Translation of Foreign Financial Statements

FISCHER | TAYLOR | CHENG

Learning Objectives
1. 2. 3. 4. 5. 6. 7. Define the functional currency, and identify factors suggesting the functional currency. Explain the objectives of the translation process. Apply the functional currency translation process to a trial balance, and calculate the translation adjustment. Explain how the translation adjustment is accounted for and how a hedge may be employed. Describe the consolidation process and the sophisticated equity method, giving particular attention to modifications due to translation. Apply the remeasurement process to a trial balance, and explain how to account for the remeasurement gain or loss. Differentiate between the two methods for converting functional currency to the parent/investors currency, and explain the circumstances under which each should be used.

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Foreign Currency Translation

The process of expressing amounts denominated or measured in foreign currencies into amounts measured in the reporting currencies of the domestic entity Relationships suggesting the need for translation
Home office/branch Parent/subsidiary Investor/investee

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FASBs Statement No. 52

Adopted a functional currency approach Focuses on whether the domestic reporting entitys cash flows will be indirectly or directly affected by changes in the exchange rates of the foreign entitys currency

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Functional Currency
ASC 830-10-55-5 The currency of the primary economic environment in which the entity generates and expends cash A number of factors must be evaluated in order to properly identify the functional currency These factors should be considered both individually and collectively in order to identify the functional currency
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Factors Suggesting the Functional Currency

Exhibit 11-1:

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Objectives of the Translation Process

Provide information that is generally compatible with the expected economic effects of a rate change on an enterprises cash flows and equity Reflect in consolidated statements the financial results and relationships of the individual consolidated entities as measured in their functional currencies in conformity with U.S. GAAP

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Expected Economic Effects of Rate Changes: Functional Currency Is Not the Foreign Currency
Foreign entity is a conduit for the U.S. parents operations The foreign subsidiarys translated financial statements are identical to those statements that would have resulted had the transactions been originally recorded in the dollar functional currency The financial statement relationships for the translated financial statements are identical to those that would have resulted had the transactions been originally recorded in the dollar functional currency The transactions of the foreign entity had an immediate or potentially immediate impact on the dollar cash flows and equity; therefore, the impact was included in net income

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Expected Economic Effects of Rate Changes: Functional Currency Is the Foreign Currency The foreign subsidiary operates independently of the U.S. parent, not as a conduit Rate changes are not expected to have an immediate impact on the parents cash flows

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Expected Economic Effects of Rate Changes: Functional Currency Is the Foreign Currency No translation gains/losses should be included in current net income
Translation adjustments should be classified as a separate component of other comprehensive income
IFRS Uses exchange difference rather than translation adjustment Method of translating is the same as US-GAAP Exchange difference is reported in other comprehensive income

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The Translation Process

Identify the Books of Record (BR) or local currency and the Functional Currency (FC)

Start

Convert foreign financial statements to GAAP

Use functional method to translate

No

Is FC an inflationary currency?
Yes

Is BR the FC?

Yes End
apply the remeasurement process (shown later)

No

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Current Rate / Functional Method

Account Assets and Liabilities Revenues and Expenses Equity accounts (excluding RE) Translate Using Current exchange rate Weighted average rate Historical rate on date of investment in the subsidiary Beginning balance translated using rate on date of investment plus translated net income less dividends translated at rate on date of declaration Components translated at rate in effect at time of the cash flow; operations at rate used for revenues and expenses

Retained Earnings

Statement of Cash Flows

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The Cumulative Translation Adjustment

The adjustment is NOT included in net income The adjustment is shown as a separate component of other comprehensive income (OCI) The adjustment may be recognized as a component of net income when there is a partial or complete sale/liquidation of the investment in the foreign entity

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Direct Calculation of the Current-Period Translation Adjustment

1. Net assets at the beginning of the period multiplied by the change in exchange rates during the period [0 FC ($1.05 $1.00)] = $0 2. Change in net assets (excluding capital transactions) multiplied by the difference between the current rate and the average rate used to translate income

[39,000 FC ($1.05 $1.03)] = $780

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continued . .14.

