1. Chapter 8 Accounting for Foreign Investments © 2013 Advanced Accounting, Canadian Edition by G. Fayerman

2. Defining Functional Currency In order to determine what is considered to be a “foreign currency,” a “functional currency” must be first identified. Once a company’s functional currency is identified, then inherently, all other currencies are considered to be foreign. Functional currency is determined on a company-by- company basis, and reflects the primary economic environment in which a company operates. We now expand the criteria to relate to a group of companies that are required to report together. LO 1

3. Hierarchy of Criteria: Step 1 A company’s functional currency is determined through a hierarchy (found in IFRS 21). STEP 1: Consider the primary indicators, which require the determination of the functional currency to be based on the currency: o that mainly influences sales prices for goods and services o of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services o that mainly influences labour, material, and other costs of providing goods or services (this will often be the currency in which such costs are denominated and settled). LO 1

4. Hierarchy of Criteria: Step 2 STEP 2: When the functional currency is not clearly evident from the primary indicators, consider the following secondary indicators: o the currency in which funds from financing activities are generated and o the currency in which receipts from operating activities are usually retained. The functional currency will normally be evident at this point. LO 1

5. Hierarchy of Criteria: Step 3 When a group is present, an additional step is required. STEP 3: When the functional currency is being determined for a foreign operation (i.e., a subsidiary, branch, associate, or joint venture of a parent company), IFRS 21 provides additional criteria to the primary and secondary indicators in assessing the functional currency of those foreign operations. When a foreign operation’s functional currency is different from that of its parent, it is inherently considered to be a foreign company. LO 1

6. Hierarchy of Criteria This process can be understood as a decision tree outlined in Illustration 8.5. LO 1

7. Hierarchy of Criteria: Summary Under IFRS: The functional currency for each company in the group must be determined first before foreign currencies can be identified. The determination of a company’s functional currency requires the application of a hierarchy to determine the primary economic environment in which a company operates. LO 1

8. Hierarchy of Criteria: Summary Under ASPE: The Canadian dollar is assumed to be the reporting currency, although any currency can be determined to be the reporting currency. The guidance on the determination of functional currency is from the perspective of the reporting company and is limited to whether a foreign operation is fully integrated or self-sustaining. LO 1

9. Foreign Currency Transactions Within the Group Foreign currency transactions are initially recorded using the exchange rate at the date of the transaction (i.e., spot rate). For practical purposes, an average rate to approximate the actual exchange rate at the date of the transaction may be used. If a parent company is transacting with a subsidiary that has a functional currency different than theirs, both companies may potentially have foreign currency transactions. LO 2

10. Foreign Currency Transactions Within the Group Each company in the group records its foreign currency transactions at the rate when the transaction occurred. Monetary items are restated at the closing rate at the financial statement date and any gain or loss is recorded in income. Changes in functional currency occur only if there are significant economic changes in a company’s operations, and the changes are accounted for prospectively. LO 2

11. Translating Individual Financial Statements Into a Group Presentation Currency Most large corporate structures do not share the same functional currency among all entities within the group. Such structures normally comprise operations with a number of functional currencies. The functional currency may not be the same as the presentation currency. When a group is involved, one presentation currency must be selected for presentation of the entire group. LO 3

12. Presentation Currency Differing from the Functional Currency Financial statements can be presented in any currency. When the currency selected for presentation purposes differs from a company’s functional currency, the financial statements need to be translated into this selected presentation currency. LO 3

13. Financial Statement Translation The translation of the financial statements into a presentation currency is completed in the following steps: 1.Assets and liabilities (including comparatives) are translated at the closing rate at the date of the statement of financial position. 2.Income and expenses (including comparatives) for each statement of comprehensive income or separate income statement presented are translated at exchange rates at the dates the transactions took place. (For practical purposes, an average rate to approximate the actual exchange rate at the date of the transactions for income and expenses may be used.) 3.All resulting exchange differences are recognized in other comprehensive income. LO 3

14. Financial Statement Translation Parent Company (PC) has the euro as its functional currency and acquired 100% of Subsidiary Limited (SL), a Canadian company with the Canadian dollar as its functional currency, on November 1, 2013. At acquisition, PC paid $100. PC determined that the fair value of the net assets of SL were equal to their carrying value of $100. The goodwill arising on acquisition was therefore $0. LO 3 Example 8.5

