Foreign Currency Financial Statements

ARTHIK DAVIANTI

Identifying the factors that should be considered when

determining an entity’s functional currency

Functional Currency Concept

Functional currency:The currency of the primary economic environment in which an entity operates.Factors for determining functional currency – US GAAP:1. Cash flow of assets and liabilities foreign entity –

denominated and settled in the foreign currency, functional currency: local currency.

2. Sales price is determined by local competition or local government, functional currency: local.

3. Sales market in the parent company’s country – denominated in the parent’s currency, functional currency: parent’s currency.

Functional Currency Concept

Factors for determining functional currency (continue):4. Expenses (labor and material) are provided in

local costs – the functional currency: foreign currency.

5. Financing is dominated in the foreign entity’s local currency – the functional currency: foreign currency.

6. High volume of intercompany transactions and arrangements – functional currency: parent’s currency.

TermsForeign currency: a currency other than the entity’s functional currency.Local currency: the currency of the country to which the reference is made.The reporting currency: the currency in which the consolidated financial statements are prepared.Foreign currency statements: statements prepared in a currency that is not the reporting currency of the parent investor.

Mata Uang FungsionalMata Uang Fungsional – PSAK 10, paragraf 9:Menentukan mata uang fungsional:a) Mata uang (1) yang mempengaruhi harga jual barang

dan jasa; dan (2) dari negara yang kekuatan persainan dan pengaturannya sebagian besar menentukan harga jual barang dan jasa entitas.

b) Mata uang yang paling mempengaruhi biaya tenaga kerja, bahan baku, dan biaya lain dari pengadaan barang atau jasa.

Paragraf 10: bukti mata uang fungsional (a) mata uang sumber dana, (b) matauang sumber penerimaan aktivitas operasi.

Determining the Functional Currency

Two major issues that must be addressed when financial statements are translated from a foreign currency into U.S. dollars (local currency):• Which exchange rate should be used to translate foreign

currency balances to domestic currency?• How should translation gains and losses be accounted

for? Should they be included in income?

Date Currency on Deposit

Current Exchange Rate

Dollar Equivalent

12/31/20X1 £100 $1.80 $180

12/31/20X2 £100 $1.70 $170

Determining the Functional Currency

Exchange rates that may be used in converting foreign currency values to the U.S. dollar:

• The current rate • The historical rate • The average rate for the period

Determining the Functional

Currency• “The currency of the primary economic

environment in which the entity operates; normally that is the currency of the environment in which an entity primarily generates and receives cash”

• Used to differentiate between foreign operations that are self-contained and integrated into a local environment, and those that are an extension of the parent and integrated with the parent

Functional Currency Indicators

Functional Currency Indicators

Functional currency designation in highly inflationary economies• The volatility of hyperinflationary currencies

distorts the financial statements if the local currency is used as the foreign entity’s functional currency • In such cases, the reporting currency of the U.S.

parent (parent’s reporting currency)—the U.S. dollar—should be used as the foreign entity’s functional currency

Understand and explain the differences between

translation and remeasurement.

MethodsMethods for converting the foreign subsidiary’s financial statement (foreign entity’s functional currency:1. If the functional currency is the parent’s currency,

the foreign financial statements are remeasured into the parent’s currency using the temporal method.

2. If the functional currency is the local currency of the foreign entity, the foreign financial statements are translated into the parent’s currency using the current rate method.

Translation Versus Remeasurement of Foreign Financial Statements

Methods used to restate foreign entity statements to U.S. dollars (parent): 1. The translation of the foreign entity’s functional

currency statements into U.S. dollars (parent)2. The remeasurement of the foreign entity’s

statements into the functional currency of the entity• 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

Translation Versus Remeasurement

Summary for U.S. Parent Companies:If LC = FC Translate to U.S. DollarsIf LC ≠ FC Remeasure to FC• If FC = U.S. Dollars, no further work is needed

(this is the case for hyperinflationary currencies)• If FC ≠ U.S. Dollars Translate to U.S. Dollars

LC = Local CurrencyFC = Functional Currency

Translation Versus Remeasurement

Patriot Corp, a US company has a wholly owned subsidiary, Regal Corporation, operates in UK.Translation/remeasurement possibilities are:

Functional Currency

Currency for Accounting

Records

Required Procedures for Consolidating or

CombiningCase 1 British pounds British pounds TranslationCase 2 US dollar British pounds RemeasurementCase 3 Euro British pounds Remeasurement and

translation

The exchange rate to be used for remeasurement and translation in Exhibit 14-11 (Beams et al. 2012, p. 490).

