1. Chapter 11 Slide 1 Introduction Translation and Consolidation of Foreign Operations

2. Chapter 11 Slide 2 Introduction  Two major accounting questions are posed by the translation to Canadian dollars of subsidiary financial statements presented in a foreign currency:  What exchange rates are appropriate for each balance?  How should the resulting exchange gains and losses be reflected in the Canadian dollar financial statements?  The answers depend on the type of foreign currency exposure the parent faces with the foreign subsidiary

3. Chapter 11 Slide 3 Accounting Exposure Versus Economic Exposure  Foreign currency exposure is the risk that a loss (or gain) could occur as a result of changes in foreign exchange rates  Foreign currency exposure has three components:  Translation exposure (accounting exposure)  Transaction exposure  Economic exposure

4. Chapter 11 Slide 4 Accounting Exposure Versus Economic Exposure  Translation exposure – accounting exposure results from the translation of foreign-currency-denominated financial statements into Canadian dollars, giving rise to exchange gains and losses  Only those financial statement items translated at the closing rate or forward rate create an accounting exposure since the Canadian dollar value of those items changes every time the exchange rate changes (these changes are referred to as “translation adjustments”)  The value of items translated using the historical rate is fixed and does not fluctuate with rate changes Positive translation adjustments increase shareholders’ equity; negative adjustments decrease shareholders’ equity

5. Chapter 11 Slide 5 Accounting Exposure Versus Economic Exposure  Transaction exposure – this exposure represents the foreign exchange loss or gain that can occur between the the time of entering a transaction (e.g. sale or purchase) involving a foreign currency-denominated receivable or payable, and the time of settling it in cash with the customer or vendor  Refer to discussion and examples in Chapter 10  The resulting cash gains and losses are realized and affect the enterprise’s cash flow, working capital, and earnings

6. Chapter 11 Slide 6 Accounting Exposure Versus Economic Exposure  Economic exposure – represents a longer-term risk to the parent that the overall value of its investment in a foreign subsidiary will change (decrease or increase) as a result of exchange rate fluctuations (the PV of future cash flows changes as a result of changes in exchange rates)  Economic exposure varies depending on how closely linked the activities of the parent are to the subsidiary

7. Chapter 11 Slide 7 Functional Currency  IAS 21 provides two methods of translating subsidiary financial statements, depending on the functional currency of the foreign operation  Functional currency is the currency of the primary economic environment in which the entity operates  Normally the currency in which the entity primarily generates and expends cash

8. Chapter 11 Slide 8 Functional Currency Factors to consider in determining functional currency a) The currency: i. that mainly influences sales prices for goods and services (this will often be the currency in which sales prices for its goods and services are denominated and settled); and ii. of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services b) The currency that mainly influences labour, material and other costs of providing goods or services (this will often be the currency in which such costs are denominated and settled)

9. Chapter 11 Slide 9 Functional Currency Other factors to consider in determining functional currency a) the currency in which funds from financing activities (i.e., issuing debt and equity instruments) are generated b) the currency in which receipts from operating activities are usually retained

10. Chapter 11 Slide 10 Functional Currency Additional factors to consider in determining functional currency a) whether the activities of the foreign operation are carried out as an extension of the reporting entity, rather than being carried out with a significant degree of autonomy b) whether transactions with the reporting entity are a high or a low proportion of the foreign operation's activities c) whether cash flows from the activities of the foreign operation directly affect the cash flows of the reporting entity and are readily available for remittance to it d) whether cash flows from the activities of the foreign operation are sufficient to service existing and normally expected debt obligations without funds being made available by the reporting entity

11. Chapter 11 Slide 11 Translation Methods  The translation method used should reflect the parent’s exposure to exchange rate changes  If the functional currency is the same as the functional currency of the reporting entity there is transaction exposure  This is referred to as an integrated foreign operation in the Hilton text  If the functional currency is different from the functional currency of the reporting entity there is economic exposure  This is referred to as a self sustaining foreign operation in the Hilton text

12. Chapter 11 Slide 12 Translation Methods  Functional currency is the same as the functional currency of the reporting entity (integrated foreign operation)  F/S prepared as if the transactions had been transacted by the reporting entity  Functional currency is different from the functional currency of the reporting entity (self sustaining foreign operation)  Preserves the foreign operation’s F/S relationships

