Advanced Accounting II
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1
Accounting for the Effects of
Changes in Foreign Exchange
Rates
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Learning Objectives
1.
Understand the concept of foreign exchange exposure;
2.
Differentiate between operating exposure and accounting exposure;
3.
Understand the concept of functional currency;
4.
Understand the accounting treatment of foreign currency transactions;
5.
Understand the effects on foreign exchange on disposal and partial
disposal of foreign operations;
6.
Understand the procedures for translating foreign currency financial
statements in a non-hyperinflationary environment;
7.
Understand the special issues relating to translation; and
8.
Understand the difference between the effects on foreign exchange
arising from step-by-step and direct method of consolidation in complex
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group structure and its effects on disposal.
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Unit Outline
1.
Introduction
2.
Types of Foreign Exchange Rate Management Regimes
3.
How Exchange Rates Are Quoted
4.
Spot Rate and Forward Rate
5.
Types of Foreign Exchange Rate Exposures
6.
Concept of Functional Currency
7.
Foreign Currency Transactions of a Stand-alone Entity (IAS
21:20–26)
8.
Translation of Foreign Currency Financial Statements
9.
Special Issues
10.
Evaluation of Translation Approaches
4
Introduction
Year
1974
Fixed / Official Exchange Rate
System
• Currencies were pegged to US
Dollar
• US Dollar was pegged to gold
prices
International Monetary System
•Floating exchange rate system
•Volatility of exchange rates
• Affect businesses reported
earnings.
5
Types of Foreign Exchange Rate
Management Regimes
Floating Rate
System
Exchange Rate
Linked to a Key
Currency
Managed
Floating Rate
System
Exchange Rate
Linked to a
Basket of
Currencies
Currency Board
System
– Currencies
fluctuate freely
according to
demand and
supply.
– E.g. USD, GBP,
AUD, CAD
6
Types of Foreign Exchange Rate
Management Regimes
Floating Rate
System
Managed
Floating Rate
System
– Largely based on
demand and
supply forces,
Exchange Rate
Linked to a Key
Currency
Exchange Rate
Linked to a
Basket of
Currencies
– but the central
bank can freely
intervene by
Currency Board
System
buying or selling
the currency
7
Types of Foreign Exchange Rate
Management Regimes
Floating Rate
System
Managed
Floating Rate
System
– Exchange rate is fixed to
a key currency such as
USD (e.g. HK, Argentina)
Exchange Rate
Linked to a Key
Currency
Exchange Rate
Linked to a
Basket of
Currencies
– Affected by economic
conditions/policies (e.g.
inflation, money supply)
Currency Board
System
of the key currency
8
Types of Foreign Exchange Rate
Management Regimes
Floating Rate
System
Managed
Floating Rate
System
– Exchange rate is
based on a basket of
currencies of their
Exchange Rate
Linked to a Key
Currency
Exchange Rate
Linked to a
Basket of
Currencies
major trading partners.
(E.g. Singapore)
– More stable than
Currency Board
System
pegging currency to
single country
9
Types of Foreign Exchange Rate
Management Regimes
Floating Rate
System
Managed
Floating Rate
System
– Money supply of
currency is backed by
an equivalent amount
Exchange Rate
Linked to a Key
Currency
Exchange Rate
Linked to a
Basket of
Currencies
of a strong currency
(e.g. USD or EUR)
– Shares many
Currency Board
System
characteristics of
fixed rate systems
10
How Exchange Rate are Quoted?
• Foreign exchange rate
– The price of a currency expressed in terms of another currency
• Exchange rates are quoted in two ways:
– Direct quotation:
• 1 unit of foreign currency : X units of domestic currency
– Indirect quotation:
• X units of foreign currency : 1 unit of domestic currency
• To translate a direct quotation to an indirect quotation
– 1 unit of foreign currency/ X units of domestic currency
• To translate an indirect quotation to a direct quotation
– 1 unit of local currency/ X units of foreign currency
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Spot Rate and Forward Rate
Foreign
Currency Market
Spot Rate Market:
Rate are quoted for immediate
delivery on a particular day
Forward market:
Contractual agreement between
two parties where the rate is
fixed today but the delivery
is at a future time
Forward rate> Spot rate = Premium
Forward rate < Spot rate = Discount
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Spot Rate and Forward Rate
•
Economic concept of interest parity
– Forward premium or discount on the exchange rate between two currencies
is equal to the difference in interest rates between two countries
 Assumption: perfect market conditions and free flow of capital
– If forward premium or discount on exchange rate ≠ difference in interest
rates:
 Covered interest arbitrage occurs: arbitragers (currency traders)
transfer funds to country where interest rate is higher in order to earn
higher return while covering the FX risk with forward sales contract
– Consequences:
1. Large amount of funds flowing to higher interest rate countries 
pressure for interest rate to decrease
2. Outflow of liquidity in lower interest rate countries  pressure for
interest rate to increase
3. Forward sale creates downward pressure on forward rate of
country with lower interest rate.
