3. Multinational Operations

Question 1

Define “local currency”.

Answer 1

Local currency is the currency of the country being referred to.

Question 2

Define “functional currency”.

Answer 2

The functional currency, determined by management, is the currency of the primary economic environment in which the entity operates. It is usually the currency in which the entity generates and expends cash. The functional currency can be the local currency or some other currency.

Question 3

Define “presentation (reporting) currency”.

Answer 3

The presentation (reporting) currency is the currency in which the parent company prepares its financial statements.

Question 4

Which are the two methods used to remeasure or translate the financial statements of a foreign subsidiary to the parent’s presentation (reporting) currency?

Answer 4

• Remeasurement: involves converting the local currency into functional currency using the temporal method.
• Translation: involves converting the functional currency into the parent’s presentation (reporting) currency using the current rate method. The current rate method is also know as the all-current method.

Question 5

How is determined which method (remeasurement-temporal or translation-current) will be used to remeasure or translate the financial statements of a foreign subsidiary to the parent’s presentation (reporting) currency?

Answer 5

The translation method, current rate or temporal, is determined by the functional currency relative to the parent’s presentation currency. But since the functional currency is chosen by management, it may not be completely objective.

Question 6

Which factors management should consider in deciding on the functional currency?

Answer 6

• the currency that influences sales prices for goods and services
• currency of the country whose competitive forces and regulations mainly determine the sale price of goods and services
• the currency that influences labor, material and other costs
• the currency from which funds are generated
• the currency in which receipts from operating activities usually retained

Question 7

Which is the appropriate translation method if the functional currency and the parent’s presentation currency differ?

Answer 7

Current rate.

Functional currency —> presentation

Question 8

Which is the appropriate translation method if the functional currency is the same as the parent’s presentation currency?

Answer 8

Temporal method.

Local currency —> functional

Question 9

Which is the appropriate translation method in the case where the local currency, the functional currency, and the presentation currency all differ?

Answer 9

In this case, the temporal method is used to remeasure from the local currency into the functional currency and the current method is used to translate from the functional currency to the presentation currency.

Question 10

In the context of international transactions, define “current rate”.

Answer 10

Current rate is the exchange rate in the balance sheet date.

Question 11

In the context of international transactions, define “average rate”.

Answer 11

Average rate is the average exchange rate over the reporting period.

Question 12

In the context of international transactions, define “historical rate”.

Answer 12

Historical rate is the actual rate that was in effect when the original transaction occurred.

Question 13

Which are the steps of applying the Current Rate Method? How to translate income statement itens, BS itens, stocks, dividends,…?
How report gain or loss?

Answer 13

. All income statements account are translated at the average rate

. All balance sheet accounts are translated at the current rate except for common stock, which is translated at the historical (atual) rate that applied when the stock was issued

. Dividends are translated at the rate that applied when they were declared

. Translation gain or loss is reported in shareholders’ equity as of the cumulative translation adjustment (CTA)

Question 14

Which the procedures to applying the Temporal Method?

Answer 14

. Monetary assets and liabilities are remeasure using the current exchange rate. Monetary assets and liabilities are fixed in the amount of currency to received or paid and include: cash, receivables, payables, and short-term and long-term debt

. All other assets and liabilities are considered non-monetary and are remeasure at the historical (actual) rate. The most common non-monetary assets include inventory, fixed assets, and intangible assets. An example of a non-monetary liability is unearned (deferred) revenue.
* there is one exception, non-monetary assets and liabilities measured on the balance sheet at ‘fair value’ are remeasure at the current exchange rate, not the historical rate

. Just like the current rate method, common stock and dividends paid are remeasure at the historical (actual) rate

. Expenses related to non-monetary assets such as COGS, depreciation expense, and amortization expense are remeasured based on the historical rates prevailing at the time of purchase

. Revenues and all other expenses are translated at the average rate

. Remeasurement gain or loss is recognized in the income statement. This results in more volatile net income as compared to the Current Rate Method whereby the translation gain or loss is reported in shareholders’ equity

Question 15

How should be translated the inventory under the Current Rate Method?

Answer 15

All balance sheet accounts are translated at the current rate except for common stock, which is translated at the historical (actual) rate that applied when the stock was issued.

Question 16

How should be remeasure inventory under the Temporal Method?

Answer 16

All non-monetary assets and liabilities should be remeasured at the historical (actual) rate.

Remember, the historical rate is the actual rate in effect when the original transaction occurred. Thus, there can be numerous historical rates to keep track of as a firm purchases inventory or other non-monetary assets over time.

Inventory can be particularly complicated since the firm’s cost flow assumptions (i.e. FIFO, LIFO, or average cost) must be considered.

