Advanced Financial Accounting: Chapter 7 Accounting for the Effects of Changes in Foreign Exchange...

Advanced Financial Accounting: Chapter 7

Accounting for the Effects of Changes in Foreign Exchange

Rates

Tan & Lee Chapter 7 1© 2009

Content

Tan & Lee Chapter 7 © 2009 2

1. Introduction

2. Types of foreign exchange rate management regimes

3. How exchange rates are quoted

4. Types of foreign exchange rate exposures

5. Concept of functional currency

6. Foreign currency transactions of a stand-alone entity

7. Translation of foreign currency financial statements

8. Special issues in translation

9. Evaluation of translation approaches


Change of Functional Currency

• A change of functional currency may be due to a change:

– In primary economic environment

– In the nature of operating relationship between the foreign operation

and the parent

• Functional currency changes are implemented prospectively

– No restatement of prior-year financial statements


Change of functional currency


Functional currency is changed

Translation proceduresFrom To

Local currency Parent’s currency

• Cumulative translation differences remain in equity until disposal

• Non-monetary assets are translated at the rate on the date when the change is effected

Parent’s currency

Local currency • All assets and liabilities are translated at closing rate

• Translation differences are taken to equity

Exchange Differences Arising from Intercompany Transactions• Intercompany transactions are normally denominated in either the

parent’s currency or the subsidiary’s currency– Results in translation gain or loss recorded by one party

– Translation gain or loss is not eliminated as they are one-sided

• Long term loan from parent that are “quasi-equity”– Considered as part of parent’s net investment in the subsidiary

– Eg. Interest free loans, loans with no definite or scheduled payment

– IAS 21 Para 32 requires exchange difference to be reclassified to equity in consolidation

– Reclassification journal entries in consolidation:

Dr Exchange gain on loan (I/S)

Cr FCTR (equity)

Dr FCTR (equity)

Cr Exchange loss on loan (I/S)


Exchange Differences Arising from Intercompany Transactions


Nature of monetary item

Monetary item denominated

in:

In parent’s book

In foreign operation’s

books

In consolidated

accounts

Forms part of parent’s net investment

“Quasi-equity”

loans

Parent’s functional currency

No exchange difference is

recorded

Records exchange

difference on monetary item

in I/S

Exchange difference on

monetary item is reclassified to equity (FCTR)

Foreign operation’s currency

Records exchange


in I/S


recorded

3rd currency

Records exchange


in I/S

Records exchange


in I/S

Exchange Differences Arising from Intercompany Transactions


Nature of monetary item

Monetary item denominated

in:

In parent’s book

In foreign operation’s

books

In consolidated

accounts

Is not part of parent’s net investment

Parent’ functional currency


recorded

Records exchange


in I/S

Flows through to consolidated

I/S

Foreign operation’s currency

Records exchange


in I/S


recorded

3rd currency

Records exchange


in I/S

Records exchange


in I/S

Goodwill Arising from the Acquisition of Foreign Subsidiaries


Is goodwill a foreign currency asset?

An asset in the acquirer?

No translation required

An asset of the acquiree?

Needs to be translated

The position in IAS 21 is that goodwill is a foreign currency asset of the acquiree and has to be translated using the closing rate method.

Equity Accounting for Foreign Associates

• Associate companies are more likely than subsidiaries to be

autonomous entities than integral operations of the investor

– Functional currency is likely to be the foreign operation’s currency

– Financial statements are first translated to the presentation currency

(the investor’s currency) using the closing rate method

– Equity accounting is applied subsequently to the translated financial

statements

• Apply the usual equity accounting entries

• Allocate to investor the proportionate share of foreign currency

translation reserves (FCTR)


Carrying Value of Inventories

• Inventory is carried at lower of cost or net realizable value (NRV)

• If NRV of inventory is measured in a foreign currency:

– Reported carrying value is the lower of:

• Inventory cost (foreign currency) X Actual (historical) rate

• Inventory at NRV (foreign currency ) X Closing rate


Foreign Operation in a Hyperinflationary Environment• Indicators of a hyperinflationary economy:

– Inflation rate of 100% or more over a period of 3 years;

– Interest rates, wages and prices that are linked to a price index;

– Prices that are quoted in a stable currency; and

– A general population that prefers to keep its wealth in non-monetary assets or in a stable currency

• Financial statements that are not adjusted for inflation are not useful– Misleading to compare transactions that occurred at different times due

to loss of purchasing power at a rapid rate

• IAS 21 requires a restate-then-translate approach – Restate using the procedures in IAS 29

– All restated amounts (including comparatives) are translated at closing rate at the most recent balance sheet date, except that:

– Previous year comparable figures in non-hyperinflationary economy currency are not restated


Content


1. Introduction

2. Types of foreign exchange rate management regimes

3. How exchange rates are quoted

4. Types of foreign exchange rate exposures

5. Concept of functional currency

6. Foreign currency transactions of a stand-alone entity

7. Translation of foreign currency financial statements


9. Evaluation of translation approaches 9. Evaluation of translation approaches

Evaluation of Translation Approaches

Objective of translation under SFAS 52 in US GAAP:

1. Provide information that is generally compatible with the expected economic effects of a rate change on the enterprise’s cashflows and equity; and

2. Reflect in the consolidated statements the financial results and relationships of the individual consolidated entities as measured in their functional currencies



• Evaluate the closing rate method against the objectives:

An appreciation in the foreign operation currency will result in a translation gain and a loss when the currency depreciates

Financial relationships among items in the original financial statements are preserved

A major flaw is that the translated balance sheet is neither at historical nor current value



• Evaluate the remeasurement/temporal method against the objectives of translation:

– Distorts the original financial ratios (use of mixed rates)

– However, it is argued that if the foreign operation’s functional

currency is the same as the parent’s functional currency:

• The financial ratios should be determined using the

functional currency and not the local currency

– Therefore, this method attempts to “put things right” as though

the foreign operation had been conducted in the parent’s

functional currency


Conclusions

• Functional currency should be determined in relation to the primary economic environment of the entity but presentation currency is a “free choice”

• Remeasurement is used to translate the foreign currency transactions of a stand-alone entity or the financial statements of a foreign operation to its functional currency

• Apply the closing rate method when translating from the subsidiary’s functional currency to the parent’s presentation currency

• Special considerations apply to goodwill, intercompany loans that are quasi-equity and translation in hyper-inflationary economies.


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Advanced Financial Accounting: Chapter 7 Accounting for the Effects of Changes in Foreign Exchange...

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