1. CHAPTER Translation of Foreign Financial Statements Fundamentals of Advanced Accounting 1 st Edition Fischer, Taylor, and Cheng 7 7

2. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #2 Foreign Currency Translation The process of expressing amounts denominated or measured in foreign currencies into amounts measured in the reporting currencies of the domestic entity Relationships suggesting the need for translation –Home office/branch –Parent/subsidiary –Investor/investee

3. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #3 FASB’s Statement No. 52 Adopted a functional currency approach –Focuses on whether domestic entity cash flows will be directly or indirectly affected by changes in the exchange rates of foreign currencies

4. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #4 Functional Currency The currency of the primary economic environment in which the entity generates and expends cash A number of factors must be evaluated in order to properly identify the functional currency

5. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #5 Objectives of the Translation Process Provide information that is generally compatible with the expected economic effects of a rate change on an enterprise’s cash flows and equity Reflect 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

6. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #6 Expected Economic Effects of a Rate Change Exchange rates may or may not affect cash flows of related company Foreign entity conducts business in its own currency –Exchange rate changes relative to parent do not affect do not affect foreign entity’s cash flow –Translation should not affect net income The foreign entity conducts business in a foreign currency: –Cash inflows/outflows are affected –Translation gains/losses should be included in net income

7. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #7 Summary: Identification of Functional Currency

8. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #8 Basic Translation Process: Functional Currency To Reporting Currency Foreign financial statements should be restated into U.S. GAAP before translation begins If not affected by rate changes, the relationship between accounts (e.g., current ratio, debt-to- equity ratio) should be the same after translation as they were before If affected by rate changes, relationships between accounts are different than they were prior to translation, therefore, reflecting the economic effect of rate changes

9. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #9 Step 2 In Translation Process – Identify Functional Currency Of Foreign Entity If functional currency is foreign entity’s local currency use current rate method to translate –Also called functional or translation method If functional currency is not foreign entity’s local currency use historical rate method to translate –Also called temporal or remeasurement method

10. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #10 Translation Process Applied The basic translation process is applied to foreign sub’s trial balance before it is included in consolidated/combined financial statements.

11. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #11 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 Yes No apply the remeasurement process (shown later)

12. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #12 Current Rate Method

13. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #13 Accounting for the Translation Adjustment Results from the process of translating foreign financial statements from their functional currency into the domestic entity’s reporting currency Since various rates are used, equality of accounting equation is lost Translation adjustment is necessary to balance foreign entity’s trial balance Adjustment is NOT included in net income Adjustment is shown as a separate component of other comprehensive income (OCI)

14. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #14 Direct Calculation: Current Period Translation Adjustment Current period’s adjustment is calculated as follows: 1)Domestic investor’s amount of net assets held at beginning of the period X change in exchange rates during the period 2)Increase/decrease in net assets traceable to net income (excluding capital transactions) X (difference between weighted average exchange rate used in translating income elements and end of period exchange rate) 3)Increase/decrease in net assets traceable to capital transactions X (difference between end of period exchange rate and exchange rate at time of transaction)

15. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #15 Reconciliation of Annual Translation Adjustment – Illustration 7-4 1.Net assets at the beginning of the period multiplied by the change in exchange rates during the period [0 FC  ($1.05 – $1.00)] = $0 2.Increase in net assets (excluding capital transactions) multiplied by the difference between the current rate and the average rate used to translate income [39,000 FC  ($1.05 – $1.03)] = $780 3.Increase in net assets due to capital transactions multiplied by the difference between the current rate and the rate at the time of the capital transaction [100,000 FC  ($1.05 – $1.00)] = 5,000 Translation adjustment = $5,780

16. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #16 Subsequent Recognition Of Translation Adjustment Translation adjustments may affect income when there is a partial or complete sale or complete or substantially complete liquidation of the investment in the foreign entity In this case, some or all of the translation adjustment would be included in the gain/loss on disposition of the investment

17. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #17 Consolidating The Foreign Subsidiary Assume price paid for investment in sub was in foreign currency (FC) Calculation of excess cost is in FC –Any excess of cost over book value is translated at the end of the period exchange rate –Will be translated separately Any amortization of excess is translated at the average exchange rate for the period The translation adjustment is allocated between the controlling and noncontrolling interests

18. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #18 Consolidating The Foreign Subsidiary (continued) Unrealized intercompany profits must ALWAYS be eliminated using the rate of exchange which existed at the date of the intercompany transaction

19. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #19 Other Comprehensive Income Includes Gains and Losses Attributable 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 Intercompany foreign currency transactions that are long-term investments in 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

20. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #20 Remeasured Financial Statements The 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 Remeasurement is based on the temporal method

21. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #21 Unconsolidated Investments – Cost Method Unconsolidated investments are accounted for by –Cost method –Equity method Cost method – complete translation of foreign financial statements not required –Parent records cost of investment in $ Use exchange rate at date of acquisition –Investment income is recorded in $ Use exchange rate at declaration date

22. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #22 Unconsolidated Investments – Sophisticated Equity Method This method requires adjustments of –sub income/loss for amortization of differences between book and market values Translated at weighted average exchange rate –Intercompany profits and losses Investor must recognize its share of cumulative translation adjustment

23. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #23 Remeasurement Is Necessary When The 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 The foreign entity’s financial statements must be remeasured into the functional currency before they are translated into parent’s domestic currency

24. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #24 Remeasured Financial Statements Remeasurement process intended to produce financial statements that are the same as if the foreign entity’s transactions had been originally recorded in the functional currency Historical exchange rates between the functional currency and foreign currency are used to remeasure certain accounts Adjustment from remeasurement process is remeasurement gain/loss –Included as component of net income

25. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #25 The Remeasurement Process Start 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 No A apply the translation process (shown earlier)

26. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #26 Remeasurement of Financial Statement Accounts

27. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #27 Special Remeasurement Issues Application of lower of cost or market (LCM) for inventory –Inventory cost and market values must be expressed in functional currency before LCM is applied Amounts to be remeasured at historical rates precede parent’s date of acquisition –Use rate at date of acquisition Remeasured financial statements may still need to be translated Equity method of accounting for an investment should include the appropriate share of remeasurement gains or losses

28. Copyright 2008 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 7, Slide #28 Highly Inflationary Economies If foreign entity’s financial statements are expressed in functional currency –Statements are translated directly into parent’s reporting currency This procedure not followed if foreign country has highly inflationary economy –Cumulative inflation rate of 100% or more over 3 years –Unstable measure of value likely to produce misleading results Domestic currency serves as foreign entity’s functional currency –Results in remeasurement of statements into $ –No further translation necessary –Remeasurement gain/loss included in current period net income