4. 1, 2 and 3 continue until difference in interest rates is offset by FX
premium or discount
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Types of FX Rate Exposures
How changes in FX rates affect a firm’s exposure
Market rate movements
(due to macro-economic,
political forces and govt.
monetary policies)
Firm’s strategies and
operations (including foreign
transactions and operations)
Jointly determine
FX exposure
Accounting exposure
Operating exposure
Impacts the reported
earnings and statement of
financial position items
Affects the competitive
position of entity and value of
the firm
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Operating Exposure
• Not easily quantifiable
• Purchasing Power Parity
– Exchange rate changes between two countries = inflation
differential between two countries
– If the above does not hold, the real exchange rate between the
two countries has changed
– It will affect the competitive positions of firms operating in the two
countries
• Operating exposure arises from strategic decision a firm makes about
its input and output markets
– Input markets: countries where firm incurs cost
– Output markets: countries where firm derives its revenues
• The presence of foreign competitors in domestic market affects a
firm’s operating exposure
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Operating Exposure
• The extent of operating exposure of firm depends on
– Cost responsiveness and price responsiveness of its products to
changes in FX rates
o Cost responsiveness: extent to which costs change in
response to exchange rate changes
o Price responsiveness: extent to which selling price changes
because of exchange rate changes. Influenced by:
Demand elasticity of goods produced
Competitor response to price changes by a firm
o Operating exposure comes from mismatches between cost
and price responsiveness
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Accounting Exposure
It is the exposure to changes in exchange rates as a result of a firm:
1. Entering into foreign currency transactions (date of transaction)
This results in contractual rights and obligations, e.g. accounts
receivables or payables denominated in foreign currency
2. Translating the foreign currency financial statements (date of
reporting)
This is to translate the financial statements of foreign operations/
investments (e.g. subsidiaries, associates, joint ventures and
branches) from foreign currency to the currency of the parent for
the purpose of preparing consolidated financial statements of a
Group.
Accounting exposures:
• Quantifiable
• Have impacts on the reported profits, assets and liabilities in the
financial statements
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Accounting Exposure
Accounting Exposure
Transaction exposure:
Arises from foreign currency
transactions e.g. Account receivable
denominated in a foreign currency
Translation exposure:
Arises from translation of foreign currency
financial statements of foreign operations
Results in transaction gains or losses
Results in translation gains or losses
Recorded in the books
of the individual entity
Presented in consolidated
financial statements (group level)
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Local, functional and presentation
currency
•
IAS 21 recognises the following
currencies:
– Local currency
•
the currency in which the foreign operation
measures and records its transactions
– Functional currency
•
the currency of the primary economic environment
in which the entity operates
– Presentation currency
•
the currency in which the financial statements are
presented
Concept of Functional Currency
•
Functional currency under IAS 21:
– Currency of the “primary economic environment in which the entity
operates”
– Currency that influences the sale prices of goods and services
– Currency in which sales prices are denominated and settled
•
Currencies other than the functional currency are foreign currencies
– The effects of exchange rate changes on a firm’s cash flows is measured
and reported through functional currency
•
A firm’s primary environment is not determined by national or political
boundaries
– Example: Neptune Orient Lines (NOL): revenue is mainly in form of freight
charges, with significant proportion of operating costs attributable to fuel
oil
– Prices of freight charges and fuel oil: denominated in US dollars (main
currency in shipping and commodities)
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– Functional currency: USD; NOT SGD
Concept of Functional Currency
•
Primary Economic Environment HKAS
21:9 :
The primary economic environment in
which an entity operates is normally the
one in which it primarily generates and
expends cash.
Factors to Indicate an Entity’s
Functional Currency
Primary indicators (IAS21:9):
•
The currency that mainly influences the sale prices of goods and
services
•
The currency of country whose competitive forces and regulations
determine the sales prices of goods and services
•
The currency that mainly influences the labour, material and other
cost of goods and services
Supportive indicators (IAS21:10)
•
The currency in which financing is obtained
•
The currency in which receipts from operating activities are
retained
Factors to determine an Entity’s Functional
Currency
• Primary indicators for identifying the functional currency: First three
indicators above (IAS 21:9)
• In event where indicators give mixed signals
– Management will have to consider all factors taken together
and
– Exercise judgment “to determine the functional currency that
most faithfully represents the economic effects of underlying
transactions, events and conditions.” (IAS 21:12)
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Foreign Operation’s Functional Currency
• Foreign operation’s functional currency can be one of the
following:
– Local currency
Adopted in most situations
– Parent’s functional currency; or
– A third currency
• Additional factors to determine foreign operation’s
functional currency (IAS 21:11) aside from guidelines set
out in (IAS 21 para 9 -10)
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Factors to Determine the Functional
Currency of a Foreign Operation
Additional
Indicators(IAS21:11)
Indicators that foreign
operation’s functional
currency is local currency
Indicators that foreign
operation’s functional
currency is parent’s
functional currency
Operating relationship
with the parent
The foreign operation has
significant degree of
autonomy from the parent
The foreign operation is
an extension of the parent
Transactions with the
parent
Low proportion
High proportion
Cash flow
interdependencies
Foreign operation’s cash
flow don’t directly affects
the parent company
Foreign operation’s cash
flow directly affects the
parent company
Financial independence
Foreign operation is selfsufficient and not
dependent on the parent
company
Foreign operation is
dependent on the parent
company
Identifying the functional currency Case 1
•
•
•
•
A Ltd (US) owns a subsidiary in Hong Kong,
Dragon Ltd (D).
A manufactures all goods in USA, sells them to
D, who in turn sells to Hong Kong local
customers, based on a sales price determined
by A.
D has a long-term loan from A which was
advanced when the subsidiary was established.
All profits made by D are remitted back to A.
Identifying the functional currency Case 2
•
•
•
•
A Ltd (US) owns a subsidiary in Hong Kong,
Dragon Ltd (D).
D manufactures all goods in Hong Kong using
local labour and sells them to Hong Kong local
customers. Selling prices are based on a 25%
mark-up on cost.
The company has no long-term loans.
All profits made by D are reinvested back into
the business for expansion purposes. The only
remittances made to A are in the form of
dividends.
Identifying the functional currency Case 3
•
•
•
•
A Ltd (US) owns a subsidiary in Hong Kong,
Dragon Ltd (D)
D assembles all goods in Hong Kong using a
combination of locally sourced materials and
materials manufactured by A.
All goods are then exported and sold in
Thailand, based on selling prices determined
by A.
The company has a small loan from a Thai
bank.
