CHAPTER 13
FOREIGN CURRENCY FINANCIAL STATEMENTS
Comprehensive Chapter Outline
US CORPORATIONS CONVERT THE FOREIGN CURRENCY FINANCIAL
STATEMENTS OF THEIR FOREIGN SUBSIDIARIES AND BRANCHES INTO U.S.
DOLLARS UNDER THE PROVISIONS OF FASB STATEMENT NO, 52
(Illustration 13-1)
A.
Foreign currency financial statements are statements prepared in a currency other than the
reporting currency (the U.S. dollar) of the U.S. parent-investor. Statements of operations
located outside the U.S. that are prepared in U.S. dollars are not foreign currency statements
and FAS 52 provisions do not apply.
B.
The method for converting the foreign currency statements into U.S. dollars and the
classification of the resulting gain or loss depends on the foreign entity’s functional currency.
APPLICATION OF THE FUNCTIONAL CURRENCY CONCEPT
A.
Foreign currency statements must be in conformity with generally accepted accounting
standards before they can be translated.
B.
Account balances on the foreign currency statements that are denominated in a foreign
currency from the viewpoint of the foreign entity must be adjusted to reflect current exchange
rates.
C.
An objective of the functional currency concept is to measure a foreign entity’s assets,
liabilities, and operations in its functional currency. Before the foreign entity’s financial
statements can be combined or consolidated with the U.S. parent, they must be converted to
the reporting currency (the U.S. dollar).
1.
When the foreign entity’s books are maintained in its functional currency, the
statements are translated into the currency of the reporting entity. In this case, the
local currency of the foreign entity is its functional currency.
a.
Translation involves expressing functional currency measurements in the
reporting currency.
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2.
3.
b.
All elements of financial statements (assets, liabilities, revenues, and
expenses) are translated using a current exchange rate (the current rate
method.) As an expedient, revenues and expenses are usually translated at a
weighted average exchange rate for the period.
c.
The effects of the exchange rate changes are reported as stockholders’ equity
adjustments because they are not expected to impact the cash flows of the
parent-investor.
d.
The equity adjustments from translation are accumulated until the
investment is sold or liquidated, at which time they are treated as adjustments
to the gain or loss on sale.
When the foreign entity’s books are not maintained in its functional currency, the
statements are remeasured in the functional currency. If the functional currency is
the reporting currency (the U.S. dollar) the conversion is complete. (If the functional
currency is not the U.S. dollar, the remeasured statements must then be translated
into U.S. dollars.)
a.
When the U.S. dollar is the functional currency, the foreign currency financial
statements are remeasured under the temporal method in which monetary
assets and liabilities are remeasured at current exchange rates and other assets
and equities are remeasured at historical rates.
b.
Gains or losses from remeasuring the foreign currency statements are
included in income because they are expected to impact cash flows of the
parent-investor.
Intercompany transactions between a U.S. parent and its foreign subsidiary may be
a foreign currency transaction to one affiliate, neither affiliate or to both affiliates.
a.
The transaction is a foreign currency transaction of a particular affiliate if it
results in a receivable or payable balance denominated in a currency other
than that entity’s functional currency.
b.
Intercompany account balances denominated in a foreign currency are
adjusted at the balance sheet date to the current exchange rate.
1)
If the intercompany balances are not of a long-term investment
nature, the exchange gain or loss is included in income for the period.
An exchange gain or loss on settlement is also included in income for
the period.
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2)
If the intercompany balances are of a long-term investment nature
(settlement is not expected in the foreseeable future), the exchange gain
or loss is reported in stockholders’ equity as an equity adjustment from
translation.
FOREIGN ENTITIES OPERATING IN HIGHLY INFLATIONARY ECONOMIES
A.
A highly inflationary economy under the provisions of FAS 52 is one with a cumulative
three-year inflation rate of approximately 100 percent or more.
B.
Foreign currency financial statements of entities operating in highly inflationary economies
are remeasured using the U.S. dollar reporting currency as the functional currency.
C.
Exchange gains and losses are recognized in the income for the period.
A CHANGE IN THE FUNCTIONAL CURRENCY DOES NOT REQUIRE RESTATEMENT
OF PRIOR PERIOD FINANCIAL STATEMENTS BECAUSE IT IS NOT A CHANGE IN
AN ACCOUNTING PRINCIPLE
BUSINESS COMBINATIONS
A.
