Accounting for Foreign Currency

Accounting for Foreign Currency

Publication Date: September 2020

Accounting for Foreign Currency

Copyright © 2020 by

DELTACPE LLC

All rights reserved. No part of this course may be reproduced in any form or by any means, without permission in

writing from the publisher.

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tax, accounting, or similar professional services. While the legal, tax, and accounting issues discussed in this

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—-From a Declaration of Principles jointly adopted by a committee of the American Bar Association and a

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Course Description

In today’s modern economy, the growth of foreign operations is continuing upward and the number of companies

with foreign operations has expanded. For example, a company often operates in different economic and currency

environments to stay competitive in the global marketplace. Thus, it must have a process for reporting foreign

currency balances to address several financial reporting issues, such as determining functional currencies,

accounting for foreign currency transactions, and translating its foreign entity’s financial statements. ASC 830

Foreign Currency Matters provides guidance for transactions denominated in a foreign currency, and for

operations undertaken in a foreign currency environment. This course covers key aspects of the guidance and

includes specific examples to illustrate its application. Relevant references to and excerpts from ASC 830 are

discussed throughout the course.

Field of Study Accounting

Level of Knowledge Intermediate

Prerequisite None

Advanced Preparation None

Learning Objectives

After completing this section, you should be able to:

1. Recognize key areas of guidance in ASC 830 Foreign Currency Matters

2. Identify steps to remeasure foreign currency transactions to the functional currency

3. Identify steps to translate foreign currency financial statements to the reporting currency

Table of Contents

I. Basic Principles of ASC 830 .................................................................................. 1

A. Scope and Scope Exceptions ........................................................................................... 1

B. The Accounting Model for Foreign Currency Matters ...................................................... 2

Example 1: The Translation Process of Foreign Currency Transactions and Financial Statements ............4

II. Determine the Functional Currency ................................................................... 5

A. General Rules ................................................................................................................. 5

B. Classes of Foreign Operations ......................................................................................... 6

C. Factors in Determining the Functional Currency .............................................................. 8

Example 2: Determination of the Functional Currency ...............................................................................9

D. Highly Inflationary Environment ................................................................................... 10

Example 3: Determination of Highly Inflation ......................................................................................... 10

E. Change in the Functional Currency ................................................................................ 11

Example 4: Change in Functional Currency ............................................................................................. 12

Example 5: Functional Currency Changes Because the Economy is No Longer Highly Inflationary ........ 13

The SEC’s View on Changes in Functional Currency................................................................................. 14

Review Questions – Section 1 .............................................................................. 16

III. Remeasure Foreign Currency Transactions to the Functional Currency ........... 17

A. General Rules ............................................................................................................... 17

Example 6: Remeasurement Requirements ............................................................................................. 17

B. Selection of Exchange Rates for Remeasurement .......................................................... 18

Monetary Accounts ........................................................................................................................... 18

Nonmonetary Accounts ..................................................................................................................... 18

C. Transaction Gains or Losses .......................................................................................... 20

Example 7: Determining Transaction Gains or Losses ............................................................................. 20

D. Foreign Currency Transactions ...................................................................................... 22

1. Property, Plant and Equipment .................................................................................................. 22

Example 8: Depreciation of Fixed Assets ................................................................................................. 22

2. Inventories.................................................................................................................................. 23

Example 9: Write-down of Inventory Measured Using FIFO ................................................................... 23

3. Debt ............................................................................................................................................ 24

4. Debt and Equity Securities ......................................................................................................... 25

Trading Debt Securities ............................................................................................................................... 26

Available-for-Sale Debt Securities ............................................................................................................... 26

Held-to-Maturity Debt Securities ................................................................................................................ 26

Equity Securities .......................................................................................................................................... 27

5. Foreign Currency Leases ............................................................................................................ 27

Lessee Accounting ....................................................................................................................................... 27

Lessor Accounting ........................................................................................................................................ 28

Comprehensive Illustration: Remeasurement of Foreign Currency Transactions to the

Functional Currency .......................................................................................................... 29

1. Accounts Receivable................................................................................................................... 29

2. Inventory .................................................................................................................................... 30

3. Held-to-Maturity Debt Securities ............................................................................................... 31

4. Foreign Subsidiary Accounts ...................................................................................................... 33


IV. Translate Foreign Currency Financial Statements............................................ 36

A. General Rules ............................................................................................................... 36

B. Selection of Exchange Rates for Translation .................................................................. 37

Example 10: Exchange Rate When Exchangeability is Lacking Temporarily ........................................... 38

1. Balance Sheet ............................................................................................................................. 39

2. Income Statement ...................................................................................................................... 39

3. Cash Flow Statement.................................................................................................................. 39

C. Translation Adjustments ............................................................................................... 39

Example 11: Reporting Gains or Losses ................................................................................................... 40

D. Highly Inflationary Environment ................................................................................... 40

E. Derecognition ............................................................................................................... 42

1. Disposition of a Foreign Entity ................................................................................................... 42

Example 12: Reporting Translation Adjustments .................................................................................... 43

2. Partial Sale of Ownership Interest ............................................................................................. 44

Example 13: Partial Sale of Ownership Interest ...................................................................................... 45

Release of Cumulative Translation Adjustment Decision Tree ................................................................... 46

3. Cumulative Translation Adjustment in Impairment Assessment .............................................. 47

Example 14: Impairment Assessment ...................................................................................................... 47

Comprehensive Illustration: Translation of Foreign Entity Financial Statements ................ 48

V. Other Matters ................................................................................................. 51

A. Intercompany Profits .................................................................................................... 51

Example 15: Elimination of Intercompany Profits ................................................................................... 51

B. Hedging ........................................................................................................................ 52

C. Disclosures .................................................................................................................... 54

1. Aggregate Transaction Gains or Losses ...................................................................................... 54

2. Cumulative Translation Adjustments ......................................................................................... 54

3. Exchange Rate Changes .............................................................................................................. 54

4. Footnote Disclosure ................................................................................................................... 55

5. Excluding a Foreign Entity from Financial Statements ............................................................... 56

The SEC’s View on Disclosures, if the U.S. Dollar is Not the Reporting Currency ..................................... 56

D. Difference between U.S. GAAP and IFRS ....................................................................... 57

Determination of Functional Currency .............................................................................................. 58

Highly Inflationary Economy .............................................................................................................. 59


Glossary ............................................................................................................... 61

Index ................................................................................................................... 63

Review Question Answers ................................................................................... 64

Review Questions − Section 1 ........................................................................................... 64



1

I. Basic Principles of ASC 830

A. Scope and Scope Exceptions

Financial statements are intended to effectively communicate financial information about the performance,

financial position, and cash flows of a reporting entity to investors and creditors and other parties. Thus, the

financial statements of separate entities within a reporting entity, which may exist and operate in different

economic and currency environments, are consolidated and presented as though they were the financial

statements of a single reporting entity. That is, the reporting entity must prepare financial statements in a single

reporting currency. If the foreign statements have any accounts expressed in a currency other than their own,

they have to be converted into the foreign statement's currency prior to translation into U.S. dollars or any other

reporting currency.

According to ASC 830, a reporting entity is an entity or group whose financial statements are being referred to.

Those financial statements reflect any of 1) the financial statements of one or more foreign operations by

combination, consolidation, or equity accounting 2) foreign currency transactions. Reporting currency is the

currency in which an entity prepares its financial statements

ASC 830 Foreign Currency Matters (formerly FAS 52 Foreign Currency Translation) provides accounting and

reporting requirements for converting transactions and financial statements from a foreign currency to the

reporting currency. ASC 830 applies to the financial statements of ALL entities prepared in conformity with U.S.

generally accepted accounting principles (GAAP), whether the U.S. dollar or a foreign currency is the reporting

currency. That is, a foreign entity may report in its local currency in conformity with U.S. GAAP. For example, a

Chinese entity whose reporting currency is the Chinese yuan but reports in conformity with U.S. GAAP should

follow the requirements of ASC 830.

According to ASC 830, a foreign entity is an operation (for example, subsidiary, division, branch, joint venture, and

so forth) whose financial statements are both: 1) prepared in a currency other than the reporting currency of the

reporting entity 2) combined or consolidated with or accounted for on the equity basis in the financial statements

of the reporting entity.

ASC 830-10-15-3 specifies that ASC 830 applies to:

✓ Foreign currency transactions, including imports and exports denominated in a currency other than the

company's functional currency.

✓ Foreign currency financial statements of divisions, branches, and other investees included in the financial

statements of a U.S. company by consolidation, combination, or the equity method.

2

According to ASC 830, an entity's functional currency is 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.

ASC 830-10-15-7 indicates that ASC 830 does NOT apply to the translation of financial statements for purposes

other than consolidation, combination, or the equity method. For example, it does not cover translation of the

financial statements of a reporting entity from its reporting currency into another currency for the convenience

of readers accustomed to that other currency. ASC 830-20-15-2(a) also states that ASC 830 does NOT apply to

transactions involving derivative instruments. The derivatives guidance is codified in ASC 815 Derivatives and

Hedging.

B. The Accounting Model for Foreign Currency Matters

It is important to know that before applying ASC 830, a foreign entity's financial statements must be prepared in

accordance with GAAP. ASC 830 requires two accounting tasks for reporting foreign currency balances:

1. Foreign currency remeasurement: This is the process of expressing transactions denominated in a foreign

currency in its functional currency.

2. Foreign currency translation: This is the process of converting a foreign entity’s functional currency

financial statements into the reporting currency for preparing the reporting entity's (consolidated)

financial statements.

The following diagram illustrates the two distinct processes:

As shown in the example above, a U.S.-based conglomerate has a subsidiary in Norway that keeps its books and

records using the krone (Kr) (its local currency). But its primary operations involve Eurozone entities. Accordingly,

to prepare the consolidated financial statements, the parent first must remeasure all unsettled transactions of

the subsidiary from kroner to functional currency (euros). It then must translate those remeasured amounts into

reporting currency (U.S. dollars).

A key distinction between remeasurement and translation is:

U.S.

Reporting currency

(consolidated statements)

$

Eurozone

Functional currency

€

Norway

Local currency

(books of the subsidiary)

Kr

Step 1:

Remeasurement

Step 2:

Translation

3

• Transaction gains or losses, changes in functional currency amounts resulting from the remeasurement

process, are recognized in the income statement (net income from continuing operations) in the period

in which the exchange rate changes (affecting earnings).

• Translation adjustments, changes resulting from the process of converting financial statements from the

entity's functional currency into the reporting currency, are included in other comprehensive income

(affecting equity).

According to ASC 830, the exchange rate is the ratio between a unit of one currency and the amount of another

currency for which that unit can be exchanged at a particular time.

The following table summarizes the difference between remeasurement and translation.

Foreign currency

remeasurement

The process of expressing transactions

denominated in a foreign currency in its

functional currency.

Cash flow

consequence

Affects

earnings

Foreign currency

translation

The process of expressing in the reporting

currency of the enterprise those amounts that

are denominated or measured in a different

currency

No cash flow

consequence

Affects

equity

It is presumed under ASC 830 that the reporting currency for a company is U.S. dollars; however, it is possible that

the reporting currency may be other than U.S. dollars.

The objectives of remeasurement and translation are to:

✓ Provide information that is generally compatible with the expected economic effects of a rate change on

an entity's cash flows and equity; and

✓ Reflect in consolidated statements the financial results and relationships as measured in its functional

currency.

The key steps in accomplishing the objectives include:

Determine the functional currency: An essential purpose in translating foreign currency is to preserve the

financial performance and relationships expressed in the foreign currency. This is achieved by using the foreign

entity's functional currency.

Details are discussed in the “Determine the Functional Currency” chapter.

Determine the functional currency

Remeasure foreign currency transactions to the functional currency

Translate foreign currency financial

statements

4

Remeasure foreign currency transactions: Once the functional currency of an entity is identified, transactions

denominated in a currency other than its functional currency should be measured in the functional currency.

Details are discussed in the “Remeasure Foreign Currency Transactions” chapter.

Translate foreign currency financial statements: After the remeasurement process is complete, the financial

statements stated in the functional currency should be translated to the reporting currency via the current rate

method.

Details are discussed in the “Translate Foreign Currency Financial Statements” chapter.

Since the FASB released its initial guidance on foreign currency in 1981, there have been very few amendments

within ASC 830.

Example 1: The Translation Process of Foreign Currency Transactions and Financial Statements

Smith Corp., a U.S. company, has a Mexican subsidiary, PETRO, whose records are maintained in Mexican pesos.

However, due to other factors, the functional currency for the subsidiary is actually Canadian dollars. The accounts

of PETRO must be remeasured into Canadian dollars before the financial statements are then translated into the

reporting entity's currency (in this case, U.S. dollars). An ensuing translation gain or loss from Mexican pesos to

Canadian dollars is included in the remeasured net income.

However, if PETRO’s functional currency was instead the Mexican peso, there is only a need to translate to the

reporting currency (U.S. dollars).

Finally, if PETRO's functional currency was the same as that of the reporting entity, Smith, remeasurement is only

from the Mexican peso to the reporting currency (U.S. dollars).

5

II. Determine the Functional

Currency “The assets, liabilities, and operations of a foreign entity must be measured using the functional currency of that

entity.”

ASC 830-10-45-2

A. General Rules

The FASB believes that the most meaningful measurement unit for the assets, liabilities, and operations of an

entity is the currency in which it primarily conducts its business, assuming that currency has reasonable stability.

Thus, ASC 830-10-45-2 requires that the assets, liabilities, and operations of a foreign entity be measured in the

functional currency of that entity.

A reporting entity must determine the functional currency of each foreign entity (distinct and separable operation)

included in its consolidated financial statements. The choice of functional currency often depends on the

relationship between the reporting entity (parent) and foreign operation (subsidiary). However, if the currency of

the primary economic environment is highly inflationary, the parent's reporting currency should be adopted.

The functional currency should not change unless there are significant changes in economic facts and

circumstances. Changes in the functional currency should be reported prospectively from the date of change.

Therefore, previously issued financial statements are NOT restated for a change in the functional currency.

This chapter addresses the following key principles of determining the functional currency:

✓ Classes of Foreign Operations

✓ Factors in Determining the Functional Currency

✓ Highly Inflationary Environment

✓ Change in the Functional Currency

6

B. Classes of Foreign Operations

For purposes of determining functional currency, ASC 830-10-45-4 divides foreign operations into two broad

classes:

1. Self-contained and integrated within a particular country or economic environment: If a foreign

subsidiary's activities are situated within one country, are basically self-contained, and do not rely on the

parent's economic environment, the subsidiary's functional currency is the currency of the country in

which it is located. For example, if a U.S. company has a foreign subsidiary in France that is an independent

entity and received cash and incurred expenses in euros, the euro is the functional currency.

2. Direct and integral component or extension of the parent entity’s operations: If the foreign subsidiary's

daily activities are a direct and important element of the parent's operations and environment, the

parent's currency will be the functional currency. In other words, the day-to-day operations are

dependent on the economic environment of the parent’s currency, and the changes in the foreign entity’s

individual assets and liabilities impact directly on the cash flows of the parent entity in the parent’s

currency. For example:

− Significant assets may be acquired from the parent entity or otherwise by expending dollars

− The sale of assets may generate dollars that are available to the parent

− Financing is primarily by the parent or otherwise from dollar sources

An entity may have more than one distinct and separable operation (e.g., branch, division). If those operations

are conducted in different economic settings, they may have different functional currencies. For example:

• A foreign entity might have one operation that sells parent-entity-produced products and another

operation that manufactures and sells foreign-entity-produced products. If they are conducted in

different economic environments, those two operations might have different functional currencies.

• A single subsidiary of a financial institution might have relatively self-contained and integrated operations

in each of several different countries.

According to ASC 830-10-55-6, in those circumstances, each operation may be considered to be an entity, and,

based on the facts and circumstances, each operation might have a different functional currency. PwC believes

that an entity should demonstrate all of the following characteristics to conclude that an operation within an

entity is distinct and separable.