Direct Calculation of the Current-Period Translation Adjustment (continued)

Change in net assets due to capital transactions (including investments by the domestic investor) multiplied by the difference between the current rate and the rate at the time of the capital transaction [100,000 FC ($1.05 $1.00)] = 5,000 Current-period translation adjustment = $5,780

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Consolidating the Foreign Subsidiary

Determination of excess is calculated in foreign currency All intercompany balances, except for intercompany profits and losses, should be translated at the rates used for all other accounts Profits and losses are translated at average rates or approximations

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Elimination Entries to Consolidate Translated Foreign Subsidiary

Date alignment and EL eliminations follow usual procedures CT elimination allocates P% of Cumulative Translation Adjustment to controlling interest D and A eliminations generate CTA amounts:
D Markup (markdown) of accounts translated at current rate D Investment in Sub account charged at historical rate D Sub Retained Earnings charged at historical rate Difference is CTA amount; allocated to Parent and Sub A Depreciation/Amortization Expense translated at average rate A Contra accounts charged at current rate Difference is CTA amount; allocated to Parent and Sub
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continued . .17.

Elimination Entries to Consolidate Translated Foreign Subsidiary

IA and IS follow usual procedures Intercompany profit where foreign entity currency is the functional currency
Use exchange rate at date of original transaction to determine the amount of unrealized profit to eliminate

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Gains and Losses Excluded from Income

Cumulative translation adjustment Gains and losses attributable to foreign currency transactions that are designated and effective as economic hedges of a net investment in a foreign entity Intercompany foreign currency transactions that are long-term investments in nature

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Unconsolidated Foreign Investments

Cost method
If investment was in foreign currency, translate investment using rate from date of acquisition Investment income (dividends) translated at rate from date of declaration

Sophisticated equity method

Record the amortization of the excess of cost over book value (average rate) Record share of the current years translation adjustment
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Historical Rate / Temporal Method

Remeasurement is necessary when
Foreign entity financial statements are prepared in a currency that is not the functional currency
Functional currency is another foreign currency Functional currency is the U.S. dollar

The functional currency is that of a highly inflationary economy IFRS When an entity's functional currency is the currency of a hyperinflationary economy, restatement of financial statement amounts requires applying changes in general price levels (i.e., the inflation-adjusted approach).

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Historical Rate / Temporal Method

Remeasure into functional currency before translating into parents domestic currency The remeasurement process is intended to produce financial statements that are the same as if the entitys transactions had been originally recorded in the functional currency The resulting remeasurement gain or loss is included as a component of net income.

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The Remeasurement Process

Convert foreign financial statements to GAAP Identify the Books of Record (BR) currency and the Functional Currency (FC)
Use current rate/functional method to get FC into $

Start

No
Use historical rate/ temporal method

Yes

Is FC = $?

No

Is BR = FC?

Yes

Is FC an inflationary currency?

No
End
Use historical rate/temporal method to remeasure into functional currency
Use historical rate/ temporal method

Yes
End

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Historical Rate / Temporal Method

Account Assets and Liabilities: Monetary items or measured at current values Not monetary items and not measured at current values Revenues and Expenses: Representing amortization of historical amounts Other income and expense items Equity accounts (excluding RE) Retained Earnings Historical exchange rate Weighted average exchange rate for the period Historical exchange rates Beginning remeasured balance plus (minus) remeasured net income (loss) less dividends remeasured at historical rates Component of current period net income
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Remeasure Using

Current exchange rate Historical exchange rate

Remeasurement gain or loss

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Historical Rate / Temporal Method (continued)

Monetary items: Rights to receive or pay an amount of money which is:
Fixed in amount or Determinable without reference to future prices of specific goods/services; that is, its value does not change according to changes in price levels

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