. If the presentation currency differs from the entity’s functional currency, it translates its results and financial position into the presentation currency.
For example, when a group contains individual entities with different functional currencies, the results and financial position of each entity are expressed in a common currency so that consolidated financial statements may be presented.
An entity is required to translate its results and financial position from its functional currency into a presentation currency (or currencies) using the method required for translating a foreign operation for inclusion in the reporting entity’s financial statements.
The results and financial position of an entity whose functional currency is not the currency of a hyperinflationary economy shall be translated into a different presentation currency using the following procedures:
(a) assets and liabilities for each statement of financial position presented (i.e. including comparatives) shall be translated at the closing rate at the date of that statement of financial position;
(b) income and expenses for each statement of comprehensive income or separate income statement presented (i.e. including comparatives) shall be translated at
exchange rates at the dates of the transactions; and
(c) all resulting exchange differences shall be recognized in other comprehensive income.
Any goodwill arising on the acquisition of a foreign operation and any fair value adjustments to the carrying amounts of assets and liabilities arising on the acquisition of that foreign operation shall be treated as assets and liabilities of the foreign operation. Foreign operation is an entity that is a subsidiary, associate, joint venture or branch of a reporting entity, the activities of which are based or conducted in a country or currency other than
those of the reporting entity.
On the disposal of a foreign operation, the cumulative amount of the exchange differences relating to that foreign operation, recognized in other comprehensive income and accumulated in the separate component of equity, shall be reclassified from equity to profit or loss (as a reclassification adjustment) when the gain or loss on disposal is recognized (see IAS 1 Presentation of Financial Statements (as revised in 2007)).
On the partial disposal of a subsidiary that includes a foreign operation, the entity shall re-attribute the proportionate share of the cumulative amount of the exchange differences recognized in other comprehensive income to the non-controlling interests in that foreign operation. In any other partial disposal of a foreign operation the entity shall reclassify to profit or loss only the proportionate share of the cumulative amount of the exchange differences recognized in other comprehensive income.
SOURCE: ifrs.org
IFRS/GAAP MAJOR DIFFERENCES
FUNCTIONAL CURRENCY DETERMINATION
|
Primary Indicators |
Secondary Indicators |
|
|
IFRS |
1. Currency that mainly influences sales prices for goods and services; often the price sales transaction is denominated 2. Currency of the country whose competitive forces and regulations that determines the sales prices of its goods and services. 3. Currency that mainly influences the labor, materials, and other costs of providing goods and services. |
1. Currency in which financing activities are generated. 2. Currency in which receipts from operating activities are usually retained. 3. Extensions of reporting entity or autonomous. 4. Reporting entity transaction are high or low proportion. 5. Affect of cash flows on reporting entity. 6. Can fulfill debt service without funds from reporting entity. |
|
U.S. GAAP |
1. Currency in which the entity primarily generates and expends cash, if direct extension of parent, may not be local currency. 2. Operations are self contained and integrated in that country. |
NO similar indicators |
SOURCE: www.grantthornton.com April 2012 IFRS vs. US GAAP Reporting Webinar
PLEASE USE THE LINK BELOW FOR DETAILS REGARDING POSTING JOURNAL ENTRIES.
· Preparation of Journal Entries
AIS documentation:
http://docs.oracle.com/cd/E16582_01/doc.91/e15123/enterforeigncurrencyje.htm
This link will serve as your reference (textbook) for this topic. There are five sections included in this Chapter 11 Entering and Processing Foreign Currency Journal Entries.
IAS FUNCTIONAL CURRENCY INDICATORS
Factors Considered in Determining the Functional Currency. Keep in mind that the functional currency of an entity can be difficult to determine in some cases.
In accordance with IAS 21, The Effects of Changes in Foreign Exchange Rates, the following factors should be considered first in determining an entity’s functional currency:
1. The currency (a) that mainly influences sales prices for goods and services and (b) of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services.
2. The currency that mainly influences labor, material, and other costs of providing goods and services.
If the primary factors listed above are mixed and the functional currency is not obviously, the following secondary factors must be considered:
3. The currency is which funds from financing activities are generated.
4. The currency in which receipts from operating activities are usually retained.
5. Whether the activities of the foreign operation are an extension of the parent’s or are carried out with a significant amount of autonomy.
6. Whether transaction with the parent are a large or a small proportion of the foreign entity’s activities.
7. Whether cash flows generated by the foreign operation directly affect the cash flow of the parent and are available to be remitted to the parent.
8. Whether operating cash flows generated by the foreign operation are sufficient to service existing and normally expected debt or whether the foreign entity will need funds from the parent to service its debt.
*International Accounting, Doupnik and Perera, 3rd edition, page 419 Exhibit 8.3
Homework Assignment
This week we are discussing functional currency…what is the definition?
Functional currency is the currency of the subsidiary’s primary economic environment. It is usually identified as the currency in which the company generates and expends cash.
Your assignment is to report on the functional currency of your MNC. When researching your answer keep in mind the following and include details regarding your MNC:
Both U.S. GAAP and IFRS recommend the following factors:
· the location of primary sales markets,
· sources of materials and labor,
· the source of financing, and
· the amount of intercompany transactions should be evaluated in identifying an entity’s functional currency.
U.S. GAAP does not provide any guidance as to how these factors are to be weighted (equally or otherwise) when identifying an entity’s functional currency. Unlike U.S. GAAP, IAS 21 provides a hierarchy of factors to consider (reference the exhibit on the next page for details).
Your initial post reporting on your MNC’s functional currency must be posted up by nlt Saturday evening in order to give everyone in the class the opportunity to respond.
ALSO, you are required to read the postings and respond to at least two of them. If someone asks a question of you, please take the time to also respond to those questions.
Your homework is to be posted in the chapter conference.