1. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved. 12 Multinational Accounting: Translation of Foreign Entity Statements

2. 12-2 Multinational Accounting When a U.S. multinational company prepares its financial statements for reporting to its stockholder, it must include its foreign operations measured in U.S. dollars and reported using U.S. GAAP. These foreign operations may be subsidiaries, branches, or investments of the U.S. company.

3. 12-3 Multinational Accounting This chapter presents the translation of the financial statements of a foreign business entity into U.S. dollars. A restatement that is necessary before the statements can be combined or consolidated with the U.S. company’s statements, which are already reported in dollars.

4. 12-4 Multinational Accounting Accountants preparing financial statements must consider both the differences in accounting principles and the differences in currencies used to measure the foreign entity’s operations.

5. 12-5 Multinational Accounting For example, a British subsidiary of a U.S. company provides the parent with statements measured in British pounds sterling, using the British system of accounting, which is different from U.S. accounting methods and measures.

6. 12-6 Multinational Accounting The U.S. parent company must typically perform the following steps in the translation and consolidation of the British subsidiary (see next slide):

7. 12-7 Multinational Accounting Receive British subsidiary’s financial statements, which are reported in pounds sterling. Restate the statements to conform to U.S. generally accepted accounting principles.

8. 12-8 Multinational Accounting Translate the statements measured in pounds sterling into their equivalent U.S. dollar amounts. Consolidate the translated subsidiary’s accounts, which are now measured in dollars, with the parent company’s accounts.

9. 12-9 Differences in Accounting Principles Some countries develop their accounting principles based on the information needs of the taxing authorities. Other countries have accounting principles designed to meet the needs of the central government economic planners.

10. 12-10 Differences in Accounting Principles U.S. accounting standards focus on the information needs of the common stockholder or the creditors. Another major financial reporting model is being developed by the International Accounting Standards Board (IASB). The IASB’s website may be found at http://www.iasb.org.uk http://www.iasb.org.uk

11. 12-11 Differences in Accounting Principles The IASB promulgates International Financial Reporting Standards (IFRS). US GAAP is used by more than half of the world’s companies.

12. 12-12 Differences in Accounting Principles Existence of multiple models of accounting standards has significant implications for U.S. firms. FASB is working with the IASB to improve the quality of reporting standards and to “converge” the two sets of standards.

13. 12-13 Differences in Accounting Principles It is felt by some accountants that the U.S. accounting standards are more “rules-based” while the IASB’s accounting standards are more “principles-based.”

14. 12-14 Differences in Accounting Principles If convergence efforts are successful, it is anticipated that there will be a uniform set of international financial reporting standards that “harmonize” the best from U.S. GAAP and from the IASB’s IFRS.

15. 12-15 Differences in Accounting Principles What this means is that the principles-based do not prescribe precisely every standard for every situation, but provide more general guidance that accountants use in their professional judgments. The U.S.’s rules-based standards are much more detailed and describe the accounting treatments for many more circumstances and cases.

16. 12-16 Differences in Accounting Principles One area of concern is that U.S. GAAP has more disclosure requirements than the IASs. This is a major reason that the U.S. Securities and Exchange Commission (SEC) has supported global standards but it still does not accept IAS financial statements without an additional reconciliation statement to U.S. GAAP.

17. 12-17 Differences in Accounting Principles A number of international firms gain access to U.S. securities markets via American Depository Receipts (ADR) which are essentially derivative instruments representing shares of a non-U.S. company. ADRs are traded on the NYSE and other U.S. exchanges. About fifteen percent of the total companies listed on the NYSE are foreign companies.

18. 12-18 Differences in Accounting Principles The ADRs are issued by a depository bank, such as J.P. Morgan or Citibank, that holds the actual shares of the foreign company’s stock. Thus, the ADRs are a security that represents the shares of a non-US company.

19. 12-19 Differences in Accounting Principles Foreign companies with ADRs traded on U.S. exchanges must be registered with the SEC and must annually file a Form 20-F statement that presents the company’s financial statements with reconciliation to U.S. GAAP.

20. 12-20 Differences in Accounting Principles If convergence efforts are successful, it is anticipated that there will be a uniform set of international financial reporting standards that “harmonizes” the best from U.S. GAAP and from the IASB’s IASs.

21. 12-21 Differences in Accounting Principles In turn, it is anticipated that there will eventually be one set of International Financial Reporting Standards that will be used by companies listed on any of the major stock exchanges of the world.

22. 12-22 Determining the Functional Currency There are three possible alternatives for the exchange rate to be used in converting foreign currency values to the U.S. dollar: –Current Rate: the exchange rate at the end of the trading day on the balance sheet date. –Historical Rate: the exchange rate that existed when an initial transaction took place. –Average Rate: the period is usually a simple average for a period of time.