7

Characteristics of a Distinct and Separable Operation

Operation is distinct and separable Operation is not distinct and separable

Separate operations

Operations are managed independently and

can be separated, both operationally and

for financial reporting purposes, from the

reporting entity’s other operations

Operations are not managed independently

or cannot be separated, either

operationally or for financial reporting

purposes, from the reporting entity’s other

operations

Assets and liabilities

Assets and liabilities of the operation can be

separated from those of the reporting

entity’s other operations and relate directly

to the operation’s activities

Assets and liabilities of the operation

cannot be separated from those of the

reporting entity’s other operations, the

operation holds only certain assets and

liabilities (e.g., receivables and inventory),

or they hold assets and liabilities that relate

directly to a reporting entity’s other

operations

Financial statements

A meaningful set of all-inclusive financial

statements could be routinely prepared for

the operation

The operation cannot produce financial

statements or produces a limited set of

financial statements

Source: PwC, Foreign currency, June 2019

The different operating and economic characteristics of various types of foreign operations will be distinguished

in their accounting. FAS 52 states that:

• The economic effects of an exchange rate change on an operation that is relatively self-contained and

integrated within a foreign country relate to the net investment in that operation. Translation

adjustments that arise from consolidating that foreign operation do NOT impact cash flows and are NOT

included in net income.

• The economic effects of an exchange rate change on a foreign operation that is an extension of the

parent's domestic operations relate to individual assets and liabilities and impact the parent's cash flows

directly. Accordingly, the exchange gains and losses in such an operation are included in net income.

• Contracts, transactions, or balances that are, in fact, effective hedges of foreign exchange risk will be

accounted for as hedges without regard to their form.

8

C. Factors in Determining the Functional Currency

It is important to determine the functional currency because remeasurement and translation are both based on

the functional currency of the entity. An entity’s functional currency is usually the currency of the primary

economic environment in which the entity operates. According to ASC 830-10-45-6, the functional currency of an

entity is, in principle, a matter of fact. In some cases, the facts will clearly identify the functional currency; in other

cases, they will not. For example, if a foreign entity conducts significant amounts of business in two or more

currencies, the functional currency might not be clearly identifiable. In those instances, the economic facts and

circumstances of a particular foreign operation should be assessed in relation to the stated objectives for foreign

currency translation.

When an entity carries out major operations in more than one currency, management must determine which

currency to use as the functional currency. ASC 830-10-55-5 provides the following economic factors that should

be considered individually and collectively when determining a foreign operation’s functional currency:

Indicator

Foreign Subsidiary’s Currency as

Functional Currency

Parent’s Currency as Functional

Currency

Cash Flow

Cash flows related to the foreign entity’s

assets and liabilities are primarily in the

foreign currency and do not directly affect

the parent entity’s cash flows.

Cash flows related to the foreign entity’s

assets and liabilities directly affect the

parent’s cash flows currently and are

readily available for remittance to the

parent entity.

Selling Price

Selling prices arise from local factors such

as competition and government law

rather than exchange rates.

Selling prices are influenced by

international factors such as worldwide

competition and international prices.

Sales Market There is a strong local sales market. The sales market is primarily in the

parent's country.

Expenses

Manufacturing costs or services are

typically incurred locally and denominated

in foreign currency.

Manufacturing and service costs are

mostly component costs obtained from

the parent's country.

Financing

Financing is secured locally and

denominated in local currency. Funds

obtained are adequate to meet debt

obligations.

Financing is mainly provided by the

parent or denominated in the parent’s

currency.

Intercompany

Transactions

Intercompany transactions are few. There

is no major interrelationship between the

parent and the foreign entity.

Intercompany transactions are high. A

substantial interrelationship exists

between the parent and foreign entity.

9

Example 2: Determination of the Functional Currency

MAX Corp. is a U.S. company that uses the U.S. dollar as its reporting currency. Sino is a wholly-owned subsidiary

of MAX located in China, which functions as a manufacturing facility of MAX.

Consider the following facts regarding Sino:

• MAX manufactures parts for one of its products at a facility in the U.S., packages the parts, and ships them

to Sino for assembly.

• Sino has a manufacturing facility in Guangzhou, China. This facility receives the parts from MAX. Sino’s

employees assemble the parts into the final product. They also test them to ensure that the quality of the

product meets MAX’s standards.

• Sino then ships the completed product back to MAX for sale to customers.

• The local currency of Sino is the yuan.

• MAX funds the expenses of Sino each month, plus a small margin.

What is the functional currency of Sino?

Solution:

According to ASC 830-10-45-4, when a foreign subsidiary is a direct and integral component or extension of the

parent entity’s operations, the parent's currency will be the functional currency. That is, the foreign subsidiary's

daily activities are a direct and important element of the parent's operations and environment.

Sino is a direct and integral extension of USA Corp’s operations because Sino’s assembly is considered a direct and

important element of MAX’s operations. Besides, Sino’s manufacturing costs are mostly component costs

obtained from MAX. Finally, Sino cannot operate without financing from MAX. Therefore, the functional currency

of Sino is the U.S. dollar, the reporting currency of its parent, MAX.

10

D. Highly Inflationary Environment

According to ASC 830-10-45-11, a highly inflationary economy is one that has cumulative inflation of

approximately 100% or more over a 3-year period. A currency in a highly inflationary environment is not

considered stable enough to serve as a functional currency and the more stable currency of the reporting parent

is to be used instead. In other words, the financial statements of a foreign entity in a highly inflationary economy

must be remeasured as if the functional currency were the reporting currency.

The International Monetary Fund of Washington, D.C. publishes information about the international inflation

rates.

ASC 830-10-45-12 explains that the determination of a highly inflationary economy must begin by calculating the

cumulative inflation rate for the three years that precede the beginning of the reporting period, including interim

reporting periods:

• If that calculation results in a cumulative inflation rate in excess of 100%, the economy is considered highly

inflationary in all instances. In other words, the inflation rate must be increasing at an average rate of

about 26% per year for three consecutive years, given compounding. Projections cannot be used to

overcome the presumption that an economy is highly inflationary.

• if that calculation results in the cumulative rate being less than 100%, historical inflation rate trends

(increasing or decreasing) and other pertinent economic factors should be considered to determine

whether such information suggests that classification of the economy as highly inflationary is appropriate.

The definition of a highly inflationary economy is necessarily an arbitrary decision. In some instances, the trend of

inflation might be as important as the absolute rate. The definition of a highly inflationary economy should be

applied with judgment.

The following example illustrates the application of ASC 830-10-45-12.

Example 3: Determination of Highly Inflation

ASC 830-10-55-23

The following Cases illustrate the application of 830-10-45-12:

• Case A: The cumulative 3-year inflation rate exceeds 100%

• Case B: The cumulative 3-year inflation rate drops below 100% but no evidence suggests that drop is other

than temporary.

• Case C: The cumulative 3-year inflation rate drops below 100% after having spiked above 100%.

Case A: Cumulative 3-Year Inflation Rate Exceeds 100%

ASC 830-10-55-24

11

Country A’s economy at the beginning of 20X9 continues to be classified as highly inflationary because the

cumulative 3-year rate is in excess of 100% (see the following table). The recent trend of declining inflation rates

should not be extrapolated to project future rates to overcome the classification that results from the calculation.

Fiscal Year X1 X2 X3 X4 X5 X6 X7 X8

Annual inflation rate 9% 8% 12% 17% 33% 52% 30% 15%

Cumulative three-year rate (a) 32% 42% 74% 137% 163% 127%

(a) Amounts are calculated as a compounded three-year inflation rate.

Case B: Cumulative 3-Year Inflation Rate Drops Below 100%

ASC 830-10-55-25

Country B’s economy at the beginning of 20X9 should continue to be classified as highly inflationary even though

the cumulative 3-year rate is less than 100% (see the following table) because there is no evidence to suggest that

the drop below the 100% cumulative rate is other than temporary and the annual rate of inflation during the

preceding 8 years has been high.





Case C: Cumulative 3-Year Inflation Rate Drops Below 100% After Spike

ASC 830-10-55-26

Country C’s economy at the beginning of 20X9 should no longer be classified as highly inflationary because the

cumulative 3-year rate is less than 100% (see the following table) and the historical inflation rates suggest that

the prior classification resulted from an isolated spike in the annual inflation rate.





E. Change in the Functional Currency

There should be consistent use of the functional currency unless significant economic changes required a change.

ASC 830 does not provide guidance on identifying significant changes in economic facts and circumstances.

However, changes in economic facts or circumstances that are considered significant are rare. E&Y identified the

following examples that may necessitate the functional currency to change:

12

✓ A foreign entity that sells only parent-produced products assumes all manufacturing functions itself.

✓ A foreign entity that sells its products only to its parent establishes a significant local sales market for

those products.

✓ The currency mix of the revenue for a given foreign entity changes.

✓ An entity with predominantly USD-based revenue changes to predominantly euro-based revenue due to

the shift in targeted consumer groups.

Moreover, when a country experiences high rates of inflation, ASC 830-10-45-11 requires a change in functional

currency (a functional currency other than the reporting currency). That is, the parent's reporting currency should

be adopted. As an example, in a highly inflationary economy, any assets recently acquired at higher prices due to

inflation will appear significantly larger than assets purchased only a few years prior.

Example 4: Change in Functional Currency

A&E, located in Mexico, is a wholly-owned subsidiary of Johnson Corp. The U.S. dollar is Johnson’s functional

currency and A&E has previously identified the peso as its functional currency. The functional currency was

identified because A&E’s sales and purchases were denominated primarily in peso, as were all of its labor costs.

During the second quarter, A&E’s operations began to change. A&E’s sales decreased due to a loss of some sizable

contracts while Johnson’s sales increased due to new significant contracts. To meet its sales orders, Johnson began

using A&E’s manufacturing facilities. A&E shut down its sales department since it will no longer need to generate

its own sales and more than 70% will originate from Johnson’s operations. Johnson has built a new facility to

produce the materials needed. As of the end of the fiscal year, A&E began receiving all materials from Johnson

instead of from suppliers.

Based on the changes in A&E’s business, it expects cash inflows and outflows, except for wages, primarily to be

denominated in U.S. dollars. A&E’s functional currency may have changed because of the following significant

changes in economic facts and circumstances:

• The currency of revenues has changed from the peso to primarily the US dollar. This change does not

seem to be short-term as the sales department was closed down.

• The currency of cash outflows for materials has changed to the US dollar. As Johnson has built a new

facility to produce these materials, this change does not seem to be short-term either.

• The position of A&E’s operations within Johnson’s overall operating strategy has changed, from a

relatively self-contained operating entity to an extension of Johnson’s manufacturing operation.

As discussed, once a determination of the functional currency is made, that decision should be consistently used

for each foreign entity unless significant changes in economic facts and circumstances indicate clearly that the

functional currency has changed. Changes resulting from economic factors (e.g. inflation) should not be

considered a change in accounting principles. Thus, previously issued financial statements should NOT be restated

for any change in the functional currency in accordance with ASC 830-10-45-7. In other words, a change in the

13

functional currency is treated as a change in estimate. Such change is accounted for on a prospective basis (only

over current and future years).

In general, entities should follow these requirements for a change in functional currency:

1. Change from reporting currency to foreign currency: ASC 830-10-45-9 indicates that the adjustment

attributable to a currency-rate translation of nonmonetary assets as of the date of the change should be

reported in other comprehensive income.

ASC 830-10-45-9 does NOT apply to circumstances in which the functional currency changes from the

reporting currency to a foreign currency because the economy is no longer highly inflationary. Instead, ASC

830-10-45-15 should be followed.

2. Change from foreign currency to reporting currency: ASC 830-10-45-10 indicates that translation

adjustments for prior periods should NOT be removed from equity.

The translated amounts for nonmonetary assets at the end of the prior period become the accounting

basis for those assets in the period of the change and subsequent periods. This guidance should be used

also to account for a change in functional currency from the foreign currency to the reporting currency

when an economy becomes highly inflationary.

A change in accounting estimate is accounted for on a prospective basis (only over current and future years.) It

should NOT be accounted for by restating or retrospectively adjusting amounts reported in financial statements

of prior periods or by reporting pro forma amounts for prior periods.

As discussed, ASC 830-10-45-15 specifically applies to functional currency changes from the reporting currency to

a foreign currency due to a change in an inflationary economy. When an entity’s subsidiary’s functional currency

changes from the reporting currency back to the local currency because the economy ceases to be considered

highly inflationary, the entity should restate the functional currency accounting bases of nonmonetary assets and

liabilities at the date of the change as follows:

✓ The reporting currency amounts at the date of change should be translated into the local currency at

current exchange rates.

✓ The translated amounts should become the new functional currency accounting basis for the

nonmonetary assets and liabilities

ASC 830 provides the following example to illustrate the application of ASC 830-10-45-15.

Example 5: Functional Currency Changes Because the Economy is No Longer Highly Inflationary

ASC 830-10-55-13

A foreign subsidiary of a U.S. entity operating in a highly inflationary economy purchased equipment with a 10-

year useful life for 100,000 local currency (LC) on January 1, 20X1. The exchange rate on the purchase date was

LC 10 to USD 1, so the U.S. dollar equivalent cost was USD 10,000. On December 31, 20X5, the equipment has a

net book value on the subsidiary’s local books of LC 50,000 (original cost of LC 100,000 less accumulated

14

depreciation of LC 50,000) and the current exchange rate is LC 75 to the U.S. dollar. In the U.S. parent’s financial

statements, annual depreciation expense of USD 1,000 has been reported for each of the past 5 years, and on

December 31, 20X5, the equipment is reported at USD 5,000 (foreign currency basis measured at the historical

exchange rate).

ASC 830-10-55-14

As of the beginning of 20X6, the economy of the subsidiary ceases to be considered highly inflationary. Under

paragraph 830-10-45-15, a new functional currency accounting basis for the equipment would be established as

of January 1, 20X6, by translating the reporting currency amount of USD 5,000 into the functional currency at the

current exchange rate of LC 75 to the U.S. dollar. The new functional currency accounting basis at the date of

change would be LC 375,000. For U.S. reporting purposes, the new functional currency accounting basis and

related depreciation would subsequently be translated into U.S. dollars at current and average exchange rates,

respectively.

The Securities and Exchange Commission (SEC) indicates that registrants with foreign operations in economies

that have recently experienced economic turmoil should evaluate whether significant changes in economic facts

and circumstances have occurred that warrant reconsideration of their functional currencies.

The SEC also noted that ASC 830 does not prescribe specific disclosures about a change in functional currency.

However, the SEC believes that disclosures in the financial statements and MD&A may be necessary to permit an

investor to understand the foreign operations and their impact on the registrant's results of operations, liquidity,

and cash flows.

Details of the SEC’s view on changes in functional currency are addressed below.

The SEC’s View on Changes in Functional Currency

Excerpt from the SEC publication Division of Corporation Finance: Frequently Requested Accounting and Financial

Reporting Interpretations and Guidance

D. Changes in Functional Currency

FASB Statement No. 52, Foreign Currency Translation [ASC 830], requires the assets, liabilities, and operations of

a foreign operation to be measured using the functional currency of that foreign operation. The functional

currency is the currency of the primary economic environment in which the entity operates, normally the currency

in which the operation generates and expends cash. Appendix A to SFAS 52 provides guidance for determination

of the functional currency. Once the functional currency has been determined, SFAS 52 requires that

determination to be used consistently unless significant changes in economic facts and circumstances indicate

clearly that the functional currency has changed.

Registrants with foreign operations in economies that have recently experienced economic turmoil should

evaluate whether significant changes in economic facts and circumstances have occurred that warrant

reconsideration of their functional currencies. Registrants with foreign operations in economies that have adopted

15

the Euro currency should make similar evaluations. Determination of the functional currency is also required when

the economy in which a foreign operation is located ceases to be highly inflationary.

The staff would expect a registrant's analysis to focus on factors that affect the specific foreign operation's cash

flows. For example, problems in an Asian economy could cause local currency cash flow sources to severely

diminish for a self-contained foreign operation and clearly indicate a different primary currency. Conversely, these

problems generally would not indicate a change in functional currency for a foreign operation that is an integral

component or extension of the parent company's operations. The staff generally will be skeptical that currency

exchange rate fluctuations alone would cause a self-contained foreign operation to become an extension of the

parent company. Remeasurement of assets and results using the registrant's reporting currency in lieu of

determining the functional currency is appropriate only when the foreign operations are in a highly inflationary

economy as defined by SFAS 52.

