Foreign Currency Financial Statements

Chapter 14
Foreign Currency
Financial Statements
to accompany
Advanced Accounting, 11th edition
by Beams, Anthony, Bettinghaus, and Smith
Copyright ©2012 Pearson Education,

14-1
Inc. Publishing as Prentice Hall
Foreign Currency Financial Statements:
Objectives
1. Identify the factors that should be considered
when determining an entity’s functional
currency.
2. Understand how functional currency
assignment determines the way the foreign
entity’s financial statements are converted into
its parent’s reporting currency.
3. Understand how a foreign subsidiary’s
economy is determined to be highly inflationary
and how this affects the conversion of its
financial statements to its parent’s reporting
currency. Copyright ©2012 Pearson Education,
14-2
Objectives (Cont.)
4. Understand how the investment in a
foreign subsidiary is accounted for at
acquisition.
5. Understand which rates are used to
translate balance sheet and income
statement accounts under the current rate
method and the temporal method on a
translation/ remeasurement worksheet.
6. Know how the translation gain or loss, or
remeasurement gain or loss, is reported
under the current rate and temporal
methods. Copyright ©2012 Pearson Education,
14-3
Objectives (Cont.)
7. Know how a parent accounts for its
investment in a subsidiary using the
equity method depending on the
subsidiary’s functional currency
determination.
8. Understand consolidation under the
temporal and current rate methods.
9. Understand how a hedge of the net
investment in a subsidiary is accounted
for under the current rate and temporal
methods. Copyright ©2012 Pearson Education,
14-4
Foreign Currency Financial Statements
1: FUNCTIONAL CURRENCY

14-5
Functional Currency
Definition: Currency of the primary economic
environment in which the entity operates.
Primarily, this means the currency received from
customers and used to pay liabilities. Other
factors include the currency:
 Used in setting sales prices
 That is dominant in the sales market
 Used to pay operating expenses
 Financing the company
 Used in intercompany transactions

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2: FUNCTIONAL CURRENCY
DETERMINES CONVERSION
METHOD

14-7
Restatement Method Selection
If the functional currency is the U.S. dollar, use
the Temporal method.
If the functional currency is the local currency,
use the Current Rate method.
Examples:
1. A Mexican subsidiary of a U.S. firm has the
peso as its functional currency.
2. A Japanese subsidiary of a U.S. firm has the
U.S. dollar as its functional currency.
3. An Australian subsidiary of a U.S. firm,
keeping its own records in Australian
dollars, determines its functional currency is
the euro. Copyright ©2012 Pearson Education,
14-8
Selecting the Method
Local currency Functional currency Reporting currency
Ex 1 Peso Peso U.S.$

Translate (current rate method) from Peso to US$
Ex 2 Yen U.S.$ U.S.$

Remeasure (temporal method) from Yen to US$
Ex 3 Aus$ Euro U.S.$

Remeasure from Aus$ to Euros,
then Translate from Euros to U.S.$
14-9
Exchange Rates
Translation (the Current Rate method) will
convert financial statements using
 Current (FYE): assets, liabilities
 Historical: equity, dividends (retained earnings
is not translated)
 Current (average): revenues, expenses
Remeasurement (the Temporal Method) will
convert financial statements using
 Current (FYE): monetary assets, liabilities
 Historical: other assets, liabilities
 Historical: equity, dividends (retained earnings
is not remeasured)
 Current (average) and Historical: revenues,
expenses Copyright ©2012 Pearson Education,
14-10
3: HIGHLY INFLATIONARY
ECONOMIES

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Inflation and Functional Currency
For subsidiaries of U.S. firms in highly

inflationary economies, assume that the
functional currency is the U.S. dollar.
Remeasure the statements

using the Temporal method.
Highly inflationary = cumulative inflation of

100% or more over 3 years.
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4: BUSINESS COMBINATIONS

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Translation at Acquisition
Foreign assets and liabilities are
translated using the current rate at the
date of acquisition.
If functional currency = local currency
 Translation is appropriate
 Analysis of fair value/book value differentials
is performed in local currency
 Results are translated at current rates

14-14
Remeasurement at Acquisition
Foreign assets and liabilities are
translated using the current rate at the
date of acquisition.
If functional currency = US$ or reporting
currency
 Remeasurement is appropriate
 Analysis of fair value/book value
differentials is performed in U.S.$
 The 'earliest' historical rate generally used in
remeasurement is the date of the acquisition.
14-15
Noncontrolling Interest
For both, remeasurement and translation,
the consolidation process is applied to
the financial statements as restated in
U.S.$.
Measures of noncontrolling interest,

noncontrolling interest share, and
controlling interest share are computed
in U.S.$.
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5: CURRENT RATE METHOD

AND TEMPORAL METHOD

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Assets
Copyright ©2012 Pearson Education, 14-18

Liabilities and Equity

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Revenues and Expenses
Note that "current" rate, as used for income

statement items, is usually the average rate for
the year. Firms with seasonal business
fluctuations would use a weighted average rate.
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6: TRANSLATION
ADJUSTMENTS AND
REMEASUREMENT
GAIN/LOSS

14-21
Current Rate Method: Example
Translate the adjusted trial balance:
 Assets and Liabilities at the year-end (“current”)
rate
 Equity at the historical rate (from the date of the
related transaction)
 Except Retained Earnings which is a composite
rate from each year
 Revenues and Expenses will be at the average
rate for the related period
The entry needed to balance the trial balance after
the translation is complete will be an entry to
Accumulated Other Comprehensive Income, and
thus will appear on the balance sheet.
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Current Rate Method: Example (cont.)
See calculation, next slide…