Identifying the functional currency
Sales prices
Sales market
Expenses
Financing
Intragroup transactions
Conclusion: FC =
Case 1
HK$
$
$
$
High
$
Case 2
HK$
HK$
HK$
Low
HK$
Case 3
Baht
$
$/HK$
Baht
Medium
?? 1
1. In this case it would be necessary to determine the underlying economic substance of
the transactions and events to correctly determine the functional currency
Choice of Functional Currency
Nature of operating and financial relationship
between a parent and its foreign operation
Foreign operation operates
independently in economic
and financial matters
Foreign operation is
integrated with parent’s operation
Functional currency should be
either local or a 3rd currency
Functional currency
should be parent’s currency
Closing rate method
Remeasurement Method
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Foreign Currency Transactions of a
Stand-alone Entity (IAS 21:20-26)
Accounting Exposure
Transaction exposure:
Arises from foreign currency
transactions e.g. account receivable
denominated in a foreign currency
Translation exposure:
Arises from translation of foreign currency
financial statements of foreign operations
Results in exchange gains or losses
Results in translation gains or losses
Recorded in the books
of the individual entity
Presented in consolidated
financial statements (group level)
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Foreign Currency Transactions of a
Stand-alone Entity
Timeline of a typical foreign currency transaction
Foreign currency
transaction recorded at
actual (historical)
exchange rate giving
rise to monetary asset
or monetary liability
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Financial year end
Outstanding monetary
asset/liability translated
at year-end rate
Settlement of monetary
asset/liability translated
at rate on settlement
date
32
Foreign Currency Transactions of a
Stand-alone Entity
• Monetary Vs Non-monetary items from foreign currency
transaction:
– Monetary items are “units of currency held and assets and liabilities to
be received or paid in fixed or determinable number of units of currency”
– Examples of monetary assets and liabilities:
• Cash
• Time deposits in the bank
• Accounts and loan receivable/payable
• Tax payable (including deferred tax)
– Examples of non-monetary assets and liabilities:
• Investment in equity instruments
• Unearned revenue
• Non-refundable deposits
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Foreign Currency Transactions of a
Stand-alone Entity
• At foreign currency transaction date (IAS21:12):
– The transaction is recorded at actual spot rate
• At the ends of subsequent reporting periods (IAS21:23):
– Monetary items are remeasured or retranslated using the closing rate
• Rationale: monetary items are contractual amounts that will be settled in a
specific currency which needs to be adjusted for a change in spot rate
– Non-monetary items are translated using the rate at the date of the
transaction. No re-translation is made at subsequent reporting dates
• Rationale: non-monetary Items are originally transacted and measured at
historical rate (i.e. date of transaction)
– Non-monetary items measured at fair value are translated using the
exchange rate at date of fair value determination
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Transaction Exposure
• Items exposed to foreign exchange risks
– Foreign currency monetary items
– Non-monetary items carried at fair value
– Remeasurement at the ends of subsequent reporting periods and
settlement date will give rise to exchange gains or losses
Foreign currency
depreciates
Foreign currency
appreciates
Exposed asset
Exchange loss
Exchange gain
Exposed liability
Exchange gain
Exchange loss
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Treatment of Transaction Gains and
Losses
• Monetary items:
– Exchange gain or losses are recognized in profit or loss of the
entity (IAS21:28): date of settlement/reporting date
– Exchange gains or losses on a monetary item (e.g. an intercompany loan) that forms part of the reporting entity’s net
investment in a foreign operation shall be recognized in profit
or loss in the separate financial statements of the reporting
entity or the individual financial statements of the foreign
operation. But, in the consolidated financial statements ,
such exchange differences shall be recognized initially in
other comprehensive income and reclassified from equity to
profit or loss on disposal of the net investment. (IAS21:32)
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Treatment of Transaction Gains and
Losses
• Non-monetary items:
– Exchange gain or losses are recognized in the same way
as the gain or loss on the non-monetary item is recognized
(IAS21:30)
– E.g. Available-for-sale investment (equity): exchange
differences is recognized in equity (i.e. Other
Comprehensive Income)
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Net Investment in Foreign Operation
•
A monetary item in the form of a receivable or payable to a foreign operation for
which settlement is neither planned for nor it is likely to occur in the foreseeable
future.
− Such items (and their FX differences) are, in substance, a part of the entity’s net
investment in the foreign operation.
− In the foreign operation’s separate FS, the exchange differences are recognized
in P/L
− In the consolidated FS, the exchange differences are recognized initially in OCI
and accumulated in equity. Upon disposal (or loss of control) of the net
investment, the cumulative amount are reclassified from equity to P/L. (Similar to
the accounting treatment for an autonomous foreign operation, it is considered a
passive investment and thus the closing rate method is applied here)
38
Illustration 1:
Foreign Currency Transaction
• Ace Corporation, whose functional currency is the domestic currency
(DC) entered into the following transaction during 20x2 and 20x3
– 1/11/20x2: Purchased 1,000 shares of Hi-tech Inc (listed company
in US) at price of US$80 per share. Ace classified the investment
as trading securities
 DC/US$ as at 1/11/20x2: DC 1.79
 DC/US$ as at 31/12/20x2: DC 1.82
 Price of Hi-tech as at 31/12/20x2: US$100
– 10/12/20x2: Purchased equipment from German company
invoiced at €100,000 to be settled on 28/2/20x3.