SFAS 52 does not prescribe specific disclosures about a change in functional currency. However, the staff believes

that disclosures in the financial statements and MD&A may be necessary to permit an investor to understand the

foreign operations and their impact on the registrant's results of operations, liquidity, and cash flows. Registrants

should consider the need to disclose the nature and timing of the change, the actual and reasonably likely effects

of the change, and economic facts and circumstances that led management to conclude that the change was

appropriate. The effects of those underlying economic facts and circumstances on the registrant's business should

also be discussed in MD&A.

16

Review Questions – Section 1 1. In preparing consolidated financial statements of a U.S. parent company with a foreign subsidiary, what is the

foreign subsidiary's functional currency?

A. The currency in which the subsidiary maintains its accounting records

B. The currency of the country in which the subsidiary is located

C. The currency of the country in which the parent is located

D. The currency of the environment in which the subsidiary primarily generates and expends cash

2. What is the currency in which the parent company prepares its financial statements?

A. The functional currency

B. The reporting currency

C. The historical currency

D. The base currency

3. The economic effects of a change in foreign exchange rates on a relatively self-contained and integrated

operation within a foreign country relate to the net investment by the reporting enterprise in that operation.

What can be said about the translation adjustments that arise from the consolidation of that operation?

A. They directly affect cash flows but should not be reflected in income

B. They directly affect cash flows and should be reflected in income

C. They do not directly affect cash flows and should not be reflected in income

D. They do not directly affect cash flows but should be reflected in income

4. Which of the following is considered a highly inflationary environment?

A. A cumulative inflation rate of 100% or more over a three-year period

B. A cumulative inflation rate of 50% per year over a five-year period

C. A cumulative inflation rate of 25% per year over a four-year period

D. A cumulative inflation rate of 15% per year over a two-year period

17

III. Remeasure Foreign Currency

Transactions to the Functional Currency “If an entity’s books of record are not maintained in its functional currency, remeasurement into the functional

currency is required. That remeasurement is required before translation into the reporting currency.”

ASC 830-10-45-17

A. General Rules

Common foreign currency transactions denominated in a currency other than the entity’s functional currency

arise when a reporting entity:

1. Buys or sells on credit goods or services whose prices are denominated in foreign currency,

2. Borrows or lends funds and the amounts payable or receivable are denominated in foreign currency,

3. Is a party to an unperformed forward exchange contract,

4. Acquires or disposes of assets denominated in foreign currency, or

5. Incurs or settles liabilities.

For example, foreign currency transactions may result in receivables or payables fixed in the amount of foreign

currency to be received or paid. If books and records of a foreign entity are not maintained in the functional

currency, foreign currency transactions must be remeasured into the functional currency. For example, the U.S.

dollar has been designated as the functional currency for a Mexican subsidiary, but books and records at the

subsidiary are recorded using the Mexican peso. In this case, remeasurement is required since the subsidiary’s

book of records is maintained in peso instead of its functional currency (U.S. dollar).

The objective of the remeasurement process is to generate the same result as if the entity's books and records had

been kept in the functional currency. To achieve the objective, ASC 830-10-45-17 requires entities to account for

its monetary and nonmonetary assets and liabilities that are not denominated in the functional currency. ASC 830-

20-30-1 states that at the date a foreign currency transaction is recognized, each asset, liability, revenue, expense,

gain, or loss arising from the transaction should be measured initially in the functional currency of the recording

entity using the current exchange rate.

If exchangeability between two currencies is temporarily lacking at the transaction date or balance sheet date,

ASC 830-20-30-2 requires the use of the first subsequent rate at which exchanges could be made. If the lack of

exchangeability is other than temporary, the propriety of consolidating, combining, or accounting for the foreign

operation by the equity method should be carefully considered.

Example 6: Remeasurement Requirements

Johnson Corp. is a U.S. company. Johnson’s functional currency is the U.S. dollar.

18

Johnson borrows 3,000,000 Swiss francs from a bank in Switzerland in the form of a note payable bearing interest

at 8% per annum. This is a foreign currency transaction entered into by Johnson resulting in recognition of

monetary assets and liabilities denominated in a foreign currency (cash, note payable, and interest payable).

Therefore, remeasurement is required.

B. Selection of Exchange Rates for Remeasurement

Monetary Accounts

Monetary accounts are remeasured at the current exchange rate. Monetary accounts include assets and liabilities

whose amounts are fixed or determinable without reference to future prices of specific goods or services.

Examples include cash, short- or long-term accounts receivable and notes receivable in cash, short- or long-term

accounts payable and notes payable in cash, and inventories carried at market, and marketable securities carried

at fair value.

At each balance sheet date, balances related to monetary assets and liabilities should be remeasured to reflect

the current exchange rate. This measurement gives rise to foreign currency transaction gains or losses; the

increase or decrease in expected functional currency cash flows. For example, if the exchange rate changes

between the date of a purchase or sale and the time of actual payment or receipt, a foreign exchange transaction

gain or loss arises.

Details about transaction gains or losses are discussed in the “Transaction Gains or Losses” section.

Nonmonetary Accounts

Nonmonetary accounts should be remeasured using historical exchange rates (i.e. the exchange rate at the date

of the nonmonetary account originated). Nonmonetary accounts include assets and liabilities other than

monetary ones. The economic significance of nonmonetary accounts depends heavily on the value of specific

goods and services. According to ASC 255 Changing Prices, nonmonetary assets include all of the following:

✓ Goods held primarily for resale or assets held primarily for direct use in providing services for the

business of the entity

✓ Claims to cash in amounts dependent on future prices of specific goods or services

✓ Residual rights such as goodwill or equity interests

Nonmonetary liabilities include both of the following:

✓ Obligations to furnish goods or services in quantities that are fixed or determinable without reference

to changes in prices.

✓ Obligations to pay cash in amounts dependent on future prices of specific goods or services.

19

Examples include inventories, investments in common stocks, property, plant and equipment, and liabilities for

rent collected in advance.

It is important to note that nonmonetary assets and liabilities are NOT subsequently remeasured. Once purchased

or incurred, nonmonetary assets and liabilities are recorded in the functional currency of the purchaser. Likewise,

amounts recognized in the income statement related to nonmonetary assets and liabilities (e.g. cost of goods sold,

depreciation) are accounted for in the functional currency of the purchaser.

ASC 830-10-45-18 lists the following common balance sheet and income statement accounts that should be

remeasured using historical exchange rates.

Accounts to Be Remeasured Using Historical Exchange Rates

• Equity securities without readily determinable

fair values accounted for in accordance with

paragraph 321-10-35-2. The historical rate to

be used shall be the exchange rate as of the

later of the acquisition date or the most recent

date on which the equity security was adjusted

to fair value in accordance with paragraphs

321-10-35-2 through 35-3, if applicable

(Amended by ASU 2019-04 Codification

Improvements to Topic 326, Financial

Instruments—Credit Losses, Topic 815,

Derivatives and Hedging, and Topic 825,

Financial Instruments)

• Inventories carried at cost

• Prepaid expenses such as insurance,

advertising, and rent

• Property, plant, and equipment

• Accumulated depreciation on property, plant,

and equipment

• Patents, trademarks, licenses, and formulas

• Goodwill

• Other intangible assets

• Deferred charges and credits, except deferred

income taxes and policy acquisition costs for life

insurance companies

• Deferred income

• Common stock

• Preferred stock carried at issuance price

• Examples of revenues and expenses related to

nonmonetary items:

− Cost of goods sold

− Depreciation of property, plant, and

equipment

− Amortization of intangible items such as

goodwill, patents, licenses, etc.

− Amortization of deferred charges or credits

except for deferred income taxes and

policy acquisition costs for life insurance

companies

20

C. Transaction Gains or Losses

Transaction gains or losses should be included in the income statement (net income from continuing operations)

for the period in which the exchange rate changes. This accounting treatment was adopted because transaction

gains or losses on remeasurement affect functional currency cash flows.

However, ASC 830-20-35-3 requires that transaction gains or losses on the following foreign currency transactions

should NOT be included in determining net income. Instead, they should be reported in the same manner as

translation adjustments (reported in other comprehensive income):

1. Foreign currency transactions engaged in net investment hedges in a foreign entity, beginning as of the

designation date. A foreign currency transaction is deemed a hedge of an identifiable foreign currency

commitment provided BOTH of the following two conditions exist:

✓ The foreign currency commitment is firm; and

✓ The foreign currency transaction is intended as a hedge.

A net investment hedge protects against adverse movement of exchange rates impacting any foreign

currency exposure. A foreign currency hedge can, for example, involve either fair value or cash flow

hedges in foreign currency or a net investment in a foreign business activity when there is concern over

the impact that a devaluation of a foreign currency would have on the entity’s investment in an overseas

subsidiary.

Details about foreign currency hedge are discussed in the “Hedging” section.

2. Intra-entity foreign currency transactions that are of a long-term investment nature (settlement is not

planned or anticipated in the foreseeable future), when the entities to the transactions are consolidated,

combined, or accounted for under the equity method in the reporting company's financial statements.

Reporting requirements of translation adjustments are discussed in the “Translation Adjustments” section.

Example 7: Determining Transaction Gains or Losses

Example 7-1

On September 14, 20X2, ABC Company bought goods from an unaffiliated foreign company for 30,000 units of the

foreign company's local currency. On that date, the spot rate was $.57. ABC paid the bill in full on March 27, 20X3,

when the spot rate was $.64. The spot rate was $.68 on December 31, 20X2. ABC should report as a foreign

currency transaction loss $3,300 in its income statement for the year ended December 31, 20X2, calculated as

follows:

Liability—12/31/20X2: 30,000 × $.68 $20,400

Liability—9/14/20X2: 30,000 × $.57 17,100

Foreign currency transaction loss at 12/31/20X2: 30,000 × $.11 $ 3,300

21

Example 7-2

On September 1, a U.S. company bought foreign goods requiring payment in euros (EUR) in 30 days after their

receipt. The title to the merchandise passed on November 15. The goods were still in transit on November 30, the

fiscal year-end. The exchange rates were:

September 1: USD 1 = EUR 2.2

November 15: USD 1 = EUR 2.0

November 30: USD 1 = EUR 2.1

The transaction was recorded on November 15, when title to the merchandise passed, and was recorded at an

exchange rate of USD 1 = EUR 2.0 (i.e., it would cost $.5 to buy one euro). On November 30, the exchange rate

increased to 2.1 euros (it would cost less than $.5 to buy one euro). Because the dollar equivalent of the liability

declined from November 15 to November 30, it gave rise to a gain included in income from continuing operations.

Example 7-3

An exchange gain or loss takes place when the exchange rate changes between the purchase and payment dates.

Merchandise is purchased for 300,000 euros. The exchange rate is 3 euros to 1 U.S. dollar. The journal entry is:

Purchases $100,000

Accounts payable $100,000

300,000 euros/3 = $100,000

When the goods are paid for, the exchange rate is 3.5 euros to 1 U.S. dollar. The journal entry is:


Cash $85,714

Foreign exchange gain 14,286

300,000 euros/3.5 = $85,714

The $85,714, using an exchange rate of 3.5 to 1, can buy 300,000 euros. The transaction gain is the difference

between the cash required of $85,714 and the initial liability of $100,000.

Example 7-4

Klemer Corporation bought merchandise for 240,000 pesos when the exchange rate was 12 pesos to a dollar. The

journal entry expressed in dollars follows:

Purchases $20,000


When the merchandise is paid for, the exchange rate changes to 15:1. The journal entry in dollars is:


Cash $18,667

22

Foreign exchange gain $ 1,333

At a 15:1 exchange rate, $18,667 can buy 240,000 pesos. The difference between $18,667 and the initial

liability of $20,000 represents a foreign exchange gain. If payment is made when the exchange rate is below 12

pesos to a dollar, a foreign exchange loss would arise.

D. Foreign Currency Transactions

1. Property, Plant and Equipment

Property, plant and equipment whose values change substantially over time are considered nonmonetary assets.

When property, plant and equipment are acquired in a foreign currency, they should be recorded in the functional

currency using the exchange rate on the date of purchase. They should NOT be subsequently remeasured for

changes in exchange rates during the period they are held.

The entity should perform the impairment evaluation using its functional currency. Impairment testing may result

in a functional currency impairment or a reversal of local currency impairments. That is, when an entity keeps its

books and records in a currency other than its functional currency (local currency), it is possible that an asset is

not impaired for its local currency books, but is impaired for its functional currency financial statements (or vice

versa). In this case, an entity should either record or reverse impairment charges to produce its functional currency


Example 8: Depreciation of Fixed Assets

TEX Corp. is a U.S. company with a U.S. dollar functional currency. ViTa is a foreign entity of TEX located in

Switzerland. ViTa keeps its books and records in the local currency, Swiss franc (CHF). However, management

determined its functional currency is the euro (EUR).

ViTa purchased machinery for CHF 600,000 on January 1, 20X5 when the exchange rate was EUR 1.2 = CHF 1. The

machinery has a useful life of five years.

How should ViTa account for annual depreciation expense in the currency of its books and records, Swiss franc,

and its functional currency (EUR)?

Solution:

ViTa should record the machinery using the exchange rate in effect at the date of purchase.

CHF 600,000 × [1.2 EUR / 1 CHF] = EUR 720,000.

ViTa should also calculate annual depreciation using the exchange rate in effect on the date of purchase. The

following table shows the calculation of the annual depreciation expense.

23

CHF EUR

Purchase price CHF 600,000 EUR 720,000

Useful life 5 years 5 years

Annual depreciation 120,000 144,000

Changes in exchange rates subsequent to the purchase of the machinery do NOT affect depreciation or the

carrying amount of the machinery in the functional currency financial statements.

2. Inventories

Inventory measured using the subsequent measurement guidance in ASC 330-10 in an entity’s books of record

that are maintained in a foreign currency requires special application of ASC 830.

ASC 830-10-55-8 requires that inventories carried at cost in the books of record in another currency should be

first remeasured to cost in the functional currency using historical exchange rates. Then, the historical cost in the

functional currency should be evaluated for impairment under the subsequent measurement guidance using the

functional currency, which may require a write-down in the functional currency statements even though no write-

down has been made in the books of record maintained in another currency. Similarly, a write-down in the books

of record may need to be reversed if the application of the subsequent measurement guidance in the functional

currency does not require a write-down. If inventory has been written down to market in the functional currency

statements, that functional currency amount should continue to be the carrying amount in the functional currency

financial statements until the inventory is sold or a further write-down is necessary. That is, the write-down should

not be reversed until the inventory is sold.

ASC 830-10-55-9 states that an inventory write-down may occur if the value of the currency in which the books of

record are maintained has declined in relation to the functional currency between the date the inventory was

acquired and the date of the balance sheet. However, such a write-down may not be necessary. For example, a

write-down may not be necessary for inventory measured using the first-in, first-out (FIFO) methodology if the

net realizable value expressed in the local currency has increased sufficiently so that net realizable value exceeds

its historical cost measured in the functional currency.

ASC 830 provides the following example to illustrate the application of ASC 830-10-55-9 (Amended by ASU 2015-

11 Inventory).

Example 9: Write-down of Inventory Measured Using FIFO

ASC 830-10-55-15

The following cases illustrate the remeasurement of inventory that is measured using FIFO and is not recorded in

the functional currency:

a. Historical cost in functional currency exceeds net realizable value in functional currency (Case A)

b. Net realizable value in functional currency exceeds historical cost in functional currency (Case B)

24

ASC 830-10-55-16

Cases A and B share all of the following assumptions:

a. BR is the currency in which the books of record are maintained.

b. FC is the functional currency.

c. When the rate is BR 1 = FC 2.40, a foreign subsidiary of a U.S. entity purchases a unit of inventory at a cost

of BR 500 (measured in functional currency, FC 1,200).

d. At the foreign subsidiary’s balance sheet date, the current rate is BR 1 = FC 2.00.

Case A: Historical Cost in Functional Currency Exceeds Net Realizable Value in Functional Currency

ASC 830-10-55-18

Assume the net realizable value of the unit of inventory is BR 560 (measured in functional currency, FC 1,120).

Because net realizable value as measured in the functional currency (FC 1,120) is less than historical cost as

measured in the functional currency (FC 1,200), an inventory write-down of FC 80 is required in the functional

currency financial statements.

Case B: Net Realizable Value in Functional Currency Exceeds Historical Cost in Functional Currency

ASC 830-10-55-19

Assume the net realizable value at the foreign subsidiary’s balance sheet date is BR 620. Because net realizable

value as measured in the functional currency (BR 620 x FC 2.00 = FC 1,240) exceeds historical cost as measured in

the functional currency (BR 500 x FC 2.40 = FC 1,200), an inventory write-down is not required in the functional

currency financial statements.