15. Financial Statement Translation The exchange rates were as follows: At acquisition, November 1, 2013 C$1 = €0.6993 Average through the two month period C$1 = €0.7201 Closing rate, December 31, 2013 C$1 = €0.7233 Since the group’s presentation currency is the same as PC’s functional currency (the euro), the following is required to be performed to represent SL’s financial statements in the group’s presentation currency: LO 3 Example 8.5

16. Financial Statement Translation Illustrative Example 8.5 LO 3 Example 8.5

17. Financial Statement Translation Calculation note (a): The amount in the cumulative translation account represents the difference in exchange rates used to convert the assets and liabilities at the spot rate at the reporting date and the rate used to convert income and expense items that are translated at the historical rate. The calculation of this translation gain or loss was illustrated in Chapter 7. Opening equity $10,000 × (0.6993 – 0.7233) = 240 Net income $5,000 × (0.7201 – 0.7233) = 16 Foreign currency gain 256 LO 3 Example 8.5

18. Financial Statement Translation Note that in this example, the gain of 256 for the month is the same as the cumulative foreign currency gain since PC only acquired SL at the beginning of the month. When PC consolidates with SL, it will use this translated statement for the purpose of consolidating with SL. As such, the € 256 gain in the cumulative translation account will carry forward to the consolidated statements. LO 3 Example 8.5

19. Translating Individual Financial Statements Into a Group Presentation Currency: Summary When the functional currency is not the same as the presentation currency, the investee must translate the financial statements using the year-end closing rate for balance sheet accounts and the rate when the transaction occurred for income statement accounts. Any gain or loss on translation into the presentation currency is recorded in other comprehensive income. LO 3

20. Translating Individual Financial Statements Into a Group Presentation Currency: Summary When a company is in a hyperinflationary environment, it must translate all items on its financial statements following IAS 29 Hyperinflationary Economic Environment (see Appendix 8A). When a company chooses to report using a currency of convenience, it must provide sufficient disclosure to the reader. LO 3

21. Preparing Foreign Currency Adjustments for Consolidation or the Equity Method The process of consolidation is very procedural; that is, there are several steps involved in producing consolidated financial statements that reflect appropriate balances where transactions denominated in foreign currencies are concerned. Step 1: Translate foreign currency transactions into a company’s functional currency. LO 4

22. Preparing Foreign Currency Adjustments for Consolidation or the Equity Method Step 2: Translate balances into the presentation currency for the purposes of consolidation or the equity method. Step 3: Execute consolidation adjustments. o Eliminate intercompany balances and transactions. o Account for any fair value adjustments. o Account for any non-controlling interests. LO 4

23. Preparing Foreign Currency Adjustments for Consolidation or the Equity Method Consolidation adjustments must be restated to the presentation currency. Intercompany transactions are eliminated at the rate when the transaction occurred. Monetary balances are eliminated using the year-end rate. LO 4

24. Preparing Foreign Currency Adjustments for Consolidation or the Equity Method Fair value adjustments must be reflected on the balance sheet at the closing rate for the year. Non-controlling interest is allocated its portion of group comprehensive income and net assets based on the statement prepared for presentation purposes. LO 4

25. Preparing Foreign Currency Adjustments for Consolidation or the Equity Method Intragroup monetary balances are translated, with the resulting exchange gain or loss being reflected in net income, unless it forms part of the net investment in the foreign operation, in which case it is reflected in other comprehensive income. When the financial statements of a foreign operation are prepared as of a different date (but within three months of the reporting company), they are translated at the exchange rate at the end of the reporting period of the foreign operation, with adjustments being made for any significant events or other transactions between the different dates. LO 4

26. Preparing Foreign Currency Adjustments for Consolidation or the Equity Method Goodwill and fair value adjustments related to a foreign operation are treated as assets and liabilities of the foreign operation for the purposes of foreign currency translation. LO 4

27. Appendix 8A: Hyperinflationary Environment A hyperinflationary economy is one in which there is a loss of purchasing power of money at such a high rate that to compare amounts from transactions and other events that have occurred at different times, even within the same accounting period, would be misleading. A company cannot avoid restatement in accordance with IAS 29 Financial Reporting in Hyperinflationary Economies by, for example, adopting a stable currency (such as the functional currency of its parent) as its functional currency (IAS 21.14). LO 5

28. Appendix 8A: Preparing Financial Statements If the functional currency is that of a hyperinflationary economy, a company should restate its financial statements in terms of the measuring unit current at the end of the reporting period (this applies to comparative figures as well). In a hyperinflationary economy, all items are restated based on the general price index. These financial statements are sometimes referred to as “purchasing power adjusted financial statements.” LO 5

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