1、 1Winter 2011 Advanced Financial AccountingRSM 321 Class 11:Translation and Consolidation of the Financial Statements of Foreign Operations 2IntroductionnTwo major accounting questions are posed by the translation to Canadian dollars of subsidiary financial statements presented in a foreign currency
2、:qWhat exchange rates are appropriate for each balance?qHow should the resulting exchange gains and losses be reflected in the Canadian dollar financial statements?nThe answers depend on the type of foreign currency exposure the parent faces with the foreign subsidiary 3Accounting Exposure versus Ec
3、onomic ExposurenForeign currency exposure is the risk that a loss(or gain)could occur as a result of changes in foreign exchange rates.nForeign currency exposure has three components:qTranslation exposure(accounting exposure)qTransaction exposureqEconomic exposure 4Accounting Exposure versus Economi
4、c ExposurenTranslation exposure this exposure results from the translation of foreign-currency-denominated financial statements into Canadian dollars,giving rise to exchange gains and lossesqOnly those financial statement items translated at the closing rate or forward rate create an accounting expo
5、sure since the Canadian dollar value of those items changes every time the exchange rate changes.These changes are referred to as“translation adjustments”.qThe value of items translated using the historical rate is fixed and does not fluctuate with rate changesqPositive translation adjustments incre
6、ase shareholders equity;negative translation adjustments decrease shareholders equity 5Accounting Exposure versus Economic ExposurenTranslation exposure(summary):nNote that gains and losses that result from translation are usually unrecognized in the sense they do not represent actual cash flows.It
7、is important to assess if these gains/losses represent transaction and/or economic exposure.6Accounting Exposure versus Economic ExposurenTransaction exposure this exposure represents the foreign exchange loss or gain that can occur between the time of entering a transaction(e.g.sale or purchase)inv
8、olving a foreign currency-denominated receivable or payable,and the time of settling it in cash with the customer or vendorqRefer to discussion and example in Chapter 10nThe resulting cash gains and losses are realized and affect the enterprises cash flows,working capital,and earnings 7Accounting Ex
9、posure versus Economic ExposurenEconomic exposure Represents a longer-term risk to the parent that the overall value of its investment in a foreign subsidiary will change(decrease or increase)as a result of exchange rate fluctuations.Economic exposure varies depending on how closely linked the activ
10、ities of the parent are to the subsidiary 8Translation MethodsnIAS 21 provides two methods of translating subsidiary financial statements,described using their traditional Canadian GAAP names:qTemporal methodqCurrent rate methodnThe translation method used should reflect the parents exposure to exch
11、ange rate changesnThe temporal method is used if the parent is closely linked to the subsidiary with the same functional currency and therefore has transaction exposurenThe current rate method is used if the subsidiary is less closely linked with the parent and uses a different functional currency,a
12、nd therefore has economic exposure 9Translation Methods-TemporalnThe temporal methodqReflects parents close involvement with subsidiary and its cash flows by measuring exposure to monetary assets and liabilitiesqUses the Canadian dollar as the underlying unit of measure,producing the same result as
13、if the transaction had occurred in Canada in the first placeqAll monetary items are translated at the balance sheet closing rateqAll nonmonetary Items carried at fair value are translated at the closing rate on the date when the fair value determination was madeqNonmonetary items are translated at a
14、pplicable historical rates(generally,the rate on the date of acquisition of the item)qExchange gains and losses are recorded in income 10Translation Methods-TemporalnMonetary items represent money and claims to money the value of which,in terms of the monetary unit,whether foreign or domestic,is fix
15、ed by contract or otherwiseqPayables and receivables and all other fixed claims to money are monetary items;inventory is notqFuture income tax liabilities and assets are classified as monetary itemsqEstimated liabilities(such as provisions for warranties)are not considered monetary items 11Translati
16、on Methods Current RatenThe current rate method qReflects the exposure of the subsidiarys net assets,and therefore parents investment in subsidiary,to currency fluctuations qUses the foreign currency as the underlying unit of measureqAll assets and liabilities are translated at closing rateqShare ca
17、pital is translated at the historical rateqThe translated statements retain the same ratios and relationships that exist in local currency originals,so the translated financial statements can provide an effective tool for the evaluation of local managementqExchange gains and losses are recorded in O