3. Debt

When a debt is denominated in a currency other than its functional currency, it should initially be measured using

the exchange rate in effect at the issuance date. Because a debt is a monetary liability, the debt balance is

remeasured in the functional currency each reporting date using the exchange rate in effect at the reporting date.

Debt premium, discount, and debt issuance costs should be included in the balance measured in the reporting

entity’s functional currency since they are part of the carrying amount of the debt. By measuring the premium,

discount, and issuance costs at current exchange rates, an entity ensures that a level of effective yield in the

foreign currency is maintained.

ASC 830 does not identify the rates at which amortization of the discounts or premiums should be reported in the

income statement. However, PwC believes that it is acceptable to record amortization for a period using the

average spot rate for that period since the amortization is occurring throughout the period.

25

An exchange of debt instruments between or a modification of a debt instrument resulting in more than a 10%

change in cash flows is treated as an extinguishment and issuance of new debt (the 10% test). When a debt

instrument is modified such that the currency of the debt changes, the change in currency should be included in

the cash flows as part of the 10% test. To convert the cash flows on the new debt into the currency of the original

debt, PwC identifies two acceptable methods:

1. Use the spot rate in effect at the debt modification date, or

2. Use the forward rates corresponding to the payment date of each cash flow (e.g. interest payment and

principal).

4. Debt and Equity Securities

The accounting for a foreign currency denominated investment security is based on its classification under ASC

320 Investments – Debt Securities or ASC 321 Investments – Equity Securities.

Debt securities are financial instruments evidencing a creditor relationship with a company or government.

Examples are redeemable preferred stock, corporate bonds, municipal bonds, U.S. government obligations,

convertible debt, collateralized mortgage obligations, strips, and commercial paper. Debt securities do not include

futures contracts and option contracts. ASC 320-10-25-1 classifies debt securities into one of the following three

categories:

1. Trading Debt Securities

2. Available-for-Sale Debt Securities

3. Held-to-Maturity Debt Securities

In accordance with ASU 2016-01 Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement

of Financial Assets and Financial Liabilities, equity securities are no longer classified as trading or available for sale.

The following table summarizes the treatment of foreign currency denominated investment securities.

Trading Debt Securities Nonmonetary

Changes in fair value due to both the market

factors and the foreign currency exchange rate

fluctuations are reflected in net income.

Available-for-Sale Debt Securities Nonmonetary



fluctuations are reported in other comprehensive

income.

Held-to-Maturity Debt Securities Monetary Foreign currency transaction gains or losses are

included in net income.

Equity Securities Nonmonetary



fluctuations are reflected in net income.

Each security is discussed in the following sections.

26

Trading Debt Securities

Trading debt securities (not classified as held-to-maturity) are bought and held primarily for sale in the near term

(usually three months or less). Trading debt securities are considered nonmonetary assets since the amount

received depends on the future prices of specific goods or services. Thus, these debt securities do NOT give rise

to transaction gains and losses. However, trading debt securities should be subsequently measured at fair value,

with changes in fair value (including changes in market price and foreign currency exchange rates) reflected in net

income (presented separately in the income statement).

Available-for-Sale Debt Securities

Available-for-sale debt securities are not held for short-term profits, nor are they to be held to maturity.

Therefore, they are in between trading and held-to-maturity classifications. In other words, investments in debt

securities not classified as trading debt securities or as held-to-maturity debt securities should be classified as

available-for-sale debt securities.

Available-for-sale debt securities are considered nonmonetary assets since the amount received depends on

future prices of specific goods or services. Thus, these debt securities do NOT give rise to transaction gains and

losses. However, according to ASC 830-20-35-6, the entire change in the fair value of foreign currency

denominated available-for-sale debt securities due to both the market factors (e.g. interest rate, credit risk) and

the foreign currency exchange rate fluctuations should be reported in other comprehensive income.

Upon the adoption of ASU 2016-13 Financial Instruments—Credit Losses (Topic 326): Measurement of Credit

Losses on Financial Instruments, the change in the fair value of foreign currency denominated available-for-sale

debt securities, excluding the amount recorded in the allowance for credit losses, should be reported in other

comprehensive income.

For public business entities, ASU 2016-13 is effective for fiscal years beginning after December 15, 2019. For

entities other than public business entities, ASU 2016-13 is effective for fiscal years beginning after December 15,

2022.

Held-to-Maturity Debt Securities

Held-to-maturity debt securities are securities that entities purchase and have the positive intent and ability to

hold those securities to maturity. These securities are considered monetary assets since the amount received at

maturity is fixed and does not depend on future prices.

Held-to-maturity debt securities in the balance sheet are presented under noncurrent assets at amortized cost.

However, those securities maturing within one year are presented under current assets. An example is a 30-year

bond that is maturing next year (its thirtieth year).

Foreign currency transaction gains or losses are recognized in the income statement for the period in which the

exchange rate changes.

27

Equity Securities

Upon the adoption of ASU 2016-01, equity securities are no longer be eligible for trading or available-for-sale

classification. Entities must measure these equity securities (including other ownership interests, such as

partnerships and unincorporated joint ventures) at fair value, with changes in fair value (including changes in

market price and foreign currency exchange rates) reflected in net income. For equity investments that do not

have readily determinable fair values, an entity may elect the measurement alternative to measure those

investments at cost minus impairment.

The FASB issued ASU 2019-04 Codification Improvements to Topic 326, Financial Instruments—Credit Losses, Topic

815, Derivatives and Hedging, and Topic 825, Financial Instruments to clarify that foreign currency denominated

equity securities using the measurement alternative are considered nonmonetary assets. Thus, they should be

remeasured at historical exchange rates. In addition, the amendments clarify that the rate used should be the

historical exchange rate as of the later of the acquisition date or the most recent date on which the equity security

was adjusted to fair value in accordance with ASC 321-10-35-2 through 35-3, if applicable.

5. Foreign Currency Leases

Lessee Accounting

Under ASC 842 Leases, lessees classify leases as either finance lease or operating lease. Both financing and

operating leases create an asset (right-of-use) and a liability. Lessees must recognize a right-of-use asset and a

lease liability as of the lease commencement date for all leases except for a lease term of 12 months or less. In

general, at the commencement date, the cost of the right-of-use asset consists of all of the following:

✓ The amount of the initial measurement of the lease liability

✓ Any lease payments made to the lessor at or before the commencement date, minus any lease incentives

received

✓ Any initial direct costs incurred by the lessee

When computing the right-of-use asset and lease liability for a foreign currency denominated lease, the present

value of lease payments, payments made to the lessor at or before the commencement date, lease incentives,

and initial direct costs are measured in the functional currency using the exchange rate at the lease

commencement date (or the date the cash flow is paid or received, if before lease commencement).

According to ASC 842-20-55-10, the right-of-use asset is a nonmonetary asset while the lease liability is a

monetary liability. Therefore, in accordance with ASC 830 on foreign currency matters, when accounting for both

operating and finance leases denominated in a foreign currency, if remeasurement into the lessee’s functional

currency is required:

• The right-of-use asset is remeasured using the exchange rate as of the commencement date

• The lease liability is remeasured using the current exchange rate

Lease expense comprises of two elements:

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1. Amortization expense (of the right-of-use asset) is remeasured using the exchange rate on the lease

commencement date.

2. Interest expense (associated with interest on the lease liability) is remeasured using the average exchange

rate during the period in which it is incurred.

Lessor Accounting

ASC 842 requires lessors to classify leases as one of three types of leases: sales-type, direct financing, or operating

lease.

Sales-type Lease

In a sales-type lease, a lessor should derecognize the leased asset and recognize:

• A net investment (lease receivable + unguaranteed residual asset) at the commencement date

• Selling profit or selling loss arising from the lease at the commencement date

• Interest income on the net investment over the lease term

ASC 255-10-55-7A indicates that since the unguaranteed residual asset arising from a sales-type lease or a direct

financing lease is not a claim to a fixed sum of money, it is a nonmonetary item. Thus, when computing the net

investment in a foreign currency denominated lease, the lease payments and the unguaranteed residual asset are

measured in the functional currency using the exchange rate at the lease commencement date.

Because selling profit or loss and interest income are monetary items, they should be measured in the functional

currency using the average exchange rate during the period in which it is recognized. The net investment is a

monetary asset that should be remeasured at the end of each reporting period using the exchange rate at that

date.

Direct Financing Lease

In a direct financing lease, a lessor should derecognize the leased asset and recognize:

• A net investment (lease receivable + unguaranteed residual asset) at the commencement date

• Selling loss arising from the lease at the commencement date

• Interest income on the net investment over the lease term

The net investment is measured in the same manner as a sales-type lease adjusted for selling profit and initial

direct costs. That is, when computing the net investment in a foreign currency denominated lease, the lease

payments and the unguaranteed residual asset are measured in the functional currency using the exchange rate

at the lease commencement date.

Selling profit and initial direct costs are deferred at the commencement date and included in the measurement of

the net investment in the lease. These amounts and interest income should be recognized over the lease term

and measured in the functional currency using the average exchange rate during the period in which it is

29

recognized. Losses on sale should be recognized using the impairment guidance for inventory or property, plant,

and equipment, as applicable.

The net investment is a monetary asset that should be remeasured at the end of each reporting period using the

exchange rate at that date.

Operating Lease

A lessor should recognize the lease payments as rental revenue over the lease term on a straight-line basis using

the average exchange rate during the period in which it is recognized.

Comprehensive Illustration: Remeasurement of

Foreign Currency Transactions to the Functional

Currency

1. Accounts Receivable

A U.S. company sells merchandise to a customer in Italy on 10/1/20X6, for 20,000 euros (EUR). The exchange rate

is 1 EUR to $.40. Hence, the transaction is valued at $8,000 (20,000 euros × $.40). The terms of sale require

payment in four months. The journal entry for the sale is:

10/1/20X6

Accounts receivable—Italy $8,000

Sales $8,000

Accounts receivable and sales are measured in U.S. dollars at the transaction date using the spot rate.

Even though the accounts receivable are measured and reported in U.S. dollars, the receivable is fixed in

euros. Hence, a transaction gain or loss can occur if the exchange rate changes between the date of sale

(10/1/20X6) and the settlement date (2/1/20X7).

Because the financial statements are prepared between the transaction date (date of sale) and settlement

date, receivables denominated in a currency other than the functional currency (U.S. dollar) must be

restated to reflect the spot rate on the balance sheet date. On 12/31/20X6, the exchange rate is 1 euro

equals $.45. Thus, 20,000 euros are now valued at 9,000 (20,000 × $.45). In consequence, the accounts

receivable denominated in euros should be increased by $1,000.

The journal entry to do this on 12/31/20X6 is:


Foreign exchange gain $1,000

30

The income statement for the year ended 12/31/20X6 shows an exchange gain of $1,000. It should be

pointed out that sales is not affected by the exchange gain because sales relates to operational activity.

On 2/1/20X7, the spot rate is 1 EUR equals $.43. The journal entry is:

Cash $8,600*

Foreign exchange loss $ 400


* 20,000 euros × $.43 = $8,600

The 20X7 income statement presents an exchange loss of $400.

2. Inventory

On January 15, 20X7, ABC Company, which uses a perpetual inventory system, shipped merchandise costing

$45,000 to XYZ Company, a German company, for 100,000 euros (EUR). On February 15, 20X7, ABC Company

received a draft for 100,000 euros from XYZ Company. The draft was immediately converted. The spot rates were

as follows:

1 EUR =

Buying Rate Selling Rate

January 15, 20X7 0.60 0.65

January 31, 20X7 0.65 0.70

February 15, 20X7 0.55 0.60

Assuming that monthly statements are prepared, ABC Company will make the following journal entries:

1/15/20X7 Accounts receivable

[100,000 euros × $.60] $60,000

Sales $60,000

1/15/20X7 Cost of goods sold $45,000

Inventory $45,000

1/31/20X7 Accounts receivable $ 5,000

[100,000 euros × ($0.65 - $0.60)

Transaction gain or loss $ 5,000

2/15/20X7 Cash [100,000 euros × 0.55] $55,000

Transaction gain or loss $10,000

Accounts receivable [$60,000 +

$5,000]

$65,000

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3. Held-to-Maturity Debt Securities

TMC Corp. is a U.S. company with a U.S. dollar (USD) functional currency.

On October 1, 20X6, TMC pays 95,000 euros (EUR) for a 10-year bond issued by Motoren with a par value of

100,000 euros. The bond pays a coupon of 8% semi-annually. TMC bought the bond at a discount with an effective

interest rate of 8.5%. TMC classifies its Motoren bond as held-to-maturity debt security.

The following table summarizes the exchange rate on the date TMC purchased the Motoren bond and on the date

of its financial statements and the average exchange rate for the reporting period.

Date Exchange Rate

October 1, 20X6 EUR 1 = USD 1.48

December 31, 20X6 EUR 1 = USD 1.42

Average exchange rate for Q4 20X6 EUR 1 = USD 1.44

How should TMC measure and record this foreign currency transaction?

Solution:

TMC should record the purchase of the Motoren bond in its functional currency using the exchange rate on the

purchase date. The held-to-maturity debt security is purchased for 95,000 euros. The exchange rate is 1 euro to

1.48 U.S. dollars. The journal entry is:

Investment in held-to-maturity security USD 140,600

Cash USD 140,600

EUR 95,000 × (EUR 1 / USD 1.48) = USD 140,600

The following is a simplified bond amortization table in EUR showing the initial purchase on October 1, 20X6, and

the interest accrual and discount amortization for the period ending December 31, 20X6. Assume that:

• No principal and interest payments were made during the period

• The discount is amortized on a straight-line basis

EUR Balance as

of 10/1/20X6

EUR Quarterly

entries

EUR Balance as

of 12/31/20X6

Bond principal amount 100,000 100,000

Discount 5,000 4,875

Discount amortization 125

Interest accrual 2,000

Carrying amount 95,000 95,125

To generate its December 31, 20X6 financial statements, TMC should record the interest accrual and amortization

of the discount on its Motoren bond using the average exchange rate for Q4 20X6 (1.44). The journal entry is:

32

Accrued interest receivable USD 2,880

Investment in held-to-maturity security USD 180

Interest income USD 2,880

Interest income (discount amortization) USD 180

The quarterly accrued interest: EUR 2,000 × (EUR 1 / USD 1.44) = USD 2,880

The amortization of the bond discount: EUR 125 × (EUR 1 / USD 1.44) = USD 180

The interest accrual and held-to-maturity security are monetary assets. Thus, they should be measured using the

rate on December 31, 20X6.

The Interest Accrual

The difference between the accrued interest recorded using the average exchange rate and the accrued interest

balance using the exchange rate on December 31, 20X6 should be recognized in the income statement as a foreign

currency transaction gain or loss.

Accrued interest

on 12/31/X6

(EUR)

Exchange rate on

12/31/X6

Accrued interest

on 12/31/X6

(USD)

Recorded accrued

interest balance

(USD)

Foreign currency

transaction

gain/(loss)

EUR 2,000 EUR 1 = USD 1.42 USD 2,840 USD 2,880 (USD 40)

To record the difference between measuring the quarterly interest accrual of EUR 2,000 at the average exchange

rate during the quarter (EUR 1 = USD 1.44) and the period end exchange rate (EUR 1 = USD 1.42), TMC makes the

following adjustment:

Foreign currency transaction loss USD 40

Accrued interest receivable USD 40

The Bond

TMC classified the bond as a held-to-maturity security. Thus, it is a monetary asset and should be measured at the

December 31, 20X6 spot rate.

Bond carrying

amount on

12/31/X6 (EUR)

Exchange rate on

12/31/X6

Bond carrying

amount on

12/31/X6 (USD)

Recorded bond

carrying amount

(USD)

Foreign currency

transaction

gain/(loss)

EUR 95,125 EUR 1 = USD 1.42 USD 135,078 USD 140,780 (USD 5,702)

As a result of measuring the carrying amount of the bond using the December 31, 20X6 exchange rate, TMC makes

the following adjustment:

Foreign currency transaction loss USD 5,702

Investment in held-to-maturity security USD 5,702

33

4. Foreign Subsidiary Accounts

FNC is a wholly-owned German subsidiary of multinational corporations. The functional currency is U.S. dollars

(USD). The following accounts, for the year ended December 31, 20X7, are stated in euros.

