BA606 FINANCIAL ACCOUNTING

BA606 FINANCIAL ACCOUNTING Professor Garry Carnegie Lectures 17 & 18

Lectures 17 & 18: Foreign currency translation • Introduction • Unit of measurement • Currency translation • Foreign currency translation • Accounting standards • Hedging of transactions

Introduction • Many Australian entities engage in international activities • Such activities include exporting or importing goods and services, operating a foreign entity in another country and borrowing from, or lending to, entities located in other countries • Foreign transactions and foreign currency financial statements are required to be translated into the currency of the reporting entity

Introduction • This topic deals with the accounting issues that result from transactions with entities that are located overseas and from the overseas operations of local entities • Two “preliminary matters” require attention: • Unit of measurement • Currency translation

Unit of measurement • Transactions and other past events are to be expressed in financial statements in a common unit of measurement, such as the Australian dollar (AU$) as required for entities that are incorporated under the Corporations Act 2001 • The currency of the country in which the entity is incorporated is known as the “domestic” currency • Domestic currency, as the unit of measurement, is generally used in preparing financial statements

Unit of measurement • Two other related terms are relevant • AASB 121 “The Effects of Changes in Foreign Exchange Rates” introduces the following terms: - Functional currency - Presentation currency

Unit of measurement • “Functional currency” is defined as “the currency of the primary economic environment in which the entity operates” (para. 8) • “Presentation currency” is defined as “the currency in which the financial report is presented” (para. 8)

Unit of measurement • Each entity must determine its functional currency and measure its financial performance and financial position in accordance with that currency • The presentation currency is then selected • AASB 121 states “… for the purpose of reporting under the Corporations Act, entities are only permitted to present a financial report which purports to be drawn up in accordance with the Corporations Act in one presentation currency (para. AUS 38.1)

Unit of measurement • When an entity chooses a presentation currency other than its functional currency, AASB 121 prescribes the procedures for translating (or converting) from the functional currency to the presentation currency (paras. 38 and 39)

Currency translation • Transactions in a foreign currency are to be “translated” (that is, converted) into the domestic currency • A foreign exchange rate is to be ascertained and applied for this purpose • A foreign exchange rate is the price at which one country’s currency can be converted into the currency of another country in the foreign exchange market

Currency translation • The exchange may be immediate or at some future (that is, forward) moment • The immediate rate is known as the “spot rate” • On Wednesday, 17 September 2008, the following retail exchange rates are stated in the Australian Financial Review (page 51): - Buying rate US$0.7977 (2007 $0.8909) - Selling rate US$0.7829 (2007 $0.8816)

Currency translation • The terms “buying” and “selling” refer to buying and selling Australian dollars • The difference between these two rates is the foreign currency dealer’s margin • Where the exchange rate is determined now but the currency is delivered later, such as in three or six months’ time, the rate is known as the “forward rate”

Currency translation • Exchange rates are determined by the supply of and demand for the respective currencies concerned • Changes in exchange rates can lead, of course, to exchange gains or losses • An entity can protect itself against the risk of exchange loss in three main ways

Currency translation • An entity may borrow foreign currency equal in amount and maturity to its overseas accounts receivable • An entity may simultaneously sell goods and purchase goods in a foreign currency for identical amounts • An entity may enter a “forward exchange agreement” (that is, a written agreement) to cover its transactions

Currency translation • A forward exchange agreement is entered into with a bank or another party to exchange currencies of different countries one or two months in the future at a price (the forward exchange rate) that is specified at the time of the agreement • The entity’s bank or other party charges a commission for entering into this commitment

Currency translation • Such agreements enable domestic sellers or purchasers of goods and services to establish, at the time of sale or purchase, the actual amount in AU$ that will be received or paid for a specific foreign currency amount • Accordingly, the agreement insulates the entity against the effects of exchange rate fluctuations

Foreign currency translation • Foreign currency translation may be classified broadly as relating to: - Foreign currency transactions - Foreign-based operations

Foreign currency translation • Foreign currency transactions • Foreign sales and purchases that are made on credit give rise to accounts receivable and accounts payable respectively • The effects of changes in exchange rates on short-term monetary items dominated in a foreign currency are reflected in the entity’s accounts

Foreign currency translation • Short-term monetary items include the following two categories: - Foreign sales - Foreign purchases

Foreign currency translation • Foreign sales • Where an entity sells goods or services on credit with settlement in a fixed amount of foreign currency, the entity will incur foreign exchange gains and losses if there is a change in exchange rates between the date of sale and the settlement date • Study Example 29.2 (H, P & H, pp. 953-955)

Foreign currency translation • Foreign purchases • Where an entity purchases goods or services on credit with settlement in a fixed amount of foreign currency, the entity will incur foreign exchange gains and losses if the exchange rates between the date of purchase and the date of settlement changes • Study Example 29.3 (H, P & H, pp. 955-956)

Foreign currency translation • Long-term monetary items • Entities that borrow or lend in a foreign currency are also susceptible to foreign exchange gains and losses • Such gains and losses are to be recognised in the income statement on the same basis, as outlined, for foreign sales and foreign purchases (that is, in the period in which they arise)

