Chapter 11 Translation of Foreign Financial Statements

C112 Foreign currency translation uThe process of expressing amounts denominated or measured in foreign currencies into amounts measured in the reporting currencies of the domestic entity uRelationships suggesting the need for translation –home office/branch –parent/subsidiary –investor/investee

C113 FASB’s Statement No. 52 uAdopted a functional currency approach uThe previous standard (SFAS No. 8) employed the temporal method

C114 Functional currency uThe currency of the primary economic environment in which the entity generates and expends cash uA number of factors must be evaluated in order to properly identify the functional currency

C115 Objectives of the translation process uProvide information that is generally compatible with the expected economic effects of a rate change on an enterprise’s cash flows and equity uReflect 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

C116 Expected economic effects of a rate change The foreign entity is a conduit: uCash inflows/outflows are affected uTranslation gains/losses should be included in net income

C117 Expected economic effects of a rate change (con’t) The foreign entity is not a conduit: uCash inflows/outflows are not affected uNo translation gains/losses should be included in net income (include as a component of other comprehensive income)

C118 Reflect financial results and relationships in conformity with U.S. GAAP uIf 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 uIf affected by rate changes, relationships between accounts are different than they were prior to translation, therefore, reflecting the economic effect of rate changes uForeign financial statements should be restated into U.S. GAAP before translation begins

C119 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 inflationary currency? Yes No Is BR = FC? Use functional method to get FC into $’s No apply the remeasurement process (shown later)

C1110 The translation of financial statement accounts

C1111 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.

C1112 Accounting for the translation adjustment uThe adjustment is NOT included in net income uThe adjustment is shown as a separate component of other comprehensive income (OCI) uThe 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

C1113 Reconciliation of the annual translation adjustment ¬Net assets at the beginning of the period multiplied by the change in exchange rates during the period [100,000 FC  ($ $1.00)] = $5,000 ­Increase in net assets (excluding capital transactions) multiplied by the difference between the current rate and the average rate used to translate income [50,000 FC  ($ $1.03)] = $1,000 continued...

C1114 ®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  ($ $1.00)] = 3,000 Translation adjustment (credit) = $9,000 Reconciliation of the annual translation adjustment (con’t)

C1115 OCI gains and losses uAttributable 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.

C1116 OCI gains and losses (con’t) uAttributable 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.

C1117 Special issues related to consolidating the foreign subsidiary uThe translation adjustment is allocated between the controlling and noncontrolling interests uAny excess of cost over book value is translated at the end of the period exchange rate uAny amortization of excess is translated at the average exchange rate for the period

C1118 Special issues related to consolidating the foreign subsidiary (con’t) uUnrealized intercompany profits must be eliminated using the rate of exchange which existed at the date of the intercompany transaction

C1119 Special issues related to the sophisticated equity method uThe investor’s share of the investee’s translated net income uAmortization of any excess of cost over book value uThe investor’s share of the cumulative translation adjustment The investment account includes:

C1120 Remeasured financial statements uThe 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 uRemeasurement is based on the temporal method

C1121 Remeasurement is necessary when uThe 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 uThe foreign entity’s functional currency is that of a highly inflationary economy

C1122 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 currency End Yes No Yes No Yes A apply the translation process shown earlier No

C1123 Remeasurement of financial statement accounts

C1124 Special remeasurement issues uApplication of lower of cost or market for inventory uHistorical exchange rates for purchase accounting uRemeasured financial statements may still need to be translated uEquity method of accounting for an investment should include the appropriate share of remeasurement gains or losses

C1125 Tax allocation implications uInterperiod tax allocation: appropriate if translation/remeasurement adjustments are included in income in a different period for tax purposes versus accounting purposes uIntraperiod tax allocation: appropriate if translation adjustments are included in other comprehensive income rather than operating net income

C1126 Disclosure requirements uBeginning and ending amount of cumulative translation adjustments uThe 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:

C1127 Disclosure requirements (con’t) uThe amount of income taxes for the period allocated to translation adjustments uThe 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