 DC/EUR€ as at 10/12/20x2: DC 2.82
 DC/EUR€ as at 31/12/20x2: DC 2.85
 DC/EUR€ as at 28/2/20x3: DC 2.95
39
Illustration 1:
Foreign Currency Transaction
1 November 20x2
Dr
Investment in trading securities
Cr
Cash
143,200
143,200
Record purchase of shares at FX rate of DC1.79/US$1
10 December 20x2
Dr
Equipment
Cr
Accounts Payable (Euros)
282,000
282,000
To record the purchase of equipment
Comprises: 31 December 20x2
exchange
gain (2,400) Dr
Investment in trading securities
and other
Cr
Gain in FV of trading securities
gain in FV
(36,400)
Investmen
t in shares
is nonmonetary
item
carried at
FV
Equipment
is
translated
at spot
rate at
date of
purchase
38,800
38,800
Gain in FV of Hi-tech’s shares
40
Illustration 1:
Foreign currency transaction
31 December 20x2
Dr
Exchange loss
Cr
Accounts payable (euros)
3,000
3,000
To record exchange loss on A/P in euros (100k€ x [DC 2.85 – DC 2.82])
28 February 20x3
Dr
Exchange loss
Cr
Accounts payable (euros)
10,000
Account
payables
in euros is
monetary
item and
is remeasured
using the
closing
rate at
reporting
date
10,000
To record exchange loss on A/P in euros (100k€ x [DC 2.95 – DC 2.85])
28 February 20x3
Dr
Accounts payable (euros)
Cr
Cash
295,000
295,000
To record settlement of A/P in euros at spot rate of DC 2.95/€1
41
Translation of Foreign Currency
Financial Statement
Accounting Exposure
Transaction exposure:
Arises from foreign currency
transactions e.g. Account receivable
denominated in a foreign currency
Translation exposure:
Arises from translation of foreign currency
financial statements of foreign operations
Results in transaction gains or losses
Results in translation gains or losses
Recorded in the books
of the individual entity
Presented in consolidated
financial statements (group level)
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Presentation Vs Functional Currency
• A company may choose any currency as its presentation currency
• For stand-alone entity:
The presentation currency of the entity is also its functional
currency
• For the group entity:
– The presentation currency of the group is the presentation
currency of the parent company
• IAS 21 specific two approaches to translate the financial statement
Foreign
Currency
Functional
Currency
Remeasurement /
Temporal Method
Presentation
Currency
Closing Rate Method
Translation of Foreign Currency
Financial Statements
Translation from Functional Currency to Presentation Currency
• Under IAS21, Closing Rate Method is used to translate financial
statements from the functional currency to the presentation currency
• This method is applicable to:
– Stand-alone entity that record books in its functional currency but
presents its financial statements in another currency
– Foreign operation (branch, subsidiary or associate) that records its
books in its functional currency but needs to translate its financial
statements into the parent’s presentation currency for consolidation
purposes
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Foreign Operation as an Independent Entity:
Functional to Presentation Currency
• Foreign operation is viewed as a passive investment by the parent
– Parent’s aims to obtain returns from foreign operations in the
form of dividends and capital appreciation
– Value of investment is influenced by:
 Profitability of foreign operation
 Change in exchange rates
– Effect of exchange rate movements is measured using closing
rate
– Translation differences will not have an immediate impact on the
parent’s cash flow, therefore, they are taken to equity rather than
income statement
– Cumulative translation difference is taken to income when
foreign operation is disposed
45
Translation Exposure
•
Translation exposure = Net amount of assets or
liabilities in a foreign currency balance sheet that is
translated at the closing exchange rate.
•
Under closing rate method, all assets and liabilities are
translated at closing rate. So exposed item is the net
assets (assets – liabilities)
Sources of Translation Differences
Under Closing Rate Method
• Opening net assets translated at the previous closing
rate versus the current closing rate;
• Effect of exchange rate on increase or decrease in net assets
or equity during the year, e.g.
–
Net profit or loss for the year,
–
Dividends paid during the year,
–
Injection of new capital during the year
–
Other changes in equity during the year
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Translation of Foreign Currency
Financial Statements
•
Features of Closing Rate Method (IAS21, Para.39):
Items
Assets and liabilities (both monetary and non-monetary)
Income and expense items
Rate
Closing rate
Actual or average rate
Translation gain or losses are taken to equity until disposal of foreign operation
•
For practical reasons, a rate that approximates the exchange rates at
the dates of the transactions, for example an average rate for the
period, is often used to translate income and expense items. However,
if exchange rates fluctuate significantly, the use of the average rate for
a period is inappropriate. (IAS21, Para.40)
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Exchange Rates Used for Translating Items
of Statement of Financial Position
Items in SFP
Share capital and pre-acquisition retained
earnings
Post-acquisition retained earnings
Closing Rate Method
Historical rate at Acquisition Date
Usually, the Balancing figure. Not
translated using a single exchange
rate
Monetary assets and liabilities
Closing rate
Non-monetary assets and liabilities
Closing rate
Non-monetary items at fair value *
Closing rate
Translation gains or losses
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Taken to equity
(Foreign Exchange Translation
Reserve)
49
Exchange Rates Used for Translating
Items of Income Statement
Items in Income Statements
Closing Rate Method
Sales, purchases, expenses and income
statement items that result in inflow/outflow of
Actual / average rate
monetary items
Costs of sales
Depreciation, amortization and other allocation
of non-monetary items
Dividends and other appropriation of profits
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Actual / average rate
Actual / average rate
Actual rate
50
Foreign Operations Integrated with Parent:
Functional to Presentation Currency
• Parent and the foreign operation is a single economic entity
– Foreign operation’s transactions are deemed to be the parent’s
