Translation Of Foreign Currency Transactions Chapter 9 Translation Of Foreign Currency Transactions

The Need For Translation Foreign Currency Transaction Buying or selling goods or services Borrowing or lending money denominated in a foreign currency Acquiring investments that must be paid for in a foreign currency Hedging transaction © 2008 Clarence Byrd Inc.

The Need For Translation Foreign Currency Financial Statements Significantly influenced companies Subsidiaries Integrated Self-sustaining Joint ventures © 2008 Clarence Byrd Inc.

Terminology SPOT RATE: The term spot rate is used to refer to the exchange rate at a particular point in time. In accounting literature, the most relevant spot rate is the one that prevails at the Balance Sheet date and, in this context, it is generally referred to as the current rate. There are at least two “spot” rates at any point in time Bid rate Ask rate © 2008 Clarence Byrd Inc.

Terminology HISTORIC RATE: This term is used to refer to the exchange rate that prevailed at the time a particular Balance Sheet item was: - acquired (asset) or - incurred (liability). © 2008 Clarence Byrd Inc.

Alternative Methods of Translation Current / Non-Current Method Monetary / Non-Monetary Method Temporal Method Current Rate Method Completely Discredited © 2008 Clarence Byrd Inc.

The Temporal Method The Concept Items valued at current values are translated using current exchange rates. Items valued at historic values are translated using historic exchange rates. © 2008 Clarence Byrd Inc.

The Temporal Method Example Inventories carried at cost would be translated at historic rates Inventories carried at net realizable value would be translated at current rates © 2008 Clarence Byrd Inc.

Temporal As Per CICA Handbook Paragraph 1651.03(c)(i) The temporal method is a method of translation that translates assets, liabilities, revenues and expenses in a manner that retains their bases of measurement in terms of the Canadian dollar (i.e., it uses the Canadian dollar as the unit of measure). In particular: monetary items are translated at the exchange rate in effect at the balance sheet date; non-monetary items are translated at historical exchange rates, unless such items are carried at market, in which case they are translated at the exchange rate in effect at the balance sheet date; revenue and expense items are translated at the exchange rate in effect on the dates they occur; depreciation or amortization of assets translated at historical exchange rates is translated at the same exchange rates as the assets to which it relates. © 2008 Clarence Byrd Inc.

Temporal As Per CICA Handbook Monetary Items Defined Paragraph 1651.03(b) Monetary items are money and claims to money the value of which, in terms of the monetary unit, whether foreign or domestic, is fixed by contract or otherwise. Future Income tax liabilities and assets are classified as monetary items. © 2008 Clarence Byrd Inc.

Temporal As Per CICA Handbook Items specified as non-monetary Investments in equity instruments carried at cost Inventories carried at cost Prepaid items Property, plant and equipment and accumulated amortization Patents, trademarks, licenses and formulas Goodwill Other intangible assets (including deferred charges) Deferred income Share capital (see Paragraph 9-31) Revenue and expenses related to non-monetary items, including: Cost of goods sold Depreciation and amortization (including amortization of deferred income) © 2008 Clarence Byrd Inc.

Temporal As Per CICA Handbook Other Guidance On Monetary Items Paragraph 1651.47 Preference shares of a foreign operation held by the reporting enterprise are translated in the same manner as common shares (i.e., at historical rates) unless redemption is either required or imminent, in which case the current rate is used. ... Paragraph 1651.52 Future income tax liabilities and assets are monetary items and, as such, are translated at the current rate. © 2008 Clarence Byrd Inc.

Conceptual Definition Vs. CICA The two approaches provide identical results References to monetary confuse temporal with monetary vs. non-monetary © 2008 Clarence Byrd Inc.

Temporal Method and FC Transactions Paragraph 1651.14 At the transaction date, each asset, liability, revenue or expense arising from a foreign currency transaction of the reporting enterprise should be translated into Canadian dollars by the use of the exchange rate in effect at that date. [October, 2006] Use Of Averages If Transactions occur uniformly over the period Exchange rate changes uniformly over the period © 2008 Clarence Byrd Inc.

