advanced accounting 6e by jeter chaney chapter 13

Advanced Accounting

Jeter ● Chaney

Translation of Financial
Statements of Foreign Affiliates

1

Prepared by Sheila Ammons, Austin Community College


Learning Objectives

•
•
•
•

Distinguish between the current exchange rate and the historical exchange rate.

•

Distinguish between the circumstances under which each of the two methods is appropriate
under current GAAP.

Understand the objectives of financial statement translation.
Identify the functional currency of a foreign entity.
Compare the two methods used to convert the financial statements of a foreign entity into U.S.
dollars.

2
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Learning Objectives

•
•
•
•
•

Explain the factors involved in translating the statements of a foreign entity operating in a
highly inflationary economy.
Translate the statements of a foreign entity when the functional currency is the local currency.
Translate the statements of a foreign entity when the functional currency is the U.S. dollar.
Understand the concept of comprehensive income in the context of foreign currency translation.
Identify the disclosure requirements for firms with foreign entities.

3
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Translation of Financial Statements

•

A U.S. company may be involved in foreign activities through the operations of a:

•

If the foreign entity maintains its books in a foreign currency,

– branch,
– subsidiary, or
– investee company.

– Its accounts must be restated into U.S. dollars before they are combined or consolidated or
the equity method of accounting applied.

4
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Accounting for Operations in Foreign Countries

•

A foreign subsidiary is consolidated if the parent company owns, directly or indirectly, a
controlling interest in the voting stock of the subsidiary. Exceptions include:

– The intent to control is likely to be temporary.
– Control does not actually rest with the parent company.
• Government imposed:
– Restriction on withdrawal of assets
– Exchange restrictions.

Foreign statements that are not in conformity with U.S. GAAP must be adjusted to conform to U.S. standards
before conversion into U.S. dollars.

5
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Translating
Statements
of Foreign
Accounting for Operations
in Foreign
CountriesAffiliates

•

The conversion from another currency into the currency of the parent company is frequently
called “translation.”

Translation Process

Current Exchange Rate
Financial Statements in U.S.

Financial Statements in Euros

Dollars
Historical Exchange Rate

LO 1 Current versus historical exchange6 rates.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.

Translating Statements of Foreign Affiliates
Translation Adjustment or Translation Gain or Loss

•
•

The difference between translating some accounts using the current exchange rate and others
using the historical exchange rate.
Current accounting standards require the translation adjustment (gain or loss) be reported

– currently in income or
– deferred as a component of stockholders’ equity,
– depending on the method used to translate the accounts.

Not a Choice

LO 1 Current versus historical exchange7 rates.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Objectives of Translation
Functional Currency Concept

•
•

Objectives of translation – FASB ASC section 830-30:
Provide information regarding the exposed economic effects of an exchange rate change on an
enterprise’s cash flows and equity.

•

Reflect in consolidated statements the financial results and relationships measured in their
functional currencies in conformity with U.S. GAAP.

The Board believes that the operating performance and financial condition of a foreign entity are best measured by expressing its accounts in the currency of the
economic environment in which it primarily conducts its operations and generates and expends its cash, its functional currency.

8
LO 2 The objectives of translation.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Translation Methods
• To accomplish the objectives of translation, two translation methods are

used depending on the

functional currency of the foreign entity.

1.
2.
•

Current rate method
Temporal method

Current rate method

–

–

All assets and liabilities are translated at current exchange rate.
Revenues and expenses are translated at the exchange rate on the date which each transaction
occurred .

•

An appropriate average rate can be used.

9
LO 4 Two methods of conversion.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Translation Methods
•

Temporal Method

–
–
–
–
–

Monetary assets and liabilities (cash, a/r, a/p).

•

Translated at current exchange rate.

Assets and liabilities carried at historical cost.

•

Translated at historical exchange rates.

Assets and liabilities carried at current values.

•

Translated at current exchange rate.

Revenues and expenses related to assets and liabilities translated at historical rates.

•

Translated at historical exchange rates.

Other revenues and expenses

•

Translated at exchange rate on date transaction occurred.

10
LO 4 Two methods of conversion.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.

Identifying the Functional Currency
The Functional Currency may be

1.

The local currency of the foreign entity,

2.

The U.S. dollar, or

3.

The currency of a third country.

Economic Indicators of Functional Currency:



Cash flow



Expenses



Sales prices



Financing



Sales market



Intercompany transactions

11
LO 3 Identifying the functional currency.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Identifying the Functional Currency
Review Question
Indicators that the local currency is also the functional currency include all of the following except:

a)
b)
c)
d)

The majority of the cash flows are in the local currency.
Sales prices are determined by local market conditions.
Financing is generally from the parent or guaranteed by the parent.
Production costs and expenses are determined by local conditions.

12
LO 3 Identifying the functional currency.
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Translation of Foreign Currency Financial Statements

•

Remeasurement is the process of translating the accounts of a foreign entity into its functional
currency when they are stated in another currency.

•

Translation. Accounts measured in the functional currency are translated into the reporting
currency using the current rate method.

“Translation” may be used synonymously with the current method, “remeasurement” is used synonymously with the temporal method.