foreign currency transactions
– Translation differences have a direct impact on the parent’s cash
flows, thus they are taken to income statement
– Remeasurement procedures are the same as the treatment of
foreign transaction of a standalone entity
51
Translation Exposure: Remeasurement
Method
•
Under remeasurement method, monetary items and non-monetary items that
are measured at fair value are the “exposed” items as they are translated at
closing rate
•
Net exposed position can be either
– Net monetary asset
– Net monetary liability
•
Sources of Translation Difference:
– Effect of exchange rate changes arise on:





Opening/closing net monetary items
Increase/decrease in monetary items during the year
Non-monetary items measured at fair value
Change in basis of measurement for non-monetary items (e.g. from
historical cost to NRV)
Revaluation of non-monetary items during the year (e.g. property
revaluations)
52
Translation Exposure: Remeasurement
Method
• Under remeasurement method, exchange gain or loss on any nonmonetary items measured at fair values (i.e. revaluation or change in
basis of measurement) is accounted in the same way that gain or
loss on the revalued item is recognized
• Example:
– Gain/loss on revaluation of land is taken to equity
– Gain/loss on Available for Sale (AFS) instrument is taken to
equity
53
Exchange Rates Used for Translating
Balance Sheet Items
Balance Sheet Items
Share capital and preacquisition retained
earnings
Post-acquisition retained
earnings
Monetary assets and
liabilities
Closing Rate Method
Remeasurement Method
Historical rate
Historical rate
Not translated using a
single exchange rate
Not translated using a
single exchange rate
Closing rate
Closing rate
Non-monetary assets and
liabilities
Closing rate
Non-monetary items at fair
value*
Closing rate
Translation gains or losses
Taken to equity (foreign
currency translation
reserve)
Historical rate
(For items acquired before
acquisition date: rate at
acquisition date)
Rate at the date of the
revaluation or FV
determination
Taken to income statement
(except* is taken to equity if
the revaluation gains or
losses is taken to equity)
54
Exchange Rates Used for Translating
Income Statement Items
Income Statements Items
Closing Rate Method
Remeasurement method
Actual / average rate
Actual / average rate
Sales, purchases,
expenses, revenues and
income statement items that
result in inflow/outflow of
monetary items
Costs of sales
Actual / average rate
Actual / average rate
monetary items
Dividends and other
appropriation of profits
purchase of inventory
Historical rate of original
Depreciation, amortization
and other allocation of non-
Historical rate of original
acquisition (if acquired
before acquisition date, use
rate at acquisition date)
Actual rate
Actual rate
55
Illustration 2:
Translation Example
On 31 December 20x0 Durian Pie Ltd, whose functional and presentation
currency is the dollar ($), acquired entire share capital of Mango Pie, a foreign
company whose financial statements are prepared in local currency (FC).
MANGO PIE
Statement of financial position at 31.12.20x0
Assets
FC
Fixed assets
290,000
Prepaid insurance
18,000
Inventories
60,000
Account receivables
50,000
Cash
14,000
Accounts payable
(100,000)
Net assets
332,000
Share capital
Retained earnings
Total Equity
300,000
32,000
332,000
56
Illustration 2:
Translation Example
Additional information
a.Fixed assets comprised of the following
Net book value (FC)
Annual depreciation
Land
50,000
0
Building
100,000
5,000
Equipment
140,000
28,000
290,000
33,000
57
Illustration 2:
Translation Example
Mango Pie’s financial statements for the year ended 31 December 20x1 and
20x2 are as follows:
Income statement for years
Sales
COGS
Gross profit
Depreciation
Insurance
Operating expenses
Profit before tax
Taxation
Profit after tax
Dividend paid
Retained profit for year
31 Dec 20x1
FC
600,000
(380,000)
220,000
(33,000)
(12,000)
(78,000)
97,000
(20,000)
77,000
(25,000)
52,000
58
Illustration 2:
Translation Example
Balance sheet at
31 Dec 20x1
FC
Fixed assets (net)
Inventories
Prepaid insurance
257,000
80,000
6,000
Account receivables
70,000
Cash
89,000
Accounts payable
(98,000)
Tax payable
(20,000)
Net assets
384,000
Share capital
300,000
Retained earnings
Revaluation surplus
Total equity
84,000
0
384,000
59
Illustration 2:
Translation Example
Additional information:
1.
Sales and expenses were incurred evenly throughout each reporting period
2.
Relevant exchange rates are as follows:
At 31.12.20x0
Average for 20x1
At 31 Dec 20x1
Average rate when closing inventories (20x1) acquired
Average rate when closing inventories (20x2) acquired
Average rate for 20x2
Dividends paid (20x1)
Dividends paid (20x2)
30.09.20x2
At 31.12.20x2
1FC =
$0.81
$0.78
$0.76
$0.77
$0.74
$0.75
$0.77
$0.72
$0.71
$0.70
60
Illustration 2:
Translation Example
Required:
(a) Translate the 20x1 financial statements of Mango Pie into
dollars assuming that Mango Pie’s functional currency is the
local currency (FC)
(b) Remeasure the 20x1 financial statements of Mango Pie into
dollars assuming that Mango Pie’s functional currency is the
dollar.
61
Illustration 2:
Translation Example
Translated Profit & Loss Account (Closing Rate method)
FC
Rate
$
Sales
600,000
0.78
468,000
COGS
(380,000)
0.78
(296,400)
Gross profit
220,000
Depreciation
(33,000)
0.78
(25,740)
Insurance expense
(12,000)
0.78
(9,360)
Operating expenses
(78,000)
0.78
(60,840)
Profit before tax
Taxation
171,600
97,000
(20,000)
Profit after tax
77,000
Dividend paid
(25,000)
Retained profit for year
52,000
Retained profit b/f (1.1.20x1)
32,000
Retained profit c/f (31.12.20x1)
84,000
Sales and
expenses occur
evenly
throughout year
75,660
0.78
(15,600)
60,060
0.77
(19,250)
40,810
0.81
25,920
66,730
Represent
entirely preacquisition
earnings
(translated
at rate as at
acquisition)
62
Illustration 2:
Translation Example
Statement of Financial Position at 31.12.20x1
Assets
FC
Rate
$
Fixed assets
257,000
0.76
195,320
Inventories
80,000
0.76
60,800
Prepaid insurance
6,000
0.76
4,560
Accounts receivable
70,000
0.76
53,200
Cash
89,000
0.76
67,640
Accounts payable
(98,000)
0.76
(74,480)
Tax payable
(20,000)
0.76
(15,200)
Net assets
384,000
291,840
63
Illustration 2:
Translation Example
Statement of Financial Position at 31.12.20x1 (continued)
FC
Rate
$
Share capital
300,000
0.81
243,000
Retained earnings
84,000
From P/L
66,730
Bal. fig.
