1. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-1 Chapter 36 Translating the financial statements of foreign operations

2. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-2 Objectives of this lecture Understand why it is necessary to translate the financial statements of foreign subsidiaries to a specific presentation currency before the consolidation process is performed Be able to translate the financial statements of a foreign operation into a particular functional currency Be able to translate the financial statements of a foreign operation into a particular presentation currency Understand which rates to use when translating the financial statements of a foreign operation

3. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-3 Introduction to translating the financial statements of foreign operations The consolidation process involves combining the financial statements of a parent and its controlled entities (that is, its subsidiaries) If some of the controlled entities are foreign entities with account balances denominated in different foreign currencies, there is a need to translate these accounts to a given presentation currency (e.g. Australian dollars) before the consolidation process Accounting standard relating to the translation of foreign subsidiaries is AASB 121 The Effects of Changes in Foreign Exchange Rates

4. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-4 Introduction to translating the accounts of foreign operations (cont.) Note AASB 121 permits selection of a presentation currency, which need not be Australian dollars A single method of translation is to be used to translate the accounts of foreign subsidiaries into a particular presentation currency

5. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-5 Different classifications of currencies Reference can made to three different types of currencies, these being local currency, functional currency, and presentation currency. These currencies can be defined as follows: Local currency: the currency used in the country in which the foreign operation is located Functional currency: AASB 121, paragraph 8, defines functional currency as ‘the currency of the primary economic environment in which the entity operates’ Presentation currency: AASB 121, paragraph 8, defines the presentation currency as ‘the currency in which the financial statements are presented’

6. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-6 Considerations of the functional currency In this lecture we will consider two situations –First, we will consider translating the financial statements of an entity into a particular functional currency –Then, we will consider how to translate the financial statements of an entity from a particular functional currency into a particular presentation currency (which is required prior to consolidation) If the functional currency is the same as the local currency, then there will be no need to translate the financial statements of the foreign operation into the functional currency, as the financial statements prepared in the local currency will already have been prepared in the functional currency In such circumstances we will only need to translate the foreign operation’s financial statements into the group’s presentation currency (a one-step as opposed to a two-step process)

7. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-7 Translating the accounts into a particular functional currency According to AASB 121, functional currency is ‘the currency of the primary economic environment in which the entity operates’ According to paragraph 12 of AASB 121, management uses its judgment ‘to determine the functional currency that most faithfully represents the economic effects of the underlying transactions, events and conditions’

8. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-8 Translating the accounts into a particular functional currency (cont.) If a parent entity has a subsidiary located in another country then the first task to be undertaken prior to the consolidation process is to determine the functional currency of the overseas subsidiary For example, if an Australian parent has a subsidiary that is located in New Zealand then it is likely that the subsidiary would maintain its accounts in the local currency, which is New Zealand dollars For the functional currency of the subsidiary to be Australian dollars there would be an expectation that there is a high degree of dependence between the subsidiary and the parent entity. Perhaps the entity acquires products directly from the parent entity and sells the products at prices based on the Australian dollar

9. . Translating the accounts into a particular functional currency (cont.) If the functional currency is determined to be Australian dollars then there will be a need to translate the New Zealand accounts from New Zealand dollars into Australian dollars. By contrast, if the subsidiary operates quite independently of the Australian parent — perhaps because it produces the goods locally, and sells its products at prices based on New Zealand dollars — then the functional currency might be New Zealand dollars and there would be no need to translate the accounts into a different functional currency Once the subsidiary’s accounts have been translated into the appropriate functional currency then the accounts will need to be translated to the appropriate presentation currency prior to consolidation (e.g. for BHP Billiton the presentation is US$) Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-9

10. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-10 Translating the accounts into a particular functional currency (cont.) Paragraphs 21 and 23 of AASB 121 provide the rules for translating one currency into another currency. In relation to items included within the statement of comprehensive income, paragraph 21 states: A foreign currency transaction shall be recorded, on initial recognition in the functional currency, by applying to the foreign currency amount the spot exchange rate between the functional currency and the foreign currency at the date of the transaction There is a general requirement that each item of expense and revenue shall be translated at the spot exchange rate between the functional currency and the local currency on the dates the respective transactions took place

