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Advanced Financial Accounting: Chapter 7 Accounting for the Effects of Changes in Foreign Exchange Rates Tan & Lee Chapter 71© 2009.

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Presentation on theme: "Advanced Financial Accounting: Chapter 7 Accounting for the Effects of Changes in Foreign Exchange Rates Tan & Lee Chapter 71© 2009."— Presentation transcript:

1 Advanced Financial Accounting: Chapter 7 Accounting for the Effects of Changes in Foreign Exchange Rates Tan & Lee Chapter 71© 2009

2 Learning Objectives 1.Understand the concept of foreign exchange exposure 2.Differentiate between operating and accounting exposure 3.Understand the concept of functional currency 4.Understand the accounting treatment of foreign currency transactions 5.Understand the procedures for translating foreign currency financial statements in a non-hyperinflationary environment 6.Understand the special issues relating to translation Tan & Lee Chapter 72© 2009

3 Content Tan & Lee Chapter 7© Introduction 2.Types of foreign exchange rate management regimes 3.How exchange rates are quoted 4.Types of foreign exchange rate exposures 5.Concept of functional currency 6.Foreign currency transactions of a stand-alone entity 7.Translation of foreign currency financial statements 8.Special issues in translation 9.Evaluation of translation approaches 1. Introduction

4 Introduction Tan & Lee Chapter 7© Year 1974 Fixed / Official Exchange Rate System Currencies were pegged to US Dollar US Dollar was pegged to gold prices International Monetary System Floating exchange rate system Volatility of exchange rates Affect businesses reported earnings

5 Content Tan & Lee Chapter 7© Introduction 2.Types of foreign exchange rate management regimes 3.How exchange rates are quoted 4.Types of foreign exchange rate exposures 5.Concept of functional currency 6.Foreign currency transactions of a stand-alone entity 7.Translation of foreign currency financial statements 8.Special issues in translation 9.Evaluation of translation approaches 3. How exchange rates are quoted

6 Types of Foreign Exchange Rate Management Regimes Tan & Lee Chapter 7© International Monetary System Floating Rate System Managed Floating Rate System Exchange Rate Linked to a Key Currency Exchange Rate Linked to a Basket of Currency Currency Board System Currencies fluctuate freely according to demand and supply Based on demand and supply forces, but the central bank can freely intervene Exchange rate is fixed to a key currency such as USD Exchange rate is based on a basket of currencies of their major trading partners Money supply of currency is backed by an equivalent amount of a strong currency

7 Content Tan & Lee Chapter 7© Introduction 2.Types of foreign exchange rate management regimes 3.How exchange rates are quoted 4.Types of foreign exchange rate exposures 5.Concept of functional currency 6.Foreign currency transactions of a stand-alone entity 7.Translation of foreign currency financial statements 8.Special issues in translation 9.Evaluation of translation approaches 4. Types of foreign exchange rate exposures

8 How Exchange Rate are Quoted Foreign exchange rate –The price of a currency expressed in terms of another currency Exchange rates are quoted in two ways: –Direct quotation: 1 unit of foreign currency : X units of domestic currency –Indirect quotation: X units of foreign currency : 1 unit of domestic currency To translate a direct quotation to an indirect quotation – 1 unit of foreign currency/ X units of domestic currency To translate an indirect quotation to a direct quotation –1 unit of local currency/ X units of foreign currency Tan & Lee Chapter 7© /x : x/x

9 Spot Rate and Forward Rate Tan & Lee Chapter 7© Foreign Currency Market 外匯市場 Spot Rate Market: Rate are quoted for immediate delivery on a particular day Forward market: Contractual agreement between two parties where the rate is fixed today but the delivery is at a future time Forward rate> Spot rate = Premium Forward rate < Spot rate = Discount : 加價, 溢價 : 折扣 ; 打折扣

10 Types of Foreign Exchange Rate Exposures Tan & Lee Chapter 7© Foreign Exchange Exposure Accounting Exposure: Impacts the reported earnings and Financial Position items Operating Exposure: Affects the competitive position of the entity and the value of the entity