(17,890)
Foreign Currency Translation
Reserve
Total Equity
384,000
291,840
• Two ways of determining the translation loss of $17,890
 Balancing figure as shown above
 Reconciliation check (or proof of translation gain or loss)
64
Illustration 2:
Translation Example
• Reconciliation check (or proof of translation gain or loss)
Exposed Items
FC
Rate
$
Net assets b/f
332,000
0.81
268,920
Increase in net assets:
Net profit after tax
77,000
0.78
60,060
Decrease in net assets:
Dividend paid
(25,000)
0.77
(19,250)
0.76
309,730 (A)
291,840 (B)
Net assets c/f
384,000
Translation difference for the year (B – A)
(17,890)
65
Illustration 2:
Translation Example
Remeasured Profit & Loss Account (functional currency is $)
FC
Rate
$
Sales
600,000
0.78
468,000
COGS
(380,000)
Note 1
(299,000)
Gross profit
220,000
Depreciation
(33,000)
0.81 Note 2
(26,730)
Insurance expense
(12,000)
0.81 Note 3
(9,720)
Operating expenses
(78,000)
0.78
(6,840)
Note 4
10
Remeasurement loss
Profit before tax
Taxation
169,000
97,000
(20,000)
Profit after tax
77,000
Dividend paid
(25,000)
Retained profit for year
52,000
Retained profit b/f
32,000
Retained profit c/f
84,000
71,720
0.78
(15,600)
56,120
0.77
(19,250)
36,870
0.81
25,920
62,790
66
Illustration 2:
Translation Example
Note 1 – COGS
Opening inventories
Purchases
Closing inventories
COGS
FC
60,000
400,000
(80,000)
380,000
Rate
0.81
0.78
0.77
$
48,600
312,000
(61,600)
299,000
Note 2 – Depreciation expense
Depreciation expense is translated at the related fixed asset’s historical rate.
Similarly, amortization expense (if any) is also translated at related intangible
assets historical rate
Note 3 – Insurance expense
Insurance expense is amortized from prepaid insurance arising as at
31.12.20x0
67
Illustration 2:
Translation Example
Note 4: Remeasurement loss
Exposed item
Net monetary liabilities b/f
∆ in monetary assets/liabilities:
Sale
Purchases
Operating expenses
Taxation
Dividend paid
Net monetary assets c/f
Remeasurement gain (B–A)
FC
Rate
S$
(36,000)1
0.81
(29,160)
600,000
(400,000)
(78,000)
(20,000)
(25,000)
0.78
0.78
0.78
0.78
0.77
41,0002
0.76
468,000
(312,000)
(60,840)
(15,600)
(19,250)
31,150 (A)
31,160 (B)
10
68
Illustration 2:
Translation Example
1 Opening exposed monetary items:
FC
Accounts Receivable
50,000
Cash
14,000
Accounts payable
(100,000)
Net monetary item
(36,000)
2 Closing exposed monetary items:
Accounts receivable
700,000
Cash
89,000
Accounts payable
(98,000)
Tax payable
(20,000)
Net monetary item c/f
41,000
69
Illustration 2:
Translation Example
Mango Pie
Statement of Financial Position at 31.12.20x1
FC
Rate
$
Fixed assets (net)
257,000
0.81
208,170
Inventories
80,000
0.77
61,600
Prepaid insurance
6,000
0.81
4,860
Accounts receivables
70,000
0.76
53,200
Cash
89,000
0.76
67,640
Accounts payables
(98,000)
0.76
(74,480)
Tax payables
(20,000)
0.76
(15,200)
Net assets
384,000
Share capital
300,000
0.81
243,000
Retained earnings
84,000
From P/L
62,790
384,000
305,790
305,790
70
Special Issues:
Change of Functional Currency
• A change of functional currency may be due to a change:
– In primary economic environment
– In the nature of operating relationship between the foreign
subsidiary and the parent
• Functional currency changes are implemented
prospectively from the date of the change(IAS21:35)
– No restatement of prior-year financial statements
2019/10/4
71
Special Issues:
Change of Functional Currency
The Impacts are summarized as follows:
Functional currency is
changed
From
To
Local currency
Parent’s
currency
Parent’s
currency
2019/10/4
Local currency
Translation procedures
• Cumulative translation differences remain in
equity until disposal
• Non-monetary assets are translated at the
rate on the date when the change is effected
• All assets and liabilities are translated at
closing rate
• Translation differences are taken to equity
72
Change of Functional Currency
•
IAS 21 para 37 requires all assets and liabilities to be translated into the new
functional currency using exchange rate at the date of change
•
New translated amount of a non-monetary assets becomes its new historical
cost and gives rise to:
– Revised depreciation / amortization / cost of sales expense in subsequent
period
• Example: Functional currency of company is changed from dollar
(parent’s currency) to the local currency (LC)
Previously ($)
Revised (LC)
Fixed assets
1,000,000
1,500,000
Monetary net assets
200,000
300,000
Net assets
1,200,000
1,800,000
Share capital
500,000
750,000
Retained earnings
700,000
1,050,000
Equity
1,200,000
1,800,000
73
Special Issues: Goodwill Arising from
the Acquisition of Foreign Subsidiaries
Is goodwill a foreign currency asset?
