ACCT 6010 Advanced Financial Reporting
Foreign Currency Translation
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Learning Objectives
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After completing this topic students should be able to:
Text reference & other readings
Translate foreign currency financial statements of a net investment in a foreign operation
Arthur et al.
sections 10.3,10.7, 10.8, 10.10
Determine the functional currency of a foreign subsidiary
Arthur et al. sections 10.5
Understand the effects of exchange rate movements on consolidated financial statements
Arthur et al.
sections 10.3, 10.8, 10.10 & the potential differences between accounting and economic effects of exchange rate movements
Arthur et al.
sections 10.9 & Radhakrishnan & Tsang
Critically evaluate the current rate and “temporal” methods of translation
Arthur et al. sections 10.9
The University of 2
LS Class 10 1
References
– AASB 121 (September 2011) Arthur et al. Chapter 10
– Class 12 supplementary readings – Radhakrishnan & Tsang (2006) – Wendell (2010)
– IAS Plus Summary of IAS 21
– Link is also on Canvas
– http://www.iasplus.com/standard/ias21.htm
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1. Foreign Operations
Definition of a foreign operation:
An entity that is a subsidiary, associate, joint venture or branch of a reporting entity, the activities of which are based or conducted in a country or currency other than those of the reporting entity [AASB 121.8].
E.g., the branch of a Beijing corporation whose functional currency is (CNY) is foreign operation of that corporation.
The University of 4
LS Class 10 2
2. Functional Currency
Recall from last week:
Functional currency is the currency of the primary operating
environment in which the entity operates [AASB 121.8]
The University of 5
3. Foreign Subsidiaries
– From the perspective of Australian reporting entities, foreign subsidiaries are:
– incorporated overseas
– required to consolidate accounts with parent entity
– Where functional currency of foreign subsidiary ≠ AUD, normally need to translate foreign currency financial statements to AUD.
The University of 6
LS Class 10 3
3. Foreign Subsidiaries (cont.)
– Ramsay survey:
– Controlled entities
• Australia 65% • US 8%
– Foreign associates
– translate earnings to AUD
– Accounting for foreign currency transactions are highly contentious;
– particularly because most countries moved to a floating exchange rate system
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Subsidiaries
Australia US
Treatment of Exchange Differences
Several issues arise:
– Which exchange rates should be used to translate revenues,
expenses, assets, cash flows etc;
– Should gains or losses resulting from exchange differences be included in profit and loss (P&L), or other comprehensive income (OCI)?
The University of 9
LS Class 10 4
Translation Methods
Two methods to translate Financial Statements Current rate (C.R.) method.
– Use the C.R. method when the functional currency of the subsidiary is not the AUD. [AASB 121.39]
Temporal method
– Use when the functional currency of the subsidiary is the AUD.
Ø Refer class 11 re choice of rate
The University of 10
4. Current Rate Method – Functional currency ≠ AUD
C.R. Translation method [AASB 121.39] – All assets and liabilities:
– Translate using the closing rate, (i.e., exchange rate prevailing at the end of the reporting period.)
– Income and expenses:
– Translate at the exchange rate at the
time of the transaction;
• i.e. historical rates.
• Can use an average rate if it is a practical approximation to actual historical rates [AASB 121.40]
• Note: we do not translate profit as a separate line item Profit = translated income – translated expenses
The University of 11
LS Class 10 5
4. Current Rate Method – Functional currency ≠ AUD Capital items:
AASB 121 does not specify the rate to be used to translate equity balances (except re gains/losses recognised directly in equity [AASB 121.41(a)]
Prior standard AASB 124 specified:
Type of balance
Share Capital at acquisition
Pre-acquisition reserves/surplus
Post acquisition movements in share capital and reserves/surplus
The University of rate
rate at date of acquisition (“Historical rate”)
rate at date of acquisition (“Historical rate”)
rate at time that movement recognised in the accounts
4. Current Rate Method – Functional currency ≠ AUD
Translation gain/loss has 2 components:
– Gain (or loss) on opening net assets; and
– Gain (or loss) on increase/decrease in net assets during the year
Translation gain/loss is recognised in Other Comprehensive Income [AASB 121.39(c)]:
– “Foreign Currency Translation Reserve”
– Movement and balance disclosed in Statement of Changes in
Equity [AASB 101]
– FCTR can have a debit balance (exchange losses)
v Now do: Arthur et al. E10.2 The University of 13
LS Class 10 6
5. When Functional Currency = AUD
– Lesscommoncase.
– Applies where the foreign operation is “integrated” with parent.
