ADVANCE ACCOUNTING Ch13

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Translation of FinancialTranslation of FinancialStatements of Foreign AffiliatesStatements of Foreign Affiliates

Advanced Accounting, Fifth Edition

1313

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1. Distinguish between the current exchange rate and the historical exchange rate.

2. Understand the objectives of financial statement translation.

3. Identify the functional currency of a foreign entity.4. Compare the two methods used to convert the financial

statements of a foreign entity into U.S. dollars.5. Distinguish between the circumstances under which

each of the two methods is appropriate under current GAAP.

Learning ObjectivesLearning Objectives

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6. Explain the factors involved in translating the statements of a foreign entity operating in a highly inflationary economy.

7. Translate the statements of a foreign entity when the functional currency is the local currency.

8. Translate the statements of a foreign entity when the functional currency is the U.S. dollar.

9. Understand the concept of comprehensive income in the context of foreign currency translation.

10. Identify the disclosure requirements for firms with foreign entities.

Learning ObjectivesLearning Objectives

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A U.S. company may be involved in foreign activities through the operations of a:

branch,

subsidiary, or

investee company.

Translation of Financial StatementsTranslation of Financial Statements

Accounts of foreign activities, maintained in a foreign currency, must be restated into U.S. dollars before they are combined or consolidated or the equity method of accounting applied.

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Accounting for Operations in Foreign Accounting for Operations in Foreign CountriesCountriesA foreign subsidiary is consolidated if the parent company owns, directly or indirectly, a controlling interest in the voting stock of the subsidiary. Exceptions include:

The intent to control is likely to be temporary.Control does not actually rest with the parent company.

Restriction on withdrawal of assets Exchange restrictions.Foreign statements that are not in conformity with GAAP in

the United States must be adjusted to conform to U.S. standards before conversion into U.S. dollars.

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The conversion from another currency into the currency of the parent company is frequently called “translation.”

Translating Statements of Foreign Translating Statements of Foreign AffiliatesAffiliates

LO 1 Current versus historical exchange rates.LO 1 Current versus historical exchange rates.

Translation Process

Financial Statements in U.S. Dollars

Financial Statements in

Euros

Current Exchange Rate

Historical Exchange Rate

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Translating Statements of Foreign Translating Statements of Foreign AffiliatesAffiliates

LO 1 Current versus historical exchange rates.LO 1 Current versus historical exchange rates.

The difference between translating some accounts using the current exchange rate and others using the historical exchange rate. Current standards require the translation adjustment (gain or loss) be reported

currently in income or deferred as a component of stockholders’ equity, depending on the method used to translate the

accounts.

Translation Adjustment or Translation Gain or Loss

Not a Choic

e

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Objectives of TranslationObjectives of Translation

LO 2 Objectives of translation.LO 2 Objectives of translation.

Objective of Translation – FASB ASC section 830-30:1. Provide information regarding the exposed economic

effects of an exchange rate change on an enterprise’s cash flows and equity [par. 4(a)].

2. Reflect in consolidated statements the financial results measured in their functional currencies in conformity with U.S. GAAP [par. 4(b)].

Functional Currency Concept

The Board believes that the operating performance and financialcondition of a foreign entity are best measured by expressing its accounts inthe currency of the economic environment in which it primarily conducts its operations and generates and expends its cash, its functional currency.

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Translation MethodsTranslation Methods

LO 4 Two methods of conversion.LO 4 Two methods of conversion.

Current rate methodAll assets and liabilities.Revenues and expenses.

TranslationCurrent exchange rate.Exchange rate on the date each transaction occurred.

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Translation MethodsTranslation Methods

LO 4 Two methods of conversion.LO 4 Two methods of conversion.

Temporal MethodMonetary assets and liabilities (cash, a/r, a/p). Assets and liabilities carried at historical cost. Assets and liabilities carried at current values.Revenues and expenses related to assets and liabilities translated at historical rates.Other revenues and expenses.

TranslationCurrent exchange rate.