Intercompany Foreign Currency Transactions

Foreign currency transactions – receivable or payable balances denominated in a currency other than the entity’s (parent’s or subsidiary’s) functional currency.Illustration: A US parent company borrows $1,600,000 (£1,000,000) from its British subsidiary.

Loan Denominated

Currency

Functional Currency of Subsidiary

Foreign Currency Transaction of

Subsidiary? Parent?

Case 1 British pounds British pounds No YesCase 2 British pounds US dollar Yes YesCase 3 US dollar British pounds Yes NoCase 4 US dollar US dollar No No

Translation

Illustration: Background Information

• Pat Corp, a US firm, paid $525,000 cash to acquire all Star Company’s stock (a British firm).

• The business combination was established on December 31, 2011, when exchange rate was $1.50.

• During 2012, the British pound weakened against US dollar – year-end current exchange rate was $1.40.

• Average exchange rate for 2014 were $1.45.• Star paid £30,000 dividend on December 1, 2012,

when exchange rate was $1.42 (US) per British pound.

Item British Pounds

Exchange Rate £/$

US Dollars

AssetsCash 140,000 1.50 210,000Account receivable 40,000 1.50 60,000Inventory (cost) 120,000 1.50 180,000Pland assets 100,000 1.50 150,000Less: Accumulated depreciation (20,000) 1.50 (30,000) Total assets 380,000 570,000

EquitiesAccount payable 30,000 1.50 45,000Bonds payable 100,000 1.50 150,000Capital stock 200,000 1.50 300,000Retained earnings 50,000 1.50 75,000 Total equities 380,000 570,000

Intercompany Transaction• Non-interest bearing advance by Star to Pat on January

4, 2012, for $84,000, when exchange rate was $1.50.• Star’s adjusted trial balance at December 31, 2012,

reflects advance to Pat £60,000, and the exchange gain £4,000.

• Entry on Star’s books:

Advance to Pat (+A) £4,000Exchange gain (+Ga, +SE)

£4,000

To adjust receivable denominated in dollars [($84,000/$1.40) - £56,000 per books]

Translating the Foreign Subsidiary’s Adjusted Trial Balance

• Pat translates Star’s adjusted trial balance at December 31, 2012, into US dollars before it accounts for its investment in Star.

• Assets and liabilities – balance sheet date’s currency• Capital stock and other paid in capital – historical

currency (when subsidiary is acquired)• Income statement’s items – average exchange rate• Translation of foreign subsidiary accounts into US

dollars in Exhibit 14-2 (Beams et al. 2012, p. 494)• Translated financial statements in Exhibit 14-3

(Beams et al. 2012, p. 495)

Equity Method of Accounting

• Pat records the investment in Star at its $525,000 fair value on December 31, 2011.

• Star’s translated financial statement are used by Pat in applying the equity method.

• The entry to record receipt of the £30,000 or $42,600, dividend from Star on December 1, 2012.

• Exchange rate was $1.42 when dividend was paid.

Cash (+A) £42,600Investment in Star (-A)

£42,600

Equity Method of Accounting• Pat recognizes its equity in Star’s income from 2012 in

an entry that also recognized Star’s unrecognized loss on translation.

• Pat recognizes 100% of Star’s 2012 net income in dollars, and it includes the $28,600 loss from translation – in other comprehensive income.

• The reported income $121,800 less lost on translation $28,600 equals $93,200 investment increase.