– Normalruleapplies–recordtransactionsinFC – ThereforetransactionsshouldberecordedinAUD
(and financial statements prepared in AUD);
– BUT,ifbooksarekeptinalocalcurrency,balancesandtransactionswill need to be translated to the functional currency (AUD) :
– Monetary assets and liabilities:
translated to AUD at the rate applying at balance date. [AASB 121.23(a)]
– Non-monetary assets and liabilities:
translated at the rate at which they were first recognised (or revalued) [AASB 121.23(b)]
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5. When Functional Currency = AUD
– Translate income and expense items:
– translated at the rate applicable at the time they were
recognised, i.e. historic rates [AASB 121.21]
– Except for items that relate to non-monetary quantities (e.g. Depn. & COGS) which are translated at the rate that applies to the non-monetary item (i.e. the asset).
– Owners’ Equity items:
– same as ‘current rate method.’
The University of 15
LS Class 10 7
5. When Functional Currency = AUD
– Translation gain/loss is a function of net monetary assets. – i.e. monetary assets – monetary liabilities
– Gain/loss is normally taken directly to income statement. – Accounting is similar in substance to “Temporal Method”
Ø Refer Arthur et al. Table 10.2 in 10.8.1 (pp. 570 – 571).
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6. Evaluation of the methods
Current-rate method For:
– relatively simple to understand
– preserves balance sheet ratios of foreign subsidiaries
– ‘net assets’ is a more sensible definition of exposure risk of parent entity (c.f. net monetary assets)
– The FCTR has been found to be “value relevant” Against:
– Historic cost x current rate = what?
• No conceptual foundation, neither in AUD historic cost of the asset or current value of the asset
– Distorts relationship between IS and BS accounts
– Amount that parent receives as dividend may not be the same as
translated profits of subsidiary. Why? _____________
The University of 19
LS Class 10 8
6. Evaluation of the methods (cont.)
Temporal Method For:
– Consistent with the historic cost model
– Does not retain financial relationships that existed in the financial statement of the foreign subsidiary;
– Arguably, inconsistent with the effects of exchange rate movements on foreign operations from the perspective of the parent company;
– More volatility in earnings
Ø Refer Windell (2010) & Radhakrishnan and Tsang (2006)
The University of 20
7. Translation of Cash Flows
– Apply exchange rates that apply at the date that the cash flow occurs.
– Average rates are sometimes used as an approximation
– The statement of cash flows includes a line item for the effect of
exchange rate changes
– Arises because the closing balance of cash (balance sheet) is translated at the end of period rate.
– Example follows
The University of 21
LS Class 10 9
7. Translation of Cash Flows (cont.)
Translation of Cash Balances
Opening Bal.
Cash flow Effect of Exch. Rate
Closing Bal.
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8. Consolidation
Elimination of the investment
Apply exchange rates as at the date of acquisition
Intra group transactions
Normal principles apply: If inventory is transferred at a markup, adjustment is required to return the carrying value of inventory to cost to the group;
• Related tax effect will also be recorded –
based on the difference between the carrying amount to the group and the carrying amount to the individual entity
• Choice of tax rate is determined by tax rate applicable to entity selling the intra group inventory.
Ø Refer Arthur et al. examples 10.11.2 & 10.11.3 (pp. 584-586).
The University of 23
LS Class 10 10
8. Consolidation
– Goodwill
– Goodwill relating to the foreign operation is translated at
current rate at each year end
– Exchange differences go to FCTR [AASB 121.47]
– Foreign exchange gains/losses recognised in parent entitys accounts for loans being part of net investment in foreign subsidiary are transferred to FCTR in the consolidated financial statements [AASB 121.32]
Ø Refer Arthur et al. example in section 10.14.1.
– This is an exception to the general rule (par. 28) that
exchange differences go to income statement.
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9. Consolidation of the translated cash flow statement.
Prepare consolidation worksheet
– Includesacolumnfortranslatedcashflowamountsfrom foreign operation and parent CFS
– Worksheeteliminationentries:
• Transactions between entities within the group, e.g.
dividends, loans
• Elimination of cash balance of foreign subsidiary as at the date of acquisition against the cost of acquisition. Report (gross cash paid – cash held by subsidiary) as a cash flow.
The University of 25
LS Class 10 11
10. Disclosure
Disclosures include AASB 121.51-57
– Net translation gain (loss) included in profit and loss
– Reconciliation of opening and closing balances of the foreign currency translation reserve
– Statement if functional currency ≠ presentation currency
– Change of functional currency of reporting entity or
significant foreign operations, and reason for change
Ø Refer Bluescope Steel financial statements
The University of 26
LS Class 10
The University of 27
11. FX translation gain/loss (OCI)
The University of 28
11. FX translation gain/loss (OCI)
The University of 29
LS Class 10 13
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