11 Operating Exposure (the entity) Purchasing Power Parity –Exchange rate changes between two countries = inflation differential between two countries –If the above does not hold, the real exchange rate between the two countries has changed –It will affect the competitive positions of firms operating in the two countries Operating exposure arises from strategic decisions a firm makes about its input and output markets –Input markets: countries that a firm incurs cost –Output markets: countries where a firm derives its revenues The presence of foreign competitors in domestic market will affect a firm’s operating exposure Tan & Lee Chapter 7©

12 Accounting Exposure (FP item & earning) Tan & Lee Chapter 7© Accounting Exposure Transaction 買賣 exposure: Arises from foreign currency transactions e.g. Account receivable denominated in a foreign currency Translation 翻譯 exposure: Arises from translation of foreign currency financial statements of foreign operations Results in transaction gains or losses Recorded in the books of the individual entity Results in translation gains or losses Presented in consolidated financial statements (group level)

13 Content Tan & Lee Chapter 7© Introduction 2.Types of foreign exchange rate management regimes 3.How exchange rates are quoted 4.Types of foreign exchange rate exposures 5.Concept of functional currency 6.Foreign currency transactions of a stand-alone entity 7.Translation of foreign currency financial statements 8.Special issues in translation 9.Evaluation of translation approaches 5. Concept of functional currency

14 Concept of Functional Currency Functional currency under IAS 21: –Currency of the “primary economic environment in which the “entity operates” (eg. Hong Kong dollars). –The currency that influences the sale prices of goods and services –Normally the currency that sales prices are denominated and settled in. (eg. Hong Kong dollars). –The currency in which the costs are accumulated in A firm’s “primary economic environment” is not determined by national or political boundaries All currencies other than the functional currency are considered as foreign currencies –The effects of exchange rate changes on a firm’s cash flows is measured and reported with reference to the functional currency Tan & Lee Chapter 7©

15 Factors to Indicate an Entity’s Functional Currency 1.The currency that mainly influences the sale prices of goods and services 2.The currency of country whose competitive forces and regulations determine the sales prices of goods and services 3.The currency that mainly influences the labour, material and other cost of goods and services (eg. salary paid in H.K. dollars) 4.The currency in which financing is obtained ($ borrow from bank) 5.The currency in which receipts from operating activities are retained Tan & Lee Chapter 7©

16 Content Tan & Lee Chapter 7© Introduction 2.Types of foreign exchange rate management regimes 3.How exchange rates are quoted 4.Types of foreign exchange rate exposures 5.Concept of functional currency 6.Foreign currency transactions of a stand-alone entity 7.Translation of foreign currency financial statements 8.Special issues in translation 9.Evaluation of translation approaches 6. Foreign currency transactions of a stand-alone entity

17 Foreign Currency Transactions (x translation) of a Stand-alone Entity 獨立經營 Tan & Lee Chapter 7© Timeline of a typical foreign currency transaction Foreign currency transaction recorded at actual (historical) exchange rate giving rise to monetary asset or monetary liability Financial year end Outstanding monetary asset/liability translated at year-end rate Settlement of monetary asset/liability translated at rate on settlement date 1FC:$1.5

18 Foreign Currency Transactions of a Stand-alone Entity Monetary Vs Non-monetary items from foreign currency transaction (x translation): –Monetary items are “units of currency held and assets and liabilities to be received or paid in fixed or determinable number of units of currency” –E.g. of monetary assets and liabilities- FP: Cash Time deposits in the bank Accounts and loan receivable/payable (receive $ in the future) Tax payable (including deferred tax) (pay $ in the future) –E.g. of non-monetary assets and liabilities - FP: Investment in equity instruments (No right to receive, just based on market condition) Unearned revenue (Later, Dr D.R. Cr Sales, not Dr D.R. Cr Cash) Non-refundable deposits (nothing to be paid in future) ©

