Advanced Financial Accounting: Chapter 7 Accounting for the Effects of Changes in Foreign Exchange Rates Tan & Lee Chapter 7 © 2009

Content Introduction Types of foreign exchange rate management regimes How exchange rates are quoted Types of foreign exchange rate exposures Concept of functional currency Foreign currency transactions of a stand-alone entity Translation of foreign currency financial statements Special issues in translation Evaluation of translation approaches 8. Special issues in translation Tan & Lee Chapter 7 © 2009

Change of Functional Currency A change of functional currency may be due to a change: In primary economic environment In the nature of operating relationship between the foreign operation and the parent Functional currency changes are implemented prospectively No restatement of prior-year financial statements Tan & Lee Chapter 7 © 2009

Change of functional currency Functional currency is changed Translation procedures From To Local currency Parent’s currency Cumulative translation differences remain in equity until disposal Non-monetary assets are translated at the rate on the date when the change is effected All assets and liabilities are translated at closing rate Translation differences are taken to equity Tan & Lee Chapter 7 © 2009

Exchange Differences Arising from Intercompany Transactions Intercompany transactions are normally denominated in either the parent’s currency or the subsidiary’s currency Results in translation gain or loss recorded by one party Translation gain or loss is not eliminated as they are one-sided Long term loan from parent that are “quasi-equity” Considered as part of parent’s net investment in the subsidiary Eg. Interest free loans, loans with no definite or scheduled payment IAS 21 Para 32 requires exchange difference to be reclassified to equity in consolidation Reclassification journal entries in consolidation: Dr Exchange gain on loan (I/S) Cr FCTR (equity) Dr FCTR (equity) Cr Exchange loss on loan (I/S) Tan & Lee Chapter 7 © 2009

Exchange Differences Arising from Intercompany Transactions Nature of monetary item Monetary item denominated in: In parent’s book In foreign operation’s books In consolidated accounts Forms part of parent’s net investment “Quasi-equity” loans Parent’s functional currency No exchange difference is recorded Records exchange difference on monetary item in I/S Exchange difference on monetary item is reclassified to equity (FCTR) Foreign operation’s currency 3rd currency Tan & Lee Chapter 7 © 2009

Exchange Differences Arising from Intercompany Transactions Nature of monetary item Monetary item denominated in: In parent’s book In foreign operation’s books In consolidated accounts Is not part of parent’s net investment Parent’ functional currency No exchange difference is recorded Records exchange difference on monetary item in I/S Flows through to consolidated I/S Foreign operation’s currency 3rd currency Tan & Lee Chapter 7 © 2009

Goodwill Arising from the Acquisition of Foreign Subsidiaries Is goodwill a foreign currency asset? An asset of the acquiree? An asset in the acquirer? Needs to be translated No translation required The position in IAS 21 is that goodwill is a foreign currency asset of the acquiree and has to be translated using the closing rate method. Tan & Lee Chapter 7 © 2009

Equity Accounting for Foreign Associates Associate companies are more likely than subsidiaries to be autonomous entities than integral operations of the investor Functional currency is likely to be the foreign operation’s currency Financial statements are first translated to the presentation currency (the investor’s currency) using the closing rate method Equity accounting is applied subsequently to the translated financial statements Apply the usual equity accounting entries Allocate to investor the proportionate share of foreign currency translation reserves (FCTR) Tan & Lee Chapter 7 © 2009

Carrying Value of Inventories Inventory is carried at lower of cost or net realizable value (NRV) If NRV of inventory is measured in a foreign currency: Reported carrying value is the lower of: Inventory cost (foreign currency) X Actual (historical) rate Inventory at NRV (foreign currency ) X Closing rate Tan & Lee Chapter 7 © 2009

Foreign Operation in a Hyperinflationary Environment Indicators of a hyperinflationary economy: Inflation rate of 100% or more over a period of 3 years; Interest rates, wages and prices that are linked to a price index; Prices that are quoted in a stable currency; and A general population that prefers to keep its wealth in non-monetary assets or in a stable currency Financial statements that are not adjusted for inflation are not useful Misleading to compare transactions that occurred at different times due to loss of purchasing power at a rapid rate IAS 21 requires a restate-then-translate approach Restate using the procedures in IAS 29 All restated amounts (including comparatives) are translated at closing rate at the most recent balance sheet date, except that: Previous year comparable figures in non-hyperinflationary economy currency are not restated Tan & Lee Chapter 7 © 2009

Content Introduction Types of foreign exchange rate management regimes How exchange rates are quoted Types of foreign exchange rate exposures Concept of functional currency Foreign currency transactions of a stand-alone entity Translation of foreign currency financial statements Special issues in translation Evaluation of translation approaches 9. Evaluation of translation approaches Tan & Lee Chapter 7 © 2009

Evaluation of Translation Approaches Objective of translation under SFAS 52 in US GAAP: Provide information that is generally compatible with the expected economic effects of a rate change on the enterprise’s cashflows and equity; and Reflect in the consolidated statements the financial results and relationships of the individual consolidated entities as measured in their functional currencies Tan & Lee Chapter 7 © 2009

Evaluation of Translation Approaches Evaluate the closing rate method against the objectives: An appreciation in the foreign operation currency will result in a translation gain and a loss when the currency depreciates Financial relationships among items in the original financial statements are preserved A major flaw is that the translated balance sheet is neither at historical nor current value Tan & Lee Chapter 7 © 2009

Evaluation of Translation Approaches Evaluate the remeasurement/temporal method against the objectives of translation: Distorts the original financial ratios (use of mixed rates) However, it is argued that if the foreign operation’s functional currency is the same as the parent’s functional currency: The financial ratios should be determined using the functional currency and not the local currency Therefore, this method attempts to “put things right” as though the foreign operation had been conducted in the parent’s functional currency Tan & Lee Chapter 7 © 2009

Conclusions Functional currency should be determined in relation to the primary economic environment of the entity but presentation currency is a “free choice” Remeasurement is used to translate the foreign currency transactions of a stand-alone entity or the financial statements of a foreign operation to its functional currency Apply the closing rate method when translating from the subsidiary’s functional currency to the parent’s presentation currency Special considerations apply to goodwill, intercompany loans that are quasi-equity and translation in hyper-inflationary economies. Tan & Lee Chapter 7 © 2009