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

2. Learning Objectives
Understand the concept of foreign exchange exposure
Differentiate between operating and accounting exposure
Understand the concept of functional currency
Understand the accounting treatment of foreign currency transactions
Understand the procedures for translating foreign currency financial statements in a non-hyperinflationary environment
Understand the special issues relating to translation
Tan & Lee Chapter 7
© 2009

3. Content Introduction 1. 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
Introduction
Tan & Lee Chapter 7
© 2009

4. Introduction Year1974 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
Tan & Lee Chapter 7
© 2009

5. 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
How exchange rates are quoted
Tan & Lee Chapter 7
© 2009

6. Types of Foreign Exchange Rate Management Regimes
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
Tan & Lee Chapter 7
© 2009

7. 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
Types of foreign exchange rate exposures
Tan & Lee Chapter 7
© 2009

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
1/x : x/x
Tan & Lee Chapter 7
© 2009

9. Spot Rate and Forward Rate
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
Tan & Lee Chapter 7
© 2009

10. Types of Foreign Exchange Rate Exposures
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
Tan & Lee Chapter 7
© 2009

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
© 2009

12. Accounting Exposure (FP item & earning)
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)
Tan & Lee Chapter 7
© 2009

13. 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
Concept of functional currency
Tan & Lee Chapter 7
© 2009

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
© 2009

15. Factors to Indicate an Entity’s Functional Currency
The currency that mainly influences the sale prices of goods and services
The currency of country whose competitive forces and regulations determine the sales prices of goods and services
The currency that mainly influences the labour, material and other cost of goods and services (eg. salary paid in H.K. dollars)
The currency in which financing is obtained ($ borrow from bank)
The currency in which receipts from operating activities are retained
Tan & Lee Chapter 7
© 2009

16. 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
Foreign currency transactions of a stand-alone entity
Tan & Lee Chapter 7
© 2009

17. Timeline of a typical foreign currency transaction
Foreign Currency Transactions (x translation) of a Stand-alone Entity 獨立經營
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
Tan & Lee Chapter 7
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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)
© 2009

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
1FC:$1.5
Tan & Lee Chapter 7
© 2009

20. Transaction (x translation) Exposure
Items exposed to foreign exchange risks (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
Foreign currency depreciates #
Foreign currency appreciates #
Exposed asset*
Exchange loss
Exchange gain
Exposed liability*
1FC:$1.5
1FC:$1.45
1FC:$1.45
1FC:$1.48
*Accounts receivable/ payable in US$
# If the foreign currency increase, you would receive more $ in future as you sign
the contract in the past.
Tan & Lee Chapter 7
© 2009

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
© 2009

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.
Exchange rates 1FC =
1 November 20x1 $1.50
31 December 20x1 $1.45
1 January 20x $1.48
1/11/20x1
Delivery date
31/12/20x1
Year-end
31/1/20x2
Settlement date
1FC = $ FC = $ FC = $1.48
Exchange gain Exchange loss
of $12,500 of $7,500
Tan & Lee Chapter 7
© 2009

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

24. 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
Translation of foreign currency financial statements
Tan & Lee Chapter 7
© 2009

25. Translation of Foreign Currency Financial Statements
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
Results in translation gains or losses
Recorded in the books
of the individual entity
Presented in consolidated
financial statements (group level)
Tan & Lee Chapter 7
© 2009

26. Case study:2010 Midland Consolidated Statement of Comprehensive Income
2010yr yr
Profit for the year $567, $713,723
Other comprehensive income:
Currency translation differences $5, $ 17
Change in fair value of land and buildings upon transfer of properties to investment properties $6, $3,448
Change in fair value of available-for-sale financial assets
$(877) $1,320
Total comprehensive income for the year
$579, $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
Foreign
Currency
Functional
Presentation
Re-measurement / Temporal Method
Closing Rate Method
Tan & Lee Chapter 7
© 2009

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
© 2009

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
© 2009

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 parent
Low proportion
High 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
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31. Choice of Functional Currency
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 3rd currency
Functional currency
should be parent’s currency
Closing rate method
Re-measurement /Temporal Method
(if books kept in foreign currency)
Tan & Lee Chapter 7
© 2009

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
Items
Rate
Assets and liabilities (both monetary and non-monetary)
Closing rate
Income and expense items
Actual or average rate
Translation gain or losses are taken to equity (until disposal of foreign operation)
Tan & Lee Chapter 7
© 2009

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
© 2009

34. Exchange Rates Used for Translating Balance Sheet Items
Financial Position Items
Closing 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
Non-monetary assets and liabilities
(For items acquired before acquisition date: rate at acquisition date)
Non-monetary items at fair value *
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 )
Tan & Lee Chapter 7
© 2009

35. Exchange Rates Used for Translating Income Statement Items
Income Statements Items
Closing Rate Method
Remeasurement / Temporal method
Sales, purchases, expenses and income statement items that result in inflow/outflow of monetary items
Actual / rate
Actual / average rate
Costs of sales
Actual / 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
© 2009

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
© 2009

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
© 2009

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
© 2009

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:
Beta Company
Balance sheet at x3
Assets FC
Plant & equipment
200,000
Inventories
100,000
Account receivable
150,000
Account payable
(80,000)
Net assets
370,000
Share capital
Retained earnings
170,000
Equity
Tan & Lee Chapter 7
© 2009

40. Illustration 2: Translation example
Beta’s financial statements for the year ended 31 December 20x4 are as follows:
Income statement FC
Sales
800,000
Cost of goods sold
(470,000)
Gross profit
330,000
Depreciation
(25,000)
Operating expenses
(200,000)
Profit before tax
105,000
Taxation
(20,000)
Profit after tax
85,000
Dividends paid
Retained profit for year
60,000
Retained profit at 1 Jan
170,000
Retained profit at 31 Dec
230,000
Tan & Lee Chapter 7
© 2009

