Chapter Ten Translation of Foreign Currency Financial Statements Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education Worldwide Consolidated Financial Statements To prepare worldwide consolidated financial statements a U S parent must: (1) convert the foreign GAAP financial statements of its foreign operations into U.S GAAP and (2) translate the financial statements from the foreign currency into U.S dollars 10-2 Worldwide Consolidated Financial Statements This conversion and translation process is required whether the foreign operation is a branch, joint venture, majority-owned subsidiary, or affiliate accounted for under the equity method Two major related theoretical issues are: (1) which translation method should be used and (2) where the resulting translation adjustment should be reported in the consolidated financial statements 10-3 Learning Objective 10-1 Explain the theoretical underpinnings and the limitations of the current rate and temporal methods 10-4 Translation Methods: Temporal and Current Rate Two major translation methods are currently used: (1) the current rate (or closing rate) method and (2) the temporal method Each method is presented from the perspective of a U.S.–based multinational company translating foreign currency financial statements into U.S dollars 10-5 Comparison of the Two Translation Methods 10-6 Treatments for Translation Adjustment Two issues arise related to the translation of foreign currency financial statements: (1) selecting the appropriate method (2) deciding where to report the resulting translation adjustment in the consolidated financial statements The two major translation methods and the two possible treatments for the translation adjustment give rise to four possible combinations: 10-7 Learning Objective 10-2 Describe guidelines as to when foreign currency financial statements are to be translated using the current rate method and when they are to be translated using the temporal method 10-8 Two Translation Combinations Some subs are so closely tied to their U.S parents They use a U.S dollar perspective to translation, so most of their transactions are recorded in U.S dollars using the temporal method Other subs use the local currency perspective; they operate relatively independent of their U.S parents and use the current rate method for translation Translation adjustment appears in the equity section FASB does not express preference for either of the two theoretical views 10-9 Functional Currency To determine whether a subsidiary is integrated with the parent or operates independently, we look at the functional currency A company’s functional currency is the primary currency of the foreign entity’s operating environment 10-10 Consolidation of a Foreign Subsidiary On December 31, 2015, two years after the acquisition date, Bradford submitted the following trial balance for consolidation (credit balances are in parentheses): Cash £ 600,000 Accounts Receivable 2,700,000 Inventory 9,000,000 Plant and Equipment (net) 17,200,000 Accounts Payable (500,000) Long-Term Debt .(2,000,000) Common Stock (20,000,000) Retained Earnings, 1/1/15 (3,800,000) Sales (13,900,000) Cost of Goods Sold 8,100,000 Depreciation Expense 900,000 Other Expenses 950,000 Dividends Declared, 6/30/15 750,000 £ -010-32 Consolidation of a Foreign Subsidiary Although Bradford generated net income of £1,100,000 in 2014, it declared or paid no dividends that year Other than the payment of dividends in 2015, no intra-entity transactions occurred between the two affiliates Altman has determined the British pound to be Bradford’s functional currency Relevant exchange rates for the British pound were: January June 30 December 31 Average 2014 $1.51 –0– $1.56 $1.54 2015 1.56 $1.58 1.53 1.55 10-33 Consolidation of a Foreign Subsidiary The initial step in consolidating the foreign subsidiary is to translate its trial balance from British pounds into U.S dollars Because the British pound is the functional currency, the translation uses the current rate method The historical exchange rate for translating Bradford’s common stock and January 1, 2014, retained earnings is the exchange rate that existed at the acquisition date—$1.51 10-34 Consolidation of a Foreign Subsidiary Translation of Foreign Subsidiary Trial Balance 10-35 Consolidation of a Foreign Subsidiary A positive (credit balance) cumulative translation adjustment of $401,500 is required in 2014 to make the trial balance actually balance because the British pound appreciated against the U.S dollar The translation adjustment in 2015 is negative because the British pound depreciated against the U.S dollar that year 10-36 Determination of Balance in Investment As a result of these two journal entries, Altman has a Cumulative Translation Adjustment of $401,500 on its separate balance sheet 10-37 Investment in Foreign Subsidiary Account The carrying value of the investment account in U.S dollar terms at December 31, 2015, is $44,783,000 In addition, Altman reports equity income on its December 31, 2015, trial balance in the amount of $6,122,500 10-38 Consolidation Worksheet with Foreign Subsidiary 10-39 Translation Adjustment with Foreign Subsidiary When the foreign currency is the functional currency, the excess is translated at the current exchange rate with a resulting translation adjustment Neither the parent nor the subsidiary has recorded the translation adjustment related to the excess, and it also must be entered in the consolidation worksheet 10-40 IFRS and Translations IFRS and US GAAP are consistent on most points Significant differences between IFRS and U.S GAAP relate to: (a) the hierarchy of factors used to determine the functional currency and (b) the method used to translate the foreign currency statements of a subsidiary located in a hyperinflationary country 10-41 IFRS and Translations IAS 21 indicates that the primary factors to be considered in determining the functional currency of a foreign subsidiary are: The currency that mainly influences sales price The currency of the country whose competitive forces and regulations mainly determine sales price The currency that mainly influences labor, material, and other costs of providing goods and services 10-42 IFRS and Translations Other factors to be considered are: The currency in which funds from financing activities are generated The currency in which receipts from operating activities are retained Whether the foreign operation carries out its activities as an extension of the parent or with a significant degree of autonomy 10-43 IFRS and Translations Other factors to be considered (continued): The volume of transactions with the parent Whether cash flows generated by the foreign operation directly affect the cash flows of the parent Whether cash flows generated by the foreign operation are sufficient to service its debt 10-44 IFRS and Translations IAS 21 states that when the above indicators are mixed and the functional currency is not obvious, the parent must give priority to the primary indicators in determining the foreign entity’s functional currency U.S GAAP is silent with respect to weights to be assigned to various indicators to determine the functional currency and no hierarchy is provided It is possible that a foreign subsidiary could be determined to have a different functional currency under IFRS than under U.S GAAP 10-45 IFRS and Translations Under IAS 21, financial statements of a foreign subsidiary located in a hyperinflationary economy are translated into the parent’s currency using a two-step process Neither the temporal method nor the current rate method is used (1) the financial statements are restated for local inflation in accordance with IAS 29, “Financial Reporting in Hyperinflationary Economies.” (2) each financial statement line item, which has been restated for local inflation, is translated using the current exchange rate 10-46 ... method, all revenues and expenses are translated at the exchange rate in effect at the date of accounting recognition The weighted average exchange rate is used when revenues and expenses have