13. Chapter 11 Slide 13 Translation Under IAS 21  Same functional currency (integrated foreign operation)  Temporal method  Different functional currency (self-sustaining operation)  Current rate method  Exception exists for self-sustaining subsidiaries in highly inflationary economies where temporal method is more relevant IAS 29 requires judgment to determine when an economy is highly inflationary by examining such factors as whether the population maintains its wealth and financial transactions in more stable foreign currencies

14. Chapter 11 Slide 14 Translation Methods - Temporal  The temporal method  Reflects parent’s close involvement with subsidiary and its cash flows by measuring exposure to monetary assets and liabilities  Uses Canadian dollar as the underlying unit of measure, producing the same result as if the transaction had occurred in Canada in the first place  All monetary items are translated at the balance sheet closing rate  Items carried at fair value are translated at the closing rate on the date when the fair value determination was made  Non-monetary items at historical cost are translated at applicable historical rates (generally, the rate on the date of acquisition of the item)  Exchange gains and losses are recorded in income

15. Chapter 11 Slide 15 Translation Methods - Temporal  Monetary items represent 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  Payables and receivables and all other fixed claims to money are monetary items; inventory is not  Future income tax liabilities and assets are classified as monetary items  Estimated liabilities (such as provisions for warranties) are not considered monetary items

16. Chapter 11 Slide 16 Translation Methods – Current Rate  The current rate method  Reflects the exposure of the subsidiary’s net assets and therefore parent’s investment in subsidiary, to currency fluctuations  Uses the foreign currency as the underlying unit of measure  All assets and liabilities are translated at closing rate  Only net assets (i.e. equity balances) are translated at the historical rate  The translated statements retain the same ratios and relationships that exist in local currency originals, so the translated financial statements can provide an effective tool for the evaluation of local management  Exchange gains and losses are recorded in other comprehensive income

17. Chapter 11 Slide 17 Exhibit 11.5 Translation Under IAS 21 - Comparison Exchange Rates Financial statement itemsTemporal MethodCurrent Rate Method Integrated Self-sustaining Operations Operations MonetaryClosingClosing Non-monetary – at cost or amortized costHistoricalHistorical Closing Non-monetary – at fair value(Note 1)(Note 1) GoodwillHistoricalClosing Deferred revenuesHistoricalClosing Common sharesHistoricalHistorical DividendsHistoricalHistorical RevenuesHistoricalHistorical (2) Depreciation and amortizationHistoricalHistorical (2) Cost of SalesHistoricalHistorical (2) Opening InventoryHistorical -- PurchasesHistorical -- Ending inventoryHistorical -- Note 1:The rate of the date that fair value was determined should be used. If fair value was determined on the last day of the period, then the closing rate should be used Note 2: If even throughout the year, use Average Rate for Current Rate – for Current Rate Income statement, all items use Average Rate

18. Chapter 11 Slide 18 Translation Under IAS 21  Same functional currency (integrated subsidiaries):  Because of the interdependent relationship with the parent, translation gains and losses are reported in income just as they would be if the parent itself had conducted the underlying transactions  Different functional currency (self-staining subsidiaries): Because of the more independent relationship that exists between the parent and subsidiary, the parent’s exposure is limited to its net investment in the subsidiary Translation gains and losses are reported in other comprehensive income in the year they occur, and in cumulative other comprehensive income in subsequent years

19. Chapter 11 Slide 19 Translation Under IAS 21  When the parent sells all or part of its self-sustaining foreign operations, the cumulative exchange gains and losses on the foreign operation are removed from the cumulative other comprehensive income section of shareholder’s equity and the realized gains or losses are reported in the regular income statement

20. Chapter 11 Slide 20 Translation under IAS 21  The interrelationship of the functional currency, the classification of the foreign entity, and the translation method can be summarized as follows: Functional currency of foreign entity Classification of foreign entity Translation method Translation adjustment reported in Same as parent’sIntegratedTemporal methodNet income Currency of country where its resides Self-sustainingCurrent rate method Other comprehensive income Currency of a country other than parent’s country and other than country where it resides Self-sustainingCurrent rate method Other comprehensive income

21. Chapter 11 Slide 21 Subsequent to Acquisition  Revenues and expenses can be translated at average rates if they occur evenly  Amortization of allocation differential (AD):  Integrated subsidiaries (temporal method): The translation of AD amortization is at the historical rate on the date of acquisition  Self-staining subsidiaries (current rate method): Translate opening AD at prior year-end closing rate, translate amortization at average rate, and compare ending result to ending foreign currency AD translated at the current year’s closing rate. The difference represents a translation gain or loss recorded in OCI

