12-1 Baker / Lembke / King Multinational Accounting: Translation of Foreign Entity Statements 12 Electronic Presentation by Douglas Cloud Pepperdine University McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Differences in Accounting Principles Four major models of accounting The U.S. model, which focuses on the information needs of the common stockholder through the application of generally accepted accounting principles. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-2 Differences in Accounting Principles Four major models of accounting The British model, which focuses on the information needs of bondholders, creditors, and preferred stockholders. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-3 Differences in Accounting Principles Four major models of accounting The French-ItalianSpanish model, which is based on the information needs of the taxing authorities. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-4 Differences in Accounting Principles Four major models of accounting The German and Scandinavian countries model, which is extremely conservative and uses large number of reserves to reduce income to its lowest level possible. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-5 Determining the Functional Currency FASB 52 provides specific guidelines for translating foreign currency financial statements. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-6 Determining the Functional Currency Normally, FASB 52that defines is theitcurrency as the of currency the environment of the primary in which aneconomic entity primarily environment generates in which andthe expends entity operates. cash. McGraw-Hill/ Irwin What is functional currency? Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-7 Functional Currency Indicators Indicator Cash flows McGraw-Hill/ Irwin Factors indicating Foreign Currency (Local Currency) is the Functional Currency Primarily in foreign currency and do not affect parent’s cash flows 12-8 Factors indicating U.S. Dollar (Parent’s Currency) is the Functional Currency Directly impact the parent’s current cash flows and are readily available to the parent company Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-9 Functional Currency Indicators Indicator Sales prices McGraw-Hill/ Irwin Factors indicating Foreign Currency (Local Currency) is the Functional Currency Factors indicating U.S. Dollar (Parent’s Currency) is the Functional Currency Primarily determined by local competition or local government regulations Responsive to short-term changes in exchange rate and worldwide competition Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Functional Currency Indicators Indicator Sales markets McGraw-Hill/ Irwin 12-10 Factors indicating Foreign Currency (Local Currency) is the Functional Currency Factors indicating U.S. Dollar (Parent’s Currency) is the Functional Currency Active local sales markets for company’s products; might be significant amount of exports Sales market mostly in parent’s country, or sales contracts are denominated by parent’s currency Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Functional Currency Indicators Indicator Expenses McGraw-Hill/ Irwin 12-11 Factors indicating Foreign Currency (Local Currency) is the Functional Currency Factors indicating U.S. Dollar (Parent’s Currency) is the Functional Currency Labor, materials, and other costs are primarily local costs Production components generally obtained from the parent Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Functional Currency Indicators Indicator Financing McGraw-Hill/ Irwin Factors indicating Foreign Currency (Local Currency) is the Functional Currency Primarily obtained from and denominated in local current units, entity’s operations generate funds sufficient to service financing needs. 12-12 Factors indicating U.S. Dollar (Parent’s Currency) is the Functional Currency Primarily from the parent, or other dollar denominated financing Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Functional Currency Indicators Indicator Intercompany transactions and arrangement McGraw-Hill/ Irwin Factors indicating Foreign Currency (Local Currency) is the Functional Currency Few intercompany transactions with parent 12-13 Factors indicating U.S. Dollar (Parent’s Currency) is the Functional Currency Frequent intercompany transactions with parents or foreign entity is an investment or financing arm for the parent Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Translation Versus Remeasurement 12-14 Translation is the most common method used and is applied when the local currency is the foreign Remeasurement is the entity’s functional restatement currency. of the foreign entity’s financial statements from the local currency used by the entity into the foreign entity’s functional currency. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Translating Foreign Entity’s Trial Balance 12-15 Income statement accounts: - Revenue and expenses Generally, weighted average exchange rate for the period covered by the statement Balance sheet accounts: Current exchange rate on - Assets and liabilities balance sheet date Historical exchange rate - Stockholders’ equity Cumulative translation adjustment McGraw-Hill/ Irwin To Accumulated Other Comprehensive Income Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Translation and Consolidation 12-16 On January 1, 20X1, Peerless Products (U.S.) purchases 80 percent of the outstanding capital stock of German Company (Germany) for $54,000. The local currency for German Corporation is euro( ), which is also the functional currency. On October 1, 20X1, the subsidiary declared and paid dividends of 6,250. The subsidiary received $4,200 in sales transactions with a U.S. company when the exchange rate was $1.20 = 1. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-17 Translation and Consolidation Relevant direct spots exchange rates ($/ 1) are: Date Rate January 1, 20X1 October 1, 20X1 December 31, 20X1 20X1 average $1.20 1.36 1.40 1.30 Jan. 1, 20X1 Investment in Germany Company Stock Cash Purchase of Germany Company stock. McGraw-Hill/ Irwin 54,000 54,000 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-18 Translation and Consolidation 1/1/X1 80% P G Investment cost Book value of investment: Common stock $48,000 Retained earnings 12,000 Total $60,000 Percent of German Company’s stock acquired by Peerless Company x .80 Differential attributed to goodwill McGraw-Hill/ Irwin $54,000 (48,000) $ 6,000 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. January 1, 20X1 Workpaper Item Investment in German Co. Stock Differential Common Stock Retained Earnings Noncontrolling Interest McGraw-Hill/ Irwin Peerless Products German Company Eliminations Debits Credits 12-19 Consolidated 54,000 500,000 48,000 300,000 12,000 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-20 January 1, 20X1 Workpaper Item Investment in German Co. Stock Differential Common Stock Retained Earnings Noncontrolling Interest Peerless Products German Company Eliminations Debits Credits 54,000 Consolidated 54,000 6,000 500,000 48,000 48,000 500,000 300,000 12,000 12,000 300,000 12,000 12,000 Noncontrolling Interest = ($48,000 + $12,000) x .20 = $12,000 McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-21 January 1, 20X1 Workpaper Item Investment in German Co. Stock Differential Patent Common Stock Retained Earnings Noncontrolling Interest Peerless Products German Company Eliminations Debits Credits 54,000 500,000 48,000 6,000 6,000 48,000 300,000 12,000 12,000 Consolidated 54,000 6,000 6,000 500,000 300,000 12,000 12,000 Assign differential McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Dec. 31, 2001--Translation Trial Balance Balance Item Cash 10,750 Foreign Currency Units Current3,000 exchange Receivables rate10,500 on balance Inventory 5,000 sheet date Plant and Equipment 50,000 Cost of Goods Sold 22,500 WeightedOperating Expenses 14,500 average Foreign Currency exchange rate Historical Transaction Loss 500 exchange rate on Dividends Paid 6,250 date of Total Debits 123,000 declaration McGraw-Hill/ Irwin Exchange Rate 12-22 Balance, $ 1.40 1.40 1.40 1.40 1.40 1.30 1.30 15,050 4,200 14,700 7,000 70,000 29,250 18,850 1.30 1.36 650 8,500 168,200 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Dec. 31, 2001--Translation Trial Balance Balance Item Exchange Rate Accumulated Depreciation 7,500 Current exchange rate3,000 on balance Accounts Payable Historical sheet date Bonds Payable 12,500 exchange rate on From the Common Stock date40,000 of acquiring beginning of year Retained Earnings (1/1) 10,000 subsidiary Weighted translation Sales 50,000 average workpaper exchange Total 128,000 rate Accumulated Other Comprehensive Income-Translation Adjustment Total Credits 1.40 1.40 1.40 1.20 * 1.30 12-23 Balance, $ 10,500 4,200 17,500 48,000 12,000 65,000 157,200 11,000 168,200 *From the January 1, 20X1, translation workpaper. