13 13 Translation of Financial Statements of Foreign Affiliates Advanced Accounting, Fifth Edition Slide 13-1 Learning Learning Objectives Objectives Distinguish between the current exchange rate and the historical exchange rate Understand the objectives of financial statement translation Identify the functional currency of a foreign entity Compare the two methods used to convert the financial statements of a foreign entity into U.S dollars Distinguish between the circumstances under which each of the two methods is appropriate under current GAAP Slide 13-2 Learning Learning Objectives Objectives Explain the factors involved in translating the statements of a foreign entity operating in a highly inflationary economy Translate the statements of a foreign entity when the functional currency is the local currency Translate the statements of a foreign entity when the functional currency is the U.S dollar Understand the concept of comprehensive income in the context of foreign currency translation 10 Identify the disclosure requirements for firms with foreign entities Slide 13-3 Translation Translation of of Financial Financial Statements Statements A U.S company may be involved in foreign activities through the operations of a: branch, subsidiary, or investee company 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 Slide 13-4 Accounting Accounting for for Operations Operations in in Foreign Foreign Countries Countries A 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 Foreign statements that are not in conformity with GAAP in Exchange restrictions the United States must be adjusted to conform to U.S standards before conversion into U.S dollars Slide 13-5 Translating Translating Statements Statements of of Foreign Foreign Affiliates Affiliates The conversion from another currency into the currency of the parent company is frequently called “translation.” Translation Process Financial Statements in Euros Slide 13-6 Current Exchange Rate Historical Exchange Rate Financial Statements in U.S Dollars LO Current versus historical exchange rates Translating Translating Statements Statements of of Foreign Foreign Affiliates Affiliates Translation Adjustment or Translation Gain or TheLoss 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 Not a currently in income or Choic e deferred as a component of stockholders’ equity, depending on the method used to translate the accounts Slide 13-7 LO Current versus historical exchange rates Objectives Objectives of of Translation Translation Functional Currency Concept Objective of Translation – FASB ASC section 830-30: Provide information regarding the exposed economic effects of an exchange rate change on an enterprise’s cash flows and equity [par 4(a)] Reflect in consolidated statements the financial results measured in their functional currencies in conformity with U.S GAAP [par 4(b)] The Board believes that the operating performance and financial condition of a foreign entity are best measured by expressing its accounts in the currency of the economic environment in which it primarily conducts its operations and generates and expends its cash, its functional currency Slide 13-8 LO Objectives of translation Translation Translation Methods Methods Current rate method Slide 13-9 Translation All assets and liabilities Current exchange rate Revenues and expenses Exchange rate on the date each transaction occurred LO Two methods of conversion Translation Translation Methods Methods Temporal Method Monetary 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 Translation Current exchange rate Historical exchange rates Current exchange rate Historical exchange rates Other revenues and expenses Slide 13-10 LO Two methods rate of conversion Exchange on Translation Translation –– Temporal Temporal Method Method Temporal Method Monetary 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 Translation Current exchange rate Historical exchange rates Current exchange rate Historical exchange rates Other revenues and expenses Slide 13-23 LO The functional currency is the Exchange rateU.S on dollar Translation Translation –– Temporal Temporal Method Method 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 Franc January 1, 2008 $.5987 December 31, 2008 5321 Average for 2008 5654 Dividend declaration and payment date 5810 Required: Convert (remeasure) the financial statements of the foreign subsidiary using the temporal method of translation Slide 13-24 LO The functional currency is the local currency Translation Translation –– Temporal Temporal Method Method Exercise 13-5: (Temporal Method) Income Statement Revenue Operating expenses: depreciation Operating expenses: other Translation loss Net income Retained earnings 1/1 Dividends Retained earnings 12/31 Slide 13-25 Swiss Francs 75,000 (3,000) (27,000) 45,000 10,000 55,000 (15,000) 40,000 Translation Rate 0.5654 0.5987 0.5654 0.5987 0.5810 U.S Dollars 42,405 (1,796) (15,266) (198) 25,145 5,987 31,132 (8,715) 22,417 Balance Sheet Cash and receivables Net property, plant, equipment Total assets 55,000 37,000 92,000 0.5321 0.5987 29,266 22,152 51,418 Accounts payable Common stock Retained earnings Total liab & equity 32,000 20,000 40,000 92,000 0.5321 0.5987 17,027 11,974 22,417 51,418 Translation Translation –– Temporal Temporal Method Method Exercise 13-5: Prepare a schedule to verify the translation gain or loss Swiss Francs Net monetary liability position - 1/1 Translation Rate (10,000) $ $.5987(5,987) Adjustment for changes in net monetary position: Increase in cash and receivables from sales 75,000 5654 42,405 Less: Decrease in net asset position: Other operating expenses (27,000) 5654 (15,266) Dividends (15,000) 5810 (8,715) Net asset position translated Net monetary asset position-12/31 Translation gain (loss) Slide 13-26 23,000 12,437 5321 12,238 (199) LO The functional currency is the local currency Financial Financial Statement Statement Disclosure Disclosure Companies are required to disclose certain items, as follows: The aggregate translation gain or loss included in the determination of net income for the period 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 Exchange rate changes that occur after the balance sheet date and their effect on unsettled foreign Slide 13-27 currency transactions, if significant LO 10 Required disclosure Date Date of of Acquisition 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 Cash Slide 13-28 300,000 300,000 Date Date of of Acquisition Acquisition 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 Slide 13-29 After After Acquisition Acquisition 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 when the direct exchange rate was $.16 The book entry to record the dividend receipt is: Cash 38,400 Dividend income (300,000 francs x $.16 = $48,000 x 80 = $38,400) Slide 13-30 38,400 After After Acquisition Acquisition Workpaper entries assuming current rate method Slide 13-31 Consolidation Consolidation Assuming Assuming Temporal Temporal Method Method The major differences between the workpapers are as follows: Slide 13-32 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 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 Remeasurement Remeasurement and and Translation Translation of 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 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 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 Slide 13-33 Any transaction gain or loss resulting from this procedure is recognized currently in income Intercompany Intercompany Receivables Receivables and and Payables 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 Slide 13-34 Elimination Elimination of of Intercompany Intercompany Profit 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 Slide 13-35 Liquidation Liquidation of of aa Foreign Foreign Investment 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 Slide 13-36 Copyright Copyright Copyright © 2012 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein Slide 13-37 ... conform to U.S standards before conversion into U.S dollars Slide 13-5 Translating Translating Statements Statements of of Foreign Foreign Affiliates Affiliates The conversion from another currency... Revenues and expenses Exchange rate on the date each transaction occurred LO Two methods of conversion Translation Translation Methods Methods Temporal Method Monetary assets and liabilities... rate Historical exchange rates Other revenues and expenses Slide 13-10 LO Two methods rate of conversion Exchange on Identifying Identifying the the Functional Functional Currency Currency The