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Chapter 10

Chapter 10. Translation Of Foreign Currency Financial Statements. Basic Issues. Selecting the appropriate method of translation For transactions: the temporal method For statements: temporal or current rate. Basic Issues. Treatment of exchange gains and losses

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Chapter 10

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  1. Chapter 10 Translation Of Foreign Currency Financial Statements

  2. Basic Issues • Selecting the appropriate method of translation • For transactions: the temporal method • For statements: temporal or current rate

  3. Basic Issues • Treatment of exchange gains and losses • For transactions: Immediately to Net Income • For statements: To Net or Comprehensive Income

  4. Accounting Principles • Use of foreign principles reflects conditions in the foreign economic and legal environment • Use of Canadian principles maintains consistency of application

  5. Accounting Principles • CICA conclusion: Statements must be adjusted to reflect Canadian GAAP • Will not be an issue after changeover to IFRSs

  6. Classification - CICA • Integrated Foreign Operation: A foreign operation that is financially or operationally interdependent with the reporting enterprise such that the exposure to exchange rate changes is similar to the exposure that would exist had the transactions and activities of the foreign operation been undertaken by the reporting enterprise. A foreign subsidiary that raises its capital in Canadian markets, purchases its merchandise or other goods in Canadian markets, and/or sells its goods in Canadian markets.

  7. Classification - CICA • Self-Sustaining Foreign Operation: Self-sustaining foreign operation — A foreign operation that is financially and operationally independent of the reporting enterprise such that the exposure to exchange rate changes is limited to the reporting enterprise's net investment in the foreign operation. A foreign subsidiary that raises its capital in the foreign market, purchases its merchandise or other goods in the foreign market, and/or sells its goods in the foreign market.

  8. Factors To Consider In Classification – 1651.10 • (a) whether there are any factors which would indicate that the cash flows of the reporting enterprise are insulated from or are directly affected by the day-to-day activities of the foreign operation; • (b) whether sales prices for the foreign operation’s products or services are determined more by local competition and local government regulations or more by world-wide competition and international prices and whether such sales prices are primarily responsive on a short-term basis to changes in exchange rates or are immune to such changes;

  9. Factors To Consider In Classification – 1651.10 • (c) whether the sales market for the foreign operation’s products and services is primarily outside the reporting enterprise’s country or within it; • (d) whether labour, materials and other costs of the foreign operation’s products or services are primarily local costs or whether the foreign operation depends on products and services obtained primarily from the country of the reporting enterprise;

  10. Factors To Consider In Classification – 1651.10 • (e) whether the day-to-day activities of the foreign operation are financed primarily from its own operations and local borrowings or primarily by the reporting enterprise or borrowings from the country of the reporting enterprise; • (f) whether there is very little interrelationship between the day-to-day activities of the foreign operation and those of the reporting enterprise or whether intercompany transactions with the reporting enterprise form a dominant part of the foreign operation’s activities.

  11. Classification – IAS No. 21 • Functional Currencyis the currency of the primary economic environment in which the entity operates.

  12. Classification – IAS No. 21 • Paragraph 9 The primary economic environment in which an entity operates is normally the one in which it primarily generates and expends cash. An entity considers the following factors in determining its functional currency: • (a) the currency: • (i) that mainly influences sales prices for goods and services (this will often be the currency in which sales prices for its goods and services are denominated and settled); and • (ii) of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services. • (b) the currency that mainly influences labour, material and other costs of providing goods or services (this will often be the currency in which such costs are denominated and settled).

  13. Classification - IAS No. 21 • Foreign operations for which thefunctional currency is the reporting currency(e.g., a company that reports in Canadian dollars and has a foreign subsidiary for which the functional currency is the Canadian dollar). A foreign subsidiary that raises its capital in Canadian markets, purchases its merchandise or other goods in Canadian markets, and/or sells its goods in Canadian markets.

  14. Classification - IAS No. 21 • Foreign operations for whichthe functional currency is different from the reporting currency(e.g., a company which reports in Canadian dollars and has a German subsidiary for which the functional currency is the euro). A foreign subsidiary that raises its capital in the foreign market, purchases its merchandise or other goods in the foreign market, and/or sells its goods in the foreign market.

