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

2. Content Introduction Types of foreign exchange rate management regimes
How exchange rates are quoted
Types of foreign exchange rate exposures
Concept of functional currency
Foreign currency transactions of a stand-alone entity
Translation of foreign currency financial statements
Special issues in translation
Evaluation of translation approaches
Special issues in translation
Tan & Lee Chapter 7
© 2009

3. Change of Functional Currency
A change of functional currency may be due to a change:
In primary economic environment
In the nature of operating relationship between the foreign operation and the parent
Functional currency changes are implemented prospectively
No restatement of prior-year financial statements
Tan & Lee Chapter 7
© 2009

4. Change of functional currency
Functional currency is changed
Translation procedures
From To
Local currency
Parent’s currency
Cumulative translation differences remain in equity until disposal
Non-monetary assets are translated at the rate on the date when the change is effected
All assets and liabilities are translated at closing rate
Translation differences are taken to equity
Tan & Lee Chapter 7
© 2009

5. Exchange Differences Arising from Intercompany Transactions
Intercompany transactions are normally denominated in either the parent’s currency or the subsidiary’s currency
Results in translation gain or loss recorded by one party
Translation gain or loss is not eliminated as they are one-sided
Long term loan from parent that are “quasi-equity”
Considered as part of parent’s net investment in the subsidiary
Eg. Interest free loans, loans with no definite or scheduled payment
IAS 21 Para 32 requires exchange difference to be reclassified to equity in consolidation
Reclassification journal entries in consolidation: Dr
Exchange gain on loan (I/S) Cr
FCTR (equity) Dr
FCTR (equity) Cr
Exchange loss on loan (I/S)
Tan & Lee Chapter 7
© 2009

6. Exchange Differences Arising from Intercompany Transactions
Nature of monetary item
Monetary item denominated in:
In parent’s book
In foreign operation’s books
In consolidated accounts
Forms part of parent’s net investment
“Quasi-equity”
loans
Parent’s functional currency
No exchange difference is recorded
Records exchange difference on monetary item in I/S
Exchange difference on monetary item is reclassified to equity (FCTR)
Foreign operation’s currency
3rd currency
Tan & Lee Chapter 7
© 2009

7. Exchange Differences Arising from Intercompany Transactions
Nature of monetary item
Monetary item denominated in:
In parent’s book
In foreign operation’s books
In consolidated accounts
Is not part of parent’s net investment
Parent’ functional currency
No exchange difference is recorded
Records exchange difference on monetary item in I/S
Flows through to consolidated I/S
Foreign operation’s currency
3rd currency
Tan & Lee Chapter 7
© 2009

8. Goodwill Arising from the Acquisition of Foreign Subsidiaries
Is goodwill a foreign currency asset?
An asset of the acquiree?
An asset in the acquirer?
Needs to be translated
No translation required
The position in IAS 21 is that goodwill is a foreign currency asset of the acquiree and has to be translated using the closing rate method.
Tan & Lee Chapter 7
© 2009

9. Equity Accounting for Foreign Associates
Associate companies are more likely than subsidiaries to be autonomous entities than integral operations of the investor
Functional currency is likely to be the foreign operation’s currency
Financial statements are first translated to the presentation currency (the investor’s currency) using the closing rate method
Equity accounting is applied subsequently to the translated financial statements
Apply the usual equity accounting entries
Allocate to investor the proportionate share of foreign currency translation reserves (FCTR)
Tan & Lee Chapter 7
© 2009

10. Carrying Value of Inventories
Inventory is carried at lower of cost or net realizable value (NRV)
If NRV of inventory is measured in a foreign currency:
Reported carrying value is the lower of:
Inventory cost (foreign currency) X Actual (historical) rate
Inventory at NRV (foreign currency ) X Closing rate
Tan & Lee Chapter 7
© 2009

11. Foreign Operation in a Hyperinflationary Environment
Indicators of a hyperinflationary economy:
Inflation rate of 100% or more over a period of 3 years;
Interest rates, wages and prices that are linked to a price index;
Prices that are quoted in a stable currency; and
A general population that prefers to keep its wealth in non-monetary assets or in a stable currency
Financial statements that are not adjusted for inflation are not useful
Misleading to compare transactions that occurred at different times due to loss of purchasing power at a rapid rate
IAS 21 requires a restate-then-translate approach
Restate using the procedures in IAS 29
All restated amounts (including comparatives) are translated at closing rate at the most recent balance sheet date, except that:
Previous year comparable figures in non-hyperinflationary economy currency are not restated
Tan & Lee Chapter 7
© 2009

12. Content Introduction Types of foreign exchange rate management regimes
How exchange rates are quoted
Types of foreign exchange rate exposures
Concept of functional currency
Foreign currency transactions of a stand-alone entity
Translation of foreign currency financial statements
Special issues in translation
Evaluation of translation approaches
Evaluation of translation approaches
Tan & Lee Chapter 7
© 2009

13. Evaluation of Translation Approaches
Objective of translation under SFAS 52 in US GAAP:
Provide information that is generally compatible with the expected economic effects of a rate change on the enterprise’s cashflows and equity; and
Reflect in the consolidated statements the financial results and relationships of the individual consolidated entities as measured in their functional currencies
Tan & Lee Chapter 7
© 2009

14. Evaluation of Translation Approaches
Evaluate the closing rate method against the objectives:
An appreciation in the foreign operation currency will result in a translation gain and a loss when the currency depreciates
Financial relationships among items in the original financial statements are preserved
A major flaw is that the translated balance sheet is neither at historical nor current value
Tan & Lee Chapter 7
© 2009

15. Evaluation of Translation Approaches
Evaluate the remeasurement/temporal method against the objectives of translation:
Distorts the original financial ratios (use of mixed rates)
However, it is argued that if the foreign operation’s functional currency is the same as the parent’s functional currency:
The financial ratios should be determined using the functional currency and not the local currency
Therefore, this method attempts to “put things right” as though the foreign operation had been conducted in the parent’s functional currency
Tan & Lee Chapter 7
© 2009

16. Conclusions
Functional currency should be determined in relation to the primary economic environment of the entity but presentation currency is a “free choice”
Remeasurement is used to translate the foreign currency transactions of a stand-alone entity or the financial statements of a foreign operation to its functional currency
Apply the closing rate method when translating from the subsidiary’s functional currency to the parent’s presentation currency
Special considerations apply to goodwill, intercompany loans that are quasi-equity and translation in hyper-inflationary economies.
Tan & Lee Chapter 7
© 2009