Analysis of Multinational Operations

1. Analysis of Multinational Operations Chapter 17 Robinson, Munter and Grant

2. Learning Objectives • Foreign currency transactions and translation • Functional and measurement currency • Exchange rate • Remeasurement of financial statements • Hyperinflation Chapter 17

3. Foreign Currency Transactions • US: Transactions whose terms are denominated in a currency other than the entity’s functional currency. • International: Transaction which is denominated in, or requires settlement in, a foreign currency. Chapter 17

4. Currencies • Functional: Currency of the primary economic environment in which the entity operates (generates/expends cash). • FASB Statement 52 • Measurement: Reflects the economic substance of the underlying events and circumstances relevant to that enterprise. • IAS 21 and 29 Chapter 17

5. Foreign Currency Translations • Process of converting financial statements from one currency to another • Necessary when a parent has a foreign subsidiary and that subsidiary uses a local currency as its functional currency Chapter 17

6. Accounting for FC Transactions • Transactions are initially measured using the exchange rate between the functional currency and the foreign currency as of the transaction date • Subsequent changes in the exchange rates giving rise to a FC gain/loss are included income • Between purchasing an item and paying for it the exchange rate may change. Chapter 17

7. Analytical Issues • Accounting standards require transaction gains and losses be included in income but do not specify where • FC gains and losses could appear in a number of places • Sales • Cost of goods sold or S, G & A • A category of “other” income or expense Chapter 17

8. Analytical Issues • Placement of FC gains and losses will affect a variety of ratios and margins including • Gross profit • Operating profit • Return on sales… • Net income will not change Chapter 17

9. Disclosures • Companies are required to disclose the amount of the transaction gain or loss included in current income. • Possibly under the heading “Foreign Currency Transactions” in the notes to the financial statements Chapter 17

10. FC Translation IssuesRealizedGains and Losses • Have been settled • Realizable, has been converted into a monetary item • Both are related to FC transactions Chapter 17

11. FC Translation IssuesUnrealizedGains and Losses • Have not been settled • Unrealizable, will not be settled in the foreseeable future • Both are related to FC translations Chapter 17

12. Objectives of FC Translation • One business entity might be composed of numerous separate legal entities • Results of separate entities must be consolidated and presented as though they were the financial statements of a single enterprise • Using a single reporting currency Chapter 17

13. Objectives of FC TranslationAccording to the FASB • Provide information that is compatible with the expected economic effects of a rate change on an entity’s cash flows and equity. • Reflect in consolidated statements the financial results and relationships of the individual consolidated entities as measured in their functional currencies in conformity with GAAP. Chapter 17

14. Translation of FC Statements • Translate subsidiary financial statements from their functional/measurement currency into the reporting currency • Not recorded in the income statement • An accounting process not an economic process • A component of other comprehensive income • US and international standards are essentially the same Chapter 17

15. Translation of FC StatementsIAS 21 • Assets and liabilities (monetary and non-monetary) should be translated using the closing rate • Income and expense items should be translated at exchange rates at the dates of the transactions (unless hyperinflationary) • Resulting differences go to equity until disposal of net investment. Chapter 17

16. Translation of FC StatementsFAS 52 • Assets and liabilities – use the rate in place on the balance sheet date • Paid in capital uses historical date/rate • Income and expense items – use the rate in place on the transaction date • If numerous transactions, use a weighted average exchange rate (generally the case) • Translation adjustments are a component of equity. Chapter 17

17. Remeasurement of FC Statements • Different form Translation in terms of • Process, and • Treatment of the translation adjustment • Subtle difference Chapter 17

18. Remeasurement of FC Statements • Sometimes called the Monetary and Non-monetary method • Monetary items on the balance sheet are translated at the current rate • Non-monetary items are translated using the rates in effect when asset was acquired or liability was incurred Chapter 17

19. Remeasurement of FC StatementsIncome Statement Items • If derived from monetary items, translate using weighted-average rate • Sales, salary expense • If derived from non-monetary items are translated using the historical rate used for the balance sheet items • Cost of goods sold and inventory • Translation adjustment is a component of income Chapter 17

20. Remeasurement of FC Statements • Necessary when an entity’s records are maintained on a basis other than the entity’s functional currency • In some cases, both remeasurement and translation are necessary Chapter 17

21. Remeasurement of FC Statements Chapter 17

22. Translation of FC StatementsExchange rate summary Chapter 17

23. Hyperinflationary Environment • Significant inflation leads to currency devaluation • GAAP requires the remeasurement of the financial statement of foreign subsidiaries operating in a hyperinflationary environment • Translation adjustment will affect income Chapter 17

24. Hyperinflationary EnvironmentGAAP • Remeasure as if functional currency were the reporting currency • When the cumulative inflation is at least (or approximately) 100 percent over a 3-year period Chapter 17

25. Hyperinflationary EnvironmentInternational Standards • Without restatement, purchasing power changes could make financial results misleading • Restatement is a mater of managerial judgment • International standards provide guidelines only Chapter 17

26. Hyperinflationary EnvironmentInternational Guidelines • Population keeps wealth in non-monetary assets • Monetary amounts are in terms of a stable foreign currency • Prices compensate for expected purchasing power loss • Interest, wages and prices are linked to a price index • 3-year inflation rate approaches or exceeds 100% Chapter 17

27. Hyperinflationary EnvironmentInternational Standards • Make general price-level adjustments • Restate in local currency to reflect the impact of inflation • Gain/loss on net monetary position is a component of net income • Specific steps to follow • Then translate Chapter 17

28. Hyperinflationary EnvironmentOverview • US • Remeasure • Translation adjustment included income • International • Restate for inflation in local currency • Gain/loss on net monetary position in income • Translate restated amounts Chapter 17

29. Analytical Considerations • Period-to-period analyses can be affected by exchange rates • Some companies report “currency neutral” in addition to translated financial statements • Currency neutral is based on local currency • Discussion may be part of MD&A Chapter 17

30. Summary • Foreign currency • International and US standards • Transactions • Translations • Hyperinflation • Analytical considerations Chapter 17