FA4 Class notes
Barbara Wyntjes, B.Sc., CGA
Module 8: Translation and Consolidation of Foreign Subsidiaries:
Part 1:
•
•
•
•
Foreign currency risk is the net potential gain or loss, which can arise from changes
in the exchange rates, to the foreign currency exposure of the firm.
Once a foreign subsidiary is acquired, the parent is faced with two accounting
questions: What exchange rates are appropriate and how should the resulting foreign
exchange gains/losses be reflected in financial statements.
There were 4 translation methods, which resulted in different foreign exchange gains
and losses due to different foreign exchange exposures.
Section 1651 recommends that only the temporal method or the current-rate method
be used to translate statements of foreign operations. Which method used depends on
the substance of the relationship between the parent and the subsidiary.
Subsidiary is integrated or self-sustaining:
• Whether a subsidiary is integrated or self-sustaining depends on the exposure of the
parent to exchange rate changes.
• The six criteria to consider when determining exposure are: cash flows; sales prices;
sales market; labour, material and other costs; financing; and the degree of
interrelationship between the parent and the foreign subsidiary (see page 545).
• An integrated subsidiary is one in which the parent actively participates in the
subsidiary’s operating, investing, and financing activities. The parent’s exposure is as
if they had directly undertaken the transactions of the foreign operation themselves.
• A self-sustaining subsidiary is one that operates fairly independently of the parent.
Although the parent controls the subsidiary, it does not actively participate in the
subsidiary’s operating, investing, and financing activities. The parent’s exposure is
limited to its investment in the foreign operation.
Accounting methods the parent should use to translate the subsidiary’s statements:
Temporal method:
• The temporal method is used in translating the financial statements of an integrated
subsidiary.
• The temporal method translates financial statement elements using exchange rates
that will preserve the normal basis of valuation of these financial statement elements
and presents the results as if the parent itself had entered into these transactions.
• In module 7, the parent’s net monetary position was exposed to changes in the
foreign exchange rates because these items were translated to the year-end exchange
rate. Any resulting gain or loss was recognized immediately thru net income.
• Thus, as if the parent itself had entered into these transactions, when translating
the integrated subsidiary’s foreign financial statements, their net monetary position
will be exposed to foreign exchange fluctuations and any resulting gain or loss will be
recognized on the translated income statement.
1
FA4 Class notes
•
•
•
•
•
Barbara Wyntjes, B.Sc., CGA
For the financial statement elements that would normally be valued at historical cost,
historical exchange rate is used. Non-monetary assets and liabilities, share capital and
dividends (declared date = historical rate).
For the financial statement elements that would normally be valued at market value,
current exchange rate is used (ex: monetary assets and liabilities). Also, certain nonmonetary assets and liabilities if valued at market (i.e. inventory at market).
Income Statement items: revenue and expenses at average rate except
amortization/depreciation and COGS, which are translated at historical cost as they
relate to non-monetary items.
Retained earnings are translated with the rate in effect when acquired or earned.
Temporal method uses the Canadian dollar as the measuring unit and therefore,
financial ratios differ because different exchanges rates are used.
Current-rate method:
• The current-rate method is used in translating the financial statements of a selfsustaining subsidiary.
• Since the parent has little interactions with the subsidiary, only their net investment is
exposed. Thus the net assets are exposed to foreign exchange fluctuations.
• For net assets (assets – liabilities) to be exposed, they must be translated at the current
rate. Thus the all assets and liabilities are translated at the current rates. Dividends
(declared date = historical rate) and share capital at the historical rates.
• Income statement items: revenues and expenses at the rates in effect when the
revenues and expenses were recognized in income (average rate).
• Retained earnings are translated with the rate in effect when acquired or earned.
• Since the parent is independent of the subsidiary, any resulting gain or loss from the
translation of the subsidiary’s statements is not recognized thru net income but held
under Other Comprehensive Income (OCI) and closed to Accumulated Other
Comprehensive Income (AOCI) on the translated balance sheet.