Recall that ending inventory under FIFO consists of the costs from the most recently purchased goods. Thus, FIFO ending inventory is remeasured based on more recent exchange rates. In the other hand, FIFO COGS consists of costs that are older; thus, the exchange rate used to remeasure COGS are older.

…

Question 17

How is define the the parent’s exposure under the Current Rate Method?

Answer 17

Under the Current Rate Method, exposure is defined as the net asset or liability position of the subsidiary; the subsidiary’s equity.

Question 18

How is define the parent’s exposure under the Temporal Method?

Answer 18

Recall that under the Temporal Method, the non-monetary assets and liabilities are remeasured at historical rate.

Thus, only the monetary assets and liabilities are exposed to changing exchange rates. Therefore, under the Temporal Method, exposure is defined as the subsidiary’s net monetary assets or liabilities.

Question 19

In the context of international transactions, what’s CTA?

Answer 19

CTA, cumulative translation adjustment.

Translation gain or loss is reported in shareholders’ equity as a part of the CTA.

Question 20

Which rate should be used to
Translate/remeasure:

Monetary assets and liabilities under Temporal Method?

Answer 20

Current rate.

Question 21

Which rate should be used to
Translate/remeasure:

Monetary assets and liabilities under Current Rate Method?

Answer 21

Current rate.

Question 22

Which rate should be used to
Translate/remeasure:

Non-monetary assets and liabilities under Temporal Method?

Answer 22

Historical rates.

Question 23

Which rate should be used to
Translate/remeasure:

Non-monetary assets and liabilities under Current Rate Method?

Answer 23

Current rate.

Question 24

Which rate should be used to
Translate/remeasure:

Common stock under Temporal Method?

Answer 24

Historical rates.

Question 25

Which rate should be used to
Translate/remeasure:

Common stock under Current Rate Method?

Answer 25

Historical rates.

Question 26

Which rate should be used to
Translate/remeasure:

Equity (taken as a whole) under Temporal Method?

Answer 26

Mixed*

• Net income is remeasured at a “mixed rate” (i.e., a mix of the average rate and the historical rate) under Temporal Method because 1) the FX gain or loss is shown in the income statement, and 2) revenues and SG&A are remeasured at the average rate while COGS, depreciation, and amortization are remeasured at the historical rate. Equity is “mixed” because the change in retained earnings (which includes net income) is mixed.

Question 27

Which rate should be used to
Translate/remeasure:

Equity (taken as a whole) under Current Rate Method?

Answer 27

Current rate*

• Under the current rate method, total assets and liabilities are translated at the current rate. The total equity (equity taken as a whole) would then have to be translated at the current rate for the balance sheet to balance.

Question 28

Which rate should be used to
Translate/remeasure:

Revenues and SG&A under Temporal Method?

Answer 28

Average rate.

Question 29

Which rate should be used to
Translate/remeasure:

Revenues and SG&A under Current Rate Method?

Answer 29

Average rate.

Question 30

Which rate should be used to
Translate/remeasure:

COGS under Temporal Method?

Answer 30

Historical rates.

Question 31

Which rate should be used to
Translate/remeasure:

COGS under Current Rate Method?

Answer 31

Average rate.

Question 32

Which rate should be used to
Translate/remeasure:

Depreciation and amortization under Temporal Method?

Answer 32

Historical rates.

Question 33

Which rate should be used to
Translate/remeasure:

Depreciation and amortization under Current Rate Method?

Answer 33

Average rate.

Question 34

Which rate should be used to
Translate/remeasure:

Net income under Temporal Method?

Answer 34

Mixed rate*

• Net income is remeasured at a “mixed rate” (i.e., a mix of the average rate and the historical rate) under Temporal Method because 1) the FX gain or loss is shown in the income statement, and 2) revenues and SG&A are remeasured at the average rate while COGS, depreciation, and amortization are remeasured at the historical rate. Equity is “mixed” because the change in retained earnings (which includes net income) is mixed.

Question 35

Which rate should be used to
Translate/remeasure:

Net income under Current Rate Method?

Answer 35

Average rate.

Question 36

Which rate should be used to
Translate/remeasure:

Exposure under Temporal Method?

Answer 36

Current rate (applied on monetary net asset/liability).

Question 37

Which rate should be used to
Translate/remeasure:

Exposure under Current Rate Method?

Answer 37

Current rate (applied on net assets/liabilities).

Question 38

How translation gain or loss is reported under Current Rate Method?

Answer 38

Under Current Rate Method, the translation gain/loss is reported in shareholders’ equity as a part of the CTA.

Question 39

How remeasurement gain or loss is reported under the Temporal Method?