11. . Translating the accounts into a particular functional currency (cont.) However, this would be an extremely time-consuming and difficult task and, as such, AASB 121 allows average rates to be used. For example, an average exchange rate between the local currency and the functional currency for a month may be used to translate transactions that occurred within that month. As paragraph 22 of AASB 121 states: For practical reasons, a rate that approximates the actual rate at the date of the transaction is often used, for example, an average rate for a week or a month might be used for all transactions in each foreign currency occurring during that period. However, if exchange rates fluctuate significantly, the use of the average rate for a period is inappropriate Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-11

12. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-12 Translating the accounts into a particular functional currency (cont.) The above requirements relate to accounts contained within the statement of comprehensive income. In relation to accounts that would generally be presented within the statement of financial position, paragraph 23 of AASB 121 states: At each reporting date: (a) foreign currency monetary items shall be translated using the closing rate (b) non-monetary items that are measured in terms of historical cost in a foreign currency shall be translated using the exchange rate at the date of the transaction, and (c) non-monetary items that are measured at fair value in a foreign currency shall be translated using the exchange rates at the date when the fair value was determined

13. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-13 Translating the accounts into a particular functional currency (cont.) In relation to non-monetary assets, such as plant and equipment, AASB 116 Property, Plant and Equipment allows that either cost or fair value be used as the basis of measurement If the cost basis is used, and consistent with paragraph 23, the rate to be used to translate the local currency to the functional currency is the spot rate as at the date the asset was originally recognised by the subsidiary If fair values are used by way of undertaking revaluations, then the exchange rate to be used between the foreign currency and the functional currency will be the exchange rate in place when the valuation was made

14. . Translating the accounts into a particular functional currency (cont.) The rates to be used to translate financial statements into a given functional currency are summarised in Table 36.1 – see the next slide Applying the requirements of AASB 121 as they relate to translating the accounts from a local currency to a particular functional currency means that the final accounts, after translation, will reflect amounts that would be recorded had the transactions or events been originally recorded in the functional currency Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-14

15. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-15 Summary of rates used when translating financial statements into a functional currency CategoryRate Assets Monetary Translate at the spot exchange rate at reporting rate (that is, at the closing rate) Non-monetary—held at historical cost Translate at the spot rate at the day the asset was recorded by the subsidiary Non-monetary—fair valueTranslate at the exchange rate at the date of valuation Liabilities MonetaryTranslate at the closing rate Non-monetaryTranslate at the exchange rate at the date of valuation Equity Contributed equity—at acquisition Translated at the rate when the investment acquired Reserves—at acquisitionTranslated at the rate when the investment acquired Reserves—post acquisition If the transfer to reserves is the result of a revaluation of property plant and equipment the rate used is the rate at the date of the revaluation Retained earnings—at acquisition Translated at the rate when the investment acquired

16. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-16 Summary of rates used when translating financial statements into a functional currency (cont.) Revenues and expenses Translated at the rate in place at the date of the transaction. For practical purposes, a rate that approximates the actual rate of the transaction can be used Non-monetary related expenses, e.g. depreciation Translated at the rate used to translate the related non-monetary item Distributions Dividends paidTranslated at the current rate at the date of payment Dividends declaredTranslated at the current rate at the date the dividends are declared

17. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-17 Worked Example 36.1—Translation from a foreign currency into a functional currency On 1 July 2011, Kiwi Ltd, a New Zealand company whose shares are listed on the New Zealand Securities Exchange, acquired all the equity in Bulldog plc, a company incorporated in England Because of the high level of dependence of Bulldog plc on Kiwi Ltd, the functional currency is deemed to be the New Zealand dollar The exchange rates for the reporting period ending 30 June 2012 are shown below: 1 July 2011 UK£1 = NZ$3.00 Average rate for the year UK£1 = NZ$3.10 Ending inventory (acquired before year end) UK£1 = NZ$3.20 30 June 2012 UK£1 = NZ$3.30

18. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-18 Worked Example 36.1—Translation from a foreign currency into a functional currency (cont.) Bulldog plc Statement of comprehensive income and details of closing retained earnings for the year ended 30 June 2012 UK£000 Sales 2 500 Cost of sales: Inventory—1 July 2011 (500) Purchases (2 000) Inventory—30 June 2012 450 Administration expenses (75) Depreciation expense (100) Profit before tax 275 Income tax expense (125) Profit for the year 150 Retained earnings—1 July 2011 150 Retained earnings—30 June 2012 300

19. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-19 Worked Example 36.1—Translation from a foreign currency into a functional currency (cont.) Bulldog plc Statement of financial position as at 30 June 2012 1 July 2011 30 June 2012 UK£000 Assets Property, plant and equipment 1 050 950 Cash and debtors 100 800 Inventory 500 450 Total assets 1 650 2 200 Liabilities Bank loan 1 000 1 000 Trade creditors – 400 Total liabilities 1 000 1 400 Net assets 650 800 Equity Share capital 500 500 Retained earnings 150 300 650 800 REQUIRED Translate the financial statements of Bulldog plc into the functional currency

20. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-20 Worked Example 36.1—Solution Bulldog plc Statement of comprehensive income for the year ending 30 June 2012 Exchange UK£000 rate NZ$000 Sales 2 500 3.10 7 750.0 Cost of sales: Inventory—1 July 2011 (500) 3.00 (1 500.0) Purchases (2 000) 3.10 (6 200.0) Inventory—30 June 2012 450 3.20 1 440.0 Administration expenses (75) 3.10 (232.5) Depreciation expense (100) 3.00 (300.0) Foreign exchange loss ---– (210.0) Profit before tax 275 747.5 Income tax expense (125) 3.10 (387.5) Profit for the year 150 360.0 Retained earnings—1 July 2011 150 3.00 450.0 Retained earnings—30 June 2012 300 810.0

21. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-21 Worked Example 36.1—Solution Bulldog plc Statement of financial position as at 30 June 2012 Exchange UK£000 rate NZ$000 Assets Property, plant and equipment 950 3.00 2 850 Cash and debtors 800 3.30 2 640 Inventory 450 3.20 1 440 Total assets 2 200 6 930 Liabilities Bank loan 1 000 3.30 3 300 Trade creditors 400 3.30 1 320 Total liabilities 1 400 4 620 Net assets 800 2 310 Share capital 500 3.00 1 500 Equity Retained earnings 300 810 800 2 310

22. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-22 Worked Example 36.1—Solution (cont.) Reconciliation of foreign exchange loss Current rate NZ$ less gain/ UK£000 UK£000 rate applied (loss) Net monetary assets at 1/7/2011 Bank loan (1 000) Cash and debtors 100 (900) (3.30 – 3.00) (270) Increases in monetary assets—sales 2 500 (3.30 – 3.10) 500 Decreases in monetary assets resulting from: Purchases (2 000) (3.30 – 3.10) (400) Cash expenses (75) (3.30 – 3.10) (15) Income tax expense (125) (3.30 – 3.10) (25) (600) (210) Reconciled to net monetary items at 30 June 2012 as follows: Bank loan (1 000) Creditors (400) Cash and debtors 800 (600)

23. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-23 Translating the accounts of foreign operations into the presentation currency Before consolidating the financial statements of the parent entity and its subsidiaries it will be necessary to convert the financial statements of the various foreign subsidiaries from their respective functional currencies into the presentation currency of the parent entity Under the approach required by AASB 121 all assets and liabilities of a foreign operation are to be translated from the functional currency to the presentation currency using the spot rate applicable at reporting date Income and expenses are translated at the exchange rates in place at the dates of the various transactions If expense and revenue transactions are considered to occur uniformly throughout the period, average rates may be used Any resulting translation gains or losses are taken directly to reserves (rather than to profit or loss, which was the case when we translated the financial statements from a local currency to the functional currency)

24. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-24 Translating the accounts of foreign operations into the presentation currency (cont.) The approach to translating the accounts of a foreign subsidiary from a particular functional currency to a particular presentation currency is as follows: (a) Assets and liabilities are translated at the exchange rate current at reporting date (b) Equity at the date of the investment, including in the case of a corporation, share capital at acquisition and pre- acquisition reserves, is translated at the exchange rate current at that date of investment (c) Post-acquisition movements in equity, other than retained earnings (surplus) or accumulated losses (deficiency), are translated at the exchange rates current at the dates of those movements, except that, where a movement represents a transfer between items within equity, the movement is translated at the exchange rate current at the date that the amount transferred or returned was first included in equity

25. . Translating the accounts of foreign operations into the presentation currency (cont.) (d)Distributions from retained earnings (i.e. dividends paid or declared, or their equivalent) are translated at the exchange rates current at the dates when the distributions were first declared (e)Revenue and expense items are translated at the exchange rates current at the applicable transaction dates Table 36.2 (next slide) summarises the approach to translating the accounts of a foreign subsidiary Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-25

26. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-26 Summary of the method to be applied for translating financial statements from a given functional currency to a specific presentation currency Assets Monetary assetsTranslated at closing rate Non-monetary assets—measured at historical cost Translated at closing rate Non-monetary assets—measured at fair valueTranslated at closing rate Liabilities MonetaryTranslated at closing rate Non-monetaryTranslated at closing rate Equity Share capital and reserves at date of acquisitionTranslated at spot rate when investment acquired Post-acquisition movements in share capital and reserves (excluding retained earnings/accumulated losses) Translated at the spot rate at the date they were recognised in the accounts Post-acquisition retained earningsAmount determined from translating the statement of comprehensive income (cont.)

27. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-27 Summary of the method to be applied for translating financial statements from a given functional currency to a specific presentation currency (cont.) Revenues and expenses RevenuesTranslated at the rate in place as at the time of the transaction. For practical reasons, however, it is acceptable to use a rate that approximates the rate in place when the transactions took place (e.g. to use an average rate for the year) Expenses (apart from the amortisation or depreciation of non-current assets) Translated at the rate in place as at the time of the transaction. For practical reasons, however, it is acceptable to use a rate that approximates the rate in place when the transactions took place (e.g. to use an average rate for the year) Depreciation/Amortisation Translated at the average rate for the year Income tax expenseTranslated at the average rate for the year Distributions Dividends paid/declaredTranslated at the spot rate when paid/declared

28. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-28 Worked Example 36.2—Translation of a foreign operation’s financial statements from a functional currency into a presentation currency On 1 July 2011 Bruce Ltd, an Australian company, acquires all the issued shares in Nigel plc, a company incorporated in England. Exchange rates for the year ending 30 June 2012 are as follows: 01 July 2011 £1.00 = A$2.00 Average rate for year £1.00 = A$2.10 Ending inventory acquired (before year end) £1.00 = A$2.20 30 June 2012 £1.00 = A$2.30 The statement of comprehensive income and statement of financial position of Nigel plc are shown on the next slides. The accounts are stated in UK£, which is Nigel plc’s functional currency

29. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-29 Worked Example 36.2—Translation of a foreign operation’s financial statements from a functional currency into a presentation currency (cont.) Abbreviated statement of comprehensive income for Nigel plc for the year ending 30 June 2012 and details of closing retained earnings UK£ Sales 2 500 Cost of sales Inventory—01 July 2011 (500 ) Purchases (2 000 ) Inventory—30 June 2012 450 Administration expense (75 ) Depreciation expense (100 ) Profit 275 Income tax expense (125 ) Profit after tax 150 Retained earnings—01 July 2011 150 Retained earnings—30 June 2012 300

30. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-30 Worked Example 36.2—Translation of a foreign operation’s financial statements from a functional currency into a presentation currency (cont.) Statement of financial position for Nigel plc as at 30 June 2012 01 July 2011 30 June 2012 (UK£) Assets Plant and equipment 1 050 950 Cash and debtors 100 800 Inventory 500 450 Total assets 1 650 2 200 Liabilities Bank loan 1 000 1 000 Trade creditors – 400 Total liabilities 1 000 1 400 Net assets 650 800 Represented by: Shareholders’ funds Share capital 500 500 Retained earnings 150 300 650 800 REQUIRED Translate the financial statements of the foreign operation from the functional currency of the subsidiary into the presentation currency of the group

31. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-31 Worked Example 36.2—Solution Statement of comprehensive income and reconciliation of retained earnings, for Nigel plc for the year ending 30 June 2012 (UK£) (Rate) (A$) Sales 2 500 2.10 5 250 Cost of sales Inventory—01 July 2011 (500 ) 2.00 (1 000 ) Purchases (2 000 ) 2.10 (4 200 ) Inventory—30 June 2012 450 2.20 990 Administration expense (75 ) 2.10 (157.5 ) Depreciation expense (100 ) 2.10 (210 ) Profit 275 672.5 Income tax expense (125 ) 2.10 (262.5 ) Profit after tax 150 410 Retained earnings—01 July 2011 150 2.00 300 Retained earnings—30 June 2012 300 710

32. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-32 Worked Example 36.2—Solution (cont.) Statement of financial position for Nigel plc as at 30 June 2012 01 July 2011 30 June 2012 (UK£) (UK£) (Rate) (A$) Assets Plant and equipment 1 050 950 2.30 2 185 Cash and debtors 100 800 2.30 1 840 Inventory 500 450 2.30 1 035 1 650 2 200 5 060 Liabilities Bank loan 1 000 1 000 2.30 2 300 Trade creditors – 400 2.30 920 1 000 1 400 3 220 Net assets 650 800 1 840 Represented by: Shareholders’ funds Share capital 500 500 2.00 1 000 Foreign currency translation reserve 130 * Retained earnings 150 300 710 ** 650 800 1 840 *See calculation provided overleaf **See statement of comprehensive income

33. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-33 Worked Example 36.2—Solution (cont.) Foreign currency translation reserve All assets and liabilities of the foreign subsidiary are translated at the reporting date spot rate. Because we know that assets less liabilities equals owners’ equity, it follows that in effect the total of owners’ equity is translated at the reporting date spot rate However, the individual components of owners’ equity will be translated differently. The share capital will be translated using the rate in place when the investment was acquired Retained earnings will be the balance provided from the statement of comprehensive income (which might use a variety of rates). The translation gain, which does not go to the statement of comprehensive income but remains part of equity, is in effect the balancing item When the foreign operation is ultimately disposed of, the amount accumulated in equity as the foreign currency translation reserve will be treated as part of profits The transfer to the foreign currency translation reserve is determined as follows: Net assets at 30 June 2012 at closing rate (800 × $2.30) $1 840 less Components of net assets at their historical rates – Share capital 500 × $2.00 ($1 000 ) – Retained earnings from statement of comprehensive income ($710 ) Translation gain—to foreign currency translation reserve $130

34. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-34 Consolidation subsequent to translation After translation of foreign subsidiary’s financial statements, consolidation takes place according to normal principles (refer to Chapters 28 to 32) –Cost of investment eliminated against pre-acquisition capital and reserves of controlled entities, with resultant goodwill or discount being recognised –Pre-acquisition capital and reserves are translated at the rates in place when the investment was acquired, i.e. same rates used each year so the goodwill or discount recognised on consolidation does not fluctuate

35. . Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 6e 36-35 Consolidation subsequent to translation (cont.) –Non-controlling interests will be determined following translation of accounts –foreign currency translation reserve will reside in the subsidiaries’ statement of financial position before the consolidation adjustments and the non-controlling interests will be allocated a proportion of this reserve