• The financial statement relationships remain the same as they were when stated in the
foreign currency.
• Current rate method uses foreign currency as a measuring unit. Since most balance
sheet accounts are translated at the current rate there is no change in the underlying
relationships and thus the balance sheet financial ratios are the same. Also, the
income statement items are translated at the average rate so the relationship remains
the same and thus financial ratios are the same. However, ratios between the B/S and
I/S are different because different rates used.
Exception: Where the economic environment of the foreign operation is highly
inflationary, the temporal method should be used regardless of whether the foreign
subsidiary is self-sustaining or integrated (because non current assets and liabilities
are translated at historical rate so they are not affected by fluctuations in foreign
exchange rates).
NOTE: Never use a foreign exchange rate prior to the date of
acquisition. Thus, the most historic rate for the parent is the foreign
exchange rate on the acquisition date.
2
FA4 Class notes
Barbara Wyntjes, B.Sc., CGA
Part 2:
Exchange gain or loss under the temporal and current-rate methods:
•
Foreign exchange gains/losses for integrated foreign operations are accounted for in
exactly the same manner as foreign transactions. Monetary balances are translated at
current year-end rates. Exchange gains and losses on ALL monetary items are
reported in income. Non-monetary balances are translated at historic rates and
therefore do not result in gains and losses.
•
Unrealized foreign exchange gains and losses for self-sustaining foreign operations
are reported in ‘other comprehensive income’ (OCI) which is closed to ‘accumulated
other comprehensive income’ (AOCI) shown as a separate component of
shareholders’ equity section of the balance sheet. When all or some of the investment
in the subsidiary is sold, the cumulative unrealized foreign exchange gains or losses
are removed from AOCI and the realized foreign exchange gain or loss is reported in
the income statement.
• Option: a firm can hedge its net investment in a self-sustaining foreign subsidiary.
If the hedge is imperfect, the ineffective portion should be recognized in net income.
The effective portion of the net gain or loss would be recognized under OCI. Then
this gain or loss under OCI should be recognized in net income in the same period as
corresponding exchange gains or losses arising from the translation of the financial
statements of the self-sustaining foreign operation.
Difference between accounting exposure and economic exposure:
•
Accounting (Translation) exposure is the component of foreign currency risk that
results from translating the statements of foreign subsidiaries into Canadian dollars.
The amount of foreign exchange gains/losses recognized in the financial statements
or under Accumulated OCI varies depending on the translation method used. It does
not necessarily represent realized gains or losses. It is not a measure of economic
exposure.
•
Economic exposure is the risk that changes to foreign exchange rates have on the
earnings and cash flow of foreign operations and the long-term implications this may
have to the parent. It is measured in true economic terms, that is, whether the entity is
economically better or worse off due to the exchange rate fluctuations. Economic
wellness is difficult to measure precisely.
•
Transaction exposure exists between the transaction date and the settlement date
(Module 7).
3
FA4 Class notes
Barbara Wyntjes, B.Sc., CGA
Purchase discrepancies and goodwill for a purchased foreign subsidiary:
•
•
•
•
The purchase discrepancy calculation is complicated by having to translate each
component of the purchase price into the reporting currency, usually Canadian $.
The exchange rate in effect on the date of acquisition is used to translate each of the
underlying assets and liabilities. Do not use the exchange rate in effect when the
subsidiary acquired the assets/liabilities prior to acquisition.
In the years following acquisition, under the temporal method, in the purchase
discrepancy amortization and impairment schedule, everything is translated at historic
rates and there is no resulting gain/loss from this translation.