Answer 39

Under the Temporal Method, the remeasurement gain/loss is reported in the income statement as ‘Remeasurement gain/loss’.
Reporting the gain or loss in the income statement results in more volatile net income.

Question 40

How the Current Rate affects pure balance sheet and pure income statements ratios?

Answer 40

Pure balance sheet and pure income statements ratios are unaffected by the application of the current rate method.

Question 41

How the Current Rate Methods affect mixed balance sheet/income statements ratios?

What do you need remember for the exam day?

Answer 41

It is not a clear-cut analysis as pure ratios. But, we can make one definitive statement: mixed ratios calculated from financial statements translated using the current rate method will be different than the same ratio calculated from the local currency statements before translation.

For the exam day: JUST FOR USING eND-OF-PERIOD BALANCE SHET FIGURES

• if the foreign currency is depreciating, translated mixed ratios (with an income statement item in the numerator and an end-of-period balance sheet item in the denominator) will be larger than the original ratio
• if the foreign currency is appreciating, translated mixed ratios (with an income statement item in the numerator and an end-of-period balance sheet item in the denominator) will be smaller than the original ratio

Question 42

What happens to subsidiaries’ assets and liabilities operating in hyperinflationary economies using the Current Rate Method?

Answer 42

In hyperinflation economies, using the Current Rate Method to translate will result in much lower assets and liabilities after translation. Using the lower values, the subsidiary seems to disappear in the parent’s consolidated financial statements.

Question 43

You know: in a hyperinflationary economy, if you use the Current Rate Method, the assets and liabilities will seem disappear after translation. But, in reality the real value of the non monetary assets and liabilities is typically not affected by hyperinflation because the local currency-denominated values increase to offset the impact of inflation (e.g., real estate values rise with inflation). So you will adjust assets and liabilities for inflation under both US GAAP and IFRS and everything is ok.

TRUE OR FALSE?

Answer 43

False. Unfortunately, adjusting non-monetary assets and liabilities for inflation is not allowed under US GAAP; although, adjusting for inflation is permitted under IFRS.

Question 44

FASB and IASB definition for hyperinflationary environment.

Answer 44

According to FASB, a hyperinflationary environment is one where cumulative inflation exceeds 100% over a 3-year period. Assuming compounding, an annual inflation rate of more than 26% over there year will result in cumulative inflation over 100% (1,26^3 - 1).

IASB does not specifically define hyperinflation; however, cumulative inflation of over 100% in a 3-year period is one indication that hyperinflation exists.

Question 45

When hyperinflation is present, what change with the functional currency definition method under US GAAP and under IFRS?

Answer 45

When hyperinflation is present, the functional currency is considered to be the parent’s presentation currency; thus, the temporal method is used to remeasure the financial statements.

Unlike US GAAP, the temporal method is not used in hyperinflationary environment under IFRS. Instead, the foreign currency financial statements are restated for inflation and then translated using the Current Rate Method.

Question 46

Unlike US GAAP, the Temporal Method is not used in a hyperinflationary environment under IFRS. Instead, the foreign currency financial statements are restated for inflation and then translated using the Current Rate Method. Which the procedure for restating for inflation?

Answer 46

Restating for inflation involves the following procedures:

. Non-monetary assets and non-monetary liabilities are restated for inflation using a price index. Since most non-monetary items are reported at historical cost, simply multiply the original cost by the change in the price index for the period between the acquisition date and the balance sheet date

. It is not necessary to restate monetary assets and monetary liabilities

. The income statement items are restated by multiplying by the chance in the price index from the date the transaction occur (usually average)

. THE NET PURCHASING POWER GAIN OR LOSS US RECOGNIZED IN THE INCOME STATEMENT BASED ON THE NET MONETARY ASSET IR LIABILITY EXPOSURE. Holding monetary assets during inflation results in a purchasing power loss. Conversely, holding monetary liabilities during inflation results in a purchasing power gain. This figure forces the net income to be same as the net income figure that was the plug figure in the statements of retained earnings

. The components of shareholders’ equity (other than retained earnings) are restated by applying the change in the price index from the beginning of the period of the date of contribution if later

. Retained earnings is the plug figure that balances the balance sheet

. In the statement of retaining earnings, net income is the plug figure

Question 47

How to treat dividends under Current Rate Method and Temporal Method?

Answer 47

Dividends are remeasured/translated using the historical rate on the date the dividends were paid.

Question 48

Under IFRS, in a country that is experiencing hyperinflation, monetary liabilities will result in purchasing power gain or loss?

Answer 48

Under IFRS, non-monetary items are not exposed to purchasing gain or losses during inflation. Monetary assets will result in purchasing power loss and monetary liabilities will result in purchasing power gain.