19 Foreign Currency Transactions of a Stand-alone Entity At foreign currency transaction (x translation) date: –The transaction is recorded at actual spot rate At subsequent financial position dates: –Monetary items: Are adjusted using the closing rate at balance sheet date Rationale: monetary items are contractual amounts that will be settled in a specific currency which needs to be adjusted for a change in spot rate –Non-monetary items: No adjustment made at balance sheet date Items are measured at historical rate (i.e. date of transaction) –Non-monetary items measured at fair value Are translated using the exchange rate at date of fair value determination Tan & Lee Chapter 7© FC:$1.5

20 Transaction (x translation) Exposure Items exposed to foreign exchange risk s (foreign currency depreciates/appreciates) –Foreign currency monetary items –Non-monetary items carried at fair value (no Non-monetary items) –Re-measurement at balance sheet and settlement date will give rise to exchange gains or losses Tan & Lee Chapter 7© Foreign currency depreciates # Foreign currency appreciates # Exposed asset*Exchange lossExchange gain Exposed liability*Exchange gainExchange loss *Accounts receivable/ payable in US$ # If the foreign currency increase, you would receive more $ in future as you sign the contract in the past. 1FC:$1.51FC:$1.45 1FC:$1.48

21 Treatment of Transaction (x translation) Gains and Losses Monetary items: –Exchange gain or losses are recognized in profit or loss of the entity –Exceptions: exchange gains or losses on “an inter-company loan” that is an extension of the parent’s net investment are taken to equity (not profit and loss of the entity) in the consolidated financial statements Non-monetary items carried at fair value: (x just non-monetary items) –Exchange gain or losses are recognized in the same way as the gain or loss on the non-monetary item is recognized in profit or loss –E.g. Available-for-sale investment (equity): exchange differences is recognized in equity (not profit and loss of the entity). Tan & Lee Chapter 7©

22 Illustration 1: Foreign currency transaction (x translation) Alpha Company, whose functional currency is the dollar, purchased goods with an invoiced value of FC250,000 on 1 November 20x1 to be settled on 31 January 20x2. Alpha Company’s financial year – end is 31 December. 1/11/20x1 Delivery date 31/12/20x1 Year-end 31/1/20x2 Settlement date 1FC = $1.501FC = $1.451FC = $1.48 Exchange gainExchange loss of $12,500of $7,500 Exchange rates 1FC = 1 November 20x1$ December 20x1$ January 20x2 $1.48 Tan & Lee Chapter 722© 2009

23 Illustration 1: Foreign currency transaction (x translation) 23 1 November 20x1 (purchases date) DrInventory (250k*1.5)375,000(M.V.) CrAccounts payable375,000 Record purchase of goods at spot rate 31 December 20x1 (at year end date) DrAccounts payable (250K*( ) 12,500 CrExchange gain-I/S12,500 Record exchange gain on outstanding accounts payable 31 January 20x1 (settlement date) DrAccounts payable(375k-12.5k)362,500 DrExchange loss-I/S 7,500 CrCash/Bank (250k*1.48)370,000 To record exchange loss on settlement of accounts payable Tan & Lee Chapter 7© 2009 Company pay Lesser if foreign exchange rate depreciate 1FC=$ ,000FC= 250,000*$1.5 Can not be inventory

24 Content Tan & Lee Chapter 7© Introduction 2.Types of foreign exchange rate management regimes 3.How exchange rates are quoted 4.Types of foreign exchange rate exposures 5.Concept of functional currency 6.Foreign currency transactions of a stand-alone entity 7.Translation of foreign currency financial statements 8.Special issues in translation 9.Evaluation of translation approaches 7. Translation of foreign currency financial statements

25 Translation of Foreign Currency Financial Statements Tan & Lee Chapter 7© Accounting Exposure Transaction exposure: Arises from foreign currency transactions e.g. Account receivable denominated in a foreign currency Translation exposure: Arises from translation of foreign currency financial statements of foreign operations Results in transaction gains or losses Recorded in the books of the individual entity Results in translation gains or losses Presented in consolidated financial statements (group level)