In the years following acquisition, under the current rate method, in the purchase
discrepancy amortization and impairment schedule, amortization/impairment loss is
translated at the average exchange rate for the current year and the
unamortized/unimpaired amount is translated at the year-end current rate. The
resulting gain/loss is included in the ‘other comprehensive income’ (OCI) which is
closed to ‘accumulated other comprehensive income’ (AOCI) shown as a separate
component of shareholders’ equity section of the balance sheet. None of this gain or
loss would relate to the NCI, as they do not participate in the purchase.
Review Example 8.6-1: Current-rate method:
Purchase price discrepancy amortization and goodwill impairment schedule:
Calculation of goodwill in U.S. dollars
Purchase price
US$50,000
Book value of SF:
(US$10,000 + 27,000)
US$37,000
CP Co.’s ownership
× 0.8
29,600
Purchase price discrepancy
20,400
Allocation:
Building (US$65,000 – 55,000) × 0.8
8,000
Goodwill
US$ 12,400
Purchase price discrepancy amortization and goodwill impairment schedule:
Jan. 1
Amortization/
20X3
× 1.40
Impairment × 1.38 Dec. 31
× 1.39
2003
2003
Building US$8,000 C$11,200
Goodwill US$12,400
17,360
C$ 28,560
US$800
US$827
C$1,104
1,141
C$ 2,245
US$7,200 C$10,008
US$11,573
16,087
C$ 26,095
Translation adjustment on PD amortization and goodwill impairment loss:
Jan.1, 20X3 balance
C$28,560
Amortization
2,245
Calculated balance, December 31, 20X3
26,315
Actual balance December 31, 20X3
26,095
Accumulated other comprehensive income (loss)
C$ (220)
4
FA4 Class notes
Barbara Wyntjes, B.Sc., CGA
Part 3:
Consolidated financial statements for foreign subsidiaries:
•
•
•
•
First, if necessary, restate the foreign subsidiary financial statements using Canadian
accounting principles.
Second, translate the financial statements and then consolidate them.
Next, consolidate the financial statements
From a consolidated viewpoint, the parent indirectly acquired the assets of the
subsidiary on the date of acquisition. Use the exchange rate on the date of acquisition
as the historical rate. Ignore all exchange rates before the acquisition date.
Consolidated financial statements for integrated foreign subsidiaries:
• Calculate CGS: BI (historical) + P (historical – assumed average) – EI (historical)
• Calculate amortization expense – match to historical rate of capital asset
• The gain/loss on translation of all monetary items is calculated.
• The foreign exchange gain/loss on the income statement is the gain or loss on
translation of monetary items.
• The current year’s purchase discrepancy amortization and any impairment loss in the
income statement are translated at the historic rate.
• The NCI on the income statement is the NCI’s percentage times the subsidiary’s
translated income adjusted for any upstream transactions and after the foreign
exchange gain or loss has been included.
• The unamortized purchase discrepancy and unimpaired goodwill translated at the
historic rate is included on the balance sheet.
• NCI on the balance sheet is the NCI’s percentage times the subsidiary’s translated
shareholders’ equity adjusted for upstream transactions.
Calculation of gain or loss from translation of an integrated subsidiary:
Net monetary bal., Dec. 31, Yr.1 = Jan. 1 Yr 2 @ historical rate at beg. of year
Changes over Yr 2:
Sales
@ average rate
Purchases - Inventory
@ historical rate (assume average)
- Capital assets
@ historical rate (transaction date)
All expenses except non-cash @ average rate
Issuance of shares
@ historical rate (transaction date)
Dividends
@ historical rate (date declared)
Net changes
$
$
Calculated position Dec. 31, Yr 2
$
Actual net monetary position Dec. 31, Yr 2: @ current rate (year-end)
$
Exchange Gain/Loss on translation thru net income
$$
5
FA4 Class notes
Barbara Wyntjes, B.Sc., CGA
Consolidated financial statements for self-sustaining foreign subsidiaries:
•
•
•
•
•
•
•
•
Calculate the gain or loss on translation of net assets closed to OCI.