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-24 Proof of Translation Adjustment Peerless Products and Subsidiary Translation Rate Net assets at beginning of year 50,000 1.20 Adjustment for changes in net assets position during year: Net income for year 12,500 1.30 Dividends paid ( 6,250) 1.36 Net assets translated at: Rates during year Rates at end of year 56,250 1.40 Change in other comprehensive income-translation adjustment during year (net increase) Accumulated other comprehensive income-translation adjustment, 1/1 Accumulated other comprehensive income-translation adjustment, 12/31 (credit) McGraw-Hill/ Irwin $ 60,000 16,250 (8,500) 67,750 78,750 11,000 -011,000 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Translated Balance Sheet--12/31/X1 12-25 Translated Balance Sheet, 12/31/X1 Net assets McGraw-Hill/ Irwin $78,750 Common stock 60,000 Retained earnings 7,750 (net income less dividends) Accumulated other comprehensive income--translation adjustment 11,000 $78,750 $78,750 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Entries on Parent Company’s Books 12-26 On October 1, 20X1, Peerless Products received a dividend of DM 10,000 and immediately converted it to U.S. dollars. October 1, 20X1 Cash 6,800 Investment in German Company Stock Dividend received from foreign subsidiary. 6,800 6,250 x .80 x $1.36 exchange rate McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Entries on Parent Company’s Books 12-27 Equity in the net income of foreign subsidiary is recorded on December 31, 20X1. December 31, 20X1 Investment in German Company Stock Income from Subsidiary Equity in net income of foreign subsidiary. McGraw-Hill/ Irwin 13,000 13,000 12,500 x .80 x $1.30 average exchange rate Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Entries on Parent Company’s Books 12-28 Amortization of the parent’s portion of the differential assigned to the patent is recorded on December 31, 20X1: December 31, 20X1 Income from Subsidiary Investment in German Company Stock Amortize differential. 650 650 500 x $1.30 McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Entries on Parent Company’s Books 12-29 An entry is needed to record the portion of the translation adjustment on the increase in the differential on the investment in foreign subsidiary. December 31, 20X1 Investment in German Company Stock Other Comprehensive Income-Translation Adjustment Recognize translation adjustment on increase in differential. McGraw-Hill/ Irwin 950 950 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Entries on Parent Company’s Books 12-30 Peerless Products’ share of the translation adjustment is recorded on December 31, 20X1. December 31, 20X1 Investment in German Company Stock Other Comprehensive Income-Translation Adjustment Parent’s share of change in translation adjustment from translation of subsidiary’s accounts. McGraw-Hill/ Irwin 8,800 8,800 $11,000 x .80 ownership Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Situations Requiring Remeasurement 12-31 1. A foreign sales branch or subsidiary of a U.S. manufacturer which primarily takes orders from foreign customers for The major reason forfrom U.S.-manufactured goods, which bills and collects foreign customers. remeasurement is Item 5. 2. A foreign division, branch, or subsidiary which primarily manufactures a subassembly that is shipped to a U.S. plant. 3. A foreign shipping subsidiary which primarily transports ore from a U.S. Company’s foreign mines to the United States for processing. 4. A foreign subsidiary which is primarily a conduit for Eurodollar borrowing to finance operations in the United States 5. The foreign entity is located in a hyperinflationary economic environment. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-32 The major reason for remeasurement is Item 5. 5. The foreign entity is located in a hyperinflationary economic environment. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Remeasuring a Foreign Entity’s Trial Balance 12-33 Income statement accounts: Revenue-- Weighted-average exchange rate, except revenue from nonmonetary items (historical exchange rate) Expenses-- Weighted-average exchange rate, except costs related to nonmonetary items (historical exchange rate) McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Remeasuring a Foreign Entity’s Trial Balance 12-34 Balance sheet accounts: -Monetary accounts -Nonmonetary accounts -Equity capital accounts -Retained earnings Remeasurement gain or loss McGraw-Hill/ Irwin Current exchange rate Historical exchange rate Historical exchange rate Prior period’s balance plus income less dividends Included in net income Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 12-35 Chapter Twelve The End McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.