Historical exchange rates. Current exchange rate.

Historical exchange rates.

Exchange rate on date transaction occurred.

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Identifying the Functional CurrencyIdentifying the Functional Currency

LO 3 Identifying the functional currency.LO 3 Identifying the functional currency.

The Functional Currency may be1. The local currency of the foreign entity,2. The U.S. dollar, or3. The currency of a third country.

Economic Indicators of Functional Currency:

Cash flowSales pricesSales market

ExpensesFinancingIntercompany transactions

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Indicators that the local currency is also the functional currency include all of the following except:

a. The majority of the cash flows are in the local currency.

b. Sales prices are determined by local market conditions.

c. Financing is generally from the parent or guaranteed by the parent.

d. Production costs and expenses are determined by local conditions.

Review QuestionReview Question

Identifying the Functional CurrencyIdentifying the Functional Currency

LO 3 Identifying the functional currency.LO 3 Identifying the functional currency.

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Translation of Foreign Currency Financial Translation of Foreign Currency Financial StatementsStatements

LO 4 Which methods of conversion to use.LO 4 Which methods of conversion to use.

Remeasurement is the process of translating the accounts of a foreign entity into its functional currency when they are stated in another currency.Translation. Accounts measured in the functional currency are translated into the reporting currency using the current rate method.

“Translation” may be used synonymously with the current method, “remeasurement” is used synonymously with the

temporal method.

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LO 4 Which methods of conversion to use.LO 4 Which methods of conversion to use.

Accounts stated in local currency of foreign entity.

Is the foreign economy

highlyinflationary?

Determine the functional currency

(FC) pereconomic indicators.

Translate toU.S. dollars

using current rate method.

Remeasure toFC using temporal method.

Remeasure to U.S. dollars

using temporal method.

No

No

NoYes

Yes

Functional currency (FC) is U.S. Dollar.

Is the FC the U.S. dollar?

Is the FC the local

currency?

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LO 6 Factors in a highly inflationary economy.LO 6 Factors in a highly inflationary economy.

It is the Board’s belief that the currency of a country that has a highly inflationary economy has lost its utility as a store of value and cannot be a functional measuring unit. This means the foreign financial statements should be translated using the temporal method.

Foreign Entity Operates in Highly Inflationary Economy

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Functional currency must be identified. Translation process:

1. Local currency is the functional currency. Current rate method. Translation adjustment recorded as a component of

stockholders’ equity.

2. U.S. dollar is the functional currency. Temporal method. Translation adjustment reported in income

statement.

Foreign Entity in Economy that is Not Highly Inflationary

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Books kept in local currency

Local currency

A third currency

U.S.dollar

Local currency

U.S. dollar

Functional

currency

Remeasure-

ment

Translation


Temporal method

Temporal method

Not necessar

y

Not necessar

y

Current rate

method

Current rate

method

U. S. dollars

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Assets and liabilitiesAssets and liabilitiesPaid-in capitalPaid-in capitalBeginning R/EBeginning R/EDividendsDividends

Revenue and ExpensesRevenue and ExpensesCumulative translation Cumulative translation adjustmentadjustmentCurrent year translation Current year translation adjustmentadjustment

Current exchange rate Current exchange rate Historical rateHistorical rateEquals ending balance of last Equals ending balance of last yearyear

Historical rate when dividend Historical rate when dividend is declaredis declaredAverage exchange rateAverage exchange rateBalance amount in the Balance amount in the balance sheetbalance sheetOther comprehensive income Other comprehensive income (shareholders’ equity)(shareholders’ equity)

Translation – Current Rate MethodTranslation – Current Rate Method

Current Rate Method

Translation

LO 7 The functional currency is the local currency.LO 7 The functional currency is the local currency.