18、ther Comprehensive Income 12Translation Under IAS 21nSubsidiaries are classified as either“Integrated”or“Self-Sustaining”,determining which translation method is usedqIntegrated foreign operation-the foreign operations are more closely linked to or integrated with the parents own operations since th
19、e functional currency of the foreign operation is the same as the parents functional currencyqSelf-sustaining foreign operation the foreign operations are less linked to the parents own operations and more capable of existing on their own without the parents support,since the functional currency of
20、the foreign operation is different from the parents functional currency 13Translation Under IAS 21 Guidance in Classifying Foreign Operations 14Translation Under IAS 21-Guidance in Classifying Foreign Operations 15Translation Under IAS 21nApply the temporal method to subsidiaries classified as“Integ
21、rated”nApply the current rate method to subsidiaries classified as“Self-Sustaining”16Translation Under IAS 21-Comparison 17Translation Under IAS 21nIntegrated subsidiaries:qBecause of the interdependent relationship with the parent,translation gains and losses are reported in income just as they wou
22、ld be if the parent itself had conducted the underlying transactionsnSelf-sustaining subsidiaries:qBecause of the more independent relationship that exists between the parent and subsidiary,the parents exposure is limited to its net investment in the subsidiary.Therefore,translation gains and losses
23、 are reported in other comprehensive income in the year they occur,and in cumulative other comprehensive income in subsequent years 18Translation Under IAS 29 Highly Inflationary EconomiesnSelf-sustaining subsidiaries in highly inflationary economies restate-translate method to be used(IAS 29).This
24、means restating non-monetary items using a general price index and then translating at the closing rate.In practice,the outcome will be similar to the temporal method.nCharacteristics indicative of hyper-inflationary economy:q1)the general population prefers to keep its wealth in non-monetary assets
25、 or in a relatively stable foreign currency.q2)the general population regards monetary amounts not in terms of the local currency but in terms of a relatively stable foreign currency.Prices may be quoted in that currency.q3)sales and purchases on credit take place at prices that compensate for the e
26、xpected loss of purchasing power during the credit period,even if the period is short.q4)interest rates,wages,and prices are linked to a price index.q5)the cumulative inflation rate over 3 years is approaching,or exceeds,100%.19Translation Under IAS 29 Highly Inflationary EconomiesnFor self-sustaini
27、ng operations deemed to be in a hyper-inflationary economy,the following translation procedures apply:q1)all amounts(i.e.assets,liabilities,equity items,income,and expenses for current year)must be translated at closing rate.q2)comparative amounts must be those that were presented as current-year am
28、ounts in relevant prior-year financial statements(i.e.they are not adjusted for subsequent changes in exchange rates).q3)non-monetary items that were carried at historical costs are restated by applying a general price index.q4)non-monetary items carried at fair value or recoverable amount are not r
29、estated since already expressed in end of period monetary units.q5)monetary items are not restated since already expressed in end of period monetary units.q6)the gain or loss on the net monetary position is included in profit or loss.20Highly Inflationary Economies-ExamplenFollowing facts apply:qIn
30、Year 1,Canadian company purchases self-sustaining foreign subsidiary located in Chile.Exchange rate is 1 peso=$1.00,remains constant throughout the year.Chilean subsidiary has land at historical cost of 1,000,000 pesos.nPs 1,000,000$1.00/Ps=$1,000,000qIn Year 2,Chile experiences 500%inflation rate w
31、hile Canada experiences no inflation.As such,on December 31,Year 2,exchange rate is 1 peso=$0.20.nPs 1,000,000$0.20/Ps=$200,000nThis is clearly distorted as land is non-monetary and should keep its purchasing power.qUsing price-level-adjusted historical cost statements,the land would appear on the s
32、ubsidiarys balance sheet at Ps 5,000,000.Now,translation will not result in distorted results:nPs 5,000,000$0.20/Ps=$1,000,000qMonetary assets do not hold their purchasing power,so exchange losses can arise after restating and translating.Such losses go to the income statement.21Translation Under IA
33、S 21 Self-Sustaining SubsidiariesnWhen the parent sells all or part of its self-sustaining foreign operations,the cumulative exchange gains and losses on the foreign operation are removed from the cumulative other comprehensive income section of shareholders equity and the realized exchange gains or
