Advanced Accounting: Translation of Financial Statements of Foreign Affiliates

Advanced
Accounting
Jeter ● Chaney
Translation of
Financial
Statements of Foreign
Affiliates
1
Prepared by Sheila Ammons, Austin Community College
Learning 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.
2
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.
Learning 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.
• Identify the disclosure requirements for firms with foreign
entities.
3
Translation of Financial Statements
• A U.S. company may be involved in foreign activities
through the operations of a:
– branch,
– subsidiary, or
– investee company.
• If the foreign entity maintains its books in a foreign
currency,
– Its accounts must be restated into U.S. dollars
before they are combined or consolidated or the
equity method of accounting applied.
4
Accounting for Operations in Foreign
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.
• Government imposed:
–Restriction
Foreign statements that on
are withdrawal of assets
not in conformity with U.S. GAAP
must be adjusted to conform to U.S. standards before
–Exchange
conversion restrictions.
into U.S. dollars.
5
Translating
Accounting forStatements
Operations inof Foreign
Foreign
Affiliates
Countries
• The conversion from another currency into the currency
of the parent company is frequently called “translation.”
Translation Process
Current Exchange
Financial Rate Financial
Statements in Statements in
Euros Historical Exchange U.S. Dollars
Rate
LO 1 Current versus historical exchange rates.

6
Translating Statements of Foreign
Affiliates
Translation Adjustment or Translation Gain or Loss
• The difference between translating some accounts using
the current exchange rate and others using the historical
exchange rate.
• Current accounting standards require the translation
adjustment (gain or loss) be reported Not a
– currently in income or Choice
– deferred as a component of stockholders’ equity,
– depending on the method used to translate the
accounts.
LO 1 Current versus historical exchange rates.

7
Objectives of Translation
Functional Currency Concept
• Objectives 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.
• Reflect in consolidated statements the financial results
and relationships measured in their functional
currencies in conformity with U.S. GAAP.
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.
LO 2 The objectives of translation.

8
Translation Methods
• Toaccomplish the objectives of translation, two
translation methods are used depending on the
functional currency of the foreign entity.
1. Current rate method
2. Temporal method
• Current rate method

– All assets and liabilities are translated at current
exchange rate.
– Revenues and expenses are translated at the exchange
rate on the date which each transaction occurred .
• An appropriate average rate can be used.
LO 4 Two methods of conversion.
9
Translation Methods
• Temporal Method
– Monetary assets and liabilities (cash, a/r, a/p).
• Translated at current exchange rate.
– Assets and liabilities carried at historical cost.
• Translated at historical exchange rates.
– Assets and liabilities carried at current values.
• Translated at current exchange rate.
– Revenues and expenses related to assets and liabilities
translated at historical rates.
• Translated at historical exchange rates.
– Other revenues and expenses
• Translated at exchange rate on date transaction occurred.
LO 4 Two methods of conversion.

10
Identifying the Functional
Currency
The Functional Currency may be
1. The local currency of the foreign entity,
2. The U.S. dollar, or
3. The currency of a third country.
Economic Indicators of Functional Currency:
 Cash flow  Expenses

 Sales prices  Financing
 Sales market  Intercompany transactions
LO 3 Identifying the functional currency.

11
Identifying the Functional
Currency
Review Question
Indicators that the local currency is also the functional
currency include all of the following except:
a) The majority of the cash flows are in the local currency.
b) Sales prices are determined by local market conditions.
c) Financing is generally from the parent or guaranteed by
the parent.
d) Production costs and expenses are determined by local
conditions.
LO 3 Identifying the functional currency.

12
Translation of Foreign Currency
Financial Statements
• Remeasurement is the process of translating the
accounts of a foreign entity into its functional currency
when they are stated in another currency.
• Translation. Accounts measured in the functional
currency are translated into the reporting currency using
the current rate method.
“Translation” may be used synonymously with the current method,

“remeasurement” is used synonymously with the temporal method.
LO 4 Which methods of conversion to13use.

Accounts stated in local currency of foreign entity.
Is the foreign Determine the functional

economy highly No currency (FC) per
inflationary? economic indicators.
Yes
Functional
Is the FC the No Is the FC the local
currency (FC) is
U.S. Dollar. U.S. dollar? currency? Yes
Yes No
Translate to
Remeasure to U.S. Remeasure to U.S. dollars using
dollars using FC using temporal current rate method.
temporal method. method.
LO 4 Which methods of conversion to14use.

Foreign Entity Operates in Highly Inflationary
Economy
• It is the Board’s belief that the currency of a country
that has a highly inflationary economy has lost its utility
as a store of value and cannot be a functional
measuring unit.
– This means the foreign financial statements should
be translated using the temporal method.
LO 6 Foreign entity operating in a highly inflationary economy.

15
Foreign Entity Operates in Economy that is Not Highly Inflationary -
Functional currency must be identified. Translation process:
– Local currency is the functional currency.
• Current rate method; Translation adjustment recorded as a
separate component of stockholders’ equity.
– U.S. dollar is the functional currency.
• Temporal method; Translation adjustment reported in income
statement.
– Functional currency is the currency of a third country.
• Remeasure using temporal method, remeasured functional
amounts are translated; Translation gain or loss (temporal)is
reported in income and adjustment (current rate) is recorded as
a separate component of stockholders’ equity.
16
Translation of Foreign Currency Financial
Statements
Local Books kept in

currency local currency
Remeasure- Not Temporal Temporal

ment necessary method method
Functional Local U.S. A third

currency currency dollar currency
Translation Current rate Not Current rate

method necessary method
U.S. dollar U. S. dollars
17
Translation – Current Rate Method
• Current Rate Method • Translation
 Assets and liabilities  Current exchange rate
 Paid-in capital  Historical rate
 Beginning R/E  Equals ending balance of
last year
 Historical rate when
 Dividends dividend is declared
 Revenue and Expenses  Average exchange rate
 Cumulative translation  Balance amount in the
adjustment balance sheet
 Current year translation  Other comprehensive
adjustment income (shareholders’
equity)
LO 7 The functional currency is the local currency.
18
Exercise 13-4: On January 1, 2014, 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, 2014 $.5987
December 31, 2014 .5321
Average for 2014 .5654
Dividend declaration and payment date .5810
Required: Translate the year-end balance sheet and income statement of the
foreign subsidiary using the current rate method of translation.