•
An asset of the acquiree?
An asset in the acquirer?
Needs to be translated
No translation required
IAS 21 Para 47 states that goodwill arising on acquisition of foreign
operation shall be treated as assets of the foreign operation
•
If functional currency of the foreign operation is the local currency:
 Goodwill translated at the closing rate
•
If functional currency of foreign operation is parent’s currency:
2019/10/4  Goodwill treated as non-monetary assets and remeasured at exchange
rate at acquisition date
74
Illustration 3:
Goodwill Arising from Consolidation
• Peninsular Company, whose functional currency is the dollar ($). It
acquired the entire share capital of Straits Company on 31
December 20X1 at a cost of $2,000,000.
• At the date of acquisition, the share capital and retained earnings of
Straits Company were RM3,000,000 and RM500,000 respectively.
• The assets and liabilities of Straits Company at the date of
acquisition approximated their fair value except for a building that
was undervalued by RM100,000. Deferred tax liabilities on the
undervalued building was RM20,000.
• The exchange rate at 31 December 20X1 was RM1 = $0.50.
2019/10/4
75
Illustration 3:
Goodwill Arising from Consolidation
• The Goodwill is determined as follows:
Cost of Investment
Fair Value of Net Assets (RM3,580,000 x 0.5)
Goodwill
Goodwill in RM ($210,000 ÷ 0.50)
$2,000,000
1,790,000
$210,000
RM420,000
• The consolidation adjustment journal in $ is as follows:
Dr Share Capital
$1,500,000
Dr Retained Earnings
250,000
Dr Building
50,000
Dr Goodwill
210,000
Cr Investment in Straits Company
Cr Deferred Tax Liability
2019/10/4
$2,000,000
10,000
76
Illustration 3:
Goodwill Arising from Consolidation
• The building is depreciated on a straight-line basis over a period of 25 years.
• The exchange rate at 31 December 20X2 was RM1 = $0.45 and the average
rate for 20X2 was RM1 = $0.48.
The translation adjustments under the Closing Rate Method are:
1. Goodwill
Goodwill at 31 Dec 20X1 (RM420,000 x 0.5)
Goodwill at 31 Dec 20X2 (RM420,000 x 0.45)
Translation Adjustment
2. Fair Value Differential (after tax)
Differential at 31 Dec 20X1 (RM100,000 x 0.5 x 0.8)
Depreciation less tax (RM4,000 x 0.48 x 0.8)
Differential at 31 Dec 20X2 (RM96,000 x 0.45 x 0.8)
Translation Adjustment
2019/10/4
$210,000
189,000
($21,000)
$40,000
(1,536)
$38,464
34,560
($3,904)
77
Special Issues: Exchange Differences
Arising from Inter-company Transactions
• Inter-company transactions are normally denominated in either the
parent’s currency or the subsidiary’s currency
– Results in translation gain or loss recorded by one party
– Translation gain or loss is not eliminated as they are one-sided
• Long term loan from parent that are “quasi-equity”
– Considered as part of parent’s net investment in the subsidiary
– E.g.. Interest free loans, loans with no definite or scheduled payment
– IAS21 Para.32 requires exchange differences to be recognized initially in
Other Comprehensive Income in the consolidated financial statements
and reclassified from equity (FCTR) to profit or loss on disposal of the
net investment.
– Reclassification journal entries in consolidation:
Dr
2019/10/4
Cr
Exchange gain on loan
(I/S)
FCTR (equity)
Dr
FCTR (equity)
Cr
Exchange loss on loan 78
(I/S)
Special Issues: Exchange Differences
Arising from Inter-company Transactions
Nature of
monetary item
Monetary item
denominated
in:
Parent’s
functional
currency
Forms part of
parent’s net
investment
“Quasi-equity”
loans
Foreign
operation’s
currency
3rd currency
2019/10/4
In parent’s
book
In foreign
operation’s
books
No exchange
difference is
recorded
Records
exchange
difference on
monetary item
in I/S
Records
exchange
difference on
monetary item
in I/S
No exchange
difference is
recorded
Records
exchange
difference on
monetary item
in I/S
Records
exchange
difference on
monetary item
in I/S
In
consolidated
accounts
Exchange
difference on
monetary item
is reclassified to
equity (FCTR)
79
Special Issues: Exchange Differences
Arising from Inter-company Transactions
Nature of
monetary item
Monetary item
denominated
in:
Parent’
functional
currency
Is not part of
parent’s net
investment
Foreign
operation’s
currency
3rd currency
2019/10/4
In parent’s
book
In foreign
operation’s
books
No exchange
difference is
recorded
Records
exchange
difference on
monetary item
in I/S
Records
exchange
difference on
monetary item
in I/S
No exchange
difference is
recorded
Records
exchange
difference on
monetary item
in I/S
Records
exchange
difference on
monetary item
in I/S
In
consolidated
accounts
Flows through
to consolidated
I/S
80
Special Issues: Equity Accounting for
Foreign Associates
• Associate companies are more likely than subsidiaries to be
autonomous entities than integral operations of the investor
– Functional currency is likely to be the foreign operation’s
currency
– Financial statements are first translated to the presentation
currency (the investor’s currency) using the closing rate
method
– Equity accounting is applied subsequently to the translated
financial statements
• Apply the usual equity accounting entries
• Allocate to investor the proportionate share of foreign
2019/10/4
currency translation reserves
81
Equity Accounting for Foreign Associates
82
Equity Accounting for Foreign
Associates – illustration 4
• Strait Co. whose functional currency is $, acquired
25% interest in a foreign company, Peninsular Co.
on 31/12/20x1 for FC100,000. Peninsular’s
functional currency is FC. At the date of
acquisition, net asset of Peninsular was
FC300,000. BV is close to FV at acquisition date.