The assets and liabilities are translated into U.S. dollars using the current exchange rate in
effect at the date of the business combination.
B.
The identifiable assets and liabilities are adjusted to their fair values in local currency and
translated at the current exchange rate. Any difference between the investment cost and
translated net assets acquired is goodwill.
1.
When the foreign entity’s functional currency is its local currency, the excess cost
over book value acquired is assigned to assets, liabilities, and goodwill in local
currency units and subsequently translated at current exchange rates.
2.
When the foreign entity’s functional currency is the U.S. dollar,
remeasurement is required. The excess allocated to identifiable net assets
is amortized at the historical exchange rate in effect at the time of the
business combination.
145
MINORITY INTEREST IN A FOREIGN SUBSIDL4RY IS COMPUTED AFTER THE
FOREIGN CURRENCY FINANCIAL STATEMENTS HAVE BEEN TRANSLATED OR
REMEASURED INTO U.S. DOLLARS
THE EQUITY METHOD IS APPLIED AFTER THE FOREIGN ENTITY’S STATEMENTS
HAVE BEEN TRANSLATED OR REMEASURED INTO U.S. DOLLARS
TRANSLATION OF A FOREIGN SUBSIDIARY (Illustration 13-2)
A.
The foreign subsidiary adjusts receivables and payables from intercompany transactions that
are denominated in a foreign currency. If the intercompany transaction is of a long-term
investment nature, the gain or loss is included in the equity adjustment from translation
(other comprehensive income.) Otherwise, the gain or loss is included in income of the
period.
B.
When the foreign subsidiary’s adjusted trial balance is translated using the current rate
method:
1.
Assets and liabilities are translated at the current rate at the balance sheet date.
2.
Revenues and expenses are usually translated at an average rate.
3.
Dividends are translated at the rate in effect when the dividends are paid.
4.
Retained earnings in dollars consist of retained earnings at acquisition plus income
less dividends since acquisition, all in translated dollar amounts. In years subsequent
to the year of acquisition, the beginning retained earnings of one year are the ending
retained earnings from the translated statements of the previous year.
5.
Capital stock and other paid-in capital accounts are translated at the exchange rate in
effect when the subsidiary (or investee) was acquired.
6.
The difference between the translated debits and the translated credits is an equity
adjustment from translation (other comprehensive income).
C.
The translated financial statements are used in applying the equity method.
D.
Minority interest is computed as a percentage of the subsidiary’s translated stockholders’
equity; in other words, the equity adjustment from translation is included in the computation.
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E.
The elimination of intercompany profits should be based on the exchange rates in effect
when the intercompany transaction took place; however, reasonable approximations or
averages are permitted by FAS 52.
REMEASUREMENT OF A FOREIGN SUBSIDIARY
A.
When the functional currency is the U.S. dollar, the foreign entity’s accounts are
remeasured into U.S. dollars.
B.
The objective of remeasurement is to produce the same results as if the books of the
subsidiary had been maintained in U.S. dollars.
C.
Translation and remeasurement at acquisition are the same.
D.
When the adjusted trial balance of a foreign subsidiary is remeasured:
1.
Monetary assets are remeasured at the current rate (the same as they are in translated
statements).
2.
Dividends paid are translated at reciprocal amounts in dollars recorded by the parent
company on its own books.
3.
Inventories are remeasured at historical rates. Purchases are remeasured at average
rates. Special procedures are required for inventories carried at the lower of cost or
market.
a.
Nonmonetary assets carried at cost are remeasured at historical rates and
those carried at market are remeasured at current rates.
b.
The remeasured amounts are affected both by changes in the exchange rates
and by changes in replacement costs. Write-downs to market may be
appropriate for the foreign currency statements but not the for remeasured
statements and visa versa, or both.
4.
Expenses are remeasured at average rates during the period if they relate to
monetary items and at historical exchange rates if they relate to nonmonetary items,
such as plant assets or intangibles. If a single expense account relates to both
monetary and nonmonetary items, the remeasurement must be computed.
5.
Capital stock and other paid-in capital are remeasured at historical exchange rates
(the same as in translated amounts).
6.
The retained earnings balance is computed.
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7.
Total debits in the remeasured trial balance are subtracted from total credits and the
resulting exchange gain or loss is included in income for the period.
