Week 8 - Foreign currency translations Flashcards
What is the approach for translating FSs of foreign operations into the FUNCTIONAL currency?
Translate SOFP first then I/S
- RETAINED EARNINGS is the balancing figure for SOFP
- For the SoCI, closing R/E is transferred from SOFP & the FOREIGN EXCHANGE GAIN/(LOSS) is the balancing figure and can be reconciled
Rates used when translating SoCI items into a FUNCTIONAL currency (same as for functional-> PRESENTATION currency)
- Revenues and expenses
- Income tax expenses
- Non-monetary related expenses, eg. depreciation
- Dividends paid
- Dividends declared (dividends payable)
- Revenues and expenses - rate at date of transaction
- OR AVERAGE rate - Income tax expenses
- spot exchange rate @ balance sheet date (CLOSING RATE) - Non-monetary related expenses, eg. DEPRECIATION/amortisation
- rate used to translate related non-monetary item, usually AVERAGE RATE - Dividends paid
- spot exchange rate @ date of payment - Dividends declared (payable)
- spot exchange rate @ date the dividends are declared
Rates used when translating SOFP items into a FUNCTIONAL currency
Assets
1. Monetary
2. Non-monetary, held at historical cost
3. Non-monetary, fair value
Liabilities
4. Monetary
5. Non-monetary
Equity
6. Share capital, at acquisition
7. Reserves & retained earnings, at acquisition
8. Reserves, post acquisition
*rmb not to translate Profit & R/E! R/E is obtained as balancing figure (except R/E acquired)
Assets
1. Monetary - translate at CLOSING RATE
2. Non-monetary, held at historical cost
- spot rate @ day the asset was recorded by subsidiary
3. Non-monetary, fair value
- exchange rate @ date of valuation
Liabilities
4. Monetary - translate at CLOSING RATE
5. Non-monetary
- exchange rate @ date of valuation
Equity
6. Share capital, at acquisition
- rate when investment acquired
7. Reserves & retained earnings, at acquisition
- rate when investment acquired
8. Reserves, post acquisition
- if the transfer to reserves is the result of a revaluation of PPE, use exchange rate @ date of revaluation
What is the approach for translating FSs of foreign operations into the PRESENTATION currency?
Translate I/S first then SOFP
- the OCI (FOREIGN CURRENCY TRANSLATION RESERVE) in SOFP is the balancing figure
- in I/S, work backwards from ‘total CI for the year’ to find the closing R/E to be used in SOFP
Rates used when translating SOFP items from functional currency -> PRESENTATION currency
Assets
1. Monetary
2. Non-monetary, held at historical cost
3. Non-monetary, fair value
Liabilities
4. Monetary
5. Non-monetary
Equity
6. Share capital and reserves, at acquisition
7. Post-acquisition movements in share capital and reserves (excl. R/E or accumulated losses)
*8. Post-acquisition R/E
Translate ALL assets and liabilities at CLOSING RATE regardless of monetary or non-monetary.
Equity
6. Share capital and reserves, at acquisition
- spot rate when investment acquired
7. Post-acquisition movements in share capital and reserves (excl. R/E or accumulated losses)
- spot rate @ date they were recognised in the accounts
*8. Post-acquisition R/E
- amount determined from TRANSLATING the SoCI
How to account for DISPOSAL of foreign operation?
The amount ACCUMULATED IN EQUITY as the foreign currency translation reserve will be treated as PART OF P/L
Net assets/(liabilities) at CLOSING RATE
Less: components of net assets at historical rates
eg. Share capital
Less: Retained earnings from SoCI
» TRANSLATION GAIN to FOREIGN CURRENCY TRANSLATION RESERVE
Effects of the disposal of a foreign operations on net profit, OCI and CI
- IAS 21{The Effects of Changes in Foreign Exchange Rates} requires that the exchange differences initially recognised in OCI (and the translation reserves recorded in the separate component of equity) should be recognised in P/L on DISPOSAL of the net investment
- NO EFFECT on the total comprehensive income (CI)
- With the reclassification (‘recycling’) of OCI items to P/L, Net profit for the year may become IRRELEVANT for the evaluation of reporting period’s PERFORMANCE
- b/c exchange translation differences do not always relate to the reporting period but are the result of many years of currency exchange movements of the investment in a foreign operation - One can argue that total CI could provide a MORE RELEVANT & meaningful evaluation of firm performance (no volatility for total CI)
- supported by research finding of Chambers et al.(2007) - The ‘recycling’ may encourage parent companies not to dispose any foreign operations w/ a -ve cumulative translation reserve b/c it would affect the net profit, and therefore EPS and P/E ratio
6 reasons why many large organisations developed & engaged in numerous foreign activities
- Assessing new markets and opportunities; more investors
- Developing economies of scale {=savings in cost when production increased, as costs are spread out over a larger amount of goods}
- Take advantage of competitive benefits (eg. lower costs) in diff. locations (eg. raw materials, land, labour)
- Diversifying risk of concentrating operations in only limited geographical areas
- Accessing/exploiting new technology in other markets
- Cash flow hedging / taking advantage of lower interest rate & lower exchange rate
4 critical reviews of foreign currency translation - Should FSs of foreign operations be translated into another currency? ie. Do we need foreign currency translation?