Temporal Method and FC Transactions Paragraph 1651.16 At each balance sheet date, monetary items denominated in a foreign currency should be adjusted to reflect the exchange rate in effect at the balance sheet date. (July, 1983) Paragraph 1651.18 At each balance sheet date, for non-monetary assets of the reporting enterprise that are carried at market, the Canadian dollar equivalent should be determined by applying the exchange rate in effect at the balance sheet date to the foreign currency market price. (July, 1983) © 2008 Clarence Byrd Inc.

Exchange Gains And Losses Source Some items are translated at current rates As the rate changes, gains and losses arise © 2008 Clarence Byrd Inc.

Exchange Gains And Losses Balance Sheet Item Exchange Rate Movement Effect on Income Asset Increase Gain Decrease Loss Liability © 2008 Clarence Byrd Inc.

Required Treatment of Gains and Losses Paragraph 1651.120 An exchange gain or loss of the reporting enterprise that arises on translation or settlement of a foreign currency-denominated monetary item or a non-monetary item carried at market should be included in the determination of net income for the current period. (January, 2002) © 2008 Clarence Byrd Inc.

Required Treatment of Gains and Losses An Exception Changes in fair value on available-for-sale investments to Other Comprehensive Income Exchange gains and losses receive comparable treatment © 2008 Clarence Byrd Inc.

Required Treatment of Gains and Losses Foreign Currency Financial Statements receive different treatment (see Chapter 10) © 2008 Clarence Byrd Inc.

Disclosure Paragraph 1651.37 The amount of exchange gain or loss included in net income should be disclosed (see paragraphs 1651.20, 1651.24 and 1651.31). An entity may exclude from this amount those exchange gains or losses arising on financial instruments classified as held for trading in accordance with "Financial Instruments — Recognition And Measurement", Section 3855. An entity may also exclude from this amount exchange gains or losses on available-for-sale financial assets and cash flow hedges (see "Hedges", Section 3865) included in any gains or losses removed from accumulated other comprehensive income and included in net income for the period. (October, 2006) © 2008 Clarence Byrd Inc.

Disclosure Paragraph 1520.03 contains an identical recommendation © 2008 Clarence Byrd Inc.

Foreign Currency Purchases and Sales Two transaction approach required Transaction recorded at current rate Exchange gains and losses into income as they arise © 2008 Clarence Byrd Inc.

Foreign Currency Purchases and Sales On December 12, 2007, a Canadian company purchases Inventory in Switzerland for 100,000 Swiss Francs (SF, hereafter). At this time SF1 = $0.94. When the company closes its books on December 31, 2007, the Inventory is still on hand and the Accounts Payable has not been paid. On this later date SF1 = $0.96. © 2008 Clarence Byrd Inc.

Foreign Currency Purchases and Sales December 12, 2007 Inventory [(SF)($100,000)($0.94)] $94,000 Accounts Payable December 31, 2007 Exchange Loss [(SF100,000)($0.96 - $0.94)] $2,000 © 2008 Clarence Byrd Inc.

Foreign Currency Capital Transaction Example On December 31, 2008, a Canadian Company with a December 31 year end borrows €1,000,000. At this time €1 = $1.40. On December 31, 2009, the rate for the Euro is €1 = $1.50 and on December 31, 2010, the rate is €1 - $1.55. On this latter date the loan is repaid. Ignore interest payments. © 2008 Clarence Byrd Inc.

Foreign Currency Capital Transaction December 31, 2008 Cash [(€1,000,000)($1.40)] $1,400,000 Liabilities December 31, 2009 Exchange Loss [(€ 1,000,000)($1.50 - $1.40) $100,000 © 2008 Clarence Byrd Inc.

Foreign Currency Capital Transaction December 31, 2010 Exchange Loss [(€1,000,000)($1.55 - $1.50)] $50,000 Liabilities Liabilities [€1,000,000)($1.55)] $1,550,000 Cash © 2008 Clarence Byrd Inc.