The accumulated OCI from translating the subsidiary statements is allocated between
the parent and the NCI. The parent’s share is added under AOCI on the Consolidated
balance sheet.
The current year’s purchase discrepancy amortization and any impairment loss in the
income statement are translated at the average rate for the current year.
The unamortized purchase discrepancy and unimpaired goodwill is translated at the
current year-end rate and is included on the balance sheet.
The gain or loss resulting from the translation of the purchase discrepancy and
impairment schedule is allocated all to the parent under cumulative OCI.
The parent’s total cumulative OCI appear in consolidated shareholders’ equity.
The NCI on the income statement is the NCI’s percentage times the subsidiary’s
translated income adjusted for any upstream intercompany transactions.
NCI on the balance sheet is the NCI’s percentage times the subsidiary’s translated
shareholders’ equity (adjusted for any upstream intercompany transactions), including
their share of the AOCI from translating the subsidiary statements.
Calculation of gain or loss from translation of a self-sustaining subsidiary:
Net assets, Dec. 31, Yr.1 = Jan. 1 Yr 2
@ historical rate at beg. of year
Changes in net assets, over Yr 2
Capital stock
Net income
Dividends
@ historical rate (transaction date)
@ average rate
@ historical rate (date declared)
$
Calculated net assets, December 31, Yr 2
$
Actual net assets, December 31, Yr 2 @ current rate (year-end)
$
Exchange gain/(loss) from translation thru OCI
$$
OCI closed to AOCI and split between the parent’s and NCI %s.
6
FA4 Class notes
Barbara Wyntjes, B.Sc., CGA
Part 4:
Class example 1: Chapter 12, Problem 11, pages 589-591 in text.
The financial statements of Voll Inc. of Germany, as at December 31, Year 11:
Balance Sheet
Cash
DM 105,000
Accounts receivable
168,000
Inventory at cost
357,000
Land
420,000
Buildings
1,470,000
Accumulated deprecation
420,000
1,050,000
Equipment
483,000
Accumulated deprecation
168,000
315,000
DM 2,415,000
Accounts payable
210,000
Miscellaneous payables
105,000
Bonds payable
600,000
Common shares
850,000
Retained earnings
650,000
DM 2,415,000
Retained Earnings Statement
Balance, January 1
DM 420,000
Net income
630,000
Dividends
400,000
Balance, December 31
DM 650,000
Income Statement
Sales
Cost of sales
Depreciation – building
Depreciation – equipment
Other expenses
Net income
DM 3,150,000
1,680,000
105,000
63,000
672,000
DM 630,000
Other information:
1. On January 1, Year 11, Crichton Corporation of Toronto acquired a controlling
interest in Voll.
2. Exchange rates were:
January 1, Year 11
December 31, Year 11
Average for Year 11
CDN$1 = DM2.05
CDN$1 = DM2.20
CDN$1 = DM2.10
3. The land and buildings were purchased in Year 5 when the exchange rate was
DM1.50
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FA4 Class notes
Barbara Wyntjes, B.Sc., CGA
4. During the year, equipment costing DM 126,000 was purchased for cash.
Depreciation totaling DM 21,000 has been recorded on this equipment. The
exchange rate on the date of the equipment purchase was DM2.18.
The remaining equipment was purchased on the date the subsidiary was acquired
and no other changes have taken place since that date.
5. The December 31, Year 11, inventory was acquired during the last quarter of the
year, when the average exchange rate was DM2.04.
6. On January 1, Year 11, inventory was DM 525,000 and was acquired when the
average exchange rate was DM2.27.
7. Dividends were declared and paid on December 31, Year 11.
8. On January 1, Year 11, monetary liabilities were greater than monetary assets by
the amount of DM 1,082,000.