For:
1. COMPARABILITY, need a single currency for consolidated accounts
2. Ensure consolidated FSs REFLECT the financial results and relationships between the parent and subsidiaries, as measured in the foreign currency FSs before translation
Against:
1. differences in biz environment are reflected in individual firm’s financial performance but translation does not deal with this matter
» unique suffering in diff. countries, eg. UK
- CASH will always remain in existing exchange rate of foreign country, cash is usually retained in the foreign country to maintain a command over goods & services in that environment.
- So, translation is POTENTIALLY MISLEADING and not truly representing the economic environment of the co.
4 critical reviews of foreign currency translation - Which exchange rate(s) to use to translate?
IAS 21: current/closing rate method
1. translating all A&L at the current rate MAINTAINS underlying RATIOS and relationships that exist in the foreign currency statements
2. unfortunately, A&L translated at the current/closing rate are exposed to RISK of a translation adjustment - the SoFP EXPOSURE.
- Equity is translated at historical rates (not explicitly specified in IAS 21)
When foreign currency appreciates, there is foreign exchange gain.
3. Positive translation adjustment (GAIN) for NET ASSET
*net asset = assets>liabilities, also = parent’s investment in foreign operations
» also shows how good the decisions of the parent’s executives to invest in a foreign entity are
4. Negative translation adjustment (LOSS) for NET LIABILITY
- In contrast, A&L recorded at historical exchange rate are not exposed to a translation adjustment.
4 critical reviews of foreign currency translation - How to treat the difference/imbalance resulting from foreign currency translation?
Foreign exchange (FX) translation gain/loss = the change in the imbalance between accounting periods (due to using diff. exchange rates - current, average, historical)
IAS 21 insists on one method for consistency and comparability:
1. wants all foreign currency TRANSACTIONS to be reported in the FUNCTIONAL currency (not just where the co. is located)
2. allows only current/closing rate TRANSLATION approach for consolidation - translation to PRESENTATION currency
» If translate foreign operations to presentation currency, reported in OCI and RESERVES
(not recognised in P/L because the changes in exchange rates have little or no direct effect on present & future cash flows from operations, ie. for ‘presentation’ only)
IAS 21 requirements:
3. all exchange differences arising from MONETARY items are reported in P/L in the period
> 1 exception: exchange differences arising on MONETARY items that form part of the reporting entity’s NET INVESTMENT IN A FOREIGN OPERATION are recognised initially in OCI, and in P/L on DISPOSAL of the net investment.
Functional currency vs Presentation currency
FC is the currency of the PRIMARY ECONOMIC ENVIRONMENT in which that entity operates,
- which is normally the one in which it primarily generates and expends cash.
*FC is only at individual entity level, group FC does not exist under IFRS.
Presentation currency in consolidated accounts depends on interest of INVESTORS.
*group level
Reconciliation of foreign exchange gain/(loss)
- Start with Net monetary assets/(liabilities) at Opening date
- Calculate Increases in monetary assets
eg. from sales - Calculate Decreases in monetary assets
eg. from purchases, expense - Arrive at Net monetary assets/(liabilities) at Closing date
All the while on the RHS column = CURRENT RATE less rate applied so that the far RHS column = GAIN/LOSS
Discuss whether or not a reporting entity should be allowed to present its financial statements in a currency which is different from its functional currency.
(E&E C26 Q4)
- Most entities operating in a SINGLE COUNTRY will use that country’s currency as both its functional and presentation currency.
- However, where most of the entity’s shareholders are in one country but most of its operations are in a different country (with a different currency), it would be appropriate for the functional currency to be that where most of the OPERATIONS take place but the presentation currency will be where the company is REGISTERED.
- Another example is companies which operate in the oil industry. Most of the transactions are denominated in US dollars and this will be the functional currency. However, if the company is registered in the UK, then the presentation currency may be UK pounds.