22. Chapter 11 Slide 22 Subsequent to Acquisition  Calculation of translation gain or loss:  Integrated subsidiaries (temporal method): Calculate expected net monetary position in foreign currency, translate result at closing rate and compare to actual net monetary position Difference is a translation gain or loss recorded in income  Self-sustaining subsidiaries (current rate method): Calculate expected net asset position in foreign currency, translate result at closing rate and compare to actual net asset position Difference is a translation gain or loss recorded in OCI

23. Chapter 11 Slide 23 Illustration  Example: At the beginning of the year, parent invests 500 foreign currency units (FCU) in a subsidiary when 1 FCU = 1 Canadian dollar (CAD)  The net assets were held for the entire year, with no sales or expenses incurred  At the end of the year, the exchange rate has changed to 1 FCU = 1.5 CAD

24. Chapter 11 Slide 24 Illustration FCUExch. RateCADGain (loss) Cash and A/R 2001.5300100 Inventory at cost 3001.03000 Fixed assets at cost 5001.05000 Accounts payable -1001.5-150-50 Long-term debt -4001.5-600-200 Net assets 500 Translation loss -150 Net monetary position at end of year = 200 – 100 – 400 = - $300 - $300 x (1.5-1.0) change in exchange rate = - $150 exchange loss recorded in income

25. Chapter 11 Slide 25 Illustration FCUExch. RateCADGain (loss) Cash and A/R 2001.5300100 Inventory at cost 3001.5450150 Fixed assets at cost 5001.5750250 Accounts payable -1001.5-150-50 Long-term debt -4001.5-600-200 Net assets 500 Translation loss 250 Net asset position at end of year = $500 $500 x (1.5-1.0) change in exchange rate = $250 exchange gain recorded in other comprehensive income

26. Chapter 11 Slide 26 Illustration  The integrated subsidiary produces a $150 exchange loss recorded in income while the self-sustaining subsidiary produces a $250 gain recorded in other comprehensive income

27. Chapter 11 Slide 27 Comparative Observations of the Two Translation Methods  Temporal method – the monetary position is at risk from foreign currency fluctuations  Current rate method – the net asset position of the foreign equity is at risk from foreign currency fluctuations  For most companies monetary liabilities are greater than monetary assets so they are usually in a net monetary liability position  This will result in exchange losses for integrated subsidiaries when foreign currency appreciates in value  Most companies have positive net assets  This will result in exchange gains for self-sustaining subsidiaries when foreign currency appreciates in value

28. Chapter 11 Slide 28 Other Considerations  Conformity to IFRS: if foreign subsidiary financial statements are prepared under foreign GAAP they must be adjusted to IFRS before translation and consolidation  Lower of cost and net realizable value (NRV) – if the foreign currency weakens, NRV of a balance such as inventory might be lower than the item’s cost when translated into Canadian dollars, even though it might still be higher than cost in the foreign currency In such cases, if the foreign currency strengthens at a later date and NRV translated into Canadian dollars exceeds cost the write-down is reversed

29. Chapter 11 Slide 29 Other Considerations  Intercompany profits – Upstream and downstream intercompany profits with integrated subsidiaries are eliminated at historical cost which is the same as their carrying values in the parent or subsidiary accounting records Although assets of self-sustaining subsidiaries are translated at the closing rate, unrealized intercompany profits with self-sustaining subsidiaries are still eliminated at historical cost  Cash flow statement – Prepare from consolidated balance sheet, not from cash flow statement of parent plus translated subsidiary cash flow statement

30. Chapter 11 Slide 30 Other Considerations  Tax effects – Foreign subsidiary financial statement exchange translation gains and losses are usually not taxable or deductible until realized, and are therefore temporary differences which should be recognized as deferred income taxes for accounting purposes

31. Chapter 11 Slide 31 Translation Under ASPE  ASPE - Subsidiaries are classified as either “Integrated” or “Self-Sustaining”  Integrated foreign operation - the foreign operations are more closely linked to, or integrated with, the parent’s own operations since the functional currency of the foreign operation is the same as the parent’s functional currency Temporal method  Self-sustaining foreign operation – the foreign operations are less linked to the parent’s own operations and more capable of existing on their own without the parent’s support, since the functional currency of the foreign operation is different from the parent’s functional currency Current rate method