Held-To-Maturity Investments Example On January 1, 2008, Empire Inc. acquires £200,000 in long-term debt of a British company. At this time £1 = $2.15. On December 31, 2008, when Empire Inc. closes its books, the exchange rate is £1 = $2.25. © 2008 Clarence Byrd Inc.

Held-To-Maturity Investments January 1, 2008 Bonds [(£200,000)($2.15)] $430,000 Cash December 31, 2008 Bonds [(£200,000)($2.25 - $2.15)] $20,000 Exchange Gain © 2008 Clarence Byrd Inc.

Available-For-Sale At Cost Investments Example On January 1, 2008, Empire Inc. acquires £200,000 in equity securities of a British company. At this time £1 = $2.15. The investment is classified as available for sale and the shares do not have a quoted market price. On December 31, 2008, when Empire Inc. closes its books, the exchange rate is £1 = $2.25. © 2008 Clarence Byrd Inc.

Available-For-Sale At Cost Investments January 1, 2008 Shares [(£200,000)($2.15)] $430,000 Cash December 31, 2008 No Entry Is Required © 2008 Clarence Byrd Inc.

Held-For-Trading Investments Example On January 1, 2008, Empire Inc. acquires £200,000 in equity securities of a British company. At this time £1 = $2.15. The investment is classified as held for trading. On December 31, 2008, when Empire Inc. closes its books, the market value of the securities has increased to £215,000 and the exchange rate is £1 = $2.25. © 2008 Clarence Byrd Inc.

Held-For-Trading Investments January 1, 2008 Shares [(£200,000)($2.15)] $430,000 Cash December 31, 2008 Shares [(£215,000)($2.25) - $430,000] $53,750 Fair Value Gain – Net Income [(£215,000 - £200,000)($2.25)] $33,750 Exchange Gain – Net Income [(£200,000)($2.25 - $2.15)] 20,000 © 2008 Clarence Byrd Inc.

Available-For-Sale At Fair Value Investments Example On January 1, 2008, Empire Inc. acquires £200,000 in equity securities of a British company. At this time £1 = $2.15. The investment is classified as available for sale. On December 31, 2008, when Empire Inc. closes its books, the market value of the securities has increased to £215,000 and the exchange rate is £1 = $2.25. © 2008 Clarence Byrd Inc.

Available-For-Sale At Fair Value Investments January 1, 2008 Shares [(£200,000)($2.15)] $430,000 Cash December 31, 2008 Shares [(£215,000)($2.25) - $430,000] $53,750 Fair Value Gain – OCI [(£215,000 - £200,000)($2.25)] $33,750 Exchange Gain - OCI [(£200,000)($2.25 - $2.15)] 20,000 © 2008 Clarence Byrd Inc.

Available-For-Sale At Fair Value Investments Reclassification If investments are sold, the Other Comprehensive Income amounts will be reclassified into Net Income © 2008 Clarence Byrd Inc.

Hedging An extremely complex area Our coverage is limited to simple applications in the area of foreign exchange risk © 2008 Clarence Byrd Inc.

Hedging Paragraph 3865.02 Hedging is an activity designed to modify an entity's exposure to one or more risks by creating an offset between changes in the fair value of, or the cash flows attributable to, the hedged item and the hedging item (or changes resulting from a particular risk exposure relating to those items). © 2008 Clarence Byrd Inc.

Hedged Items In General Paragraph 3865.07(c) A hedged item is all or a specified portion of a recognized asset, a recognized liability, an anticipated transaction, or a net investment in a self-sustaining foreign operation, or a group of similar recognized assets, recognized liabilities or anticipated transactions, having an identified risk exposure that an entity has taken steps to modify. © 2008 Clarence Byrd Inc.

Hedged Items: Foreign Currency Applications Foreign currency denominated monetary assets or monetary liabilities Anticipated Transactions Firm commitments Forecasted transactions Investments in self-sustaining foreign operations © 2008 Clarence Byrd Inc.

Hedging Items In General Paragraph 3065.07(d) A hedging item is all or a specified percentage of a derivative, or all or a specified percentage of a group of derivatives offsetting a risk exposure identified in the hedged item. All or a specified percentage of: (i) a non-derivative financial asset; (ii) a non-derivative financial liability; or (iii) a group of non-derivative financial assets or non-derivative financial liabilities, provided that all non-derivative items in a group are similar; may be designated as a hedging item only for a hedge of a foreign currency risk exposure. © 2008 Clarence Byrd Inc.