23. 12-23 Determining the Functional Currency FASB 52 provides specific guidelines for translating a foreign currency into U.S. dollars to allow preparation of consolidated financial statements measured, or denominated, in dollars. The purpose of FASB 52 is to present results that are directly sympathetic to the real economic effects of exchange rate movements.

24. 12-24 Determining the Functional Currency Functional currency is defined as “the currency of the primary economic environment in which the entity operations; normally that is the currency of the environment in which an entity primarily generates and receives cash.”

25. 12-25 Determining the Functional Currency FASB 52 indicates that the following six items must be assessed in order to determine an entity’s functional currency: Cash Flows. Sales Prices. Sales Markets. Expenses. Financing. Intercompany Transactions.

26. 12-26 Determining the Functional Currency Most foreign affiliates use their local currency as the functional currency because the majority of cash transactions of a business generally take place in the currency of the country in which the entity operates. Also, the foreign affiliate usually has active sales markets in its own country and obtains financing from local sources.

27. 12-27 Determining the Functional Currency Some foreign-based entities, however, use a functional currency different from the local currency: for example, –A U.S. company subsidiary in Venezuela may conduct virtually all of its business in Brazil, –A branch or a subsidiary of a U.S. company operating in Britain may well use the U.S. dollar as its major currency although it maintains its accounting records in British pounds sterling.

28. 12-28 Determining the Functional Currency For example, the following factors would indicate that the U.S dollar is the functional currency for the British subsidiary: –Most of its cash transactions are in U.S. dollars. –Its major sales markets are in the U.S. –Production components are generally obtained from the U.S. –The U.S. parent is primarily responsible for financing the British subsidiary.

29. 12-29 Determining the Functional Currency The functional currency approach requires the translation of all the foreign entity’s transactions into the functional currency of the foreign entity. If an entity has transactions denominated in other than its functional currency, the foreign transactions must be adjusted to their equivalent functional currency value before the company may prepare financial statements.

30. 12-30 Functional Currency Designation in Highly Inflationary Economies An exception to the criteria for selecting a functional currency is specified when the foreign entity is located in countries such as Argentina and Peru, which have experienced severe inflation. Severe inflation is defined as inflation exceeding 100 percent over a three-year period.

31. 12-31 Highly Inflationary Economies The FASB concluded that the volatility of hyperinflationary currencies distorts the financial statements if the local currency is used as the foreign entity’s functional currency.

32. 12-32 Highly Inflationary Economies Therefore, in cases of operations located in highly inflationary economies, the reporting currency of the U.S. parent—the U.S. dollar—should be used as the foreign entity’s functional currency.

33. 12-33 Highly Inflationary Economies Once a foreign affiliate’s functional currency is chosen, it should be used consistently. However, if changes in economic circumstances necessitate a change in the designation of the foreign affiliate’s functional currency, the accounting change should be treated as a change in estimated: current and prospective treatment only, no restatement of prior periods.

34. 12-34 Translation versus Remeasurement Two different methods are used to restate foreign entity statements to U.S. dollars: »Translation »Remeasurement

35. 12-35 Translation versus Remeasurement Translation is the most common method used and is applied when the local currency is the foreign entity’s functional currency.

36. 12-36 Translation versus Remeasurement This is the normal case in which, for example, a U.S. company’s Swiss subsidiary uses the Swiss franc as its recording and functional currency. The subsidiary’s statements must be translated from the Swiss franc into the U.S. dollar.

37. 12-37 Translation versus Remeasurement To translate the financial statements, the company will use the current rate, which is the exchange rate on the Balance Sheet date to convert the local currency balance sheet account balances to the U.S. dollar.

38. 12-38 Translation versus Remeasurement Remeasurement is the restatement of the foreign entity’s financial statements from the local currency measures used by the entity into the foreign entity’s functional currency. Remeasurement is required only when the functional currency is different from the currency used to maintain the books and records for the foreign entity.

39. 12-39 Translation versus Remeasurement After remeasurement, the statements must then be translated if the functional currency is not the U.S. dollar. No additional work is needed if the functional currency is the U.S. dollar.

40. 12-40 Translation versus Remeasurement For example, a relatively self-contained Canadian sales branch of a U.S. company may use the U.S. dollar as its functional currency, but may select the Canadian dollar as its recording and reporting currency.

41. 12-41 Translation versus Remeasurement Of course, if the Canadian branch used the U.S. dollar for both its functional and its reporting currency. No translation or remeasurement is necessary: its statements are already measured in U.S. dollars and are ready to be combined with U.S. home office statements.

