Electronic
Presentations
in Microsoft®
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Prepared by
James Myers,
C.A.
University of
Toronto
© 2010 McGraw-Hill
Ryerson Limited
Chapter 11, Slide 1
© 2010 McGraw-Hill Ryerson Limited
Chapter 11
Translation and Consolidation of
the Financial Statements of
Foreign Operations
Chapter 11, Slide 2
© 2010 McGraw-Hill Ryerson Limited
Learning Objectives
1.
2.
3.
Contrast an enterprise’s foreign currency accounting
exposure with its economic exposure to exchange rate
changes
Differentiate between an integrated and a selfsustaining foreign operation, and describe the
translation method and functional currency that is used
in the translation of each type
Prepare translated financial statements for each type of
foreign operation
Chapter 11, Slide 3
© 2010 McGraw-Hill Ryerson Limited
Learning Objectives
4.
5.
6.
Explain how the temporal method produces results
consistent with the normal measurement and valuation
of assets and liabilities for domestic transactions and
operations
Explain why the reporting enterprise’s exposure to
exchange rate changes is limited to its net investment if
the investment is in a self-sustaining foreign operation
Use translated financial statements to prepare
consolidated financial statements, particularly in
situations where there is a acquisition differential and a
non-controlling interest
Chapter 11, Slide 4
© 2010 McGraw-Hill Ryerson Limited
Introduction

Two major accounting questions are posed by the
translation to Canadian dollars of subsidiary financial
statements presented in a foreign currency:



What exchange rates are appropriate for each balance?
How should the resulting exchange gains and losses be reflected
in the Canadian dollar financial statements?
The answers depend on the type of foreign currency
exposure the parent faces with the foreign subsidiary
LO 1
Chapter 11, Slide 5
© 2010 McGraw-Hill Ryerson Limited
Accounting Exposure versus Economic Exposure

Foreign currency exposure is the risk that a loss (or gain)
could occur as a result of changes in foreign exchange
rates.

Foreign currency exposure has three components:



LO 1
Translation exposure (accounting exposure)
Transaction exposure
Economic exposure
Chapter 11, Slide 6
© 2010 McGraw-Hill Ryerson Limited
Accounting Exposure versus Economic Exposure

Translation exposure – this exposure results from the
translation of foreign-currency-denominated financial
statements into Canadian dollars, giving rise to
exchange gains and losses



LO 1
Only those financial statement items translated at the closing
rate or forward rate create an accounting exposure since the
Canadian dollar value of those items changes every time the
exchange rate changes. These changes are referred to as
“translation adjustments”.
The value of items translated using the historical rate is fixed and
does not fluctuate with rate changes
Positive translation adjustments increase shareholders’ equity,
negative translation adjustments decrease shareholders’ equity
Chapter 11, Slide 7
© 2010 McGraw-Hill Ryerson Limited
Accounting Exposure versus Economic Exposure

Transaction exposure – this exposure represents the
foreign exchange loss or gain that can occur between
the time of entering a transaction (e.g. sale or purchase)
involving a foreign currency-denominated receivable or
payable, and the time of settling it in cash with the
customer or vendor


Refer to discussion and example in Chapter 10
The resulting cash gains and losses are realized and
affect the enterprise’s cash flows, working capital, and
earnings
LO 1
Chapter 11, Slide 8
© 2010 McGraw-Hill Ryerson Limited
Accounting Exposure versus Economic Exposure

Economic exposure – Represents a longer-term risk to
the parent that the overall value of its investment in a
foreign subsidiary will change (decrease or increase) as
a result of exchange rate fluctuations. Economic
exposure varies depending on how closely linked the
activities of the parent are to the subsidiary
LO 1
Chapter 11, Slide 9
© 2010 McGraw-Hill Ryerson Limited
Translation Methods

IAS 21 provides two methods of translating subsidiary
financial statements, described using their traditional
Canadian GAAP names:





Temporal method
Current rate method
The translation method used should reflect the parent’s
exposure to exchange rate changes
The temporal method is used if the parent is closely
linked to the subsidiary with the same functional
currency and therefore has transaction exposure
The current rate method is used if the parent is less
closely linked and uses a different functional currency,
and therefore has economic exposure
LO 2
Chapter 11, Slide 10
© 2010 McGraw-Hill Ryerson Limited
Translation Methods - Temporal

The temporal method






LO 2
Reflects parent’s close involvement with subsidiary and its cash
flows by measuring exposure to monetary assets and liabilities
Uses the Canadian dollar as the underlying unit of measure,
producing the same result as if the transaction had occurred in
Canada in the first place
All monetary items are translated at the balance sheet closing
rate
Items carried at fair value are translated at the closing rate on the
date when the fair value determination was made
Nonmonetary items are translated at applicable historical rates
(generally, the rate on the date of acquisition of the item)
Exchange gains and losses are recorded in income
Chapter 11, Slide 11
© 2010 McGraw-Hill Ryerson Limited
Translation Methods - Temporal