Hedging Items: Foreign Currency Applications Example On July 1, 2008, a Canadian company purchases merchandise in France for €200,000. At this time €1 = $1.40. The merchandise must be paid for on December 31, 2008. © 2008 Clarence Byrd Inc.

Hedging Items: Foreign Currency Applications Purchase Euros on July 1, 2008 Effective but costly (no return on funds) Purchase financial asset denominated in Euros Some rate of return Low rates on short term investments © 2008 Clarence Byrd Inc.

Hedging Items: Foreign Currency Applications Purchase non-financial assets denominated in Euros Inconvenient May or may not be effective Forward contract to take delivery of Euros on December 31, 2008 Effective Requires no investment of funds © 2008 Clarence Byrd Inc.

A Derivatives Primer Paragraph 3855.19(e) A derivative is a financial instrument or other contract within the scope of this Section with all three of the following characteristics: (i) its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or other variable (sometimes called the "underlying"), provided in the case of a non-financial variable that the variable is not specific to a party to the contract; (ii) it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and (iii) it is settled at a future date. © 2008 Clarence Byrd Inc.

A Derivatives Primer Types Contracts Options Forwards Futures Both parties must perform Options Only one party required to perform © 2008 Clarence Byrd Inc.

A Derivatives Primer Accounting procedures Initial recognition at fair value (often nil) Subsequent measurement at fair value Gains and losses to Net Income (in general) © 2008 Clarence Byrd Inc.

Forward Exchange Contracts Example (From Text Paragraph 9-99) On January 1, 2007, Sandor Inc., a Canadian public company, enters into a forward exchange contract to take delivery of £100,000 on December 31, 2007 at a rate of £1 = $2.30. On January 1, 2007, the exchange rate is £1 = $2.26. © 2008 Clarence Byrd Inc.

Forward Exchange Contracts Initial Recognition No consideration for contract Fair value = nil No recognition in the financial statements © 2008 Clarence Byrd Inc.

Forward Exchange Contracts Settlement on December 31, 2007 when rate is £1 = $2.33. December 31, 2007 Cash [(£100,000)($2.33)] $233,000 Cash [(£100,000)($2.30)] $230,000 Gain On Contract 3,000 © 2008 Clarence Byrd Inc.

Forward Exchange Contracts If Balance Sheet date occurred prior to settlement of the contract, the fair value of the contract would have to be recorded in the Balance Sheet. This would result in a gain or loss to be included in Net Income. © 2008 Clarence Byrd Inc.

Hedge Accounting Objective Hedge accounting is a method for recognizing the gains, losses, revenues and expenses associated with the items in a hedging relationship such that those gains, losses, revenues and expenses are recognized in net income in the same period when they would otherwise be recognized in different periods. © 2008 Clarence Byrd Inc.

Hedge Accounting Its use is optional Often not necessary (e.g., contract hedging a monetary asset) Sometimes cannot qualify Management may decide not to use © 2008 Clarence Byrd Inc.

Hedge Accounting Qualification Designation Documentation Evaluation for effectiveness (Beyond the scope of this text) © 2008 Clarence Byrd Inc.

Fair Value Hedges Under this approach, gains and losses on the hedging item must be included in Net Income. Gains and losses on the hedged item that are attributable to the hedged risk must also be included in Net Income. © 2008 Clarence Byrd Inc.

Fair Value Hedges Fair value hedge accounting can be used when the hedge is a hedge of the exposure to changes in the fair value of: a recognized asset or liability; an unrecognized firm commitment; or an identified portion of such an asset, liability, or firm commitment. © 2008 Clarence Byrd Inc.

Cash Flow Hedge Accounting Cash Flow Hedge Accounting Under this approach, gains and losses on the hedging item are treated as items of Other Comprehensive Income, rather than as items to be included in the determination of Net Income. © 2008 Clarence Byrd Inc.

