Chapter 12 1

Chapter 12

Translation and Consolidation of

the Financial Statements of

Foreign Operations

Chapter 12 2

Learning Objectives

– How do you consolidate statements of foreign operations which are produced in a foreign currency?

– Outline the differences between the different translation methods

– To differentiate between an integrated and a self-sustaining foreign operation, and describe the translating method and unit of measure that is used in the translation of each type

Chapter 12 3

Learning Objectives

– To prepare translated financial statements for each type of foreign operation (self-sustaining and integrated)

– To use translated financial statements to prepare consolidated financial statements

• Where sub is 100% owned and there is no purchase discrepancy

• Where sub is < 100% owned and there is a purchase discrepancy to be amortized

Chapter 12 4

Introduction

• Two major accounting questions are posed by the translation of foreign currency financial statements:

– What exchange rates are appropriate?– How should the resulting exchange gains and

loses be reflected in the financial statements?

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Translation of Financial Statements

• Translation is the conversion of a set of financial statements, originally prepared in one currency, to another currency (often so that a subsidiary may be consolidated with the parent)

• Textbook describes methods used prior to Section 1650 was issued. Read for general interest only.

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What type of foreign operation is it?• First step is to determine the type of foreign

operation:– Self-sustaining foreign operation– Integrated foreign operation

• Two types of statement translation (to be defined later)– Current method– Temporal method

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Types of foreign operations

• Integrated foreign operation - is one which is financially or operationally inter-dependent with the reporting enterprise such that the exposure to exchange rate changes is similar to the exposure which would exist had the transactions and activities of the foreign operation been undertaken by the reporting enterprise (CICA Handbook, 1650.03)

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Types of foreign operations

• Self-sustaining foreign operation – is one which is financially and operationally independent of the reporting enterprise such that the exposure to exchange rate changes is limited to the reporting enterprise’s net investment in the foreign operation (CICA Handbook, 1650.03)

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WHICH TYPE OF OPERATION IS IT?• Exhibit 12.1 – looks at 6 factors which are

used to determine whether an operation is integrated or self-sustaining

a

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Rules for Translation method• Integrated foreign operations

– Use TEMPORAL METHOD

• Self-sustaining foreign operations– Use CURRENT METHOD

EXCEPT:

– If highly inflationary economy, then use TEMPORAL METHOD to not distort statements

(ie. cumulative inflation rate of 100% over 3 years)

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TRANSLATION METHODS• The logic behind the translation methods is to best

reflect the entity’s economic exposure to changing exchange rates.

• In situations where the accounting principals used are different from Canada’s, the foreign operation financial statements must be adjusted to conform to Canadian GAAP and then translated into Canadian dollars

• F/X gains and losses:• If the operation is INTEGRATED, then it is as if the

parent company conducted all transactions itself– Therefore all f/x gains and losses are shown in income

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TRANSLATION METHODS• If the operation is SELF-SUSTAINING, the risk to the

parent is limited to the investment in the operation and day-to-day cash flows shouldn’t affect the parent because they aren’t realized until parent’s investment in sub is sold– Therefore all f/x gains and losses are shown on the balance

sheet– Prior to Oct 2006: shown in Shareholder’s equity in

“Cumulative translation adjustment”– After Oct 2006: shown in Shareholder’s equity “other

comprehensive income”– When parent sells all or part of its investment in the sub, the

cumulative f/x gains and losses are moved off the balance sheet into income

– Unrealized losses for the current year are shown in comp income on the Income Statement

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DESCRIPTION OF TRANSLATION METHODS

– CURRENT METHOD• For self-sustaining operations

– TEMPORAL METHOD• for integrated operations• For self-sustaining operations in high

inflationary environments

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1. CURRENT METHOD• Income statement: Average historical rate• All assets and liabilities on B/S: Current rate• Equity: average historical rates for the years

(calculated)• Unrealized f/x gains/losses shown in Other

comprehensive income (equity section of B/S)

• Note: financial ratios where B/S items are compared are identical whether statements are in Cdn or foreign currency

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2. TEMPORAL METHOD• Income statement: average historical rate• Monetary items on B/S: Current rate• Nonmonetary items on B/S: historical rates (generally,

the rate on the date of acquisition of the item)• Equity: historical rates(ie the average historical rate for each year- ie. calculated)

• Notes: 1. Depreciation uses the rate of when asset was aquired or date

of purchase of the sub2. COGS is calculated based on rates of Beg inventory (ie. Beg

rate), End inventory (rate at which EI was purchased) , and purchases (avg rate for yr).

3. Financial ratios where B/S items are compared will be different depending on whether statements are in Cdn or foreign currency

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SUMMARY OF EXCHANGE RATES• EXHIBIT 12.5

b

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EXAMPLE• On Dec 31, yr 1 P acquired 100% of S in

Venezuela at a cost of 2,000,000 B. Exchange rate is B1 = $0.128.

1) What is journal entry on acquisition?

2) How would you translate the balance sheet on acquisition under both methods?

c

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Example – cont’d• On Dec 31, year 2 (ie. after 1 year of

operations), how would you translate the financial statements, assuming:

A) the subsidiary is self-sustaining

B) the subsidiary is integrated

d

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CALCULATION OF GAIN/LOSSSELF-SUSTAINING:• Compare:

– Actual net assets @ current rate xxx– Calculated net assets @ hist rates

xxx• Beg. Balance @ beg x-rate• Net income @ avg for the yr• Less dividends @ hist rate

– Difference = f/x gain or lossxxx

e

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CALCULATION OF GAIN/LOSSINTEGRATED:• Compare:

– Actual net monetary position @ current rate xx– Calculated net monetary position xx

• Beg position @ beg rate• Sales @ avg rate• Less: Purchases @ avg rate• Less: other exp @ avg rate• Less: dividends @ avg rate

– Difference = f/x gain or lossxx f

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PURCHASE DISCREPANCY AND NON-CONTROLLING INTEREST

• Temporal method (integrated) – no issue• Just amortize as normal

• Current method (self-sustaining):– Creates additional f/x gain or loss

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EXAMPLE• Year of acquisition: no issue• After subsequent operations:

– Amortize GW and FV increments based on historical rates

– Calculate GW based on today’s rate– The difference is an unrealized f/x gain/loss

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AmortizationGoodwill – beg balance @ beg x-rateImpairment loss @ avg rate(A) Calculated goodwill xxxxxx

Actual goodwillGoodwill in foreign currency xxxLess: impairment in for. currency xxxActual goodwill xxx(B) @ current exchange rate xxxx

Gain/loss = A - B

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Amoritization• Same idea would hold true for fair value

increments but the depreciation would be done at the exchange rate in effect when the asset was purchased (or when the company was bought)

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CONSOLIDATION ENTRIES• Same as normal except that there is a new f/x gain

and loss:

Impairment loss xxxOther comp. income (dr or cr) xxx

Goodwill xxx

• Non-controlling interest is calculated as normal:Beg Non-Controlling InterestLess Non-controlling interest in comp. incomeLess Non-controlling interest in dividends paid

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Other Considerations

• Other items that must be considered when a foreign subsidiary is been consolidated:

– Lower of cost and market (compare market and cost at CDN values)

– Intercompany profit