9. The common shares were issued in Year 1 when the exchange rate was DM3.00.
Required:
a) Assume that Voll is an integrated foreign operation. Translate the financial statements
into Canadian dollars.
b) Assume that Voll is a self-sustaining foreign operation. Translate the financial
statements into Canadian dollars.
a) Voll is integrated – use temporal method:
DM
Dollars
Cost of sales
Inventory Jan. 1, Yr 11
Purchases (derived)
525,000 / 2.05*
256,098
1,512,000 / 2.10
720,000
2,037,000
976,098
Inventory Dec. 31, Yr 11
(357,000) / 2.04
(175,000)
1,680,000
801,098
* The historical rate of 2.27DM (prior to acquisition) is not relevant to Crichton.
Crichton’s oldest historical rate is the acquisition date.
Equipment
Purchased Yr 11
On hand Jan. 1, Yr 11
Equipment balance, Dec. 31, Yr 11
Equipment amortization expense
Yr 11 purchase
On hand Jan. 1, Yr 11
126,000 / 2.18
357,000 / 2.05
483,000
57,798
174,146
231,944
21,000 / 2.18
42,000 / 2.05
63,000
9,633
20,488
30,121
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FA4 Class notes
Accumulated amortization
Yr 11 purchase
On hand Jan. 1, Yr 11
Barbara Wyntjes, B.Sc., CGA
21,000 / 2.18
147,000 / 2.05
168,000
Net monetary position
Balance Jan. 1, Yr 11
(1,082,000) /
Changes Yr 11:
Sales
3,150,000 /
Purchases — inventory
(1,512,000) /
— equipment
(126,000) /
Other expense
(672,000) /
Dividends
(400,000) /
Net changes
440,000
Calculated position Dec. 31, Yr 11
Actual position Dec. 31, Yr 11: net monetary position
Cash
105,000
A/R
168,000
273,000
A/P
(210,000)
Misc. payables
(105,000)
Bonds
(600,000)
(642,000) /
Exchange gain on translation Yr 11
2.05
(527,805)
2.10
2.10
2.18
2.10
2.20
1,500,000
(720,000)
(57,798)
(320,000)
(181,818)
220,384
(307,421)
2.20
(291,818)
15,603
DM
Translated income statement — Yr 11
Sales
Cost of sales
Amortization — building
— equipment
Other expense
Exchange gain
Net income
3,150,000 /
1,680,000
105,000 /
63,000
672,000 /
9,633
71,707
81,340
Dollars
2.10
calc.
2.05
calc.
2.10
2,520,000
630,000
Translated retained earnings statement — Yr 11
Balance, January 1
420,000 / 2.05
Net income
630,000
1,050,000
Dividends
(400,000) / 2.20
Balance, December 31
650,000
1,500,000
801,098
51,220
30,121
320,000
(15,603)
1,186,836
313,164
204,878
313,164
518,042
(181,818)
336,224
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FA4 Class notes
Barbara Wyntjes, B.Sc., CGA
DM
Dollars
Translated balance sheet — December 31, Yr 11
Cash
Accounts receivable
Inventory
Land
Buildings
Accumulated amortization
Equipment
Accumulated amortization
Accounts payable
Miscellaneous current payables
Bonds payable
Capital Stock
Retained earnings
105,000 / 2.20
168,000 / 2.20
357,000 / 2.04
420,000 / 2.05
1,470,000 / 2.05
(420,000) / 2.05
483,000 calc.
(168,000) calc.