Rent expense 150,000

Allowance for doubtful accounts 60,000

Patent amortization expense* 85,000

* Acquired on March 23, 20X5

The exchange rates for the euros (EUR) for various dates and time periods are as follows:

Date Exchange Rate

March 23, 20X5 EUR 1 = USD 0.65

December 31, 20X7 EUR 1 = USD 0.55

Average for the year ended December 31, 20X7 EUR 1 = USD 0.60

The remeasured accounts in U.S. dollars are as follows:

EUR

Exchange

Rate USD

Rent expense 150,000 0.60 $ 90,000

Allowance for

doubtful accounts 60,000 0.55 33,000

Patent

amortization

expense 85,000 0.65 55,250

295,000 $178,250

34

Review Questions – Section 2 5. Fogg Co., a U.S. company, contracted to purchase foreign goods. Payment in foreign currency was due one

month after the goods were received at Fogg's warehouse. Between the receipt of goods and the time of payment,

the exchange rates changed in Fogg's favor. How should the resulting gain be included in Fogg's financial

statements?

A. As a component of income from continuing operations

B. As revenue

C. As a deferred credit

D. As an item of other comprehensive income

6. On September 22, 20X2, Yumi Corp. purchased merchandise from an unaffiliated foreign company for 10,000

units of the foreign company's local currency. On that date, the spot rate was $.55. Yumi paid the bill in full on

March 20, 20X3, when the spot rate was $.65. The spot rate was $.70 on December 31, 20X2. What amount should

Yumi report as a foreign currency transaction loss in its income statement for the year ended December 31, 20X2?

A. $0

B. $500

C. $1,000

D. $1,500

7. Which of the following statements regarding foreign exchange gains and losses is TRUE (where the exchange

rate is the ratio of units of the functional currency to units of the foreign currency)?

A. An exchange gain occurs when the exchange rate increases between the date a payable is recorded and

the date of cash payment.

B. An exchange gain occurs when the exchange rate increases between the date a receivable is recorded and

the date of cash receipt.

C. An exchange loss occurs when the exchange rate decreases between the date a payable is recorded and

the date of the cash payment.

D. An exchange loss occurs when the exchange rate increases between the date a receivable is recorded and

the date of the cash receipt.

8. On October 1, 20X5, Mild Co., a U.S. company, purchased machinery from Grund, a German company, with

payment due on April 1, 20X6. If Mild's 20X5 operating income included NO foreign currency transaction gain or

loss, which of the following might be TRUE?

A. The transaction could have resulted in an unrecorded gain.

B. The transaction could have been denominated in U.S. dollars.

35

C. The transaction could have caused a foreign currency gain to be reported as a contra account against

machinery.

D. The transaction could have caused a foreign currency translation gain to be reported in other


9. On October 1, Velec Co., a U.S. company, contracted to purchase foreign goods requiring payment in euros 1

month after their receipt at Velec's factory. Title to the goods passed on December 15. The goods were still in

transit on December 31. Exchange rates were one dollar to 1.06 euros, 1.04 euros, and 1.05 euros on October 1,

December 15, and December 31, respectively. How should Velec account for the exchange rate fluctuation?

A. As a loss included in net income from continuing operations

B. As a gain included in net income from continuing operations

C. As an extraordinary gain

D. As a loss included in other comprehensive income

10. How are gains or losses on foreign exchange contracts typically recognized?

A. On the balance sheet in the year that the exchange rate changes

B. In current earnings in the year that the exchange rate changes

C. Immediately

D. All of the above

11. When remeasuring foreign currency financial statements into the functional currency, which of the following

items would be remeasured using historical exchange rates?

A. Inventories carried at cost

B. Equity securities reported at fair values

C. Bonds payable

D. Accrued liabilities

12. How should gains from remeasuring a foreign subsidiary's financial statements from the local currency into its

functional currency be reported?

A. As a deferred foreign currency transaction gain

B. In other comprehensive income

C. As revenue

D. As a part of continuing operations

36

IV. Translate Foreign Currency Financial

Statements “Because it is not possible to combine, add, or subtract measurements expressed in different currencies, it is

necessary to translate into a single reporting currency those assets, liabilities, revenues, expenses, gains, and

losses that are measured or denominated in a foreign currency.”

ASC 830-10-10-1

A. General Rules

Separate entities within a company that operate in different currency environments may prepare financial

statements in their respective functional currencies. The functional currency financial statements of all entities

consolidated or accounted for by the equity method must be translated into a single unit of measure (the reporting

currency of the reporting entity). This process is referred to as foreign currency translation, which is different than

remeasuring foreign entity financial statements.

As discussed, if a foreign entity’s books and records are not maintained in its functional currency, the reporting

entity must remeasure the financial statements into its functional currency before translating the foreign entity’s

financial statements into the reporting currency. For example, a parent maintains its financial statements in U.S.

dollars and owns a foreign subsidiary whose functional currency is British pounds. If some or all of the foreign

subsidiary's records are kept in euros, its financial statements must be remeasured from euros into British pounds

before translation into U.S. dollars.

The objectives of translation include:

✓ Preserving the operating results and relationships measured in the foreign currency;

✓ Providing information in consolidated financial statements about the financial performance of each

foreign consolidated entity; and

✓ Providing information on the anticipated effects of changes in exchange rates on cash flow and equity.

The following table summarizes the steps a reporting entity should take to translate the financial statements of

its foreign entities into its reporting currency

Books and records are NOT

maintained in functional

currency

1. Remeasure the financial statements into its functional

currency.

2. Recognize transaction gains or losses in income statement.

3. Translate the financial statements from the functional

currency to the reporting currency.

4. Include translation adjustments in other comprehensive

income.

37

Books and records are

maintained in functional

currency

1. Translate the financial statements from the functional

currency to the reporting currency.

2. Include translation adjustments in other comprehensive

income.

In most cases, assets and liabilities are translated at the current exchange rate at the balance sheet date. Revenue

and expenses are usually translated at the weighted-average exchange rate for the period. Translation

adjustments are reported as a part of comprehensive income and ultimately as a separate component of

stockholders' equity as accumulated other comprehensive income. Foreign currency transaction gains and losses

are reported in the income statement.

B. Selection of Exchange Rates for Translation

FASB mandates the current rate method when the functional currency is the foreign currency, which is the usual

case. The current method that translates at current exchange rates is required under ASC 830 (except when there

is a highly inflationary environment, to be discussed shortly).

The current method ensures that financial relationships remain the same in both local currency and reporting

currency. To accomplish this goal, ASC 830-30-45-3 requires that all elements of financial statements in the foreign

entity's functional currency to be translated to the parent's reporting currency using a current exchange rate as

follows:

1. For assets and liabilities, the entity should use the exchange rate at the balance sheet date.

2. For revenues, expenses, gains, and losses, the entity should use the exchange rate at the dates on which

those elements are recognized.

According to ASC 830, the current exchange rate is the rate as of the end of the period covered by the financial

statements or as of the dates of recognition in those statements in the case of revenues, expenses, gains, and

losses.

ASC 830-30-45-3 also applies to accounting allocations (for example, depreciation, cost of sales, and amortization

of deferred revenues and expenses) and requires translation at the current exchange rates applicable to the dates

those allocations that are included in revenues and expenses. That is, not the rates on the dates the related items

originated).

Finally, a reporting entity should NOT adjust its financial statements for a rate change that occurs after the date

of its financial statements. However, the entity should follow disclosure requirements as addressed in the

“Disclosures” section.

38

The following table summarizes exchange rates used to translate the financial statements of a foreign entity.

Exchange Rates for Translation

Assets and Liabilities Current exchange rate at the balance sheet date

Shareholders’ Equity

Historical exchange rates on the date the transactions are recognized,

except for the retained earnings during the year, which is translated

at the weighted average of the historical rates used to translate each

period’s income statement

Income Statement Exchange rate at the date the income or expense was recognized

If exchangeability between two currencies is temporarily lacking at the transaction date or balance sheet date,

ASC 830-30-45-9 requires the use of the first subsequent rate at which exchanges could be made. If the lack of

exchangeability is other than temporary, the propriety of consolidating, combining, or accounting for the foreign

operation by the equity method should be carefully considered.

ASC 830 provides the following example to illustrate the application of ASC 830-10-45-9.

Example 10: Exchange Rate When Exchangeability is Lacking Temporarily

ASC 830-30-55-1

This Example illustrates the appropriate exchange rate to be used for translating financial statements when

foreign exchange trading is temporarily suspended at year-end. The following are facts involving a reporting entity

that had a significant subsidiary in Israel:

a. On December 29, 20X8, the currency market was open and foreign currencies were traded. The exchange rate

was FC 1.68 = USD 1.00.

b. On December 30, 20X8, Israeli banks were officially open but foreign exchange trading was suspended until

January 2, 20X9. A devaluation to occur on January 2, 20X9, was announced. Most businesses were closed for

the holidays.

c. On December 31, 20X8, banks were closed.

d. On January 1, 20X9, banks were closed.

e. On January 2, 20X9, foreign exchange transactions were executed but left unsettled until the following day

when a new rate was to be established.

f. On January 3, 20X9, a new exchange rate of FC 1.81 = USD 1.00 was established and was effective for

transactions left unsettled the previous day.

Thus, exchangeability was temporarily lacking and the rate established as of January 3, 20X9, the first subsequent

rate, is the appropriate rate to use for translating the December 31, 20X8, financial statements.

39

1. Balance Sheet

Balance sheet items (all assets and liabilities) are translated at the current exchange rate at the balance sheet

date. Shareholders’ equity accounts (e.g. preferred stock, additional paid-in capital) are translated using the

historical exchange rates on the date they are recognized by both the parent and subsidiary, which presumably

would be the same date. For example, common stock issued is translated at the rate in effect on the date of

issuance. Since retained earnings represent accumulated net income, it is translated at the weighted average of

the historical rates used to translate each period’s income statement.

2. Income Statement

In the usual case (when high inflation does not exist), income statement items (revenue, expenses, gains, and

losses) are translated at the exchange rate at the dates those items are recognized. Because translation at the

exchange rates at the dates of many revenues, expenses, gains, and losses is usually impractical, ASC 830-10-55-

10 allows the use of averages or other methods of approximation. An appropriately weighted-average exchange

rate for the fiscal year is typically used in translating income statement items. Average rates used should be

appropriately weighted by the volume of functional currency transactions occurring during the accounting period.

For example, to translate revenue and expense accounts for an annual period, the entity could translate individual

revenue and expense accounts for each month at the month’s average rate. The translated amounts for each

month should then be combined for the annual totals. Average quarterly or monthly rates may be used if

significant revenues and expenses occur at particular times during the year.

3. Cash Flow Statement

In the statement of cash flows, cash flows are translated based on the exchange rates in existence at the time of

the cash flows. If reasonable and practical, a weighted-average rate for the year may be used, as long as the result

is similar. Disclosure should be made in the statement of cash flows for the impact of any exchange rate changes

on cash flow.

C. Translation Adjustments

A translation adjustment occurs only if the foreign entity's functional currency is different from that of the parent.

If a foreign entity's functional currency is the U.S. dollar and the parent's currency is also the U.S. dollar, translation

adjustment is NOT required.

According to ASC 830-30-45-12, translation adjustments resulting from translating the foreign entity's financial

statements into the reporting currency should be reported in other comprehensive income. As discussed, a gain

or loss on a foreign currency transaction that hedges a net investment in a foreign entity is reported in the same

manner as a translation adjustment. In this case, the translation loss or gain should be reported in accumulated

other comprehensive income.

40

Translation adjustments can be viewed as unrealized gains or losses. Therefore, they are reported in cumulated

other comprehensive income and are reclassified to net income only when there is a sale or liquidation of the

investment in the foreign entity.

Details of sale or liquidation of an investment in a foreign entity are discussed in the “Disposition of a Foreign

Entity” section.

Example 11: Reporting Gains or Losses

Blake Company's wholly-owned subsidiary, David Company, keeps its records in euros. Because David Company's

branch offices are located in Switzerland, its functional currency is the Swiss franc. Remeasurement of David

Company's 20X2 financial statements resulted in an $8,700 gain, and translation of its financial statements

resulted in a $9,200 gain. Blake should report as a foreign exchange gain $8,700 in its income statement for the

year ended December 31, 20X2. The translation gain of $9,200 should be included in “other comprehensive

income” and the cumulative translation adjustment, which is a separate component of stockholders' equity.

D. Highly Inflationary Environment

As discussed, the foreign entity's financial statements in a very inflationary environment are unstable and should

be remeasured as if the functional currency were the reporting currency. Consequently, if a foreign entity's

financial statements in a highly inflationary economy are expressed in a currency different from the reporting

currency, they have to be remeasured into the reporting currency.

If the U.S. dollar is used directly as the functional currency because of high inflation, balance sheet conversion

would be as follows:

• Cash, receivables, and payables are converted at the foreign exchange rate in effect at the balance sheet

date.

• Other assets and liabilities are converted at foreign exchange rates (historical rates) in effect at the date

of transaction, except that the exchange rate in effect at the balance sheet date is used to translate assets

and liabilities that are accounted for based on current prices, such as marketable securities carried at

market and estimated warranty obligations.

When the U.S. dollar is used as the functional currency because of high inflation, translation of income statement

items is based on the weighted average rate for the period. However, revenues and expenses that relate to assets

and liabilities translated at historical rates should be translated at such historical rates. Examples are depreciation

on fixed assets, amortization expense on intangible assets, and amortized revenue arising from deferred revenue.

In a highly inflationary environment in a foreign country requiring the use of the reporting currency directly,

transaction gains or losses from converting foreign currency financial statements into reporting currency financial

statements are recognized in the income statement.

41

Finally, ASC 830-10-45-16 addresses the consequences for the recognition of deferred tax benefits when a foreign

entity in a highly inflationary economy adopts the reporting currency of its parent as its functional currency. That

is, ASC 740-10-25-3(f) prohibits recognition of deferred tax benefits that result from indexing for tax purposes

assets and liabilities that are remeasured into the reporting currency. Thus, deferred tax benefits attributable to

any such indexing that occurs after the change in functional currency to the reporting currency should be

recognized when realized on the tax return and not before. Deferred tax benefits that were recognized for

indexing before the change in functional currency to the reporting currency are eliminated when the related

indexed amounts are realized as deductions for tax purposes.

The following exhibit presents a portion of an annual report regarding foreign operations in a highly inflationary

environment.

2015 GE Annual Report

Venezuela

The results of our Venezuelan businesses have been reported under highly inflationary accounting since the

beginning of 2010, at which time the functional currency of our Venezuelan entities was changed from the bolivar

to the U.S. dollar.

Our activities related to Venezuela generated revenues of less than one percent of consolidated revenues,

consisting of both exports to and operations within the country. The majority of these revenues are denominated

in U.S. dollars and euro but we also transact in bolivars for certain businesses.

For our operations in Venezuela, determining the appropriate exchange rate for remeasurement of bolivar-

denominated net monetary assets into U.S. dollars continues to be subject to uncertainty. As of December 31,

2015, the Venezuelan government operated three different exchange mechanisms: the government-operated

CENCOEX (the official exchange mechanism), the government-operated auction-based SICAD mechanism and an

open market Marginal Currency System (SIMADI). The SIMADI mechanism is intended to operate with fewer

restrictions and its exchange rate on December 31, 2015, was approximately 198 bolivars per U.S. dollar compared

to SICAD at 13.5 bolivars per U.S. dollar.

At the end of each period, we remeasure the net monetary assets of our Venezuelan businesses using the rate we

expect to settle them at, including through the payment of dividends. The industries in which these businesses

operate were not selected for participation in any SICAD auctions during 2015. In light of continued uncertainty

regarding availability of exchange mechanisms and decreasing liquidity in those mechanisms, we completed an

extensive review of each of our business activities within Venezuela during the fourth quarter of 2015. Based on

that review, we decided to reduce certain business activities in Venezuela and to begin accessing the SIMADI

market to obtain U.S. dollars, to the extent possible, for our residual Oil & Gas and Power operations. Our

Appliances business in Venezuela, which is conducted through an equity method investment, similarly concluded

that the SIMADI exchange mechanism provides the most appropriate rate for measuring its net monetary assets.

We also concluded, based on our review, consolidating our remaining Venezuelan operations remains

appropriate.