The exchange rate on date of acquisition was
$1=FC1.
• There is a goodwill impairment of FC5,000 in 20x2
Equity Accounting for Foreign
Associates – illustration 4
• Peninsular Co income statement 31/12/20x2:
• Pre-tax profit in FC
80,000
• Less tax
24,000
• Profit after tax
56,000
• Less dividend
20,000
• R/E
36,000
• Average exchange rate for 20x2 FC1 =$1.20
• Closing rate for 20x2 FC1 = $1.25
• Dividend was paid 31/12
Equity Accounting for Foreign
Associates – illustration 4
• Share of Peninsular Co profit before tax =
80,000 * 1.2 * 25% = 24,000
• Share of Peninsular Co tax expense =
24,000 * 1.2 *25% = 7,200
• Share of Peninsular Co dividend =
20,000 * 1.25 * 25% = 6,250
Equity Accounting for Foreign
Associates – illustration 4
• Share of translation difference:
• Net assets b/f
300,000
1.00 300,000
• Dividend
56,000
(20,000)
1.20
1.25
• Net assets c/f
336,000
• Add change
• Net profit
• Translation (gain)
• Share of 25%
67,200
(25,000)
342,000
1.25 420,000
77,800
19,450
Equity Accounting for Foreign
Associates – illustration 4
• Share of translation difference on goodwill:
• Cost of acquisition (FC)
• Share of net assets 25%
• Goodwill
100,000
75,000
25,000
• Translation
• Goodwill
25,000
• Less impairment(5,000)
• Goodwill c/f
• Translation (gain)
20,000
1.00
1.20
25,000
(6,000)
19,000
1.25 25,000
6,000
Special Issues:
Carrying Value of Inventories
• Inventory is carried at lower of cost or net realizable
value (NRV) (IAS2)
• If NRV of inventory is measured in a foreign currency
(IAS21:25):
– Reported carrying value is the lower of:
• Inventory cost (foreign currency) X Actual
(historical) rate
• Inventory at NRV (foreign currency ) X Closing rate
2019/10/4
88
Illustration 5: Inventory measured in
Foreign Currency
• Parco Company, whose functional currency is the dollar
($). It owns a subsidiary – Sincere Company, whose
functional currency is the FC.
• However, Sincere Company keeps its books in the
currency of $.
• At 31 December 20X1, Sincere Company has
inventories at the cost of FC100,000, which were
purchased when the exchange rate was FC1 = $1.
2019/10/4
89
Illustration 5: Inventory measured in
Foreign Currency
Scenario 1:
At 31 December 20X1, the net realizable value of
inventories was
FC105,000 and the exchange rate was FC1 = $0.90.
• Cost is FC100,000 x $1.00 = $100,000
• NRV is FC105,000 x $0.90 = $94,500
• Thus, Sincere Company would report an exchange loss
of $5,500 and the inventories at $94,500 would be
reported in Sincere Company’s financial statements and
the Group financial statements.
2019/10/4
90
Illustration 4: Inventory measured in
Foreign Currency
Scenario 2:
At 31 December 20X1, the net realizable value of
inventories was
FC88,000 and the exchange rate was FC1 = $0.90.
• Cost is FC100,000 x $1.00 = $100,000
• NRV is FC88,000 x $0.90 = $79,200
• Thus, Sincere Company would report an exchange loss
of $20,800 and the inventories at $79,200 would be
reported in Sincere Company’s financial statements and
the Group financial statements.
2019/10/4
91
Illustration 4: Inventory measured in
Foreign Currency
Scenario 3:
At 31 December 20X1, the net realizable value of
inventories was
FC93,000 and the exchange rate was FC1 = $1.10.
• Cost is FC100,000 x $1.00 = $100,000
• NRV is FC93,000 x $1.10 = $102,300
• Thus, Sincere Company would not report any exchange
loss and the inventories at cost ($100,000) would be
reported in Sincere Company’s financial statements and
the Group financial statements.
2019/10/4
92
Foreign Operation in a Hyperinflationary
Environment
•
Indicators of a hyperinflationary economy:
– Inflation rate of 100% or more over a period of 3 years;
– Interest rates, wages and prices that are linked to a price index;
– Prices that are quoted in a stable currency; and
– A general population that prefers to keep its wealth in non-monetary
assets or in a stable currency
•
Financial statements that are not adjusted for inflation are not useful (IAS 29)
– Misleading to compare transactions that occurred at different times due to
loss of purchasing power at a rapid rate
•
IAS 21 requires a restate-then-translate approach
– Financial statements for the current and previous periods are stated at
the measuring unit current at the end of the reporting period (IAS 29)
– All amounts are translated at closing rate at the date of the most recent
balance sheet date
93
Evaluation of Translation Approaches
•
Objective of translation under SFAS 52 in USA:
1. Provide information that is generally compatible with the expected
economic effects of a rate change on the enterprise’s cash flow and
equity; and
2. Reflect in the consolidated statements the financial results and
relationships of the individual consolidated entities measured in
their functional currencies
•
Evaluate the closing rate method against the above objectives:
 An appreciation in the foreign operation currency will result in a
translation gain and a loss when the currency depreciates (1st
objective)
 Financial relationships among items in the original financial
statements are preserved (2nd objective)
 A serious flaw is that the translated balances sheets are measured
neither at historical nor current value  rendering figures
meaningless in accounting terms
94
Evaluation of Translation Approaches
• Evaluate the remeasurement method against the objectives:
– Distorts the original financial ratios  hampers proper
performance evaluation
– However, it is argued that if foreign operation’s functional currency
is the same as the parent’s functional currency:

Then the original financial statements do not express the
financial results and relationships in its functional currency
– Therefore, this method attempts to “put thing right” as though the
foreign operation had been conducted in the parent’s functional
currency
95