Cash Flow Hedge Accounting Cash flow hedge accounting can be used when the hedge is a hedge of the exposure to variability in cash flows associated with: a recognized asset or liability; a forecasted transaction; or the foreign currency risk in an unrecognized firm commitment. © 2008 Clarence Byrd Inc.

Hedge Of Exposed Monetary Balance Example On November 1, 2008, Torcan Ltd. a Canadian company with a December 31 year end, sells merchandise in Switzerland for 1,000,000 Swiss Francs (SF, hereafter). Assume that, at this time, the exchange rate is SF1 = $0.90. On December 31, 2008, the exchange rate is SF1 = $0.92. The merchandise is paid for on February 1, 2009 when the exchange rate is SF1 = $0.95. © 2008 Clarence Byrd Inc.

Example – No Hedge Accounting November 1, 2008 Receivable [(SF1,000,000)($0.90)] $900,000 Sales December 31, 2008 Receivable [(SF1,000,000)($0.92 - $0.90)] $20,000 Exchange Gain © 2008 Clarence Byrd Inc.

Example – No Hedge Accounting February 1, 2009 Receivable [(SF1,000,000)($0.95 - $0.92)] $30,000 Exchange Gain Cash $950,000 Receivable © 2008 Clarence Byrd Inc.

Example – Hedge With Forward Contract On November 1, 2008, Torcan Ltd. a Canadian company with a December 31 year end, sells merchandise in Switzerland for 1,000,000 Swiss Francs (SF, hereafter). Assume that, at this time, the exchange rate is SF1 = $0.90. On December 31, 2008, the exchange rate is SF1 = $0.92. The merchandise is paid for on February 1, 2009 when the exchange rate is SF1 = $0.95. Hedge On November 1, 2008, Torcan enters a contract to deliver SF1,000,000 on February 1, 2009 at a rate of SF1 = $0.92. On December 31, 2008 the one month forward rate is SF1 = $0.93, resulting in a fair value for the contract of $9,950. © 2008 Clarence Byrd Inc.

Example – Hedge With Forward Contract Do We Need Hedge Accounting? Receivable at Fair Value Contract at Fair Value Hedge Accounting Not Required © 2008 Clarence Byrd Inc.

Example – Hedge With Forward Contract November 1, 2008 Receivable [(SF1,000,000)($0.90)] $900,000 Sales December 31, 2008 Receivable [(SF1,000,000)($0.92 - $0.90)] $20,000 Exchange Gain Exchange Loss $9,950 Forward Contract (Liability) © 2008 Clarence Byrd Inc.

Example – Hedge With Forward Contract February 1, 2009 Receivable [(SF1,000,000)($0.95 - $0.92)] $30,000 Exchange Gain Exchange Loss – [(SF1,000,000)($0.95 - $0.92) - $9,950)] $20,050 Forward Contract © 2008 Clarence Byrd Inc.

Example – Hedge With Forward Contract February 1, 2009 Cash $950,000 Receivable Cash [(SF1,000,000)($0.92)] $920,000 Forward Contract ($9,950 + $20,050) 30,000 Cash [(SF1,000,000)($0.95)] © 2008 Clarence Byrd Inc.

Hedge Of Exposed Monetary Balance Example On October 1, 2008, Ardin Ltd. commits to purchasing merchandise in Germany at a cost of €500,000. At this time the spot rate for Euros is €1 = $1.57. The merchandise is to be delivered and paid for on May 1, 2009. On October 1, 2008, Ardin also acquires a term deposit with a maturity value of €500,000 (ignore the interest that would accrue on this asset). On December 31, 2008, when Ardin closes its books, the exchange rate has decreased to €1 = $1.55. On May 1, 2009, the rate is €1 = $1.52. © 2008 Clarence Byrd Inc.

Example – No Hedge Accounting October 1, 2008 Term Deposit [(€500,000)($1.57)] $785,000 Cash December 31, 2008 Exchange Loss [(€500,000)($1.55 - $1.57)] $10,000 Term Deposit © 2008 Clarence Byrd Inc.