42

Use of the SIMADI rate to remeasure our Venezuelan net monetary assets at December 31, 2015, resulted in

exchange rate losses of $83 million. Restructuring and impairment charges of $12 million also were recorded

during the fourth quarter of 2015 as a result of the review discussed above. Net monetary assets subject to

remeasurement at the SIMADI rate were approximately $5 million at December 31, 2015, including approximately

$3 million within our Appliances equity method investment. In addition to our bolivar- denominated net monetary

assets, we also have non-bolivar credit exposures of approximately $292 million at December 31, 2015, and

recoverable amounts of non-monetary assets in Venezuela of approximately $89 million at December 31, 2015,

which consists principally of inventory and property, plant and equipment.

E. Derecognition

1. Disposition of a Foreign Entity

Upon sale of complete or substantially complete liquidation of an investment in a foreign entity, ASC 830-30-40-

1 requires the cumulative translation adjustment balance associated with that foreign entity to be:

✓ Removed from the stockholders' equity section

✓ Reported as part of the gain or loss on sale or liquidation of the investment in the income statement for

the period during which the sale or liquidation occurs

ASC 830-30-40-1A clarifies that a sale of an investment in a foreign entity includes:

1. Circumstances that result in the loss of a controlling financial interest in a foreign entity (that is,

irrespective of any retained investment); and

2. An acquirer obtaining control of an acquiree in which it held an equity interest immediately before the

acquisition date (also called a step acquisition)

To qualify as a “substantial” liquidation, generally at least 90% of the assets and liabilities of a foreign entity should

be liquidated. Therefore, PwC suggests that the following transactions do NOT represent a substantially complete

liquidation:

Payment of periodic dividends to the parent out of a foreign subsidiary’s net income

Payment of liquidating dividends in amounts less than a significant portion of the investment’s assets (i.e.,

less than 90% of the assets)

Changing the nature of an intercompany advance from permanent (i.e., similar to capital) to debt intended

to be settled in the foreseeable future

ASC 830-30-40-4 indicates that under ASC 220-20 Comprehensive Income, a gain or loss on disposal of part or all

of a net investment may be recognized in a period other than that in which actual sale or liquidation occurs. ASC

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830-30-40-1 does not alter the period in which a gain or loss on sale or liquidation is recognized under existing

GAAP.

The following examples illustrate the application of 830-30-40-1.

Example 12: Reporting Translation Adjustments

Example 12-1

Johnson Corp. is a U.S. company. ENG is a wholly-owned subsidiary of Johnson located in the U.K. Johnson reduces

its ownership in ENG from 100% to 51%. Johnson still retained a controlling financial interest in ENG and should

continue to consolidate it.

How should Johnson report the cumulative translation adjustment account balance associated with ENG?

Solution:

According to ASC 830-30-40-1, a reporting entity can only remove the cumulative translation adjustment account

balance associated with that foreign entity from equity and recognize it in the income statement upon sale or

upon complete or substantially complete liquidation of an investment in a foreign entity. ASC 830-30-40-1A

clarifies that a sale of an investment in a foreign entity includes circumstances that result in the loss of a controlling

financial interest in a foreign entity (that is, irrespective of any retained investment).

In this case, the event is NOT qualified as a sale of an investment in a foreign entity since Johnson still retains

control of ENG. Accordingly, the cumulative translation adjustment related to ENG should remain in equity.

Example 12-2

Star West Corp. holds a 35% ownership interest in an equity method investment that is a foreign entity.

Subsequent to the initial investment, Star West acquires an additional 30% ownership interest in the equity

method investee, and as a result, now controls and consolidates the foreign entity.

How should Star West report the cumulative translation adjustment related to the foreign equity method

investment?

Solution:

According to ASC 830-30-40-1, a reporting entity can only remove the cumulative translation adjustment account

balance associated with that foreign entity from equity and recognize it in the income statement upon sale or

upon complete or substantially complete liquidation of an investment in a foreign entity. ASC 830-30-40-1A

clarifies that a sale of an investment in a foreign entity includes an acquirer obtaining control of an acquiree in

which it held an equity interest immediately before the acquisition date (e.g. step acquisitions).

In this case, the event is qualified as a sale of an investment in a foreign entity since Star West controls the foreign

entity through the step acquisition. Accordingly, Star West should remove the cumulative translation adjustment

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related to the foreign equity method investment from equity and recognize it in the income statement upon the

acquisition of the additional 30% interest.

2. Partial Sale of Ownership Interest

If a reporting entity sells a portion of a foreign entity that is accounted for using the equity method, and its retained

interest will also be accounted for using the equity method, it should recognize a pro rata portion of the

cumulative translation adjustment account attributable to the equity method investment when measuring the

gain or loss on the sale as prescribed by ASC 830-30-40-2.

The following table lists these levels of interest or influence and the corresponding valuation and reporting

method that companies must apply to the investment.

Three Levels of Influence and Accounting Methods

Percentage of

Ownership 0% −−−−−−− 20% 20% −−−−−− 50% 50−−−−−−−100%

Level of Influence Little or None Significant Control

Valuation Method Fair Value Method Equity Method Consolidation

When the sale of part of an equity method investment that is a foreign entity results in the loss of significant

influence, the cumulative translation adjustment account balance remaining after the pro rata recognition in net

income should become part of the cost method carrying value. ASC 323-10-35-37 and 35-39 provide guidance on

how to account for the pro rata portion of the cumulated translation adjustment component of equity attributable

to the remaining investment as follows:

ASC 323-10-35-37

Paragraph 323-10-35-39 provides guidance on how an investor shall account for its proportionate share of an

investee’s equity adjustments for other comprehensive income in all of the following circumstances:

a. A loss of significant influence

b. A loss of control that results in accounting for the investment in accordance with Topic 321

c. Discontinuation of the equity method for an investment in a limited partnership because the conditions in

paragraph 970-323-25-6 are met for accounting for the investment in accordance with Topic 321.

ASC 323-10-35-39

In the circumstances described in paragraph 323-10-35-37, an investor’s proportionate share of an investee’s

equity adjustments for other comprehensive income shall be offset against the carrying value of the investment

at the time significant influence is lost. To the extent that the offset results in a carrying value of the investment

that is less than zero, an investor shall both:

a. Reduce the carrying value of the investment to zero

b. Record the remaining balance in income

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ASC 830-30-40-3 clarifies that although partial liquidations by a parent of net assets held within a foreign entity

may be considered similar to a sale of part of an ownership interest in the foreign entity if the liquidation proceeds

are distributed to the parent, extending pro rata recognition (release of the cumulative translation adjustment

into net income) to such partial liquidations would require that their substance be distinguished from ordinary

dividends. Such a distinction is neither possible nor desirable. For those partial liquidations, no cumulative

translation adjustment is released into net income until the criteria in 830-30-40-1 are met.

Example 13: Partial Sale of Ownership Interest

Dale Corp. is a U.S. company. EPS Corp. is a foreign entity of Dale. Dale has a 40% investment in EPS using the

equity method of accounting.

Dale sells a portion of its 40% ownership interest in EPS reducing its investment to 30%. Dale still retains significant

influence.

At the date of sale, Dale’s cumulative translation adjustment account balance related to EPS is a debit balance of

$80,000.

How should Dale account for its cumulative translation adjustment in EPS upon the sale of a portion of its

investment?

Solution:

According to ASC 830-30-40-2, Dale should recognize a proportionate share of the cumulative translation

adjustment in net income. Therefore, Dale recognizes the pro rata portion as 25% (the decrease in ownership

from 40% to 30%) of the $80,000 cumulative translation adjustment account balance, or $20,000 in net income.

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Release of Cumulative Translation Adjustment Decision Tree

ASU 2013-05 provides the following flowchart to illustrate the cumulative translation adjustment derecognition

guidance in ASC 830-30-40-1 through 40-4 for the derecognition of certain subsidiaries or groups of assets within

a foreign entity and for changes in an investment in a foreign entity.

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3. Cumulative Translation Adjustment in Impairment Assessment

ASC 830-30-45-13 requires an entity that has committed to a plan to dispose of an equity method investment or

a consolidated investment in a foreign entity that will cause the cumulative translation adjustment attributable to

that entity to be reclassified to net income should include the cumulative translation adjustment as part of the

carrying amount of the investment when evaluating that investment for impairment.

Additionally, ASC 830-30-45-15 states that an entity should include the portion of the cumulative translation

adjustment that represents a gain or loss from an effective hedge of the net investment in a foreign operation as

part of the carrying amount of the investment when evaluating that investment for impairment.


Example 14: Impairment Assessment

Penny Corp. uses the U.S. dollar as its functional currency. Forest Inc. uses the euro as its functional currency.

On January 1 20X8, Penny invests $800 for a 30% ownership interest in Forest, which will be accounted for as an

equity method investment. For simplicity, the investment cost equals 30% of Forest's net book value.

Penny recognizes its share of:

• Forest’s net income for the year ended December 31, 20X8 ($200)

• The adjustment from the translation of Forest’s financial statements from the euro to the U.S. dollar (debit

of $40)

A roll-forward of the equity method investment account from the initial investment to the balance at 31 December

31, 20X8 follows:

Initial investment $800

Share of 20X8 net income 200

Share of translation adjustment (40)

$960

On December 31, 20X8, Penny commits to a plan to sell its equity method investment in Forest for $900. The

investment is sold on March, 15 20X9 for $900. The impairment test is calculated as follows:

Carrying amount of investment in Forest $960

Add: *Cumulative translation adjustment debit balance 40

Adjusted carrying amount 1,000

Fair value (900)

Impairment loss $100

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Carrying amount before impairment write-down $960

Impairment write-down (100)

Carrying amount of investment in Forest at December 20X8 $860

Accounting at the date of sale March 15, 20X9

Sale proceeds $900

Less: Asset carrying amount (860)

Cumulative translation adjustment reclassification entry (40)

Loss on disposal $0

* According to ASC 830-30-40-1, cumulative translation adjustment is reclassified into net income only upon a sale or upon a

complete or substantially complete liquidation of the foreign entity. Thus, this entry is used only for measuring impairment.

Comprehensive Illustration: Translation of Foreign

Entity Financial Statements

AGI Corp., a U.S. company, uses the U.S. dollar (USD) as its reporting currency. Novo is considered a foreign entity

of AGI located in Denmark with a functional currency of the euro (EUR). Novo maintains its books and records in

krone (DKK). Its DKK financial statements are shown below.

Balance on 1/1/x8

Balance on 12/31/x8

Balance Sheet (DKK) (DKK)

Cash 20,000 23,000

Net property, plant and equipment (PP&E) 8,000 7,000

Total assets 28,000 30,000

Common stock 18,000 18,000

Retained earnings 10,000 12,000

Total shareholders’ equity 28,000 30,000

Income Statement 12/31/x8

Gross profit 3,000

Depreciation (1,000)

Net income 2,000

Retained earnings at 1/1/x8 10,000

Retained earnings at 12/31/x8 12,000

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For simplicity, there is no opening balance in AGI’s cumulative translation adjustment account related to its

investment in Novo assuming that the 1/1/x8 exchange rate has not changed since AGI acquired Novo.

How should AGI translate Novo’s DKK financial statements for inclusion in its USD consolidated financial

statements?

Solution: Novo’s DKK financial statements should first be remeasured into its functional currency (EUR), and then

translated into the reporting currency (USD).

The following exchange rates are used to remeasure and translate Novo’s financial statements. Retained earnings

is translated using the historical exchange rate since we have assumed that exchange rates prior to 1/1/x8 had

not changed.

DKK to EUR EUR to USD

Current exchange rate as of 12/31/x8 DKK 1 = EUR 1.20 EUR 1 = USD 1.13

Current exchange rate as of 12/31/x7 DKK 1 = EUR 1.50 EUR 1 = USD 1.09

Weighted average exchange rate DKK 1 = EUR 1.18 EUR 1 = USD 1.10

Historical exchange rate in effect at the date the

common stock was issued and PP&E was purchased DKK 1 = EUR 1.15 EUR 1 = USD 1.09

REMEASUREMENT TRANSLATION

Balance Sheet DKK

Balance Exchange Rate EUR

Balance Exchange Rate USD

Balance

Cash 23,000 DKK 1 = EUR 1.20 27,600 EUR 1 = USD 1.13 31,188

Net PP&E 7,000 DKK 1 = EUR 1.15 8,050 EUR 1 = USD 1.13 9,097

Total assets 30,000 35,650 40,285

Common stock 18,000 DKK 1 = EUR 1.15 20,700 EUR 1 = USD 1.09 22,563

Retained earnings 12,000 14,950 16,330

Translation adjustment (See Table A) - - 1,392

Total shareholders’ equity 30,000 35,650 40,285

REMEASUREMENT TRANSLATION

Income Statement DKK

Balance Exchange Rate EUR

Balance Exchange Rate USD

Balance

Gross profit 3,000 DKK 1 = EUR 1.18 3,540 EUR 1 = USD 1.10 3,894

Depreciation (1,000) DKK 1 = EUR 1.15 (1,150) EUR 1 = USD 1.10 (1,265)

Foreign exchange gain (See Table B) - 1,060 1,166

Net income 2,000 3,450 EUR 1 = USD 1.10 3,795

Retained earnings at 1/1/x8 10,000 DKK 1 = EUR 1.15 11,500 EUR 1 = USD 1.09 12,535

Retained earnings at 12/31/x8 12,000 14,950 16,330

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The translation adjustment of USD 1,392 above results from translating from EUR to USD. The translation

adjustment is calculated as follows:

Table A: Calculation of Translation Adjustment (from EUR to USD)

EUR balances as of 1/1/x8 Change in exchange rate

Cumulative Translation Adjustment USD Balance

Net assets at 1/1/x8 32,200 1.13 – 1.09 = 0.04 1,288

Net income for the year 3,450 1.13 – 1.10 = 0.03 104

1,392

The foreign exchange gain of EUR 1,060 results from the remeasurement from British pounds to euros and is

included in income. It is calculated as follows:

Table B: calculation of Foreign Exchange Gain (from DKK to EUR)

DKK balances as of 12/31/x8 Change in exchange rate

Foreign Exchange Gain EUR Balance

Net monetary assets at 1/1/x8 20,000 1.20 – 1.15 = 0.05 1,000

Gross profit for the year 3,000 1.20 – 1.18 = 0.02 60

1,060

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V. Other Matters

A. Intercompany Profits

ASC 830-30-45-10 indicates that to eliminate intercompany profits that are attributable to sales or other transfers

between entities that are consolidated, combined, or accounted for by the equity method, the reporting entity

should use the exchange rate in existence at the dates of the sales or transfers. However, a reasonable average

or estimated rate is permitted. Since the elimination of intercompany profits should be based on the exchange

rates at the dates of sale or transfer, subsequent changes in the exchange rates should NOT affect the elimination

process.


Example 15: Elimination of Intercompany Profits

AME Corp. is a U.S. company that uses the U.S. dollar as its reporting currency. BRI is a wholly-owned subsidiary

of AME located in London.

On January 15, 20X8, AME sells inventory for $500,000 (cost $200,000) to BRI whose functional currency is the

pound. Upon the sale, AME realizes an intercompany profit of $300,000 ($500,000 — $200,000).

As of March 31, 20X8, the inventory has not yet been sold.

The following table summarizes the exchange rate on the date the company sold the inventory and on the date

of its financial statements.

Date Exchange Rate

January 15, 20X8 $1=£0.5

March 31, 20X8 $1=£0.8

How should AME account for the inventory sale in its consolidated financial statements for the quarter ended

March 31, 20X8?

Solution:

In order to properly compute the intercompany profit amount to be eliminated in consolidation, the inventory

recorded on BRI’s books needs to be separated into two components. The inventory recorded in BRI: £200,000

1. Cost component: £100,000 ($200,000 x (£0.5/$1.0))

2. Intercompany profit component: £150,000 ($300,000 x (£0.5/$1.0))

According to ASC 830-30-45-10, translation of intercompany profits and the elimination of such intercompany

profits on sales or transfers between entities should be based on the exchange rates at the dates of sale or

transfer. Therefore, the exchange rate of $1=£0.5 as of January 15, 20X8 is used. The intercompany profit

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component of £150,000 is translated at the historical rate into $300,000 which equals the intercompany profit

amount recognized by AME. These two balances are fully eliminated in consolidation.