E.
The equity method is applied to the remeasured financial statements. Since all
remeasurement gains and losses are recognized in current income, the equity method is the
same as for domestic subsidiaries.
F.
Because inventory and cost of sales accounts are remeasured at historical exchange rates,
intercompany profits in consolidation working papers are eliminated in the same manner as
for domestic subsidiaries.
APPENDIX A: STATEMENT OF CASH FLOWS
A.
The preparation of the consolidated statement of cash flows for a U. S. parent and a foreign
subsidiary is complicated by the existence of translation adjustments.
B.
Individual translation adjustments must be determined and their effects eliminated in
determining cash flows for a period.
APPENDIX B: HEDGING A NET INVESTMENT IN A FOREIGN ENTITY
A.
A U.S. firm may enter into a forward contract to hedge a net investment in a foreign entity
whose functional currency is other than the U.S. dollar.
1.
Translation of the financial statements of a foreign entity whose functional currency is
not the U.S. dollar produces a gain or loss that is excluded from net income and is
reported in comprehensive income and as an equity adjustment from translation, a
stockholders’ equity account.
2.
A gain and loss on a hedge of a net investment in a foreign investee is also excluded
from net income. As with the underlying gain or loss being hedged, the gain or loss is
reported in other comprehensive income and as an equity adjustment from translation.
3.
The investee’s assets and liabilities hedge each other, so only the net assets are
exposed to exchange rate gains and losses. To hedge the foreign currency
exposure, the translation adjustment from the hedge must move in the opposite
direction of the translation adjustment from the net assets of the investee.
4.
A forward contract to hedge a net investment in a foreign entity whose functional
currency is the U.S. dollar is accounted for as a speculation. This is because
conversion of the investee’s financial statements into U.S. dollars results in a gain or
loss that is included in net income. The gain or loss from the related hedge is also
included in net income.
148
Overview of FASB Statement No. 52 Provisions
Relating to Foreign Currency Financial Statements
IF THE FOREIGN ENTITY IS FUNCTIONAL CURRENCY IS ITS RECORDING
(AND LOCAL) CURRENCY:
1.
Foreign currency amounts are translated to the reporting currency using the current rate
method.
2.
Assets and liabilities are translated at the current exchange rate at the balance
sheet date.
3.
Revenues, expenses, gains, and losses are translated at appropriately weighted average
exchange rates for the period. (This is a practical expedient for exchange rates in effect on
the transaction dates.)
4.
Dividends are translated at the rate used by the U.S. parent company in recording
the dividends it receives from a foreign subsidiary.
5.
Paid-in capital accounts are translated at historical exchange rates and the foreign entity’s
retained earnings amount is measured at its beginning translated amount plus translated
income less translated dividends.
IF THE FOREIGN ENTITY’S FUNCTIONAL CURRENCY IS NOT ITS RECORDING
(OR LOCAL) CURRENCY:
1.
Foreign entity’s books of record are remeasured into the functional currency using the
temporal method. If the functional currency is the reporting currency, remeasurement
obviates translation.
2.
Monetary assets and liabilities are generally remeasured at the current exchange rate at the
balance sheet date, and nonmonetary assets at historical exchange rates. (See Statement 52,
Appendix B, for exceptions.)
3.
Revenues and expenses related to monetary items are remeasured at average exchange rates
during the period and those related to nonmonetary items are remeasured at historical
exchange rates. Gains and losses are remeasured at the rates in effect on the transaction
dates. (See Statement 52, Appendix B, for exceptions.)
4.
Dividends are remeasured at the rate used by the U.S. parent company in
recording the dividends it receives from a foreign subsidiary.
149
5.
Paid-in capital accounts are remeasured at historical exchange rates and retained earnings is
measured at its beginning remeasured amount plus remeasured income less remeasured
dividends.
6.
Exchange gains and losses on remeasurement of a foreign subsidiary’s financial
statements into U.S. dollars are recognized in income of the period.
7.
The remeasured amounts are translated into the reporting currency using the current rate
method as explained above. (Remeasurement and translation are both needed when a foreign
entity’s recording currency is other than its functional currency and its functional currency is
other than the reporting currency.)
FOREIGN ENTITIES OPERATING IN A HIGHLY INFLATIONARY ECONOMY
1.