  15. Classification – The Future • The integrated/self-sustaining approach is a conceptually flawed solution • It will disappear with the changeover

  16. Translation Method Integrated Foreign Operations • Paragraph 1651.07For integrated foreign operations, the reporting enterprise's exposure to exchange rate changes is similar to the exposure that would exist had the transactions and activities of the foreign operation been undertaken by the reporting enterprise. Therefore, the financial statements of the foreign operation are expressed in a manner that is consistent with the measurement of domestic transactions and operations. The translation method that best achieves this objective is the temporal method, because it uses the Canadian dollar as the unit of measure.

  17. Application of the Temporal Method • Expenses and Revenues • Generally at average rates • Assumes the item occurred uniformly over the period • Assumes the rate changed uniformly over the period

  18. Application of the Temporal Method • Amortization Expense • A write-off of items carried at historical cost • at historic rates

  19. Application of the Temporal Method • Cost Of Sales • Opening inventory at historic • Purchases at average • Closing inventory at historic

  20. Application of the Temporal Method • Sales of Capital Assets • Proceeds at current rate on transaction date • Cost at historical rate from acquisition date

  21. Translation MethodSelf-Sustaining Foreign Operation • Paragraph 1651.08For self-sustaining foreign operations, the reporting enterprise's exposure to exchange rate changes is limited to its net investment in the foreign operation. Therefore, measuring such operations as if they had carried out their activities in Canadian dollars is considered to be less relevant than measuring the overall effect of changes in the exchange rate on the net investment in such operations. The financial statements of the foreign operation are expressed in Canadian dollars in a manner that does not change the financial results and relationships of the foreign operation. The translation method that best achieves this objective is the current rate method, because it uses the currency of the foreign operation as the unit of measure.

  22. Current Rate Method • The current rate method is a method of translation that translates assets, liabilities, revenues and expenses in a manner that retains their bases of measurement in terms of the foreign currency (i.e., it uses the foreign currency as the unit of measure). In particular: • assets and liabilities are translated at the exchange rate in effect at the balance sheet date; • revenue and expense items (including depreciation and amortization) are translated at the exchange rate in effect on the dates on which such items are recognized in income during the period.

  23. Current Rate MethodShareholders’ Equity • Accumulated Other Comprehensive Income This account will contain the net exchange gain or loss that has resulted from the translation of assets and liabilities since the acquisition of the foreign operation. This amount can be either positive (a net gain) or negative (a net loss) with respect to the total shareholders’ equity balance.

  24. Current Rate MethodShareholders’ Equity • Retained EarningsThis balance will reflect the cumulative translated income of the foreign operation, exclusive of exchange gains and losses and reduced by dividends declared.

  25. Current Rate MethodShareholders’ Equity • Common SharesAs all of the exchange gains and losses have been allocated to Accumulated Other Comprehensive Income, the contributed capital account, Common Shares, will have to be translated at the historic exchange rate applicable to its issue date. This seeming anomaly is the only approach that will produce a total Shareholders’ Equity that equals the difference between assets and liabilities when these balances are translated at current rates. It is likely that you will have a better grasp of this point after you have worked through the comprehensive example that is presented later in this Chapter.

  26. Why The Current Rate Method Example On January 1, 2009, when €1 = $1.60, a Canadian company established a subsidiary with an investment of €3,000,000. The subsidiary borrows €3,000,000 and invests the €6,000,000 in Land. On December 31, 2009, €1 = $1.70.

  27. Why The Current Rate Method

  28. Highly Inflationary Economies • Current rate method uses foreign currency as unit of measure • Not good if highly inflationary economy • Use temporal method for self-sustaining

  29. Exchange Gains And LossesIntegrated Operations • Paragraph 1651.20 An exchange gain or loss of the reporting enterprise that arises on translation or settlement of a foreign currency-denominated monetary item or a non-monetary item carried at market should be included in the determination of net income for the current period. (January, 2002) • Paragraph 1651.24 Exchange gains and losses arising on the translation of financial statements of an integrated foreign operation should be accounted for in accordance with paragraph 1651.20. (July, 1983)

  30. Exchange Gains And LossesSelf-Sustaining Foreign Operations • Paragraph 1651.29Exchange gains and losses arising from the translation of the financial statements of a self-sustaining foreign operation should be recognized in a separate component of other comprehensive income, except when the economic environment of the foreign operation is highly inflationary relative to that of the reporting enterprise, in which case such exchange gains and losses should be treated in accordance with paragraph 1651.20. (October, 2006)

  31. Why The Difference? Example A French subsidiary of a Canadian company borrows €1,000,000 when the exchange rate is €1 = $1.55. This results in a translated value of $1,550,000. If the exchange rate goes to €1 = $1.65, the new translated value will be $1,650,000.