34、 losses are reported in the regular income statement.22Subsequent to AcquisitionnRevenues and expenses can be translated at average rates if they occur evenly.nAmortization of acquisition differential(AD):qIntegrated subsidiaries(temporal method):The translation of AD amortization is at the historic
35、al rate on the date of acquisitionqSelf-sustaining subsidiaries(current rate method):Translate opening AD at prior year-end closing rate,translate amortization at average rate,and compare ending result to ending foreign currency AD translated at this years closing rate.The difference represents a tr
36、anslation gain or loss recorded in OCIqThis is illustrated starting on slide 43 of these lecture notes 23Subsequent to AcquisitionnCalculation of translation gain or loss:qIntegrated subsidiaries(temporal method):Translation exposure arises from the subs net monetary position.If it was in a net mone
37、tary asset(liability)position during the year,it is exposed to FCU rate decreases(FCU rate increases).This requires a schedule(ex.p.587 of text)tracking net monetary position at start and end of the year.The intuitive idea is that monetary assets serve as a“hedge”of monetary liabilities,since what d
38、rives exposure is transactions exposure,and repatriation occurs daily.See the idea?24Subsequent to AcquisitionnCalculation of translation gain or loss(continued):qSelf-sustaining subsidiaries(current rate method):translation exposure arises from the subs net asset position.If it was in a net asset(l
39、iability)position during the year,it is exposed to FCU rate decreases(FCU rate increases).This requires a schedule(ex.p.582 of text)tracking net asset position at start and end of year.The intuitive idea is that assets serve as a“hedge”of liabilities,whether monetary or not,since repatriation of the
40、 net investment may be a long way off.See the idea?qConcepts of“exposure”and what“hedges”this exposure drives the calculation of translation gain or loss.As an interesting extension,if the parent wanted to,it could(see p.574 of text)hedge its investment in a SSFO with a forward exchange contract.Any
41、 re-measurement gains or losses on the latter go to OCI to offset translation gains or losses.See the idea?25IllustrationnExample:At the beginning of the year,parent invests 500 foreign currency units(FCU)in an integrated foreign subsidiary when 1 FCU=1 Canadian dollar(CAD).The net assets were held
42、for the entire year,with no sales or expenses incurred.At the end of the year,the exchange rate has changed to1FCU=1.5CAD 26Illustration Integrated SubsidiaryFCUExch.RateCADGain(loss)Cash and A/R2001.50300$100$Inventory at cost3001.00300$-$Fixed assets,at cost5001.00500$-$Accounts payable-1001.50150
43、-$50-$Long-term debt-4001.50600-$200-$Net assets500Translation loss150-$nThe company was in a net monetary liability position at the start and end of the year and FCU rate increases.Loss=300 x(1.5 1.0).Intuitively,it had unhedged monetary liability exposure and,since sub is an IFO,this is“transactio
44、ns”exposure.The parents CFO could have but did not hedge this exposure.See the idea?27Illustration Self-Sustaining SubsidiaryFCUExch.RateCADGain(loss)Cash and A/R2001.50300$100$Inventory at cost3001.50450$150$Fixed assets,at cost5001.50750$250$Accounts payable-1001.50150-$50-$Long-term debt-4001.506
45、00-$200-$Net assets500Translation loss250$nThe company was in a net asset position at the start and end of the year and FCU rate increased.Gain=500 x(1.5-1.0).If parents CFO was worried about FCU rate decrease in the future,it could hedge this net asset exposure with a forward contract or issue FCU
46、denominated debt at the parents head office or get the sub to issue FCU denominated debt to get net asset position to zero.See the idea?You are now ready to try Case 11-3!28Comparative Observations of the Two Translation MethodsnTemporal method the monetary position is at risk from foreign currency
47、fluctuationsnCurrent rate method the net asset position of the foreign equity is at risk from foreign currency fluctuationsnFor most companies monetary liabilities are greater than monetary assets so they are usually in a net monetary liability positionqThis will result in exchange losses(gains)for
48、integrated subsidiaries when foreign currency appreciates(depreciates)in valuenMost companies have positive net assetsqThis will result in exchange gains(losses)for self-sustaining subsidiaries when foreign currency appreciates(depreciates)in value 29Comprehensive Example Integrated/Self-Sustaining(
49、p.577,text)nFirst,we will illustrate self-sustaining;then,we will illustrate integrated operations.Same case facts will be used for both scenarios.nNote:for the final exam,you are only responsible for a full consolidation one year after the date of acquisition.On December 31,Year 1,Starmont,a Canadi
50、an company,acquired 100%of the common shares of Controloda SA,an Estonian company,at a cost of 2,000,000 kroons.The exchange rate was K1=$0.128 on this date.There is no acquisition differential in this example.Relevant exchange rates are as follows:December 31,Year 1K1=$0.128December 31,Year 2K1=$0.