42. 12-42 Translation versus Remeasurement One application of remeasurement is for affiliates located in countries experiencing hyperinflation. For example, an Argentinean subsidiary of a U.S. parent records and reports its financial statements in the local currency, the Argentine peso.

43. 12-43 Translation versus Remeasurement However, because the Argentine economy experiences inflation exceeding 100 percent over a three-year period, the U.S. dollar is specified as the functional currency for reporting purposes and the subsidiary’s statements must then be remeasured from Argentine pesos into U.S. dollars.

44. 12-44 Translation Most business entities transact and record business activities in the local currency. Therefore, the local currency of the foreign entity is its functional currency. The translation of the foreign entity’s statement into U.S. dollars is a relatively straightforward process.

45. 12-45 Translation Exchange Rates ACCOUNTS EXCHANGE RATES_______ Revenue & Expense Generally, weighted-average exchange rate for period covered by statement Assets & Liabilities Current exchange rate on balance sheet date Stockholders’ Equity Historical exchange rates

46. 12-46 Translation Adjustment Because a variety of rates are used to translate the foreign entity’s individual accounts, the trial balance debits and credits after translation generally are not equal. The balancing item to make the translated trial balance debits equal the credits is called the translation adjustment.

47. 12-47 Translation Adjustment The translation adjustment resulting from the translation process is part of the entity’s comprehensive income for the period. FASB 130 requires the reporting of comprehensive income as part of the primary financial statements of the entity.

48. 12-48 Remeasurement A second method of restating foreign affiliates’ financial statements in U.S. dollars is remeasurement. Although remeasurement is not as commonly used as translation, some situations exist in which the functional currency of the foreign affiliate is not local currency.

49. 12-49 Remeasurement Remeasurement is similar to translation in that its goal is to obtain equivalent U.S. dollar values for the foreign affiliate’s accounts so they may be combined or consolidated with the U.S. company’s statements.

50. 12-50 Remeasurement The exchange rates used for remeasurement, however, are different from those used for translation, resulting in different dollar values for the foreign affiliate’s accounts.

51. 12-51 Remeasurement The remeasurement process divides the balance sheet into monetary and nonmonetary accounts. Monetary assets and liabilities, such as cash, short-term or long-term receivables, and short- term or long-term payables, have their amounts fixed in terms of the units of currency.

52. 12-52 Remeasurement Nonmonetary assets are accounts such as inventories, and plant equipment, which are not fixed in relation to monetary units. The monetary accounts are remeasured using the current exchange rate.

53. 12-53 Remeasurement These accounts are subject to gains or losses from changes in exchange rates. The appropriate historical exchange rate is used to remeasure nonmonetary balance sheet account balances and related revenue, expense, gain, and loss account balances.

54. 12-54 Remeasurement Gain or Loss Because of the variety of rates used to remeasure the foreign currency trail balance, the debits and credits of the U.S. dollar equivalent trial balance will probably not be equal. In this case, the balancing item is the remeasurement gain or loss, which is included in the period’s income statement.

55. 12-55 Remeasurement Gain or Loss Any exchange gain or loss arising from the remeasurement process is included in the current period’s income statement, usually under “Other Income.” Various account titles are used, such as Foreign Exchange Gain (Loss), Currency Gain (Loss), Exchange Gain (Loss), or Remeasurement Gain (Loss).

56. 12-56 Hedge of a Net Investment FASB 133 states that the gain or loss on the effective portion of a hedge of a net investment is taken to other comprehensive income as part of the translation adjustment. –However, the amount of offset to comprehensive income is limited to the translation adjustment for the net investment.

57. 12-57 Additional Disclosure Requirements FASB 52 requires that the aggregate foreign transaction gain or loss included in income must be separately disclosed in the income statement or in an accompanying note. –This includes gains or losses recognized from foreign currency transactions, forward exchange contracts, and any remeasurement gain or loss.

58. 12-58 Additional Disclosure Requirements If not disclosed as a one-line item on the income statement, this disclosure is usually a one-sentence footnote summarizing the company’s foreign operations.

59. 12-59 You Will Survive This Chapter !!! The restatement of a foreign affiliate’s financial statements in U.S. dollars may be made using the translation or remeasurement method, depending on the foreign entity’s functional currency. Most foreign affiliates’ statements are translated using the current rate method because the local currency unit is typically the functional currency.

60. McGraw-Hill/Irwin© 2008 The McGraw-Hill Companies, Inc. All rights reserved. 12 Multinational Accounting: Translation of Foreign Entity Statements End of Chapter