26 Case study:2010 Midland Consolidated Statement of Comprehensive Income 2010yr 2009yr Profit for the year $567,949 $713,723 Other comprehensive income: Currency translation differences $5,373 $ 17 Change in fair value of land and buildings upon transfer of properties to investment properties $6,652 $3,448 Change in fair value of available-for-sale financial assets $(877) $1,320 Total comprehensive income for the year $579,097 $718,508

27 Presentation Vs Functional Currency A company may choose any currency as its presentation currency For the group entity: –The presentation currency of the group is the presentation currency of the parent company IAS 21 specific two approaches to translate the financial statement Tan & Lee Chapter 7© Foreign Currency Functional Currency Presentation Currency Re-measurement / Temporal Method Closing Rate Method

28 Functional Currency to Presentation Currency Closing rate method is used to translate financial statements from the functional to the presentation currency This method is applicable to: –Stand-alone entity that record books in its functional currency (RMB) but presents its financial statements in another currency (HKD) –Foreign operation (branch, subsidiary or associate) that records its books in its functional currency (RMB) but needs to translate its financial statements into the parent’s presentation currency (HKD) for consolidation purposes Tan & Lee Chapter 7©

29 Foreign Currency to Functional Currency Re-measurement or “Temporal method” is used to translate financial statements from a foreign currency to the functional currency This method is applicable to: –A stand-alone entity that records its books in a foreign currency but present its financial statements in its functional currency –A foreign operation that records its books in local currency but its functional currency is the presentation currency (assumed to be the parent’s functional currency) Remeasurement achieves the same results as if the transactions had been originally recorded in the functional currency Tan & Lee Chapter 7©

30 Factors to Determine the Functional Currency of a Foreign Operation Indicators Indicators that foreign operation’s (RMB) functional currency is local currency (RMB) Indicators that foreign operation’s (RMB) functional currency is parent’s functional currency (HKD) Operating relationship with the parent The foreign operation has significant degree of autonomy from the parent The foreign operation is an extension of the parent Transactions with the parentLow proportionHigh proportion Cash flow interdependencies Foreign operation’s cash flow directly affects the parent company Foreign operation’s cash flow directly affects the parent company Financial independence Foreign operation is self- sufficient and not dependent on the parent company Foreign operation is dependent on the parent company Tan & Lee Chapter 7©

31 Choice of Functional Currency Tan & Lee Chapter 7© Nature of operating and financial relationship between a parent and its foreign operation Foreign operation operates independently in economic and financial matters Foreign operation is integrated with parent’s operation Functional currency should be either local or a 3 rd currency Closing rate method Functional currency should be parent’s currency Re-measurement /Temporal Method (if books kept in foreign currency)

32 Functional to Presentation Currency Features of closing rate method: Foreign operation is viewed as a passive investment by the parent –Parent’s returns are in the form of dividends and capital appreciation –Value of investment is influenced by: Profitability of foreign operation Change in exchange rates –Effect of exchange rate movements is measured using closing rate –Translation differences will not have a direct impact on the parent’s cash flow; therefore, they are taken to equity Tan & Lee Chapter 7© ItemsRate Assets and liabilities (both monetary and non-monetary)Closing rate Income and expense itemsActual or average rate Translation gain or losses are taken to equity (until disposal of foreign operation)

33 Re-measurement Parent and the foreign operation operates as a single economic entity –Foreign operation’s transactions are deemed to be the parent’s foreign currency transactions –Translation differences have a direct impact on the parent’s cash flows, thus they are taken to income statement –Re-measurement procedures are the same as those applied to foreign currency transactions of a stand-alone entity Tan & Lee Chapter 7©

34 Exchange Rates Used for Translating Balance Sheet Items Tan & Lee Chapter 7© Financial Position ItemsClosing Rate Method Remeasurement / Temporal method Share capital and pre- acquisition retained earnings rate Post-acquisition retained earnings Not translated using a single exchange rate Monetary assets and liabilities rate Non-monetary assets and liabilities rate (For items acquired before acquisition date: rate at acquisition date) Non-monetary items at fair value * rate Rate the date of the or determination Translation gains or losses Taken to (foreign currency translation reserve) Taken to (except for * is taken to if the revaluation gains or losses is taken to )