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Exercise 13-4: On January 1, 2008, Trenten Systems, a U.S.-based company, purchased a controlling interest in Grant Management Consultants located in Zurich, Switzerland. Direct exchange rates for Swiss franc are:

Dollars per FrancJanuary 1, 2008 $.5987December 31, 2008 .5321Average for 2008 .5654Dividend declaration and payment date .5810

Required: Translate the year-end balance sheet and income statement of the foreign subsidiary using the current rate method of translation.


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Swiss TranslationIncome Statement Francs Rate U.S. DollarsRevenue 75,000 0.5654 42,405 Operating expenses (30,000) 0.5654 (16,962)

Net income 45,000 25,443 Retained earnings 1/1 10,000 0.5987 5,987

55,000 31,430 Dividends (15,000) 0.5810 (8,715) Retained earnings 12/31 40,000 22,715

Balance SheetCash and receivables 55,000 0.5321 29,266 Net property, plant, equipment 37,000 0.5321 19,688

Total assets 92,000 48,954

Accounts payable 32,000 0.5321 17,027 Common stock 20,000 0.5987 11,974 Retained earnings 40,000 22,715

92,000 51,716 Cumulative translation adjustment (2,762)

Total liab. & equity 92,000 48,954

Translation – Current Rate MethodTranslation – Current Rate MethodExercise 13-4: (Current Rate Method)

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Exercise 13-4: Prepare a schedule to verify the translation adjustment.

Exposed net asset position - 1/1 30,000 $.5987 17,961Adjustment for changes in net asset position:

Net income 45,000 .5654 25,443Dividends (15,000) .5810 (8,715)

Net asset position translated --- 34,689 Exposed net asset position - 12/31 60,000 .5321 31,926

Cumulative translation adjustment (debit) (2,763)

Swiss Translation Francs Rate $


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Under the current method of currency translation, which of the following balance sheet accounts is translated at historical exchange rates?

a. Cashb. Accounts Receivablec. Bonds Payabled. Common Stock

Review QuestionReview Question



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Translation – Temporal MethodTranslation – Temporal Method

LO 8 The functional currency is the U.S. dollar.LO 8 The functional currency is the U.S. dollar.

Temporal MethodMonetary assets and liabilities (cash, a/r, a/p). Assets and liabilities carried at historical cost. Assets and liabilities carried at current values.Revenues and expenses related to assets and liabilities translated at historical rates.Other revenues and expenses.

TranslationCurrent exchange rate.

Historical exchange rates. Current exchange rate.

Historical exchange rates.

Exchange rate on date transaction occurred.

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Exercise 13-5: On January 1, 2008, Trenten Systems, a U.S.-based company, purchased a controlling interest in Grant Management Consultants located in Zurich, Switzerland. Direct exchange rates for Swiss franc are:

Dollars per FrancJanuary 1, 2008 $.5987December 31, 2008 .5321Average for 2008 .5654Dividend declaration and payment date .5810

Required: Convert (remeasure) the financial statements of the foreign subsidiary using the temporal method of translation.


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Swiss TranslationIncome Statement Francs Rate U.S. DollarsRevenue 75,000 0.5654 42,405 Operating expenses: depreciation (3,000) 0.5987 (1,796) Operating expenses: other (27,000) 0.5654 (15,266) Translation loss (198)

Net income 45,000 25,145 Retained earnings 1/1 10,000 0.5987 5,987

55,000 31,132 Dividends (15,000) 0.5810 (8,715) Retained earnings 12/31 40,000 22,417

Balance SheetCash and receivables 55,000 0.5321 29,266 Net property, plant, equipment 37,000 0.5987 22,152

Total assets 92,000 51,418

Accounts payable 32,000 0.5321 17,027 Common stock 20,000 0.5987 11,974 Retained earnings 40,000 22,417

Total liab. & equity 92,000 51,418

Translation – Temporal MethodTranslation – Temporal MethodExercise 13-5: (Temporal Method)

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Exercise 13-5: Prepare a schedule to verify the translation gain or loss.