Monetary items represent money and claims to money
the value of which, in terms of the monetary unit,
whether foreign or domestic, is fixed by contract or
otherwise



LO 2
Payables and receivables and all other fixed claims to money are
monetary items; inventory is not
Future income tax liabilities and assets are classified as
monetary items
Estimated liabilities (such as provisions for warranties) are not
considered monetary items
Chapter 11, Slide 12
© 2010 McGraw-Hill Ryerson Limited
Translation Methods – Current Rate

The current rate method






LO 2
Reflects the exposure of the subsidiary’s net assets, and
therefore parent’s investment in subsidiary, to currency
fluctuations
Uses the foreign currency as the underlying unit of measure
All assets and liabilities are translated at closing rate
Only net assets (i.e. equity balances) are translated at the
historical rate
The translated statements retain the same ratios and
relationships that exist in local currency originals, so the
translated financial statements can provide an effective tool for
the evaluation of local management
Exchange gains and losses are recorded in Other
Comprehensive Income
Chapter 11, Slide 13
© 2010 McGraw-Hill Ryerson Limited
Translation Under IAS 21

Subsidiaries are classified as either “Integrated” or “SelfSustaining”, determining which translation method is
used



Integrated foreign operation - the foreign operations are more
closely linked to or integrated with the parent’s own operations
since the functional currency of the foreign operation is the same
as the parent’s functional currency
Self-sustaining foreign operation – the foreign operations are
less linked to the parent’s own operations and more capable of
existing on their own without the parent’s support, since the
functional currency of the foreign operation is different from the
parent’s functional currency
Exhibit 11.1 next slide provides guidance in classifying
foreign operations
LO 2
Chapter 11, Slide 14
© 2010 McGraw-Hill Ryerson Limited
Translation Under IAS 21
LO 2
Chapter 11, Slide 15
© 2010 McGraw-Hill Ryerson Limited
Translation Under IAS 21


Apply the temporal method to subsidiaries classified as
“Integrated”
Apply the current rate method to subsidiaries classified
as “Self-Sustaining”

Exception exists for self-sustaining subsidiaries in highly
inflationary economies where temporal method is more relevant


IAS 29 requires judgment to determine when an economy is highly
inflationary by examining such factors as whether the population
maintains its wealth and financial transactions in more stable foreign
currencies
See Exhibit 11.5 comparing exchange rates used in the
translation of each type of subsidiary
LO 2
Chapter 11, Slide 16
© 2010 McGraw-Hill Ryerson Limited
Translation Under IAS 21 - Comparison
LO 3
Chapter 11, Slide 17
© 2010 McGraw-Hill Ryerson Limited
Translation Under IAS 21

Integrated subsidiaries:


Because of the interdependent relationship with the parent,
translation gains and losses are reported in income just as they
would be if the parent itself had conducted the underlying
transactions
Self-sustaining subsidiaries:

Because of the more independent relationship that exists
between the parent and subsidiary, the parent’s exposure is
limited to its net investment in the subsidiary. Therefore,
translation gains and losses are reported in other comprehensive
income in the year they occur, and in cumulative other
comprehensive income in subsequent years
LO 4, 5
Chapter 11, Slide 18
© 2010 McGraw-Hill Ryerson Limited
Translation Under IAS 21

When the parent sells all or part of its self-sustaining
foreign operations, the cumulative exchange gains and
losses on the foreign operation are removed from the
cumulative other comprehensive income section of
shareholder’s equity and the realized exchange gains or
losses are reported in the regular income statement
LO 3, 4
Chapter 11, Slide 19
© 2010 McGraw-Hill Ryerson Limited
Subsequent to Acquisition


Revenues and expenses can be translated at average
rates if they occur evenly.
Amortization of allocation differential (AD):
 Integrated subsidiaries (temporal method): The
translation of AD amortization is at the historical rate
on the date of acquisition
 Self-sustaining subsidiaries (current rate method):
Translate opening AD at prior year-end closing rate,
translate amortization at average rate, and compare
ending result to ending foreign currency AD translated
at the this year’s closing rate. The difference
represents a translation gain or loss recorded in OCI
LO 3, 6
Chapter 11, Slide 20
© 2010 McGraw-Hill Ryerson Limited
Subsequent to Acquisition

Calculation of translation gain or loss:


LO 6
Integrated subsidiaries (temporal method): Calculate
expected net monetary position in foreign currency,
translate result at closing rate, and compare to actual
net monetary position. Difference is a translation gain
or loss recorded in income
Self-sustaining subsidiaries (current rate method):
Calculate expected net asset position in foreign
currency, translate result at closing rate, and compare
to actual net asset position. Difference is a translation
gain or loss recorded in OCI
Chapter 11, Slide 21
© 2010 McGraw-Hill Ryerson Limited
Illustration