A highly inflationary economy is one that has a cumulative three-year inflation
rate of 100% or more.
2.
A foreign entity operating in a highly inflationary economy adopts the reporting
currency (parent’s currency) as its functional currency.
3.
If the foreign entity’s books of record are maintained in the reporting currency
(U.S. dollar), neither remeasurement nor translation is required.
4.
If the foreign entity’s books of record are maintained in its local currency, remeasurement
into the reporting currency (U.S. dollar) is required. Remeasurement obviates translation in
this case.
150
Illustration 13-2
TRANSLATION AND CONSOLIDATION OF A FOREIGN SUBSIDIARY
Sub Corporation is a foreign firm whose local currency is designated LCU (local currency
units.)
The exchange rate on December 31, 20Xl is 2 LCU for $1 U.S., and the December 31, 20Xl
balance sheet of Sub in LCU and U.S. dollars is as follows:
LCU
Exchange
Rate
U.S.
Dollars
Cash
Plant assets-net
Total assets
5,000
20,000
25,000
$.50
.50
$ 2,500
10,000
$12,500
Capital stock
Retained earnings
Total equities
20,000
5,000
25,000
.50
$10,000
2,500
$12,500
On January 1, 20X2 Par Corporation, a U.S. firm, acquires all the capital stock of Sub for
$15,000. Par's management determines that the functional currency of its subsidiary, Sub
Corporation, is the LCU. Any excess of cost over book value is attributable to a patent and is
to be amortized over 5 years.
Cost of investment in Sub at January 1, 20X2
$15,000
Book value of interest acquired
12,500
Patent (in $)
$ 2,500
Patent in LCU $2,500/$.50 = 5,000 LCU
January 1, 20X2 purchase of Sub Corporation
Par records its investment in Sub as follows:
Investment in Sub
$15,000
Cash
To record acquisition of Sub equal to book value plus $2,500
patent (5,000 LCU patent) with a 5-year amortization period.
151
$15,000
ACTIVITIES – 20X2:
The exchange rates for LCU for 20X2 are $.475 average for the year, $.47 when the dividends
are paid, and $.45 at December 31, 20X2.
A translation worksheet to convert Sub's accounts in LCU into U.S. dollars under the current
rate method is as follows:
Cash
Plant assets-net
Expenses
Dividends
Equity adjustment,
20X2 change
LCU
17,000
18,000
8,000
2,000
Translation Worksheet
December 31, 20X2
Exchange
U.S.
Rate
Dollars
$.45 C
$ 7,650
.45 C
8,100
.475 A
3,800
.47 H
940
1,510
$22,000
45,000
Capital stock
Retained earnings
Revenue
20,000
5,000
20,000
45,000
.50 H
measured
.475 A
$10,000
2,500
9,500
$22,000
One-line Consolidation - 20X2
Par records its income and dividends from Sub for 20X2 as follows:
Cash
$ 940
Investment in Sub
To record dividends received (2,000 LCU x $.47 exchange rate).
Investment in Sub
$4,190
Equity adjustment from translation
1,510
Income from Sub
To record equity in Sub's income ($9,500 - $3,800).
Income from Sub
$ 475
Equity adjustment from translation
225
Investment in Sub
To record amortization of patent computed as follows:
5,000 LCU / 5 years x $.475 exchange rate = $475
4,000 LCU ending balance x $.45 current rate = $1,800
Patent change: $2,500 - $1,800 = $700
152
$
940
$5,700
$ 700
Consolidation - l9X2:
Working papers to consolidate the financial statements of Par and Sub for the year ended
December 31, 20X2 are illustrated as follows:
Par Corporation and Subsidiary
Consolidation Working Papers
for the year ended December 31, 20X2
Par
Sub
Adjustment and
Eliminations
Income Statement
Revenue
Income from Sub
Expenses
Net income
Retained Earnings Statement
Retained earnings-Par
Retained earnings-Sub
Net income
Dividends
Retained earnings 12/31/20X2
Balance Sheet
Cash
Plant assets-net
Investment in Sub
$30,000
5,225
(25,000)
$10,225
$9,500
$39,500
a. 5,225
(3,800) c. 475
$5,700
(29,275)
$10,225
$10,000
10,225
(6,000)
$14,225
$ 2,940
12,000
17,550
$10,000
$2,500 b. 2,500
5,700
(940)
$7,260
$32,490
940
a. 4,285
b. 13,265
c.