2,415,000
210,000 /
105,000 /
600,000 /
850,000 /
650,000
2,415,000
2.20
2.20
2.20
2.05
47,727
76,364
175,000
204,878
717,073
(204,878)
231,944
(81,340)
1,166,768
95,455
47,728
272,727
414,634
336,224
1,166,768
Part 5:
b) Voll is self-sustaining – use current-rate method
DM
Calculation of translation gain
Net assets — Jan. 1, Yr 11 (850 + 420)
Net income — Yr 11
Dividends — Yr 11
Calculated net assets — Dec. 31, Yr 11
Actual net assets — Dec. 31, Yr 11
Exchange loss from translation (OCI)— Yr 11
1,270,000 / 2.05
630,000 / 2.10
(400,000) / 2.20
1,500,000 / 2.20
Translated retained earnings statement — Yr 11
Balances, January 1
420,000 / 2.05
Net income
630,000 / 2.10
1,050,000
Dividends
(400,000) / 2.20
Balance, December 31
650,000
Dollars
619,512
300,000
(181,818)
736,694
681,818
55,876
204,878
300,000
504,878
(181,818)
323,060
10
FA4 Class notes
Barbara Wyntjes, B.Sc., CGA
DM
Dollars
Translated income statement — Yr 11
Translated income statement – all items at average rate thus net income divided by
average rate of 2.10 equals translated net income.
Net income
Other Comprehensive Income (loss)
Comprehensive Income (loss)
630,000 / 2.10
Translated balance sheet — December 31, Yr 11
Cash
105,000 /
Accounts receivable
168,000 /
Inventory
357,000 /
Land
420,000 /
Buildings
1,470,000 /
Accumulated amortization
(420,000) /
Equipment
483,000 /
Accumulated amortization
(168,000) /
2,415,000
Accounts payable
Miscellaneous current payables
Bonds payable
Shareholders’ equity
Capital Stock
Retained earnings
Accumulated Other Comprehensive Income (loss)
2.20
2.20
2.20
2.20
2.20
2.20
2.20
2.20
300,000
(55,876)
$244,124
47,727
76,364
162,273
190,909
668,182
(190,909)
219,545
(76,364)
1,097,727
210,000 / 2.20
105,000 / 2.20
600,000 / 2.20
95,455
47,727
272,727
850,000 / 2.05
650,000
414,634
323,060
(55,876)
1,097,727
2,415,000
*NOTE: Previous past exam questions may use cumulative translation adjustment
11
FA4 Class notes
Barbara Wyntjes, B.Sc., CGA
Part 6:
Segmented financial reporting:
• Consolidated statements combine and summarize results, making it hard to assess the
risks, growth potential and profitability of different segments and to identity different
products and services offered by the firm.
• Segmented financial reporting is useful to users in assessing the entity’s performance
and the amount, timing, and certainty of future cash flows.
Current standards for segment disclosures (Section 1701)
• Segmented financial information must be provided to external users for those
segments that are regularly provided to and reviewed by the entity’s chief operating
decision maker for internal purposes (insight into management's strategic direction).
• An operating segment should be reported if the segment’s revenues, profits/losses, or
assets are > 10% of combined revenues, profits, & assets of all operating segments.
• See example in text, pages 471 and 472 for application of the quantitative thresholds.
• At least 75% of a firm’s external revenues must be reported by segment disclosures.
• S1701 provides information about sales in foreign countries and major customers
(revenue to a single customer is greater than 10%)
• Segmented information includes:
o Factors to identify the reportable segment
o Types of products/services offered by segment
o Information about profits/losses and total assets
o Reconciliation to total revenues, profits/losses and assets of the entity
Goodwill impairment test for reporting units:
• The goodwill impairment test needs to be conducted for each reporting unit.
• A reporting unit is either an operating segment or one level below, a component.
• A component of an operating segment is a reporting unit when discrete financial
information is available for management review.
• In order to be able to conduct the impairment test at the reporting unit level, assets
and liabilities need to be assigned to each reporting unit so that fair values of each
reporting unit can be determined.
• If a subsidiary has goodwill, it must also test its reporting units for goodwill
impairment.
• When the parent consolidates this subsidiary, it must conduct its own reporting unit
goodwill impairment test.
• Only if goodwill were impaired at this level would the parent recognize a goodwill
impairment loss.
• Thus, if the subsidiary reported goodwill impairment on their reporting unit that does
not necessarily mean the parent will record an impairment loss as well.
THE END
12