The cost component of £100,000 is translated at the current exchange rate as of March 31, 20X8. This results in

the inventory amount of $125,000 [£100,000 ÷ (£0.8/$1.0)] recognized in the consolidated balance sheet.

B. Hedging

An entity may enter into hedging transactions to minimize the adverse effects of changes in exchange rates on

cash flows and net income. An entity's aim is to recognize a gain or loss from the hedge in the same period as the

loss or gain on the risk being hedged. The process will result in an overall reduction of risk for the entity. Foreign

currency transaction gains and losses on assets and liabilities, denominated in a currency other than the entity's

functional currency, can be hedged if the U.S. company enters into a forward exchange contract or a foreign

currency option.

Forward exchange contracts are contracts where the entity agrees to purchase an amount of foreign currency at

a specific date in the future at a specific exchange rate. Forward contracts can be difficult to create, have higher

fees, are highly customized, and may be hard exchange given their highly specific criteria.

According to ASC 815, a forward contract is an executory contract in which the parties involved agree to the terms

of a purchase and a sale of a stated amount of a commodity, foreign currency, or financial instrument, but delivery

or settlement is at a stated future date. Accordingly, a forward contract involves a commitment today to purchase

a product on a specific future date at a price determined today.

Foreign currency options give the purchaser the right to buy or sell the currency, but not the obligation, during a

specified period of time. Currency options are very flexible, and one of the most common ways for corporations

to hedge against adverse or unexpected movements in exchange rates. Currency options may be quoted in one

of two ways:

1. American terms, in which a currency is quoted in terms of the U.S. dollar per unit of foreign currency and

may be exercised at any time up to and including the expiration date; and

2. European terms, in which the U.S. dollar is quoted in terms of units of foreign currency per U.S. dollar,

and may be exercised on the expiration date of the option only, while American style options.

Options in general provide a way to reduce the risk of a loss and also the chance of a benefit from a favorable

exchange rate change.

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ASC 815-10-05 and ASC 815-20-25 permit hedge accounting for foreign currency derivatives only if the following

conditions are satisfied:

✓ The derivative is used to hedge either a fair value exposure or a cash flow exposure.

✓ The derivative is highly effective in offsetting changes in the fair value or cash flows. A highly effective

hedge would be one where the changes in the hedged item are nearly offset by the changes in the hedging

instrument.

✓ The derivative is documented as a hedge.

A fair-value exposure exists if changes in exchange rates can affect the fair value of assets or liabilities. If the

exposure is not hedged, it must have the potential to affect net income. A fair value hedge also may exist for

foreign currency firm commitments. A cash flow exposure exists if changes in exchange rates can affect the

amount of cash flow that will be realized from a transaction, where changes in cash flow are reflected in net

income.

To use hedge accounting, derivatives must be designated as either a fair value hedge or a cash flow hedge. An

entity may use either a fair value hedge or a cash flow hedge for:

1. Recognized foreign currency assets and liabilities.

2. Foreign currency firm commitments.

Hedges of forecasted foreign currency transactions can only qualify for a cash flow hedge. Gains or losses on fair

value hedges are recognized immediately in net income, whereas gains or losses on cash flow hedges are included

in other comprehensive income.

To use hedge accounting, the hedge must be expected to be highly effective in offsetting gains and losses on the

items being hedged. Critical terms of the hedging instrument, such as currency type, amount, and settlement date

should match those of the hedged item. The hedging entity should document the:

• Hedged item;

• Hedging instrument;

• Nature of risk;

• Means of assessing the hedging instrument's effectiveness; and

• Management's objectives and strategies for undertaking the hedge.

Derivative and hedge accounting can be a highly complex topic. Please review ASC 815 for more information.

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C. Disclosures

1. Aggregate Transaction Gains or Losses

ASC 830-20-45-1 requires entities to disclose the aggregate transaction gain or loss included in the determination

of net income for the period in either the financial statements or notes to the financial statements. Specifically,

disclosures in notes to the financial statements should include transaction gains or losses reclassified to other

income statement components, such as interest income and expense, sales, and cost of sales. ASC 830-20-45-2

states that banks and dealers in foreign exchange may disclose these transaction gains or losses as dealer gains or

losses rather than as transaction gains or losses.

According to ASC 830-740-45-1, a transaction gain or loss that results from remeasuring a deferred foreign tax

liability or asset may be included in the reported amount of deferred tax benefit or expense if that presentation

is considered to be more useful. If reported in that manner, that transaction gain or loss is still included in the

aggregate transaction gain or loss for the period to be disclosed.

2. Cumulative Translation Adjustments

An entity is required to disclose and analyze the changes in the accumulated amount of translation adjustments

reported in equity during the period. According to ASC 830-30-45-18, this analysis of changes in cumulative

translation adjustment should be reported in any of the following ways:

✓ In a separate financial statement

✓ In notes to financial statements

✓ As part of a statement of changes in equity

ASC 830-30-45-20 requires the analysis to include, at a minimum:

1. Beginning and ending amount of cumulative translation adjustments

2. The aggregate adjustment for the period resulting from translation adjustments and gains and losses from

certain hedges (e.g. net investment hedge in a foreign operation) and intra-entity balances (those of a

long-term investment nature)

3. The amount of income taxes for the period allocated to translation adjustments

4. The amounts transferred from cumulative translation adjustments 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.

3. Exchange Rate Changes

According to ASC 830-30-45-16, a reporting entity’s financial statements should NOT be adjusted for a rate change

that occurs:

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• After the date of the reporting entity’s financial statements; or

• After the date of the foreign currency statements of a foreign entity if they are consolidated, combined,

or accounted for by the equity method in the financial statements of the reporting entity.

However, ASC 830-20-50-2 requires the entity to disclose the following information:

1. Significant effects on unsettled balances pertaining to foreign currency transactions

2. Consideration of changes in unsettled transactions from the date of the financial statements to the date

the rate changed

3. The fact that it is not practicable to determine such changes (if applicable)

In general, such disclosure is not required only if the entity does NOT have any unsettled foreign currency

transactions. Disclosure of significant effects on unsettled foreign currency transactions of subsequent exchange

rate changes is necessary because the changes affect the remeasurement of these transactions resulting in

transaction gains or losses (i.e. cash flow consequence). However, a subsequent rate change that affects only the

translation process does not have the same impact since translation adjustments are recorded in equity (i.e. lack

of cash flow consequence). Thus, disclosure of a subsequent rate change that affects only the translation process

usually is not considered necessary.

To assist financial report users in understanding the broader economic implications of rate changes and to

compare recent results with those of prior periods, ASC 830-20-50-3 encourages management to include an

analysis and discussion of the effects of rate changes on the reported results of operations. Such disclosures may

include:

✓ The mathematical effects of translating revenue and expenses at rates that are different from those used

in a preceding period

✓ The economic effects of rate changes, such as the effects on selling prices, sales volume, and cost

structures

4. Footnote Disclosure

Footnote disclosure is required of:

• Profits earned from overseas. This also includes the amount of foreign earnings in excess of amounts

received in the U.S.

• Foreign currency transaction gains or losses, including that associated with forward exchange contracts.

• The impact on unsettled balances regarding foreign currency transactions.

• Cumulative translation adjustments are reported in stockholders' equity. This includes the reasons for the

change in the balance from the beginning to the end of the year.

• Gains or losses arising from hedging a foreign currency position.

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• Effect of exchange rate changes on operating results and financial position. This disclosure includes the

impact of a change in exchange rates from the prior year to the current year associated with the

translation of revenues and expenses. It also includes the effect of a change in exchange rate on revenue

and cost components, such as sales volume, sales price, and cost of sales. The nature of restated figures

should be noted.

• A significant change in exchange rate taking place after year-end and before the audit report date. This is

a subsequent event disclosure.

5. Excluding a Foreign Entity from Financial Statements

In some cases, a foreign entity may be excluded from consolidated or combined financial statements. This may

arise if serious political problems exist in the foreign country (e.g., civil war) or if exchange restrictions are

extremely restrictive, inhibiting any reliability to exchange rates. In this situation, the profits of a foreign activity

should be included in the financial statements only to the degree of receipt of unrestricted cash. When the foreign

entity is excluded from the financial statements, proper disclosure should be made of the reasons therefor, other

pertinent information, and dollar effect. Such disclosure may be in a supplemental schedule or in a footnote form.

The SEC’s View on Disclosures, if the U.S. Dollar is Not the Reporting Currency

Excerpt from the SEC Division of Corporation Finance Financial Reporting Manual

6620 Disclosures, if the U.S. Dollar is Not the Reporting Currency [S-X 3-20]

While not specifically referring to SFAS 52 [ASC 830], S-X 3-20 is designed to be conceptually consistent with that

standard. Assets and liabilities are translated at the period end exchange rate and the income statement is

translated at the weighted average annual exchange rate. The translation effects of exchange rate changes are

included as a separate component of equity.

6620.1 The currency used to prepare financial statements must be displayed prominently on the face of the


6620.2 The currency in which dividends are declared, if different from the reporting currency, must be disclosed.

6620.3 A description of material exchange restrictions or controls relating to the reporting currency, and the

currency of the issuer's domicile or the currency in which the issuer will pay dividends, if different, must be

provided.

6620.4 A five-year history of exchange rates setting forth rates at period end, average, highs and lows, must be

disclosed. [Item 3.A of Form 20-F] The noon buying rate in New York City for cable transfers in foreign currencies

as certified for customs purposes by the Federal Reserve Bank in New York can be obtained via the internet at:

http://www.newyorkfed.org/markets/fxrates/historical/home.cfm.

See the Division of Corporation Finance’s C&DIs for Exchange Act Forms, Question 110.01.

http://www.newyorkfed.org/markets/fxrates/historical/home.cfm

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6620.5 Dollar equivalent or convenience translations are generally not permitted, except that a convenience

translation may be presented only for the most recent fiscal year and interim period. Translation should be made

at the exchange rate on the balance sheet date or most recent date practicable, if materially different. The rate

used for the convenience translation should generally be the rate that the issuer would use if dividends were to

be paid in U.S. dollars.

6620.6 An issuer filing a registration statement on Form F-3 that incorporates financial statements previously filed

on Form 20-F does not need to amend or otherwise modify these statements to reflect a more current exchange

rate in presenting the convenience translation.

6620.7 While S-X 3-20 allows foreign private issuers to prepare financial statements in the currency it believes is

appropriate, it does not address financial statements of acquirees or equity investees. However, these financial

statements can be prepared either in the same currency as the issuer or in the currency that normally is used for

the preparation of such entities’ financial statements. Accordingly, a domestic issuer can prepare financial

statements of an acquiree or investee in U.S. dollars. (Last updated: 12/31/2010)

D. Difference between U.S. GAAP and IFRS

Increasing globalization coupled with related regulations continues to put pressure on moving towards a common

global accounting framework – International Financial Reporting Standards (IFRS) as currently, more than 100

countries use IFRS. Several similarities exist between U.S. GAAP and IFRS with respect to accounting for foreign

currency translation issues. For example, both U.S. GAAP and IFRS:

✓ The functional currency is defined as the currency of the primary economic environment in which the

entity operates, this is normally the currency of the environment in which the entity generates and

expends cash

✓ Remeasurement into the functional currency before translation into the reporting currency is required

✓ Assets and liabilities are translated at the period-end rate and income statement amounts generally are

translated at the average rate, with the exchange differences reported in equity

✓ Transactions that are not denominated in an entity’s functional currency are foreign currency

transactions. Exchange differences arising on translation are usually recognized in profit or loss

✓ Certain foreign exchange effects related to net investments in foreign operations should be accumulated

in shareholders’ equity (i.e., the cumulative translation adjustment portion of other comprehensive

income)

✓ The identification of a highly inflationary economy is required, however, there are some differences

between the two standards as discussed below.

Although there are similarities between U.S. GAAP and IFRS with respect to accounting for foreign currency

translation issues, there are also differences. The significant differences between U.S. GAAP and IFRS include:

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Determination of Functional Currency

IAS 21 The Effects of Changes in Foreign Exchange Rates contains a hierarchical structure of indicators (including

primary and secondary indicators) on the determination of the functional currency. As discussed, ASC 830

indicates that several indicators should be considered to determine the entity’s functional currency. However,

those indicators are not set up in a hierarchical structure. In other words, there is no priority given to any of the

following ASC 830 indicators, unlike IFRS. Instead, an entity should evaluate all relevant information and exercise

its judgment in determining the functional currency.

Criteria to Determine Functional Currency

ASC 830

To determine the functional currency of a foreign operation, an entity should consider the following indicators (without distinguishing between primary and secondary): 1. Cash flows generated by the assets and liabilities of the foreign operation are primarily in the foreign

currency and do not directly affect the parent’s cash flows

2. Sales prices of the foreign operation’s products or services are:

• Determined more by local competition or government regulation than by worldwide competition and international prices and

• Not generally responsive on a short-term basis to changes in exchange rates

3. There is an active local sales market for the foreign operation’s products or services

4. The foreign operation uses primarily local labor, material and other costs to produce its products or render its services

5. The financing is primarily denominated in the foreign currency and cash flows generated by the foreign operation are sufficient to service existing and anticipated financing obligations

6. The foreign operation has a low volume of intercompany transactions and no extensive inter-relationship of operations with the parent

7. The parent’s currency would generally be the functional currency if the foreign entity is a holding company or shell company for holding investments, obligations, intangible assets

IAS 21

The following factors are considered in determining an entity’s or operation’s functional currency:

1. Primary Indicators:

• The currency that mainly influences sales prices

• The currency of the country whose competitive forces and regulations mainly determine sales prices; and

• The currency that mainly influences labor, material and other costs

2. Secondary Indicators:

• The currency in which funds from financing activities are generated; and

• The currency in which receipts from operating activities are usually retained

Although US GAAP and IFRS contain different criteria in determining an entity’s functional currency, both ASC 830

and IAS 21 generally result in the same conclusion. Moreover, under IFRS, an entity may decide to present its

financial statements in a currency other than its functional currency (presentation currency). U.S. GAAP does not

address whether an entity may have more than one reporting currency. However, like IFRS, the SEC indicated that

a foreign private issuer may select any reporting currency that the issuer deems appropriate.

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Highly Inflationary Economy

As discussed, ASC 830 describes that a highly inflationary economy is one that has cumulative inflation of

approximately 100% or more over a 3-year period. Once an economy reaches a three-year period cumulative

inflation of 100%, it is automatically considered highly inflationary. IFRS does not establish an absolute rate at

which hyperinflation (highly inflationary) is deemed to arise. Instead, IAS 29.3 Financial Reporting in

Hyperinflationary Economies provides a list of characteristics that might indicate hyperinflation, including when

the cumulative inflation rate over three years is approaching or exceeds 100%. Examples of indicators

(characteristics) of a hyperinflationary economy include:

• The general population keeps its wealth in non-monetary assets or a stable foreign currency

• Sales account receivables are indexed to inflation until collection

• interest rates, wages and prices are linked to a price index

As discussed, under ASC 830, when an entity’s functional currency is the currency of a highly inflationary economy,

the financial statements are required to be remeasured as if the functional currency were the reporting currency,

with resulting exchange differences recognized in income. In contrast, IFRS requires that the functional currency

be maintained. However, local functional currency financial statements (current and prior period) is restated in

terms of the measuring unit current at the balance sheet date.

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Review Questions – Section 3 13. How should translation gains and losses resulting from translating foreign currency financial statements into

U.S. dollars be treated?

A. As a deferred item in the balance sheet

B. As an ordinary item in the income statement for losses but a deferred item in the balance sheet for gains

C. As an ordinary item in the income statement

D. In other comprehensive income

14. Which of the following is debited to other comprehensive income (OCI)?

A. Discount on convertible bonds that are dilutive potential common stock

B. Premium on convertible bonds that are dilutive potential common stock

C. Cumulative foreign currency translation loss

D. Organizational costs

15. What does a forward contract involve?

A. A commitment today to purchase a product on a specific future date at a price to be determined sometime

in the future.

B. A commitment today to purchase a product some time during the current day at its present price.

C. A commitment today to purchase a product on a specific future date at a price determined today.

D. A commitment today to purchase a product only when its price increases above its current exercise price.

16. Which of the following is NOT required to be footnoted?

A. Profits earned from domestic earnings

B. Foreign currency transaction gains or losses, including that associated with forward exchange contracts

C. The impact on unsettled balances regarding foreign currency transactions

D. Cumulative translation adjustments reported in stockholders' equity

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Glossary

Conversion. The exchange of one currency for another.