35 Exchange Rates Used for Translating Income Statement Items Income Statements ItemsClosing Rate Method Remeasurement / Temporal method Sales, purchases, expenses and income statement items that result in inflow/outflow of monetary items Actual / rateActual / average rate Costs of salesActual / rate rate of original purchase of inventory Depreciation, amortization and other allocation of non- monetary items Actual / rate rate of original acquisition (if acquired before acquisition date, use rate at acquisition date) Dividends and other appropriation of profits rate Tan & Lee Chapter 7©

36 Translation Exposure Translation exposure = Net amount of assets or liabilities in a foreign currency balance sheet that is translated at the closing exchange rate. Under closing rate method, all assets and liabilities are translated at closing rate. So exposed item is the net assets (assets – liabilities) Under the remeasurement method, only assets and liabilities that are translated at closing rate are “exposed “ (i.e. net monetary assets and assets measured on a fair value basis) Tan & Lee Chapter 7©

37 Sources of Translation Differences Under Closing Rate Method Effect of exchange rate change on opening net assets; Effect of exchange rate on increase or decrease in net assets or equity during the year, e.g. –Net profit or loss for the year, – Dividends paid during the year, – Injection of new capital during the year – Other changes in equity during the year Tan & Lee Chapter 7©

38 Translation Exposure Under re-measurement / temporal method, monetary items and non- monetary items that are measured at fair value are the exposed items as they are translated at closing rate Sources of Translation Difference: –Effect of exchange rate changes on: Increase/decrease in monetary items during the year Non-monetary items revalued during the year Tan & Lee Chapter 7©

39 Illustration 2: Translation example On 31 December 20x3 Alpha Corporation acquired the entire share capital of Beta Company, a foreign company whose currency is the FC. At the date of acquisition, Beta’s Balance Sheet was as follows: 39 Beta Company Balance sheet at x3 Assets FC Plant & equipment200,000 Inventories100,000 Account receivable150,000 Account payable(80,000) Net assets370,000 Share capital200,000 Retained earnings170,000 Equity370,000 Tan & Lee Chapter 7© 2009

40 Illustration 2: Translation example Beta’s financial statements for the year ended 31 December 20x4 are as follows: 40 Income statement FC Sales800,000 Cost of goods sold(470,000) Gross profit330,000 Depreciation(25,000) Operating expenses(200,000) Profit before tax105,000 Taxation(20,000) Profit after tax85,000 Dividends paid(25,000) Retained profit for year60,000 Retained profit at 1 Jan170,000 Retained profit at 31 Dec230,000 Tan & Lee Chapter 7© 2009

41 Illustration 2: Translation example 41 Beta Company Balance sheet at x4 Assets: Plant and equipment225,000 Inventories120,000 Accounts receivable200,000 Cash5,000 Accounts payable(120,000) Net assets430,000 Share capital200,000 Retained earnings230, ,000 Tan & Lee Chapter 7© 2009

42 Illustration 2: Translation example Additional information: 1.Assets are depreciated using the straight line method at the rate of 10%. During 20x4, equipment costing FC50,000 was purchased. A full year’s depreciation is recorded in the year of purchase. 2Relevant exchange rates are as follows: 1FC = At x At date of purchase of equipment 1.48 At date of payment of dividends 1.40 Closing inventories (20x4) purchased 1.38 Equipment purchased 1.45 Average rate for 20x At x Tan & Lee Chapter 7©

43 Illustration 2: Translation example Required: (a)Translate the financial statements of Beta Company into dollars assuming that Beta’s functional currency is the FC (b)Re-measure the financial statements of Beta Company into dollars assuming that Beta’s functional currency is the dollar Tan & Lee Chapter 7©

44 Illustration 2: Translation example Translated Income Statement (Closing Rate method) FCRateS$ Sales800,0001,136,000 COGS(470,000)(667,400) Gross profit330,000468,600 Depreciation(25,000)(35,500) Operating expenses(200,000)(284,000) Profit before tax105,000149,100 Taxation(20,000)(28,400) Profit after tax 85,000120,700 Dividends paid(25,000)(35,000) Retained profit for year60,00085,700 Retained profit at 1 Jan170,000255,000 Retained profit at 31 Dec230, ,700 Tan & Lee Chapter 744© 2009 * Rate at acquisition date