Example – No Hedge Accounting May 1, 2009 Exchange Loss [(€500,000)($1.55 - $1.52)] $15,000 Term Deposit Cash [(€500,000)($1.52)] $760,000 Merchandise [(€500,000)($1.52)] Cash © 2008 Clarence Byrd Inc.

Example – No Hedge Accounting The Problem The economic gain on the commitment (i.e., the purchase will now cost less) cannot be recognized. © 2008 Clarence Byrd Inc.

Hedge Of Exposed Monetary Balance Example On October 1, 2008, Ardin Ltd. commits to purchasing merchandise in Germany at a cost of €500,000. At this time the spot rate for Euros is €1 = $1.57. The merchandise is to be delivered and paid for on May 1, 2009. On October 1, 2008, Ardin also acquires a term deposit with a maturity value of €500,000 (ignore the interest that would accrue on this asset). On December 31, 2008, when Ardin closes its books, the exchange rate has decreased to €1 = $1.55. On May 1, 2009, the rate is €1 = $1.52. Document the hedging relationship and use Cash Flow Hedge Accounting. © 2008 Clarence Byrd Inc.

Example – Cash Flow Hedge Accounting October 1, 2008 Term Deposit [(€500,000)($1.57)] $785,000 Cash December 31, 2008 OCI - Exchange Loss [(€500,000)($1.55 - $1.57)] $10,000 Term Deposit © 2008 Clarence Byrd Inc.

Example – Cash Flow Hedge Accounting May 1, 2009 OCI - Exchange Loss [(€500,000)($1.55 - $1.52)] $15,000 Term Deposit Cash [(€500,000)($1.52)] $760,000 Merchandise [(€500,000)($1.52)] Cash © 2008 Clarence Byrd Inc.

Example – Cash Flow Hedge Accounting Alternative 1 – Reclassify Immediately May 1, 2009 Merchandise $25,000 OCI – Reclassification Adjustment © 2008 Clarence Byrd Inc.

Example – Cash Flow Hedge Accounting Alternative 2 – Reclassify When Merchandise Sold January 1, 2010 Cost Of Goods Sold $760,000 Merchandise $25,000 OCI – Reclassification Adjustment © 2008 Clarence Byrd Inc.

Hedge Of Net Investment In Self-Sustaining Operation Paragraph 3865.58 A hedge of a net investment in a self-sustaining foreign operation, including a hedge of a monetary item that is accounted for as part of the net investment (see “Foreign Currency Translation”, Section 1651), should be accounted for as follows: (a) the portion of the gain or loss on the hedging item that is determined to be an effective hedge (see paragraphs 3865.08 -.45) should be recognized in other comprehensive income (see “Comprehensive Income”, Section 1530); and (b) the ineffective portion of the gain or loss on the hedging item should be recognized in net income. The gain or loss on the hedging item relating to the effective portion of the hedge that has been recognized in other comprehensive income should be recognized in net income in the same period during which corresponding exchange gains or losses arising from the translation of the financial statements of the self-sustaining foreign operation are recognized in net income. (October, 2006) © 2008 Clarence Byrd Inc.

Hedge Of Net Investment In Self-Sustaining Operation In Effect: Cash Flow Hedge Accounting © 2008 Clarence Byrd Inc.

Hedge Of Net Investment In Self-Sustaining Operation Reduction In Net Investment Paragraph 1651.31 An appropriate portion of the exchange gains and losses accumulated in the separate component of accumulated other comprehensive income should be included in the determination of net income when there is a reduction in the net investment. (October, 2006) © 2008 Clarence Byrd Inc.

Discontinuance Of Hedge Accounting Discontinue If: The hedging item ceases to exist The hedged item ceases to exist It becomes probable that an anticipated transaction will not occur The entity terminates the hedging designation The hedging relationship ceases to be effective © 2008 Clarence Byrd Inc.

International Convergence Hedging covered in IAS No. 39, Financial Instruments No differences that impact on the material covered in this text Other foreign currency issues in Chapter 10 © 2008 Clarence Byrd Inc.

The End © 2008 Clarence Byrd Inc.