475
$15,750
$10,000 b. 10,000
7,260
(1,510)
$15,750
153
10,225
(6,000)
$14,255
$10,590
20,100
b. 2,275
$32,490
$20,000
14,225
(1,735)
a.
$ 7,650
8,100
Patent
Capital stock
Retained earnings
Equity adjustment-Par
Equity adjustment-Sub
Consolidate
d
Statements
1,800
$32,490
$20,000
14,225
(1,735)
b. 1,510
$32,490
ACTIVITIES - 20X3:
The exchange rates for LCU for 20X3 are $.425 average for the year, $.42 when the dividends
are paid, and $.40 at December 31, 20X3.
A translation worksheet to convert Sub's accounts in LCU into U.S. dollars under the current
rate method is as follows:
Cash
Plant assets-net
Expenses
Dividends
Equity adjustment,
20X3 change
LCU
10,000
36,000
12,000
2,000
Translation Worksheet
December 31, 20X3
Exchange
Rate
$.40 C
.40 C
.425 A
.42 H
2,035
$26,375
60,000
Capital stock
Retained earnings, Jan. 1
Equity adjustment balance
on January 1
Revenue
U.S.
Dollars
$ 4,000
14,400
5,100
840
20,000
15,000
25,000
60,000
.50 H
measured
$10,000
7,260
measured
.425 A
(1,510)
10,265
$26,375
One-line Consolidation - 20X3
Par records its income and dividends from Sub for 20X3 as follows:
Cash
$ 840
Investment in Sub
To record dividends received (2,000 LCU x $.42 exchange rate).
Investment in Sub
$3,490
Equity adjustment from translation
2,035
Income from Sub
To record equity in Sub's income ($10,625 - $5,100).
Income from Sub
$ 425
Equity adjustment from translation
175
Investment in Sub
To record amortization of patent computed as follows:
5,000 LCU / 5 years x $.425 exchange rate = $425
3,000 LCU ending balance x $.40 current rate = $1,200
Patent change: $1,800 - $1,200 = $600
154
$ 840
$5,525
$
600
Consolidation – 20X3:
Working papers to consolidate the financial statements of Par and Sub for the year ended
December 31, 20X3 are illustrated as follows:
Par Corporation and Subsidiary
Consolidation Working Papers
for the year ended December 31, 20X3
Par
Sub
Adjustment and
Eliminations
Income Statement
Revenue
Income from Sub
Expenses
Net income
Retained Earnings Statement
Retained earnings-Par
Retained earnings-Sub
Net income
Dividends
Retained earnings 12/31/20X2
Balance Sheet
Cash
Plant assets-net
Investment in Sub
$31,000
5,100
(26,000)
$10,100
$10,625
$41,625
a. 5,100
(5,100) c. 425
$5,525
(31,525)
$10,100
$14,225
10,100
(6,000)
$18,325
$ 2,780
12,000
19,600
$14,225
$7,260 b. 7,260
5,525
(840)
$11,945
$34,380
840
a. 4,260
b. 15,340
c.
425
$18,400
$10,000 b. 10,000
11,945
(3,545)
$18,400
155
10,100
(6,000)
$18,355
$6,780
26,400
b. 1,625
$34,380
$20,000
18,325
(3,945)
a.
$ 4,000
14,400
Patent
Capital stock
Retained earnings
Equity adjustment-Par
Equity adjustment-Sub
Consolidate
d
Statements
1,200
$34,380
$20,000
18,325
(3,945)
b. 3,545
$34,380
Reconciliation of Par’s Investment Account and Sub’s Equity at December 31, 20X3
Balance January 1, 20X2
Income 20X2
Equity adjustment20X2 change
Dividends
Balance Dec. 31, 20X2
Income 20X3
Equity adjustment,
20X3 change
Dividends
Balance Dec. 31, 20X3
Equity
in sub
Patent
Amortization
and Adjustments
Investment
in Sub
$12,500
$2,500
$15,000
5,700
(475)
5,225
(1,510)
(225)
(1,735)
(940)
(940)
15,750
17,550
5,525
(425)
5,100
(2,035)
(175)
(2,210)
(840)
$18,400
156
(840)
$1,200
$19,600