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Current Rate Method: Example (cont.)
Because all debit and credit balances are not translated

using the same exchange rate, the trial balance will not
balance at the end of the translation. In this example, the
debits happen to be $28,600 less than the credits. This is
the debit to accumulated OCI at the end of the year.
14-24
Temporal Method: Example
Remeasure the adjusted trial balance:
 Monetary Assets and Liabilities at the year-end (“current”) rate
 Non-monetary Assets and Liabilities at the rate from the date of
transaction (“historical”)
 Equity at the historical rate (from the date of the related
transaction)
 Except Retained Earnings which is a composite rate
 Revenues and most Expenses will be at the average rate for the
related period
 Cost of Goods Sold, Depreciation and Amortization Expense at
the historical rate of the related asset
The entry needed to balance the trial balance after the translation is
complete will be an Exchange Gain/(Loss), and thus will appear on
the income statement. Copyright ©2012 Pearson Education,
14-25
Temporal Method: Example (cont.)
See calculation, next slide…

14-26
Temporal Method: Example (cont.)
Because all debit and credit balances are not translated

using the same exchange rate, the trial balance will not
balance at the end of the translation. In this example, the
debits happen to be $3,300 less than the credits. This is
the exchange loss for the year.
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Adjustment Summary
Remeasurement results in
 Exchange gains or losses on the income statement
 Credit to balance = exchange gain
 Debit to balance = exchange loss
 Include the gain or loss in calculating net income
in U.S. dollars.
Translation results in
 Translation adjustment, part of accumulated other
comprehensive income
 Include as part of stockholders' equity
 Debit to balance = deduct from equity
 Credit to balance = add to equity
14-28
The Difference in Methodology
The ultimate goal is consolidation.
Use the Temporal method when the U.S. dollar is the
functional currency of the subsidiary, to best reflect the
relationship of the subsidiary as an extension of the
parent, and thus the remeasurement adjustment is part
of the current period income.
Use the Current Rate method when the local currency is
the functional currency of the subsidiary, to best reflect
the subsidiary’s status as a free-standing company in
whom the parent is merely invested, thus the translation
adjustment is shown in the equity section of the parent’s
balance sheet.

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7: EQUITY METHOD FOR

FOREIGN INVESTMENTS

14-30
Equity Method Investee
A U.S. firm has a foreign investment it accounts
for under the equity method.
 If functional currency is the local currency, then
translation is appropriate
At acquisition
 Analyze fair value and book value, compute
goodwill – in local/functional currency
Annually
 Translate statements into U.S. dollars
 Record other comprehensive income for translation
adjustment
14-31
Equity Method Entries
12/31/11 Investment in Star 525,000
Cash 525,000
Acquisition cost
12/1/12 Cash 42,600
Investment in Star 42,600
Dividends received, at current exchange rate
12/31/12 Investment in Star 93,200
OCI, translation adjustment 28,600
Income from Star 121,800
Year-end adjustment for income
The income is from the translated income

statement, with appropriate amortizations
for fair value/book value differences.
14-32
Amortization of Differentials
On 12/31/11, Pat acquired Star. Star had
unrecorded patent of £100,000. The exchange
rate was $1.50.
The patent is amortized over 10 years. The
average and year-end exchange rates are $1.45
and $1.40.
12/31/11 Patent £100,000 $1.50 $150,000
2012 Amortization expense £10,000 $1.45 $14,500
12/31/12 Patent £90,000 $1.40 $126,000
OCI translation adjustment for patent is $9,500.
$150,000 – 14,500 – 126,000 = $9,500
The adjustment brings the net value of the patent to its
translated year-end amount of $126,000.
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8: CONSOLIDATION OF
FOREIGN SUBSIDIARIES

14-34
Consolidating Foreign Subsidiaries
The parent uses the appropriately
translated or remeasured subsidiary
financial statements in its consolidation
worksheet.
 Income from the subsidiary and
Investment in subsidiary are eliminated.
 Subsidiary equity accounts are
eliminated (including accumulated OCI).
 Worksheet procedures are similar to
that for domestic subsidiaries.
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Worksheet – Income Statement
Star's balances come
from the translated
statements. Current
amortization for the
patent is recorded.

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Worksheet – Retained Earnings
Star's beginning retained

earnings and current
dividends are eliminated.

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Worksheet - Assets
The Investment in Star
and intercompany
receivables are
eliminated. Differentials
from acquisition are
recorded – the patent
and its current
amortization.

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Worksheet – Liabilities & Equity
Intercompany payable is
eliminated. All of the subsidiary
equity is eliminated, including
Accumulated OCI. Parent's
Accumulated OCI contains impact
of translation adjustments.

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9: HEDGE OF NET
INVESTMENT

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Hedge a Foreign Investment
Investee's functional currency = local
currency
 Effective hedges qualify for hedge treatment
 "Gains or losses" are translation adjustments
which are included in accumulated OCI
Investee's functional currency = reporting
currency
 "Hedging" is treated as speculative
 Gains or losses are recognized in income for
the current financial period
14-41
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Chapter 14

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Local currency Functional currency Reporting currency

Ex 1 Peso Peso U.S.$

Ex 2 Yen U.S.$ U.S.$

Ex 3 Aus$ Euro U.S.$

Copyright ©2012 Pearson Education,

For subsidiaries of U.S. firms in highly

Remeasure the statements

Highly inflationary = cumulative inflation of

Copyright ©2012 Pearson Education,

Copyright ©2012 Pearson Education,

Measures of noncontrolling interest,

5: CURRENT RATE METHOD

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Note that "current" rate, as used for income

Copyright ©2012 Pearson Education,

See calculation, next slide…

Because all debit and credit balances are not translated

See calculation, next slide…

Because all debit and credit balances are not translated

Copyright ©2012 Pearson Education,

7: EQUITY METHOD FOR

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The income is from the translated income

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Star's beginning retained

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