1. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-1 Multinational Accounting: Translation of Foreign Entity Statements 12 Electronic Presentation by Douglas Cloud Pepperdine University Baker / Lembke / King

2. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-2 The U.S. model, which focuses on the information needs of the common stockholder through the application of generally accepted accounting principles. Differences in Accounting Principles Four major models of accounting

3. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-3 The British model, which focuses on the information needs of bondholders, creditors, and preferred stockholders. Differences in Accounting Principles Four major models of accounting

4. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-4 Spanish The French-Italian- Spanish model, which is based on the information needs of the taxing authorities. Differences in Accounting Principles Four major models of accounting

5. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-5 The German and Scandinavian countries model, which is extremely conservative and uses large number of reserves to reduce income to its lowest level possible. Differences in Accounting Principles Four major models of accounting

6. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-6 Determining the Functional Currency FASB 52 provides specific guidelines for translating foreign currency financial statements.

7. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-7 Determining the Functional Currency What is functional currency? What is functional currency? FASB 52 defines it as the currency of the primary economic environment in which the entity operates. FASB 52 defines it as the currency of the primary economic environment in which the entity operates. Normally, that is the currency of the environment in which an entity primarily generates and expends cash.

8. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-8 Functional Currency Indicators Factors indicating Foreign Currency (Local Currency) is the Functional Currency Factors indicating U.S. Dollar (Parent’s Currency) is the Functional Currency Primarily in foreign currency and do not affect parent’s cash flows Directly impact the parent’s current cash flows and are readily available to the parent company Indicator Cash flows

9. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-9 Functional Currency Indicators Indicator Factors indicating U.S. Dollar (Parent’s Currency) is the Functional Currency Primarily determined by local competition or local government regulations Responsive to short-term changes in exchange rate and worldwide competition Sales prices Factors indicating Foreign Currency (Local Currency) is the Functional Currency

10. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-10 Functional Currency Indicators Factors indicating U.S. Dollar (Parent’s Currency) is the Functional Currency Active local sales markets for company’s products; might be significant amount of exports Sales market mostly in parent’s country, or sales contracts are denominated by parent’s currency Indicator Sales markets Factors indicating Foreign Currency (Local Currency) is the Functional Currency

11. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-11 Functional Currency Indicators Factors indicating U.S. Dollar (Parent’s Currency) is the Functional Currency Labor, materials, and other costs are primarily local costs Production components generally obtained from the parent Indicator Expenses Factors indicating Foreign Currency (Local Currency) is the Functional Currency

12. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-12 Functional Currency Indicators Factors indicating U.S. Dollar (Parent’s Currency) is the Functional Currency Primarily obtained from and denominated in local current units, entity’s operations generate funds sufficient to service financing needs. Primarily from the parent, or other dollar denominated financing Indicator Financing Factors indicating Foreign Currency (Local Currency) is the Functional Currency

13. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-13 Factors indicating U.S. Dollar (Parent’s Currency) is the Functional Currency Few intercompany transactions with parent Frequent intercompany transactions with parents or foreign entity is an investment or financing arm for the parent Indicator Inter- company transactions and arrange- ment Functional Currency Indicators Factors indicating Foreign Currency (Local Currency) is the Functional Currency

14. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-14 Translation Versus Remeasurement Translation is the most common method used and is applied when the local currency is the foreign entity’s functional currency. Remeasurement is the restatement of the foreign entity’s financial statements from the local currency used by the entity into the foreign entity’s functional currency.

15. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-15 Translating Foreign Entity’s Trial Balance Income statement accounts: - Revenue and expenses Generally, weighted average exchange rate for the period covered by the statement Historical exchange rate Current exchange rate on balance sheet date Balance sheet accounts: - Assets and liabilities - Stockholders’ equity Cumulative translation adjustment To Accumulated Other Comprehensive Income

16. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-16 On January 1, 20X1, Peerless Products (U.S.) purchases 80 percent of the outstanding capital stock of German Company (Germany) for $54,000. Translation and Consolidation The local currency for German Corporation is euro( ), which is also the functional currency. On October 1, 20X1, the subsidiary declared and paid dividends of 6,250. The subsidiary received $4,200 in sales transactions with a U.S. company when the exchange rate was $1.20 = 1.

17. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-17 Translation and Consolidation Relevant direct spots exchange rates ($/ 1) are: January 1, 20X1$1.20 October 1, 20X11.36 December 31, 20X11.40 20X1 average1.30 Date Rate Jan. 1, 20X1 Investment in Germany Company Stock54,000 Cash54,000 Purchase of Germany Company stock.

18. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-18 G Investment cost$54,000 Book value of investment: Common stock$48,000 Retained earnings12,000 Total$60,000 Percent of German Company’s stock acquired by Peerless Companyx.80(48,000) Differential attributed to goodwill$ 6,000 Translation and Consolidation 1/1/X1 80% P

19. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-19 Peerless German Eliminations Item Products Company Debits Credits Consolidated Investment in German Co. Stock54,000 Differential Common Stock500,00048,000 Retained Earnings300,00012,000 Noncontrolling Interest January 1, 20X1 Workpaper

20. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-20 Peerless German Eliminations Item Products Company Debits Credits Consolidated Investment in German Co. Stock54,00054,000 Differential6,000 Common Stock500,00048,00048,000500,000 Retained Earnings300,00012,00012,000300,000 Noncontrolling Interest12,00012,000 Noncontrolling Interest = ($48,000 + $12,000) x.20 = $12,000 January 1, 20X1 Workpaper

21. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-21 Peerless German Eliminations Item Products Company Debits Credits Consolidated Investment in German Co. Stock54,00054,000 Differential6,0006,000 Patent6,0006,000 Common Stock500,00048,00048,000500,000 Retained Earnings300,00012,00012,000300,000 Noncontrolling Interest12,00012,000 Assign differential January 1, 20X1 Workpaper

22. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-22 Dec. 31, 2001--Translation Trial Balance Balance Exchange Balance, Item Rate $ Cash10,7501.4015,050 Foreign Currency Units3,0001.404,200 Receivables10,5001.4014,700 Inventory5,0001.407,000 Plant and Equipment50,0001.4070,000 Cost of Goods Sold22,5001.3029,250 Operating Expenses14,5001.3018,850 Foreign Currency Transaction Loss5001.30650 Dividends Paid 6,2501.36 8,500 Total Debits123,000168,200 Current exchange rate on balance sheet date Historical exchange rate on date of declaration Weighted- average exchange rate

23. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-23 Accumulated Depreciation7,5001.4010,500 Accounts Payable3,0001.404,200 Bonds Payable12,5001.4017,500 Common Stock40,0001.2048,000 Retained Earnings (1/1)10,000*12,000 Sales 50,0001.30 65,000 Total128,000157,200 Accumulated Other Comprehensive Income-- Translation Adjustment 11,000 Total Credits168,200 *From the January 1, 20X1, translation workpaper. Current exchange rate on balance sheet date Historical exchange rate on date of acquiring subsidiary From the beginning of year translation workpaper Weighted average exchange rate Dec. 31, 2001--Translation Trial Balance Balance Exchange Balance, Item Rate $

24. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-24 Proof of Translation Adjustment Translation Rate $ Net assets at beginning of year50,000 1.2060,000 Adjustment for changes in net assets position during year: Net income for year12,500 1.3016,250 Dividends paid( 6,250)1.36(8,500) Net assets translated at: Rates during year67,750 Rates at end of year56,250 1.4078,750 Change in other comprehensive income-- translation adjustment during year (net increase)11,000 Accumulated other comprehensive income-- translation adjustment, 1/1 -0- Accumulated other comprehensive income-- translation adjustment, 12/31 (credit)11,000 Peerless Products and Subsidiary

25. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-25 Translated Balance Sheet--12/31/X1 Translated Balance Sheet, 12/31/X1 Net assets$78,750Common stock60,000 Retained earnings 7,750 (net income less dividends) Accumulated other comprehensive income--translation adjustment11,000$78,750

26. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-26 Entries on Parent Company’s Books On October 1, 20X1, Peerless Products received a dividend of DM 10,000 and immediately converted it to U.S. dollars. October 1, 20X1 Cash6,800 Investment in German Company Stock6,800 Dividend received from foreign subsidiary. 6,250 x.80 x $1.36 exchange rate

27. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-27 Entries on Parent Company’s Books Equity in the net income of foreign subsidiary is recorded on December 31, 20X1. December 31, 20X1 Investment in German Company Stock13,000 Income from Subsidiary13,000 Equity in net income of foreign subsidiary. 12,500 x.80 x $1.30 average exchange rate

28. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-28 Entries on Parent Company’s Books Amortization of the parent’s portion of the differential assigned to the patent is recorded on December 31, 20X1: December 31, 20X1 Income from Subsidiary650 Investment in German Company Stock650 Amortize differential. 500 x $1.30

29. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-29 Entries on Parent Company’s Books An entry is needed to record the portion of the translation adjustment on the increase in the differential on the investment in foreign subsidiary. December 31, 20X1 Investment in German Company Stock950 Other Comprehensive Income-- Translation Adjustment950 Recognize translation adjustment on increase in differential.

30. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-30 Entries on Parent Company’s Books Peerless Products’ share of the translation adjustment is recorded on December 31, 20X1. December 31, 20X1 Investment in German Company Stock8,800 Other Comprehensive Income-- Translation Adjustment8,800 Parent’s share of change in translation adjustment from translation of subsidiary’s accounts. $11,000 x.80 ownership

31. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-31 1.A foreign sales branch or subsidiary of a U.S. manufacturer which primarily takes orders from foreign customers for U.S.-manufactured goods, which bills and collects from foreign customers. 2.A foreign division, branch, or subsidiary which primarily manufactures a subassembly that is shipped to a U.S. plant. 3.A foreign shipping subsidiary which primarily transports ore from a U.S. Company’s foreign mines to the United States for processing. 4.A foreign subsidiary which is primarily a conduit for Eurodollar borrowing to finance operations in the United States 5.The foreign entity is located in a hyperinflationary economic environment. Situations Requiring Remeasurement 5.The foreign entity is located in a hyperinflationary economic environment. The major reason for remeasurement is Item 5.

32. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-32 5.The foreign entity is located in a hyperinflationary economic environment. The major reason for remeasurement is Item 5.

33. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-33 Remeasuring a Foreign Entity’s Trial Balance Income statement accounts: Weighted-average exchange rate, except revenue from nonmonetary items (historical exchange rate) Weighted-average exchange rate, except costs related to nonmonetary items (historical exchange rate) Revenue-- Expenses--

34. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-34 Remeasuring a Foreign Entity’s Trial Balance -Monetary accounts -Nonmonetary accounts -Equity capital accounts -Retained earnings Current exchange rate Historical exchange rate Prior period’s balance plus income less dividends Remeasurement gain or loss Balance sheet accounts: Included in net income

35. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-35 Chapter Twelve The End