Net monetary liability position - 1/1 (10,000) $.5987(5,987) Adjustment for changes in net monetary position:Increase in cash and receivables from sales 75,000 .5654 42,405Less: Decrease in net asset position:Other operating expenses (27,000) .5654 (15,266)Dividends (15,000) .5810 (8,715)Net asset position translated --- 12,437Net monetary asset position-12/31 23,000 .5321 12,238Translation gain (loss) (199)

Swiss Translation Francs Rate $



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Financial Statement DisclosureFinancial Statement Disclosure

Companies are required to disclose certain items, as follows:

1. The aggregate translation gain or loss included in the determination of net income for the period.

2. An analysis of the cumulative translation adjustment equity account should be provided in a separate statement or note or as part of a statement of changes in equity.

3. Exchange rate changes that occur after the balance sheet date and their effect on unsettled foreign currency transactions, if significant.

LO 10 Required disclosure.LO 10 Required disclosure.

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Date of AcquisitionDate of Acquisition

Illustration: Recall that on January 2, 2012, P Company acquired for 2,000,000 francs an 80% interest in SFr. Company. The direct exchange rate for francs on January 2, 2012, was $.15. The entry to record the acquisition is

Investment in SFr Company 300,000Cash

300,000

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On January 2, SFr Company reported common stock of 960,000 francs, additional paid-in capital of 300,000 francs, and retained earnings of 480,000 francs for a net asset balance of 1,740,000 francs. The difference between implied and book value in francs and dollars is allocated to land and buildings.

Date of AcquisitionDate of Acquisition

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P Company accounts for its investment by the cost method. In this case, SFr Company declared and paid a 300,000 franc dividend on September 1 when the direct exchange rate was $.16. The book entry to record the dividend receipt is:

After Acquisition After Acquisition

Cash 38,400Dividend income

38,400(300,000 francs x $.16 = $48,000 x .80 = $38,400)

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Workpaper entries assuming current rate method.

After Acquisition After Acquisition

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The major differences between the workpapers are as follows:1. Under the temporal method,

the translation gain or loss is included in the subsidiary’s income statement and becomes a part of its ending retained earnings balance.

The controlling interest in the gain or loss is recognized as part of consolidated net income in the current period.

In subsequent periods the gain or loss is included in consolidated retained earnings as part of the reciprocity entry.

2. The unamortized portion of the difference assigned to land and buildings and the amortization for the current period retain their historical dollar values since such nonmonetary assets are translated using historical rates.

Consolidation Assuming Temporal Consolidation Assuming Temporal Method Method

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Remeasurement and Translation of Remeasurement and Translation of Transactions Transactions

FASB ASC section 830–20–20 defines a foreign currency transaction as one that is denominated in a currency other than the entity’s functional currency.

1. At the transaction date, the current exchange rate is used to measure and record a foreign currency transaction in the functional currency of the recording entity.

2. At subsequent balance sheet dates, recorded balances that are denominated in a currency other than the functional currency are adjusted to the functional currency using the current exchange rate.

3. Any transaction gain or loss resulting from this procedure is recognized currently in income.

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Intercompany Receivables and Payables Intercompany Receivables and Payables

FASBASC paragraph 830–20–35–1 requires that transaction gains and losses on intercompany receivables and payables be recognized in the period that the exchange rate changes. The procedures for doing so are similar to those discussed in the preceding section. However, a company is required to distinguish between transactions that are of a long-term investment nature and other transactions.

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Elimination of Intercompany ProfitElimination of Intercompany Profit

Profits and losses attributable to intercompany sales or transfers are eliminated on the basis of the exchange rate at the date of each sale or transfer. The use of averages or reasonable approximations of specific rates in effect on the due date of each transaction is permitted.

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Liquidation of a Foreign InvestmentLiquidation of a Foreign Investment

Upon the sale of part or all of an investment in a foreign entity, a pro-rata share of the amount included in the accumulated translation adjustment equity account associated with that foreign investment is removed and reported as part of the gain or loss from the disposition of the investment.

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Economy & Finance

ADVANCE ACCOUNTING Ch13