LO 4 Which methods of conversion13to use.
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Translation of Foreign Currency Financial Statements
Accounts stated in local currency of foreign entity.

Is the foreign economy highly

Determine the functional currency (FC) per

No

inflationary?

economic indicators.

Yes
Functional currency (FC) is

Is the FC the U.S. dollar?

U.S. Dollar.

No

Is the FC the local currency?

Yes
Yes

No
Translate to

Remeasure to U.S. dollars using

Remeasure to

U.S. dollars using current rate

temporal method.

FC using temporal method.

method.

LO 4 Which methods of conversion14to use.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Translation of Foreign Currency Financial Statements
Foreign Entity Operates in Highly Inflationary Economy

•

It is the Board’s belief that the currency of a country that has a highly inflationary economy has
lost its utility as a store of value and cannot be a functional measuring unit.

– This means the foreign financial statements should be translated using the temporal
method.

15
LO 6 Foreign entity operating in a highly inflationary economy.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Translation of Foreign Currency Financial Statements
Foreign Entity Operates in Economy that is Not Highly Inflationary - Functional currency must
be identified. Translation process:

– Local currency is the functional currency.
• Current rate method; Translation adjustment recorded as a separate component of
stockholders’ equity.

– U.S. dollar is the functional currency.
• Temporal method; Translation adjustment reported in income statement.
– Functional currency is the currency of a third country.
• Remeasure using temporal method, remeasured functional amounts are translated;

Translation gain or loss (temporal)is reported in income and adjustment (current rate)
is recorded as a separate component of stockholders’ equity.

16
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Translation of Foreign Currency Financial Statements

Books kept in
Local currency

Remeasurement

local currency

Not necessary

Temporal

Temporal

method

method

Functional

Local

U.S.

A third

currency

currency

dollar

currency

Translation

Current rate method

Not necessary

Current rate method

U.S. dollar

U. S. dollars

17
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Translation – Current Rate Method
•

Current Rate Method

 Assets and liabilities
 Paid-in capital
 Beginning R/E

•

 Dividends
 Revenue and Expenses
 Cumulative translation adjustment
 Current year translation adjustment

Translation

 Current exchange rate
 Historical rate
 Equals ending balance of last year
 Historical rate when dividend is declared
 Average exchange rate

 Balance amount in the balance sheet
 Other comprehensive income (shareholders’
equity)

18
LO 7 The functional currency is the local currency.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Translation – Current Rate Method
Exercise 13-4: On January 1, 2014, Trenten Systems, a U.S.-based company, purchased a controlling interest in Grant Management
Consultants located in Zurich, Switzerland.
Direct exchange rates for Swiss franc are:
Dollars per Franc
January 1, 2014

$.5987

December 31, 2014

.5321

Average for 2014

.5654

Dividend declaration and payment date

.5810

Required: Translate the year-end balance sheet and income statement of the foreign subsidiary using the current rate method of
translation.

19
LO 7 The functional currency is the local currency.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Translation – Current Rate Method
Exercise 13-4: (Current Rate Method)

20
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Translation – Current Rate Method
Exercise 13-4: Prepare a schedule to verify the translation adjustment.
Swiss

Translation
Francs

Exposed net asset position - 1/1

Rate

30,000

$

$.5987

17,961

.5654

25,443

Adjustment for changes in net asset position:
Net
Dividends

income

45,000

(15,000)

.5810

Net asset position translated

(8,715)

---

Exposed net asset position - 12/31

60,000

Cumulative translation adjustment (debit)

34,689
.5321

31,926
(2,763)

21
LO 7 The functional currency is the local currency.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Translation – Current Rate Method
Review Question
Under the current method of currency translation, which of the following balance sheet accounts is
translated at historical exchange rates?

a)
b)
c)
d)

Cash
Accounts Receivable
Bonds Payable
Common Stock

22
LO 7 The functional currency is the local currency.

Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Translation – Temporal Method
•

Temporal Method

–
–
–
–

Monetary assets and liabilities (cash, a/r, a/p).

–

Other revenues and expenses.

Assets and liabilities carried at historical cost.
Assets and liabilities carried at current values.
Revenues and expenses related to assets and
liabilities translated at historical rates.

•

Translation

–
–

–
–
–

Current exchange rate.
Historical exchange rates.
Current exchange rate.
Historical exchange rates.
Exchange rate on date transaction occurred.

LO 8 The functional currency is the U.S.23dollar.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Translation – Temporal Method
Exercise 13-5: On January 1, 2014, Trenten Systems, a U.S.-based company, purchased a controlling interest in Grant Management
Consultants located in Zurich, Switzerland.
Direct exchange rates for Swiss franc are:
Dollars per Franc
January 1, 2014

$.5987

December 31, 2014

.5321

Average for 2014

.5654

Dividend declaration and payment date

.5810

Required: Convert (remeasure) the financial statements of the foreign subsidiary using the temporal method of translation.

24
LO 7 The functional currency is the local currency.
Copyright © 2015. John Wiley & Sons, Inc. All rights reserved.


Translation – Temporal Method
Exercise 13-5: (Temporal Method)

25
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