CHAPTER 13
Foreign operations
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© 2005 Peter Walton and Walter Aerts
Contents






Stock exchange requirements
Segment reporting
Foreign currency transactions and foreign operations
Primary translation – reporting foreign currency
transactions in the functional currency
Secondary translation – translating individual foreign
currency financial statements in a group’s
presentation currency
Alternative accounting methods for secondary
translation
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Stock exchange requirements

Stock exchange listing as a strategic issue




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Credibility
Public awareness
Financing flexibility
IFRS accepted by most stock exchanges
IFRS not yet fully accepted in the US


SEC requires reconciliation statement on net
income and shareholders’ equity
IFRS/US GAAP convergence program (“Norwalk
Agreement”)
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Segment reporting



Business and geographical segments may
vary significantly in terms of rate of
profitability, risks and growth oppportunities
Segment reporting reflects a disaggregation
of financial statement data by line of business
and/or geographical area.
IAS 14 Segment Reporting
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Reportable segments

Primary reporting format: the company
has to identify the dominant source and
nature of the risks and returns
(business or geographical segments)
 Analysis
will concentrate on the primary
format, with nonetheless some limited
information on the other segmentation
view
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Reportable segments (cont.)


A segment is identified as a reportable
segment if a majority of its revenue is
earned from sales to external customers
and a 10% threshold of total revenue,
total results or total assets is satisfied
Reportable segments should account for
at least 75% of total consolidated
revenue
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Segment information content

Segment information elements:
Segment
 Segment
 Segment
 Segment


Top-down approach: elements of consolidated
financial statements are systematically disaggregated
into segment disclosures


revenue
expense
assets
liabilities
Directly attributable elements and the relevant portion that
can be allocated on a reasonable basis to the segment
Some awkward links with consolidation procedures
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© 2005 Peter Walton and Walter Aerts
Foreign currency effects

Foreign currency issues affect two different
areas
1.
2.

Translation of foreign currency transactions and
related individual assets and liabilities which are
denominated other than in the reporting
currency (primary translation)
Translation of the financial statements of foreign
subsidiaries for inclusion in group financial
statements (secondary translation)
IAS 21 The Effects of Changes in Foreign
Exchange Rates
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© 2005 Peter Walton and Walter Aerts
Fig. 13.1 Primary and secondary translation
Business transactions,
assets and liabilities denominated
in functional currency
Business transactions, assets
and liabilities,denominated in
other currency than FC
Primary
Translation
Individual financial
statements in functional
currency
Secondary
Translation
Individual financial
statements in (group)
presentation currency
Consolidation
Consolidated financial
statements in (group)
presentation currency
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© 2005 Peter Walton and Walter Aerts
Functional currency



The functional currency concept is central in
the translation requirements
Functional currency is defined as “the
currency of the primary economic
environment in which the entity operates”
(IAS 21, par.8)
It is determined separately for each individual
entity within a group and may require
considerable professional judgement
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© 2005 Peter Walton and Walter Aerts
Foreign currency transactions



Foreign currency transactions are business
transactions that are denominated or require
settlement in a currency other than the functional
currency of the company
On initial recognition, the foreign currency
transaction will be recorded in the functional currency
by applying the spot exchange rate between the
functional currency and the foreign currency at the
date of the transaction
But which rate to use for subsequent measurement?
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Illustration – Primary translation
(table 13.1)
UK company (reporting in £) borrows $5m on 1.1.X1,
to be repaid on 31.12.X5
Balance sheet
date
Exchange rate
£=
Loan
£ equivalent
1.1.X1
$1.60
3.125m
31.12.X1
$1.55
3.226m
31.12.X2
$1.40
3.571m
31.12.X3
$1.25
4.000m
31.12.X4
$1.30
3.846m
31.12.X5
$1.40
3.571m
How should the loan be accounted for after initial recognition?
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Illustration – Primary translation
(cont.)
Historical exchange rate or closing rate for subsequent
measurement of the loan?
1.
Maintain historical rate

£3.125m (historical equivalent), stable through time

Exchange rate changes have no impact on balance-sheet value

No recognition of value increase of the loan
OR
2.
Convert at closing rate

£3.226 (on 31.12.X1), variable through time

Exchange rate changes have impact on balance sheet value

Recognition of value changes of the loan
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Primary translation – subsequent
measurement


The accounting treatment (IAS 21) of foreign
currency balance sheet items depends on the
type of asset acquired or liability incurred
Monetary items are translated using the
exchange rate at balance sheet date


Cash, receivables, payables, loans outstanding etc
Non-monetary items are translated using the
historical rate of exchange that was in effect
at the time the item was acquired or incurred

Inventory, equipment, land etc
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Primary translation – subsequent
measurement (cont.)