• The entry for 2012:

Investment in Star (+A) $93,200Other comprehensive income: equity adjustment on translation (-SE) 28,600

Income from Star (R, +SE)121,800

Illustration (continues)• Amortization when excess of fair value over book

value is allocated to identifiable assets and liabilities: patent amortization

• Pat paid $525,000 for its investment in Star.• Star’s book value and the fair value of its net assets

acquired was equal to $375,000• $150,000 excess of cost over net asset book value is

all allocable to a patent (no book value because it was internally developed).

• Under current rate method – patent-related calculation is based on local currency units (British pound).

Illustration (continues)• Calculate patent amortization – convert $150,000

allocated to the patent at acquisition into pound, $150,000 = £100,000

• Amortization 2012 = £100,000 : 10 years X $1.45 average rate 2012= $14,500

• Equity adjustment – patent:

£10,000 amortization X ($1.45 - $1.50) exchange ratedecline to midyear $500

£10,000 unamortized patent X ($1.40 - $1.50) exchangerate decline for the year 9,000

Equity adjustment 9,500

Illustration (continues)• Recorded as follows:Income from Star (-R, -SE) $14,500Other comprehensive income: Equity adjustment on translation (-SE) 9,500

Investment in Star (-A)$24,000

• Investment summary:

Investment cost December 31, 2011 $525,000Less: Dividends received 2012 (42,600)Add: Equity in Star’s net income 121,800Less: Unrealized loss on translation (28,600)Less: Patent amortization (14,500)Less: Unrealized translation loss on patent (9,500)Investment balance December 31, 2012 $551,600

Consolidation• Pat reports income from Star of $107,300. It is a

share of Star’s reported income, $121,800, less the amortization of the unrecorded patent, $14,500.

• Pat also has a $38,100 equity adjustment balance, equals Star’s equity adjustment of $28,600.

• $9,500 equity adjustment for the unrecorded patent, recorded by Pat.

• Working paper in Exhibit 14-4 (Beams et al. 2012 p. 498)

Equity Method of Accounting• Working paper entry as follows:

a. Income from Star (-R, -SE) $107,300 Dividends (+SE) $42,600 Investment in Star (-A) 64,700

• Entry b eliminates reciprocal equity investment at beginning of period and enters the beginning of patent balance.

b. Retained earnings (-SE) $75,000Capital stock – Star (-SE) 300,000Patent (+A) 150,000 Investment in Star (-A) $525,000

• Entry c adjusts the Investment in Star account for unrealized translation losses, eliminates the unrealized translation loss for the patent, and ‘ equity eliminates Star’s remaining stockholders account – the equity adjustment from translation account.

c. Investment in Star (+A) $38,100 Patent (-A) $9,500 Other comprehensive income: equity

adjustment from translation – Star (+SE) 28,600

• The current patent-amortization expense (£10,000 X $1.45 average exchange rate) and reduces the patent to $126,000 – unamortized amount at year end (£90,000 X $1.40 exchange rate).

Remeasurement

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

• The exchange rates used are different from those used for translation

Remeasurement• The process produces the same end result as if

the foreign entity’s transactions had been initially recorded in dollars• Because of the variety of rates used, the debits

and credits of the U.S. dollar–equivalent trial balance will probably not be equal

• The balancing item is a remeasurement gain or loss, which is included in the period’s income statement.

RemeasurementStatement presentation• Remeasurement gain or loss is included in the

current period income statement, usually under “Other Income”

• Upon completion of the remeasurement process, the foreign entity’s financial statements are presented as they would have been had the U.S. dollar been used to record the transactions in the local currency as they occurred

Illustration: Beams et al. (2012, p. 499-503)

Monetary AccountsMonetary Related to “Money”By definition:• Monetary accounts are those that have their amounts

“fixed” in terms of the units of currency.• They represent amounts that will be received or paid in

a fixed number of monetary units.

Generally, they include:• Cash and cash equivalents• Receivables (short- and long-term)• Payables (short- and long-term)

Nonmonetary Accounts

Summary of the Translation and Remeasurement Processes

Source:

BAKER, CHRISTENSEN, & COTTLRELLAdvanced Financial Accounting 9th

BEAMS, ANTHONY, BETTINGHAUS, & SMITHAdvanced Financial Accounting 11th