Denominate. To pay or receive in the same foreign currency. The account can be denominated only in one

currency (e.g., Euros). It is a real account (asset or liability) fixed in terms of a foreign currency regardless of the

exchange rate.

Exchange ratio. The ratio of one unit of a currency to that of another at a given date. If a temporary lack of

exchangeability exists between the two currencies at the transaction date or balance sheet date, the first rate

available thereafter should be used.

Foreign currency. A currency other than the functional currency of a business. For example, the dollar could be

a foreign currency for a foreign entity. Composites of currencies (e.g., special drawing rights) may be used to

establish prices or denominate amounts of loans.

Foreign currency transactions. Transactions in which the terms are denominated in a currency other than the

entity’s functional currency. Foreign currency transactions occur when a company (1) purchases (imports) or sells

(exports) on credit merchandise or services the prices being denominated in a foreign currency; (2) buys or sells

assets or incurs or settles liabilities denominated in foreign currency; (3) takes out or gives international loans in

which the amounts payable or receivable are denominated in a foreign currency; (4) is a participant in an

unperformed forward exchange contract; and (5) borrows or lends money, and the amounts payable or

receivable are expressed in a foreign currency.

Foreign currency statements. Financial statements using as the measuring unit of a functional currency other than

the reporting currency of the business.

Foreign entity. An operation (e.g., division, subsidiary, branch, joint venture) whose financial statements are

prepared in a currency other than the reporting currency of the reporting entity.

Foreign currency translation. Stating in a company’s reporting currency those amounts denominated or

measured in a different currency.

Functional currency. A company’s functional currency is the currency of the primary economic environment in

which the company operates. It is usually the currency of the environment in which the business mostly receives

and pays cash. Once determined, the functional currency should be used consistently unless significant changes

clearly indicate a change. Note: The currency of a highly inflationary environment (three-year rate of 100% or

more) is not stable enough to be used for this purpose. In such circumstances, the U.S. dollar is the functional

currency. The functional currency of a foreign operation may be the same as that of a related affiliate where a

foreign activity is a “key” component or extension of a related affiliate. If remeasurement (restatement) of a

subsidiary’s foreign currency financial statements is required before translation can be accomplished (i.e., when

the functional currency is the U.S. dollar), a transaction gain or loss results.

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Local currency. The currency of a particular foreign country.

Monetary assets and liabilities. Cash, receivables, and obligations to pay a fixed amount of debt.

Measure. Translating into a currency other than the original reporting currency. Foreign financial statements are

expressed in U.S. dollars by using the relevant exchange rate.

Nonmonetary items. All balance sheet items except for cash, claims to cash, and cash obligations.

Reporting currency. The currency the business prepares its financial statements in, typically U.S. dollars.

Spot Rate. The exchange rate for immediate delivery of currencies exchanged.

Translation adjustments. Adjustments derived from translating financial statements from the entity’s functional

currency into the reporting one.

Transaction gain or loss. Transaction gain or loss is produced from redeeming receivables/payables that are

fixed in terms of amounts of foreign currency received/paid. An example is a French subsidiary having a

receivable denominated in Euros from a Swiss customer. A transaction gain or loss takes place when there is a

change in exchange rates between the functional currency and the currency in which a foreign currency

transaction is denominated.

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Index

A net investment hedge, 20 Available-for-sale debt securities, 26 Balance sheet, 39 Cash flow statement, 39 Cumulative translation adjustments, 54 Debt, 24 Debt securities, 25 Derecognition, 42 Disposition of a foreign entity, 42 Equity securities, 27 Footnote disclosure, 55 Foreign currency financial statements, 1 Foreign currency transactions, 1 Foreign entity, 1 Functional currency, 8 Hedging, 52

Held-to-maturity debt securities, 26, 31 Highly inflationary economy, 10, 40 Income statement, 39 Intercompany profits, 51 Inventory, 23, 30 Lease, 27, 28, 29 Monetary accounts, 18 Nonmonetary accounts, 18 Property, plant and equipment, 22 Remeasurement, 17 Reporting currency, 1 Spot rate, 20, 24, 25, 29, 30, 32, 34, 66 Trading debt securities, 26 Transaction gains or losses, 20 Translation, 36 Translation adjustment, 39

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Review Question Answers

Review Questions − Section 1

1. In preparing consolidated financial statements of a U.S. parent company with a foreign subsidiary, what is the

foreign subsidiary's functional currency?

A. Incorrect. The currency in which the subsidiary maintains its accounting records may not be the currency

indicated by the salient economic indicators, such as cash flows, sales prices, sales markets, expenses,

financing, and intercompany transactions.

B. Incorrect. The currency of the country in which the subsidiary is located may not be the currency indicated

by the salient economic indicators, such as cash flows, sales prices, sales markets, expenses, financing,

and intercompany transactions.

C. Incorrect. The currency of the country in which the parent is located may not be the currency indicated

by the salient economic indicators, such as cash flows, sales prices, sales markets, expenses, financing,

and intercompany transactions.

D. Correct. The method used to convert foreign currency amounts into units of the reporting currency is the

functional currency translation approach. It is appropriate for use in accounting for and reporting the

financial results and relationships of foreign subsidiaries in consolidated statements. This method

identifies the functional currency of the entity (the currency of the primary economic environment in

which the foreign entity operates), measures all elements of the financial statements in the functional

currency, and uses a current exchange rate for translation from the functional currency to the reporting

currency.

2. What is the currency in which the parent company prepares its financial statements?

A. Incorrect. The functional currency is the primary currency used by the subsidiary and is usually not the

same as the parent company currency.

B. Correct. The parent company will translate the subsidiary’s currency into the parent company’s reporting

currency.

C. Incorrect. Historical currency is not accurate. However, using historical exchange rates during financial

statement preparation will occur.

D. Incorrect. ‘Base currency’ is not a description used with foreign currency transactions.

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3. The economic effects of a change in foreign exchange rates on a relatively self-contained and integrated

operation within a foreign country relate to the net investment by the reporting enterprise in that operation.

What can be said about the translation adjustments that arise from the consolidation of that operation?

A. Incorrect. When an operation is relatively self-contained, the assumption is that translation adjustments

do not affect cash flows.

B. Incorrect. Translation adjustments do not affect cash flows.

C. Correct. ASC 830 concludes that foreign currency translation adjustments for a foreign operation that is

relatively self-contained and integrated within its environment do not affect cash flows of the reporting

enterprise and should be excluded from net income. When an operation is relatively self-contained, the

cash generated and expended by the entity is normally in the currency of the foreign country, and that

currency is deemed to be the operation's functional currency.

D. Incorrect. Translation adjustments should be included in other comprehensive income, not recognized in

income.

4. Which of the following is considered a highly inflationary environment?

A. Correct. A cumulative rate exceeding 100% over 3 years meets the definition of a highly inflationary

economy, and as such, requires a change in the translation method to reporting currency instead of the

functional currency.

B. Incorrect. This rate is too low and is likely too low even if other pertinent information about the economic

factors is considered because the rate falls below the highly inflationary level.

C. Incorrect. Several economies during normal growth may exceed a 25% level, so the value is too low.

D. Incorrect. This rate is much too low to be considered highly inflationary.


5. Fogg Co., a U.S. company, contracted to purchase foreign goods. Payment in foreign currency was due one

month after the goods were received at Fogg's warehouse. Between the receipt of goods and the time of payment,

the exchange rates changed in Fogg's favor. How should the resulting gain be included in Fogg's financial

statements?

A. Correct. This foreign currency transaction resulted in a payable denominated in a foreign currency. The

favorable change in the exchange rate between the functional currency and the currency in which the

transaction was denominated should be included in determining net income for the period in which the

exchange rate changed. It should be classified as a component of income from continuing operations

because it does not meet the criteria for classification under any other caption in the income statement.

B. Incorrect. Gains or losses from exchange or translation of foreign currencies are usual in nature and may

be expected to recur in the course of customary and continuing business activities. However, they are not

recorded as revenue.

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C. Incorrect. The gain should not be deferred but should be recognized in the period in which the exchange

rate changed.

D. Incorrect. Translation adjustments, not transaction gains and losses, are included in other comprehensive

income.

6. On September 22, 20X2, Yumi Corp. purchased merchandise from an unaffiliated foreign company for 10,000

units of the foreign company's local currency. On that date, the spot rate was $.55. Yumi paid the bill in full on

March 20, 20X3, when the spot rate was $.65. The spot rate was $.70 on December 31, 20X2. What amount should

Yumi report as a foreign currency transaction loss in its income statement for the year ended December 31, 20X2?

A. Incorrect. A loss resulted when the spot rate increased.

B. Incorrect. $500 results from using the spot rates at 12/31/20X2 and 3/20/20X3.

C. Incorrect. $1,000 results from using the spot rates at 9/22/20X2 and 3/20/20X3.

D. Correct. Monetary accounts (e.g. cash, accounts receivable, accounts payable) are remeasured at the

current exchange rate. The resulting gain or loss should ordinarily be included in determining net income.

It is the difference between the spot rate on the date the transaction originates and the spot rate at year-

end. Thus, the 20X2 transaction loss for Yumi Corp. is $1,500 [($0.55 - $0.70) x 10,000 units].

7. Which of the following statements regarding foreign exchange gains and losses is TRUE (where the exchange

rate is the ratio of units of the functional currency to units of the foreign currency)?

A. Incorrect. The payable will become more expensive in the functional currency, resulting in a loss.

B. Correct. A foreign currency transaction gain or loss (commonly known as a foreign exchange gain or loss)

is recorded in earnings. When the amount of the functional currency exchangeable for a unit of the

currency in which the transaction is fixed increases, a transaction gain or loss is recognized on a receivable

or payable, respectively. The opposite occurs when the exchange rate (functional currency to foreign

currency) decreases.

C. Incorrect. The payable will become less expensive in the functional currency, resulting in a gain.

D. Incorrect. An exchange gain occurs.

8. On October 1, 20X5, Mild Co., a U.S. company, purchased machinery from Grund, a German company, with

payment due on April 1, 20X6. If Mild's 20X5 operating income included NO foreign currency transaction gain or

loss, which of the following might be TRUE?

A. Incorrect. Foreign currency transaction gains and losses are ordinarily operating items.

B. Correct. The terms of a foreign currency transaction are denominated in a currency other than the

functional currency. A fluctuation in the exchange rate between the functional currency and the other

currency is a gain or loss that ordinarily should be included in determining net income when the exchange

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rate changes. If Mild Co.'s functional currency is the U.S. dollar and the transaction was denominated in

U.S. dollars, no foreign currency transaction gain or loss occurred.

C. Incorrect. Foreign currency transaction gains and losses not included in the determination of net income

(certain intercompany transactions and certain hedges) are reported in other comprehensive income.

D. Incorrect. Translation expresses in the reporting currency amounts denominated in the functional

currency. Because the U.S. dollar is presumably the reporting and the functional currency of Mild Co., no

translation is required.

9. On October 1, Velec Co., a U.S. company, contracted to purchase foreign goods requiring payment in euros 1

month after their receipt at Velec's factory. Title to the goods passed on December 15. The goods were still in

transit on December 31. Exchange rates were one dollar to 1.06 euros, 1.04 euros, and 1.05 euros on October 1,

December 15, and December 31, respectively. How should Velec account for the exchange rate fluctuation?

A. Incorrect. The strengthening of the dollar resulted in a gain.

B. Correct. ASC 830 requires that a receivable or payable denominated in a foreign currency be adjusted to

its current exchange rate at each balance sheet date. The transaction gain or loss arising from this

adjustment should ordinarily be reflected in current income. Because title passed on December 15, the

liability fixed in euros should have been recorded on that date at the 1.04 euro exchange rate. The increase

to 1.05 euros per dollar at year-end decreases the dollar value of the liability and results in a transaction

gain. Such a gain is ordinarily treated as a component of income from continuing operations.

C. Incorrect. Extraordinary items are infrequent and unusual in nature. Exchange rates change frequently.

Besides, the FASB discontinued the accounting treatment for extraordinary items to reduce the cost and

complexity of preparing financial statements.

D. Incorrect. The transaction resulted in a gain, not a loss, and it would not be included in other


10. How are gains or losses on foreign exchange contracts typically recognized?

A. Incorrect. Foreign exchange gains or losses are not reflected on the balance sheet.

B. Correct. Gains and losses will be reported in current earnings, as a foreign exchange loss or gain.

C. Incorrect. Foreign exchange gains should be reflected in the financial statements at the completion of the

contract and at balance sheet dates.

D. Incorrect. Only one of the answers is correct. When financial statement dates fall between the transaction

and final settlement date, gains and losses should be recorded.

11. When remeasuring foreign currency financial statements into the functional currency, which of the following

items would be remeasured using historical exchange rates?

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A. Correct. GAAP requires the current rate of exchange to be used for remeasuring certain balance sheet

items and the historical rate for other balance sheet items. Nonmonetary balance sheet items and related

revenue, expense, gain, and loss accounts are remeasured at the historical rate. Monetary accounts are

remeasured at the current rate. Inventories valued at cost are nonmonetary items and are measured at

historical rates.

B. Incorrect. Equity securities reported at fair values are monetary items valued at the current rate.

C. Incorrect. Bonds payable are monetary items valued at the current rate.

D. Incorrect. Accrued liabilities are monetary items valued at the current rate.

12. How should gains from remeasuring a foreign subsidiary's financial statements from the local currency into its

functional currency be reported?

A. Incorrect. The gain is not deferred.

B. Incorrect. A gain arising from translation, not remeasurement, is reported in other comprehensive

income.

C. Incorrect. They should be recorded as a different line item in the statements, not as revenue.

D. Correct. If the books of record of a foreign entity are maintained in a currency other than the functional

currency, ASC 830 requires that the foreign currency amounts first be remeasured into the functional

currency and then translated using the current rate method into the reporting currency. The gain arising

from remeasurement should be reported as part of continuing operations.


13. How should translation gains and losses resulting from translating foreign currency financial statements into

U.S. dollars be treated?

A. Incorrect. Translations gains and losses are reported in a different section of the statements, not as a

deferred account.

B. Incorrect. Translation losses and gains are treated the same.

C. Incorrect. Transaction gains and losses are treated as ordinary income, not translation gains or losses.

D. Correct. Any resulting translation gains or losses should be included in other comprehensive income until

they are actually realized.

14. Which of the following is debited to other comprehensive income (OCI)?

A. Incorrect. A discount on bonds is a contra account to bonds payable in the liability section of the balance

sheet.

B. Incorrect. A premium on bonds is a contra account to bonds payable in the liability section.

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C. Correct. When the currency used to prepare a foreign entity's financial statements is its functional

currency, the current rate method is used to translate the foreign entity's financial statements into the

reporting currency. The translation gains and losses arising from applying this method are reported in OCI

in the consolidated statements and are not reflected in income. Accumulated OCI is a component of equity

displayed separately from retained earnings and additional paid-in capital in the statement of financial

position. Because a cumulative foreign currency translation loss reduces the balance, it is a debit item.

D. Incorrect. Organizational costs are expensed when incurred.

15. What does a forward contract involve?

A. Incorrect. The price of a forward contract is determined on the day of commitment, not some time in the

future.

B. Incorrect. Performance is deferred in a forward contract, and the price of the product is not necessarily

its present price. The price can be any price determined on the day of commitment.

C. Correct. A forward contract is an executory contract in which the parties involved agree to the terms of a

purchase and a sale, but performance is deferred. Accordingly, a forward contract involves a commitment

today to purchase a product on a specific future date at a price determined today.

D. Incorrect. A forward contract is a firm commitment to purchase a product. It is not based on a contingency.

Also, a forward contract does not involve an exercise price (exercise price is in an option contract).

16. Which of the following is NOT required to be footnoted?

A. Correct. Disclosures should include profits from overseas, includes the amount of foreign earnings in

excess of amounts received in the United States.

B. Incorrect. Transaction gains and losses should be disclosed, along with gains or losses from hedging a

foreign currency position.

C. Incorrect. All impacts from unsettled balances must be disclosed in the footnotes, along with any

significant changes in exchange rates that take place after year-end and before the audit report date.

D. Incorrect. This should include the reason for the changes in the balance from the beginning to the end of

the year.

Documents

Accounting for Foreign Currency