45 Illustration 2: Translation example Beta Company Balance sheet at x4 Assets FCRateS$ Plant and equipment225,000303,750 Inventories120,000162,000 Accounts receivable200,000270,000 Cash5,000 6,750 Accounts payable(120,000)(162,000) Net assets430,000580,500 Share capital200,000300,000 Retained earnings230,000From I/S340,700 Translation reserves_______Bal. fig.(60,200) 430, ,500 Tan & Lee Chapter 745 © 2009

46 Illustration 2: Translation example Tan & Lee Chapter 7© Movement in net exposed Items FC Rate S$ Net assets on 1 Jan370,000555,000 Increase in net assets: Net profit after tax 85,000120,700 Decrease in net assets: Dividends paid(25,000) (35,000) Net assets on 31 Dec430, ,700 (A) 580,500 (B) Translation difference for the year (B – A)(60,200)

47 Illustration 2: Translation example Remeasured Income Statement (Functional currency is S$) FCRateS$ Sales800, ,136,000 COGS(470,000)Note (a)(680,200) Gross profit330,000455,800 Depreciation(25,000)Note (b)(37,250) Operating expenses(200,000)1.42(284,000) Remeasurement loss________Note (c)(10,550) Profit before tax105,000124,000 Taxation(20,000)1.42(28,400) Profit after tax85,000 95,600 Dividends paid(25,000)1.40(35,000) Retained profit for year60,00060,600 Retained profit at 1 Jan170, (Acq date) 255,000 Retained profit at 31 Dec230, ,600 Tan & Lee Chapter 7 47 © 2009

48 Illustration 2: Translation example Tan & Lee Chapter 7© Note (a) – Cost of goods sold (COGS) FCRate$ Opening inventories100, ,000 Purchases490, ,800 Closing inventories(120,000)1.38(165,600) COGS470, ,200 Note (b) – Depreciation expense FCRate S$ Existing equipment 20,000*1.530,000 New equipment (2004) 5,000#1.45 7,250 25,00037,250 *S$200,000 ÷ 10 years # $50,000 ÷ 10 years

49 Illustration 2: Translation example Tan & Lee Chapter 7© Movement in net exposed items FCRateS$ Net monetary assets, 1 Jan 70, ,000 ∆ in monetary assets/liabilities: Sale 800, ,136,000 Purchase of equipment (50,000)1.45 (72,500) Purchases(490,000)1.42 (695,800) Operating expenses(200,000)1.42 (284,000) Taxation(20,000)1.42 (28,400) Dividends paid(25,000)1.40 (35,000) 125,300 (A) Net monetary assets, 31 Dec 85, ,750 (B) Remeasurement loss (B-A) (10,550) Note (c): Remeasurement loss

50 Illustration 2: Translation example Tan & Lee Chapter 7© Opening exposed monetary items: FC Accounts receivable150,000 Accounts payable(80,000) Net monetary assets, 1 Jan70, Closing exposed monetary items: Accounts receivable200,000 Cash 5,000 Accounts payable(120,000) Net monetary assets, 31 Dec 85,000

51 Illustration 2: Translation example Tan & Lee Chapter 7© Beta Company Balance sheet at x4 Assets FCRate $ Plant/Equipment225,000Note (d)335,250 Inventories120, ,600 Accounts receivables200, ,000 Cash 5, ,750 Accounts payables(120,000)1.35(162,000) Net assets430, ,600 Share capital200, ,000 Retained earnings230,000From I/S315, , ,600

52 Illustration 2: Translation example Tan & Lee Chapter 7© Note (d) - Equipment Existing equipment: FCRate S$ Cost200,000 Accumulated depreciation(20,000) Net carrying value180, ,000 New equipment Cost50,000 Accumulated depreciation(5,000) Net carrying value45, ,250 Total225, ,250


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