19
Exercise 13-4: (Current Rate Method)
Swiss Translation
Income Statement Francs Rate U.S. Dollars
Revenue 75,000 0.5654 42,405
Operating expenses (30,000) 0.5654 (16,962)
Net income 45,000 25,443
Retained earnings 1/1 10,000 0.5987 5,987
55,000 31,430
Dividends (15,000) 0.5810 (8,715)
Retained earnings 12/31 40,000 22,715
Balance Sheet
Cash and receivables 55,000 0.5321 29,266
Net property, plant, equipment 37,000 0.5321 19,688
Total assets 92,000 48,954
Accounts payable 32,000 0.5321 17,027

Common stock 20,000 0.5987 11,974
Retained earnings 40,000 22,715
92,000 51,716
Cumulative translation adjustment (2,762)
Total liab. & equity 92,000 48,954
20
Exercise 13-4: Prepare a schedule to verify the translation
adjustment. Swiss Translation
Francs Rate $
Exposed net asset position - 1/1 30,000 $.5987 17,961

Adjustment for changes in net asset position:
Net income 45,000 .5654 25,443
Dividends (15,000) .5810 (8,715)
Net asset position translated --- 34,689
Exposed net asset position - 12/31 60,000 .5321 31,926
Cumulative translation adjustment (debit) (2,763)

21
Review Question
Under the current method of currency translation, which
of the following balance sheet accounts is translated at
historical exchange rates?
a) Cash
b) Accounts Receivable
c) Bonds Payable
d) Common Stock

22
Translation – Temporal Method
• Temporal Method • Translation
– Monetary assets and – Current exchange rate.
liabilities (cash, a/r, a/p).
– Assets and liabilities carried – Historical exchange rates.
at historical cost. – Current exchange rate.
– Assets and liabilities carried – Historical exchange rates.
at current values.
– Revenues and expenses – Exchange rate on date
related to assets and transaction occurred.
liabilities translated at
historical rates.
– Other revenues and
expenses.
LO 8 The functional currency is the U.S. dollar.

23
Exercise 13-5: On January 1, 2014, 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, 2014 $.5987
December 31, 2014 .5321
Average for 2014 .5654
Dividend declaration and payment date .5810
Required: Convert (remeasure) the financial statements of the foreign

subsidiary using the temporal method of translation.

24
Exercise 13-5: (Temporal Method)
Swiss Translation
Income Statement Francs Rate U.S. Dollars
Revenue 75,000 0.5654 42,405
Operating expenses: depreciation (3,000) 0.5987 (1,796)
Operating expenses: other (27,000) 0.5654 (15,266)
Translation loss (198)
Net income 45,000 25,145
Retained earnings 1/1 10,000 0.5987 5,987
55,000 31,132
Dividends (15,000) 0.5810 (8,715)
Retained earnings 12/31 40,000 22,417
Balance Sheet
Cash and receivables 55,000 0.5321 29,266
Net property, plant, equipment 37,000 0.5987 22,152
Total assets 92,000 51,418
Accounts payable 32,000 0.5321 17,027

Common stock 20,000 0.5987 11,974
Retained earnings 40,000 22,417
Total liab. & equity 92,000 51,418
25
Exercise 13-5: Prepare a schedule to verify the translation gain or
loss. Swiss Translation
Francs Rate $
Net monetary liability position - 1/1 (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 --- 12,437
Net monetary asset position-12/31 23,000 .5321 12,238
Translation gain (loss) (199)

26
Financial Statement 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 currency
transactions, if significant.
LO 10 Required disclosure.
27

Advanced Accounting: Translation of Financial Statements of Foreign Affiliates

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LO 1 Current versus historical exchange rates.

LO 1 Current versus historical exchange rates.

LO 2 The objectives of translation.

• Current rate method

LO 4 Two methods of conversion.

 Cash flow  Expenses

LO 3 Identifying the functional currency.

LO 3 Identifying the functional currency.

“Translation” may be used synonymously with the current method,

LO 4 Which methods of conversion to13use.

Is the foreign Determine the functional

LO 4 Which methods of conversion to14use.

LO 6 Foreign entity operating in a highly inflationary economy.

Local Books kept in

Remeasure- Not Temporal Temporal

Functional Local U.S. A third

Translation Current rate Not Current rate

U.S. dollar U. S. dollars

LO 7 The functional currency is the local currency.

Accounts payable 32,000 0.5321 17,027

Exposed net asset position - 1/1 30,000 $.5987 17,961

LO 7 The functional currency is the local currency.

LO 7 The functional currency is the local currency.

LO 8 The functional currency is the U.S. dollar.

Required: Convert (remeasure) the financial statements of the foreign

LO 7 The functional currency is the local currency.

Accounts payable 32,000 0.5321 17,027

Net monetary liability position - 1/1 (10,000) $.5987 (5,987)

LO 7 The functional currency is the local currency.

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