Advanced Financial Accounting I
ADMS 4520 – Winter 2012 – Patrice Gelinas
Lecture 11 – Translation and Consolidation of the Financial Statements of
Foreign Operations – Mar 23
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?
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:
o Translation exposure (accounting exposure)
o Transaction exposure
o Economic exposure
- Translation exposure – this exposure results from the translation of foreigncurrency-denominated financial statements into Canadian dollars, giving rise to
exchange gains and losses
o 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”.
o The value of items translated using the historical rate is fixed and does not
fluctuate with rate changes
o Positive translation adjustments increase shareholders’ equity, negative
translation adjustments decrease shareholders’ equity
- 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
o 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
- 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
Translation Methods
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IAS 21 provides two methods of translating subsidiary financial statements,
described using their traditional Canadian GAAP names:
o Temporal method
o 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
Translation Methods – Temporal
- The temporal method
o Reflects parent’s close involvement with subsidiary and its cash flows by
measuring exposure to monetary assets and liabilities
o 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
o All monetary items are translated at the balance sheet closing rate
o Items carried at fair value are translated at the closing rate on the date when
the fair value determination was made
o Nonmonetary items are translated at applicable historical rates (generally, the
rate on the date of acquisition of the item)
o Exchange gains and losses are recorded in income
- 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
o Payables and receivables and all other fixed claims to money are monetary
items; inventory is not
o Future income tax liabilities and assets are classified as monetary items
o Estimated liabilities (such as provisions for warranties) are not considered
monetary items
Translation Methods – Current Rate
- The current rate method
o Reflects the exposure of the subsidiary’s net assets, and therefore parent’s
investment in subsidiary, to currency fluctuations
o Uses the foreign currency as the underlying unit of measure
o All assets and liabilities are translated at closing rate
o Only net assets (i.e. equity balances) are translated at the historical rate
o 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
o Exchange gains and losses are recorded in Other Comprehensive Income
Translation under IAS 21
- Subsidiaries are classified as either “Integrated” or “Self-Sustaining”, determining
which translation method is used
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o 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
o 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
Apply the temporal method to subsidiaries classified as “Integrated”
Apply the current rate method to subsidiaries classified as “Self-Sustaining”
o 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
Integrated subsidiaries:
o 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:
o 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
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
Subsequent to Acquisition
- Revenues and expenses can be translated at average rates if they occur evenly.
- Amortization of allocation differential (AD):
o Integrated subsidiaries (temporal method): The translation of AD
amortization is at the historical rate on the date of acquisition
o 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
- Calculation of translation gain or loss:
o 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
o 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
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
o This will result in exchange losses for integrated subsidiaries when foreign
currency appreciates in value
- Most companies have positive net assets
o This will result in exchange gains for self-sustaining subsidiaries when
foreign currency appreciates in value
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
- 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
- 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
Disclosure Requirements
- IAS 21 requires the following disclosures for the effects of changes in foreign
exchange rates related to foreign operations:
o Exchange gains and losses recorded in profit and loss
o Net exchange gains or losses recorded in OCI
o 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
o When there is a change in the functional currency the fact must be stated
together with the reason