Exchange differences arising on translating
monetary items at rates different from those at
which they were translated on initial recognition
or in previous balance sheets shall be
recognized in the income statement of the
period in which they arise
Identical accounting treatment for (unrealised)
exchange gains or losses
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Hedging foreign currency
transactions
UK company (reporting in £) orders a machine tool for €10,000 in
FRance (1£=€1) to be delivered in six months’ time
Risk: exchange rate € might increase leading to an increase in the
acquisition cost of the machine in £ (determined at delivery date)
Action: buy €10,000 in advance at order date (to be delivered after 6
months)
Result: machine acquisition cost in £ can be fixed at order date
IAS 21: On recognition of transaction (at delivery date)
the acquisition cost of the machine is converted at the
forward exchange rate and not at the spot rate on the
moment of delivery
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© 2005 Peter Walton and Walter Aerts
Secondary translation



Secondary translation refers to the process of
translating individual foreign currency financial
statements in a group’s presentation currency
A logical solution might be to translate all the
transactions of the foreign subsidiary as though they
had been carried by the parent company (see table
13.2)
A translation difference (gain or loss) will have to be
added to keep the translated balance sheet balancing
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Table 13.2 Consolidation exchange rates
Balance sheet item
Assets
Fixed assets
Receivables
Inventory
Cash
Financing
Equity
Share capital
Retained profit
Creditors
Long-term debt
Rate
Rate at time of acquisition
Rate at balance sheet date (best estimate of likely proceeds)
Rate at time of acquisition
Rate at balance sheet date
Rate at time of subscription
Rate ruling at successive balance sheet dates when each slice
of retained profit was added to the balance sheet
Rate at balance sheet date (best estimate of likely payments)
Rate at balance sheet date
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© 2005 Peter Walton and Walter Aerts
Illustration - Secondary translation
Historical or closing rate?
Foreign subsidiary (local currency = LC)
 1/2/20X1 – Purchase tangible fixed asset for
1m LC

Rate 1/2/20X1 – 1 LC = 10 EUR
=> Acquisition cost of fixed asset in €= €10m

31/12/20X1 – Full consolidation of subsidiary

Closing rate – 1 LC = 7 EUR
=> Translated at closing rate = €7m
What will the fixed asset value be in the group
accounts?
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© 2005 Peter Walton and Walter Aerts
Illustration - Secondary translation
Historical or closing rate? (cont.)
1.
Maintain historical rate




2.
€10m, stable through time
Exchange rate changes have no impact on balance sheet
No recognition of value decrease
Use of different exchange rates in balance sheet
Use of closing rate




€7m, variable through time
Exchange rate changes have impact on balance sheet
Recognition of value increases and decreases
One (unique) translation rate
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© 2005 Peter Walton and Walter Aerts
Secondary translation models
1.
Which translation rate for which element of
financial statements?

2.
Closing rate, historical rate, average rate
How are the translation differences treated?

Use of different translation rates always leads to
translation differences which have to be accounted for
one way or another
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Table 13.3 Exchange rates – temporal
method
Balance sheet component
Fixed assets
Depreciation
Exchange rate
Historical
Historical
Current assets
Inventory
Monetary assets
Current liabilities
Long-term liabilities
Historical
Current
Current
Current
Equity
Share capital
Retained earnings
Historical
Historical /Average
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© 2005 Peter Walton and Walter Aerts
Temporal method


Time perspective of measurement attribute
will determine the exchange rate
Rates:




Items at historical cost => Historical rate
Items at current prices/nominal value => Closing
rate
Earnings => Historical rate / Average rate
Translation differences are recognized in the
income statement
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© 2005 Peter Walton and Walter Aerts
Net investment method


Net asset value of the subsidiary is considered to be
the item to which the exchange rate risk pertains
Rates:




Closing rate (except for equity)
Equity: historical rate
Average rate for income statement
Translation differences are taken directly in equity
under a separate heading
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Worked example on translation methods





European Trading Co.plc = British parent (reporting in £)
Invests on 1/1/20X1 CHF 3M in Swiss subsidiary
Swiss subsidiary locally loans CHF 2M and buys factory
for CHF 5M
Subsidiary reports CHF 500,000 as profit for 20X1
Evolution exchange rate £ / CHF:



Rate on 1/1/20X1 :
£ 1 = CHF 4
Rate on 31/12/20X1:
£ 1 = CHF 3
Average rate during 20X1: £ 1 = CHF 3,5
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© 2005 Peter Walton and Walter Aerts
Worked example – temporal method
1 Jan 20X1 CHF' 000
Fixed assets
less Depreciation
Net current assets
Inventory
Monetary assets
Current liabilities
31 Dec 20X1 CHF'000
5,000
5,000
-250
__
__
500
750
-500
__
__
__
Long-term liabilities
Total net assets
Financed by equity
Share capital
Retained earnings
Total equity
5,000
-2,000
3,000
3,000
__
3,000
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750
5,500
-2,000
3,500
3,000
500
3,500
Worked example – temporal method
1 Jan 20X1
£’000
Fixed assets
less Depreciation
Net current assets
Inventory*
Monetary
assets
Current liabilities
Long-term liabilities
Total net assets
Equity
Share capital
Retained earnings***
Translation adjustment**
Total equity
31 Dec 20X1
£’000
1,250
—
Rate used
£=
1,250.00
-62.5
4
4
—
142.86
3.5
—
—
250
-166.67
3
3
—
1,250
-500
750
226.19
1,413.69
-666.67
747.02
750
—
—
750
750.00
142.85
-145.83
747.02
*
3
4
3.5
This rate is assumed: the temporal method requires use of the actual rate at the time the inventory was acquired, for
simplicity the example assumes that inventory was acquired uniformly throughout the year.
**
Under the temporal method the translation adjustment is charged against net income and is only shown
separately in this example in order to highlight its existence.
***Again to simplify, the depreciation cost in retained earnings is translated at the average rate and not at the historical rate.
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© 2005 Peter Walton and Walter Aerts
Worked example - closing rate method
Fixed assets
less Depreciation
Net current assets
Inventory
Monetary
assets
Current liabilities
1 Jan
20x1 £' 000
31 Dec 20x1
£' 000
1,250
1,667.67
-83.33
__
__
166.67
__
250.00
-166.67
__
__
Long-term liabilities
Total net assets
Equity
Share capital (initial)
(Translation diff.)
Retained earnings
Total equity
1,250
-500
750
750
__
__
750
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250.00
1,833.34
-666.67
1,1667.67
750.00
273.82
142.85
1,166.67
Worked example – comparing methods
Fixed assets
less Depreciation
Net current assets
Inventory
Monetary assets
Current liabilities
Long-term liability
Total net assets
Equity
Share capital
Translation
adjustment
Retained earnings
Total equity
Temporal
31 Dec 20X1
£’000
Net investment
31 Dec 20X1
£’000
1,250.00
-62.50
1,666.67
-83.33
142.86
250
-166.67
166.67
250
-166.67
226.19
1,413.69
-666.67
747.02
250.00
1,833.34
-666.67
1,166.67
750.00
750.00
-145.84
142.86
747.02
273.82
142.85
1,166.67
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Worked example – effect of translation
differences
CHF accounts
Temporal method
Net investment method
Growth
in equity
Opening
equity
Percentage
growth in year
500
3,000
16.67 %
-2.98
750
-0.40 %
416.67
750
55.56 %
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Worked example – temporal method
1 Jan
20X1
/ CHF
Fixed assets
31 Dec
20X1
/ CHF
5,000
Rate
OB
£=
(250)
4.00
(62.50)
Inventory
500
3.50
142.86
Monetary assets
750
3.00
250.00
Current liabilities
(500)
3.00
(166.67)
3.00
(666.67)
Totals
(2,000)
(2,000)
3,000
3,500
3,000
3,000
4.00
1,250
31 Dec
20X1
/£
1,250.00
LT liabilities
4.00
Rate
CB
£=
4.00
Less depreciation
5,000
1 Jan
20X1
/£
(500)
750
747.02
Financed by equity
Share capital
Retained earnings
4.00
750
500
Transl. adjustment
Totals
3,000
3,500
750
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4.00
750.00
3.50
142.86
P&L
(145.84)
747.02
Worked example – net investment method
1 Jan
20X1
/ CHF
Fixed assets
31 Dec
20X1
/ CHF
5,000
Rate OB
£=
(250)
3.00
(83.33)
Inventory
500
3.00
166.67
Monetary assets
750
3.00
250.00
Current liabilities
(500)
3.00
(166.67)
3.00
(666.67)
Totals
(2,000)
(2,000)
3,000
3,500
3,000
3,000
4.00
1,250
31 Dec
20X1
/£
1,667.67
LT liabilities
4.00
Rate
CB
£=
3.00
Less depreciation
5,000
1 Jan
20X1
/£
(500)
750
1,166.67
Financed by equity
Share capital
Retained earnings
4.00
750
500
Transl. adjustment
Totals
3,000
3,500
750
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4.00
750.00
3.50
142.85
Balance
sheet
273.82
1,166.67
Worked example – comparison of methods
Rate CB
£=
Temporal method
31 Dec 20X1 /
‘000£
Rate CB
£=
Net investment method
31 Dec 20X1 / ‘000£
Fixed assets
4.00
1,250.00
3.00
1,667.67
Less depreciation
4.00
(62.50)
3.00
(83.33)
Inventory
3.50
142.86
3.00
166.67
Monetary assets
3.00
250.00
3.00
250.00
Current liabilities
3.00
(166.67)
3.00
(166.67)
LT liabilities
Totals
3.00
(666.67)
3.00
(666.67)
747.02
1,166.67
Financed by equity
Share capital
4.00
750.00
4.00
750.00
Retained earnings
3.50
142.86
3.50
142.85
Transl. adjustment
P&L
(145.84)
Balance
sheet
273.82
Totals
747.02
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© 2005 Peter Walton and Walter Aerts
1,166.67
Functional currency and type of
foreign operation



IAS 21 sets the functional currency of a foreign
subsidiary which is heavily integrated with the
operations of the parent and for which the temporal
method is more appropriate, equal to the functional
currency of the parent
IAS 21 only refers to the closing rate method as the
method to be used whan translating foreign currency
financial statements to the presentation currency of
the group
The translation difference (under the net investment
method) is treated as a direct adjustment to equity
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© 2005 Peter Walton and Walter Aerts