  32. Why The Difference? • If integrated foreign operation • Would have to use Canadian dollar revenues to buy Euros • There would be an exchange of currencies • This would result in a real economic loss

  33. Why The Difference • If self-sustaining foreign operation • Euro debt will be repaid with Euro revenues • There would be no exchange of currencies • There would be no real economic loss

  34. Reduction In Net Investment • Paragraph 1651.31An appropriate portion of the exchange gains and losses accumulated in the separate component of accumulated other comprehensive income should be included in the determination of net income when there is a reduction in the net investment. (October, 2006)

  35. Exchange Gain or LossIntegrated Operations

  36. Exchange Gain or LossSelf-Sustaining Operations

  37. Exchange Gain or LossDifference in Calculation • Integrated Foreign Operations • Changes in Net Monetary Assets • Self Sustaining Foreign Operations • Changes in Net Assets

  38. Changes In Classification • Paragraph 1651.36When there are significant changes in the economic facts and circumstances that require the translation method applied to a particular foreign operation to be changed, the change in method should be accounted for prospectively. Disclosure should be made of the reasons for the change in the translation method. (July, 1983)

  39. Changes In Classification • Self-Sustaining To Integrated • Accumulated OCI is carried forward • Carrying values at time of change become the historical costs for items carried at historical value

  40. Changes In Classification • Integrated To Self-Sustaining • At time of change all items to current rate • Gain or loss to Accumulated OIC

  41. Disclosure • Paragraph 1651.37The amount of exchange gain or loss included in net income should be disclosed (see paragraphs 1651.20, 1651.24 and 1651.31). An entity may exclude from this amount those exchange gains or losses arising on financial instruments classified as held for trading in accordance with "Financial Instruments — Recognition And Measurement", Section 3855. An entity may also exclude from this amount exchange gains or losses on available-for-sale financial assets and cash flow hedges (see "Hedges", Section 3865) included in any gains or losses removed from accumulated other comprehensive income and included in net income for the period.

  42. Equity Method Investments • Paragraph 1651.38The financial statements of a foreign investee accounted for by the equity method (see "Investments", Section 3051) are first translated into Canadian dollars in accordance with this Section; then the equity method is applied.

  43. Other Issues • Foreign operations with transactions in another foreign currency • Translate to foreign operations currency, generally using the temporal method • Foreign operations with foreign operations • Will have to classify and translate as appropriate

  44. Other Issues Intercompany Balances • Paragraph 1651.41With respect to integrated foreign operations, exchange gains and losses relating to intercompany balances recorded by the reporting enterprise or the foreign operation will be treated in the same manner as those relating to other foreign currency receivables or payables in accordance with paragraph 1651.20 (i.e., included in income).

  45. Other Issues Intercompany Balances • Paragraph 1651.42With respect to self-sustaining foreign operations, exchange gains and losses on intercompany account balances that are not included as part of the net investment are treated in the same manner as those relating to normal foreign currency trade balances in accordance with the appropriate requirements of this Section. Exchange gains and losses on intercompany account balances that form part of the net investment are recognized in the separate component of other comprehensive income in accordance with paragraph 1651.29.

  46. Other IssuesIntercompany Profits • Integrated operations • Use transaction date rate • Self-sustaining operations • Use transaction date rate

  47. Other Issues - Differences in Financial Statement Dates • Paragraph 1651.44When the date of the financial statements of the foreign operation differs from that of the reporting enterprise, those assets and liabilities which are translated at the current rate would normally be translated at the rate in effect at the balance sheet date of the foreign operation, not at the rate in effect at the balance sheet date of the reporting enterprise. When there is a major change in exchange rates between the balance sheet dates of the foreign operation and the reporting enterprise, the effect of the change would be disclosed.

  48. Other IssuesPreference Shares • Integrated Operations • Use historic rate unless redemption is required or imminent • Self-Sustaining Operations • Use current rate

  49. Other IssuesLower of Cost and Market Example A Germansubsidiary has inventories purchased for €1,000,000 when the exchange rate was €1 = $1.65. At the Balance Sheet date, these inventories have a market value of €1,050,000. At this time €1 = $1.50.

  50. Other IssuesLower of Cost and Market Analysis The lower Euro figure is €1,000,000 cost. Translated cost = $1,650,000 [(€1,000,000)($1.65)] Translated market = $1,575,000 [(€1,050,000)($1.50)] On a translated basis, market is the lower figure.

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