41. Illustration 2: Translation example
Beta Company
Balance sheet at x4
Assets:
Plant and equipment
225,000
Inventories
120,000
Accounts receivable
200,000
Cash
5,000
Accounts payable
(120,000)
Net assets
430,000
Share capital
Retained earnings
230,000
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. 2 Relevant 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 x4 1.35
Tan & Lee Chapter 7
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43. Illustration 2: Translation example
Required:
Translate the financial statements of Beta Company into dollars assuming that Beta’s functional currency is the FC
Re-measure the financial statements of Beta Company into dollars assuming that Beta’s functional currency is the dollar
Tan & Lee Chapter 7
© 2009

44. Illustration 2: Translation example
Translated Income Statement (Closing Rate method) FC
Rate S$
Sales
800,000
1,136,000
COGS
(470,000)
(667,400)
Gross profit
330,000
468,600
Depreciation
(25,000)
(35,500)
Operating expenses
(200,000)
(284,000)
Profit before tax
105,000
149,100
Taxation
(20,000)
(28,400)
Profit after tax
85,000
120,700
Dividends paid
(35,000)
Retained profit for year
60,000
85,700
Retained profit at 1 Jan
170,000
255,000
Retained profit at 31 Dec
230,000
340,700
* Rate at acquisition date
Tan & Lee Chapter 7
© 2009

45. Illustration 2: Translation example
Beta Company
Balance sheet at x4
Assets FC
Rate S$
Plant and equipment
225,000
303,750
Inventories
120,000
162,000
Accounts receivable
200,000
270,000
Cash
5,000
6,750
Accounts payable
(120,000)
(162,000)
Net assets
430,000
580,500
Share capital
300,000
Retained earnings
230,000
From I/S
340,700
Translation reserves
_______
Bal. fig.
(60,200)
Tan & Lee Chapter 7
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46. Illustration 2: Translation example
Movement in net exposed Items FC
Rate S$
Net assets on 1 Jan
370,000
555,000
Increase in net assets:
Net profit after tax
85,000
120,700
Decrease in net assets:
Dividends paid
(25,000)
(35,000)
Net assets on 31 Dec
430,000
640,700 (A)
580,500 (B)
Translation difference for the year (B – A)
(60,200)
Tan & Lee Chapter 7
© 2009

47. Illustration 2: Translation example
Remeasured Income Statement (Functional currency is S$) FC
Rate S$
Sales
800,000
1.42
1,136,000
COGS
(470,000)
Note (a)
(680,200)
Gross profit
330,000
455,800
Depreciation
(25,000)
Note (b)
(37,250)
Operating expenses
(200,000)
(284,000)
Remeasurement loss
________
Note (c)
(10,550)
Profit before tax
105,000
124,000
Taxation
(20,000)
(28,400)
Profit after tax
85,000
95,600
Dividends paid
1.40
(35,000)
Retained profit for year
60,000
60,600
Retained profit at 1 Jan
170,000
1.50 (Acq date)
255,000
Retained profit at 31 Dec
230,000
315,600
Tan & Lee Chapter 7
© 2009

48. Illustration 2: Translation example
Note (a) – Cost of goods sold (COGS) FC
Rate $
Opening inventories
100,000
1.5
150,000
Purchases
490,000
1.42
695,800
Closing inventories
(120,000)
1.38
(165,600)
COGS
470,000
680,200
Note (b) – Depreciation expense S$
Existing equipment
20,000*
30,000
New equipment (2004)
5,000#
1.45
7,250
25,000
37,250
*S$200,000 ÷ 10 years
# $50,000 ÷ 10 years
Tan & Lee Chapter 7
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49. Illustration 2: Translation example
Note (c): Remeasurement loss
Movement in net exposed items FC
Rate S$
Net monetary assets, 1 Jan
70,0001
1.50
105,000
∆ in monetary assets/liabilities:
Sale
800,000
1.42
1,136,000
Purchase of equipment
(50,000)
1.45
(72,500)
Purchases
(490,000)
(695,800)
Operating expenses
(200,000)
(284,000)
Taxation
(20,000)
(28,400)
Dividends paid
(25,000)
1.40
(35,000)
125,300 (A)
Net monetary assets, 31 Dec
85,0002
1.35
114,750 (B)
Remeasurement loss (B-A)
(10,550)
Tan & Lee Chapter 7
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50. Illustration 2: Translation example
1. Opening exposed monetary items: FC
Accounts receivable
150,000
Accounts payable
(80,000)
Net monetary assets, 1 Jan
70,000
2. Closing exposed monetary items:
200,000
Cash
5,000
(120,000)
Net monetary assets, 31 Dec
85,000
Tan & Lee Chapter 7
© 2009

51. Illustration 2: Translation example
Beta Company
Balance sheet at x4
Assets FC
Rate $
Plant/Equipment
225,000
Note (d)
335,250
Inventories
120,000
1.38
165,600
Accounts receivables
200,000
1.35
270,000
Cash
5,000
6,750
Accounts payables
(120,000)
(162,000)
Net assets
430,000
615,600
Share capital
1.5
300,000
Retained earnings
230,000
From I/S
315,600
Tan & Lee Chapter 7
© 2009

52. Illustration 2: Translation example
Note (d) - Equipment
Existing equipment: FC
Rate S$
Cost
200,000
Accumulated depreciation
(20,000)
Net carrying value
180,000
1.5
270,000
New equipment
50,000
(5,000)
45,000
1.45
65,250
Total
225,000
335,250
Tan & Lee Chapter 7
© 2009