Foreign currency translation • Foreign-based operations • Such operations include foreign branches, subsidiaries or other reporting entities whose financial statements are expressed in the currency of the country in which they conduct business • For an Australian entity, such financial statements are to be translated into Australian dollars

Foreign currency translation • The prime purpose of translation is to incorporate the results of foreign operations into the economic entity’s financial reports • Alternatively, in evaluating the actual performance of foreign based operations, the foreign currency financial reports should be used for financial statement analysis purposes

Foreign currency translation • Translation involves no accounting entries in the books of either the “parent” entity or of the overseas operation • On translating the results of an overseas operation into the domestic currency, the statements will probably not balance due to the nature of the adjustments to be made, hence an exchange difference, as a balancing item, will arise

Foreign currency translation • Four methods are available for translating foreign currency financial statements: - Historical method - Closing-rate method - Temporal method - Current-rate method

Foreign currency translation • Historical method • Known as the “traditional” approach, this method, in general, requires that balance sheet and income statement items be translated at the “historical rate” appropriate for each respective item • The historical rate is the one that was current when the transaction or other event occurred

Foreign currency translation • There are two variations of the historical method • The first involves the translation of current assets and current liabilities at the exchange rate on reporting date, while non-current assets and non-current liabilities are translated at relevant historical exchange rates

Foreign currency translation • The second variation distinguishes between monetary assets and liabilities (whose amounts are fixed in terms of a foreign currency) and non-monetary assets and liabilities (whose amounts are not fixed in terms of a foreign currency) • Monetary items are translated at the exchange rate current on the reporting date, while non-monetary items are translated at relevant historical exchange rates

Foreign currency translation • Under both historical methods, income statement items are translated at the exchange rate prevailing at the time the income and expenses were recognised • Components of equity are also translated at relevant historical exchange rates

Foreign currency translation • Closing-rate method • Under this method, all balance sheet and income statement items, including depreciation, are translated at the exchange rate current on the reporting date • All items in the foreign operation’s financial statements are translated using the same exchange rate, thus resulting in no translation gain or loss (that is, exchange difference)

Foreign currency translation • Under AASB 121, “exchange difference” is defined as “the difference resulting from translating a given number of units of one currency into another currency at different exchange rates” (para. 8)

Foreign currency translation • Temporal method • Under this method, items in the income statement and items recorded in the balance sheet at historical cost are translated at the appropriate historical exchange rate • Assets and liabilities that are stated at current replacement cost or net market value are translated at the exchange rate current on the reporting date

Foreign currency translation • Under the temporal method, where marketable securities are shown in a foreign currency at historical cost, the historical rate is used for translation, while the same asset, if instead was recorded in the accounts in a foreign currency at current market price, would be translated at the exchange rate current on the reporting date • The translation gain or loss for the period is included in the income statement

Foreign currency translation • Current-rate method • This method is a variation of the closing-rate method • In its “pure” form, balance sheet items are translated at the exchange rate current on the reporting date, while income statement items are translated at the appropriate historical exchange rate

Foreign currency translation • Under the current-rate method, translation gains or losses are not recognised in the income statement but are accumulated in the balance sheet as a “foreign currency translation reserve” (that is, as a component of equity)

Accounting standards • Key provisions of AASB 121: Foreign currency transactions • Foreign currency receivables and payables are to be recognised by applying the spot rate on date of the transaction (para. 21) • On subsequent reporting dates, such items must be translated at “the spot rate at the reporting date” or “closing rate” (as defined in para. 8) in accordance with para. 23(a)

Accounting standards • Exchange differences, both realised and unrealised, are to be recognised as income and expenses in the reporting period in which the exchange rate changes (para. 28) • The procedures required by AASB 121 are illustrated in examples 29.2 and 29.3 as previously addressed

Accounting standards • In the case of non-monetary items, at each reporting date “non-monetary items that are measured in terms of historical cost in a foreign currency shall be translated using the exchange rate at the date of the transaction” (para. 23(b)) • Read Example 29.4 (H, P & H, pp. 957-959)

Accounting standards • On the other hand “non-monetary items that are measured at fair value in a foreign currency shall be translated using the exchange rates at the date when the fair value was determined” (para. 23(c))

Accounting standards • Key provisions of AASB 121: Foreign-based operations • The basic features for translating financial statements from one currency to another are detailed in para. 39 • The required procedure is very similar to the current-rate method, except that AASB 121 does not indicate how equity items should be translated, although it seems reasonable, for consistency purposes, to translate equity items using the closing rate at balance sheet date • Read Example 29.5 (H, P & H, pp. 962-965)

Hedging of transactions • Entities may “hedge” their exposure to risks of exchange losses in three main ways as previously outlined • Hedging of financial instruments is addressed in AASB 139 “Financial Instruments: Recognition and Measurement” (see, in particular, paras. 85-89)

Hedging of transactions • Para. 89 of AASB 139 requires that any gains and losses arising from changes in the fair value of the hedged item be offset (in the income statement) by losses and gains arising from changes in the fair value of the hedging instrument • Read Example 29.7 (H, P & H, pp. 973-976)

BA606 FINANCIAL ACCOUNTING