Example: At the beginning of the year, parent invests
500 foreign currency units (FCU) in an integrated foreign
subsidiary when 1 FCU=1 Canadian dollar (CAD). The
net assets were held for the entire year, with no sales or
expenses incurred. At the end of the year, the exchange
rate has changed to1FCU = 1.5CAD


LO 3
The next two slides illustrate the different translation results first
by assuming the subsidiary is integrated, and then by assuming
the subsidiary is self-sustaining, using the same example above
The integrated subsidiary produces a $150 exchange loss
recorded in income while the self-sustaining subsidiary produces
a $250 gain recorded in other comprehensive income
Chapter 11, Slide 22
© 2010 McGraw-Hill Ryerson Limited
Illustration – Integrated Subsidiary
FCU Exch. Rate CAD Gain (loss)
200
Cash and A/R
300
Inventory at cost
500
Fixed assets, at cost
- 100
Accounts payable
- 400
Long-term debt
500
Net assets
Translation loss
1.5
1.0
1.0
1.5
1.5
$ 300
$ 300
$ 500
-$ 150
-$ 600
$100
$0
$0
-$50
-$200
-$150
Net monetary position at end of year = 200-100-400 = -$300
-$300 x (1.5-1.0) change in exchange rate = -$150 exchange
loss recorded in income.
LO 3
Chapter 11, Slide 23
© 2010 McGraw-Hill Ryerson Limited
Illustration – Self-Sustaining Subsidiary
FCU Exch. Rate CAD Gain (loss)
Cash and A/R
200
Inventory at cost
300
Fixed assets, at cost 500
Accounts payable
- 100
Long-term debt
- 400
Net assets
500
Translation gain
1.5
1.5
1.5
1.5
1.5
$ 300
$ 450
$ 750
-$ 150
-$ 600
$100
$150
$250
-$50
-$200
$250
Net asset position at end of year = $500
$500 x (1.5-1.0) change in exchange rate = $250 exchange
gain recorded in other comprehensive income.
LO 3
Chapter 11, Slide 24
© 2010 McGraw-Hill Ryerson Limited
Comparative Observations of the Two Translation Methods



Temporal method – the monetary position is at risk
from foreign currency fluctuations
Current rate method – the net asset position of the
foreign equity is at risk from foreign currency fluctuations
For most companies monetary liabilities are greater than
monetary assets so they are usually in a net monetary
liability position


This will result in exchange losses for integrated subsidiaries
when foreign currency appreciates in value
Most companies have positive net assets

This will result in exchange gains for self-sustaining subsidiaries
when foreign currency appreciates in value
LO 1, 2, 4, 5
Chapter 11, Slide 25
© 2010 McGraw-Hill Ryerson Limited
Other Considerations


Conformity to Canadian GAAP/IFRS: if foreign
subsidiary financial statements are prepared under
foreign GAAP they must be adjusted to Canadian
GAAP/IFRS before translation and consolidation
Lower of cost and net realizable value (NRV) – if the
foreign currency weakens, NRV of a balance such as
inventory might be lower than the item’s cost when
translated into Canadian dollars, even though it might
still be higher than cost in the foreign currency. In such
cases, if the foreign currency strengthens at a later date
and NRV translated into Canadian dollars exceeds cost
the write-down can be reversed
LO 3
Chapter 11, Slide 26
© 2010 McGraw-Hill Ryerson Limited
Other Considerations


Intercompany profits – Upstream and downstream
intercompany profits with integrated subsidiaries are
eliminated at historical cost which is the same as their
carrying values in the parent or subsidiary accounting
records. Although assets of self-sustaining subsidiaries
are translated at the closing rate, unrealized
intercompany profits with self-sustaining subsidiaries are
still eliminated at historical cost
Cash flow statement – Prepare from consolidated
balance sheet, not from cash flow statement of parent
plus translated subsidiary cash flow statement
LO 3
Chapter 11, Slide 27
© 2010 McGraw-Hill Ryerson Limited
Other Considerations

Tax effects – Foreign subsidiary financial statement
exchange translation gains and losses are usually not
taxable or deductible until realized, and are therefore
temporary differences which should be recognized as
deferred income taxes for accounting purposes
LO 3
Chapter 11, Slide 28
© 2010 McGraw-Hill Ryerson Limited
Disclosure Requirements

IAS 21 requires the following disclosures for the effects
of changes in foreign exchange rates related to foreign
operations:




LO 3
Exchange gains and losses recorded in profit and loss
Net exchange gains or losses recorded in OCI
When presentation currency is different from functional currency
the fact must be stated, indicating the functional currency and the
reason for use of a different presentation currency
When there is a change in the functional currency the fact must
be stated together with the reason
Chapter 11, Slide 29
© 2010 McGraw-Hill Ryerson Limited