Advanced Financial

Accounting: Chapter 7
Accounting for the Effects of
Changes in Foreign Exchange
Rates

Tan & Lee Chapter 7 © 2009 1

Content

1. Introduction
2. Types of foreign exchange rate management regimes
3. How exchange rates are quoted
4. Types of foreign exchange rate exposures
5. Concept of functional currency
6. Foreign currency transactions of a stand-alone entity
7. Translation of foreign currency financial statements
8.
8. Special issues
Special issues in
in translation
translation

9. Evaluation of translation approaches

Tan & Lee Chapter 7 © 2009 2

Change of Functional Currency

• A change of functional currency may be due to a change:

– In primary economic environment
– In the nature of operating relationship between the foreign operation
and the parent

• Functional currency changes are implemented prospectively

– No restatement of prior-year financial statements

Tan & Lee Chapter 7 © 2009 3

Change of functional currency

Functional currency is changed

From To Translation procedures

Local currency Parent’s • Cumulative translation differences remain in

currency equity until disposal
• Non-monetary assets are translated at the
rate on the date when the change is effected
Parent’s Local currency • All assets and liabilities are translated at
currency closing rate
• Translation differences are taken to equity

Tan & Lee Chapter 7 © 2009 4

Exchange Differences Arising from
Intercompany Transactions
• Intercompany transactions are normally denominated in either the
parent’s currency or the subsidiary’s currency
– Results in translation gain or loss recorded by one party
– Translation gain or loss is not eliminated as they are one-sided

• Long term loan from parent that are “quasi-equity”

– Considered as part of parent’s net investment in the subsidiary
– Eg. Interest free loans, loans with no definite or scheduled payment
– IAS 21 Para 32 requires exchange difference to be reclassified to equity
in consolidation
– Reclassification journal entries in consolidation:

Dr Exchange gain on loan (I/S) Dr FCTR (equity)

Cr FCTR (equity) Cr Exchange loss on loan (I/S)

Tan & Lee Chapter 7 © 2009 5

Exchange Differences Arising from
Intercompany Transactions
Monetary item In foreign In
Nature of In parent’s
denominated operation’s consolidated
monetary item book
in: books accounts
Records
No exchange exchange
Parent’s difference is difference on
functional recorded monetary item
currency in I/S
Records
Foreign exchange No exchange
Forms part of operation’s difference on difference is Exchange
parent’s net currency monetary item recorded difference on
investment in I/S monetary item
is reclassified to
“Quasi-equity” Records Records
equity (FCTR)
loans exchange exchange
difference on difference on
3rd currency monetary item monetary item
in I/S in I/S
Tan & Lee Chapter 7 © 2009 6
Exchange Differences Arising from
Intercompany Transactions
Monetary item In foreign In
Nature of In parent’s
denominated operation’s consolidated
monetary item book
in: books accounts
Records
No exchange exchange
Parent’ difference is difference on
functional recorded monetary item
currency in I/S
Records
Foreign exchange No exchange
operation’s difference on difference is
currency monetary item recorded
Is not part of Flows through
parent’s net in I/S to consolidated
investment Records Records I/S
exchange exchange
difference on difference on
3rd currency monetary item monetary item
in I/S in I/S
Tan & Lee Chapter 7 © 2009 7
Goodwill Arising from the Acquisition of
Foreign Subsidiaries

Is goodwill a foreign currency asset?

An asset of the acquiree? An asset in the acquirer?

Needs to be translated No translation required

The position in IAS 21 is that goodwill is a foreign currency asset of

the acquiree and has to be translated using the closing rate method.

Tan & Lee Chapter 7 © 2009 8

Equity Accounting for Foreign Associates

• Associate companies are more likely than subsidiaries to be

autonomous entities than integral operations of the investor
– Functional currency is likely to be the foreign operation’s currency
– Financial statements are first translated to the presentation currency
(the investor’s currency) using the closing rate method
– Equity accounting is applied subsequently to the translated financial
statements
• Apply the usual equity accounting entries
• Allocate to investor the proportionate share of foreign currency
translation reserves (FCTR)

Tan & Lee Chapter 7 © 2009 9

Carrying Value of Inventories

• Inventory is carried at lower of cost or net realizable value (NRV)

• If NRV of inventory is measured in a foreign currency:
– Reported carrying value is the lower of:
• Inventory cost (foreign currency) X Actual (historical) rate
• Inventory at NRV (foreign currency ) X Closing rate

Tan & Lee Chapter 7 © 2009 10

Foreign Operation in a Hyperinflationary
Environment
• Indicators of a hyperinflationary economy:
– Inflation rate of 100% or more over a period of 3 years;
– Interest rates, wages and prices that are linked to a price index;
– Prices that are quoted in a stable currency; and
– A general population that prefers to keep its wealth in non-monetary
assets or in a stable currency
• Financial statements that are not adjusted for inflation are not useful
– Misleading to compare transactions that occurred at different times due
to loss of purchasing power at a rapid rate
• IAS 21 requires a restate-then-translate approach
– Restate using the procedures in IAS 29
– All restated amounts (including comparatives) are translated at closing
rate at the most recent balance sheet date, except that:
– Previous year comparable figures in non-hyperinflationary economy
currency are not restated
Tan & Lee Chapter 7 © 2009 11
Content

1. Introduction
2. Types of foreign exchange rate management regimes
3. How exchange rates are quoted
4. Types of foreign exchange rate exposures
5. Concept of functional currency
6. Foreign currency transactions of a stand-alone entity
7. Translation of foreign currency financial statements
8. Special issues in translation
9.
9. Evaluation of
Evaluation of translation
translation approaches
approaches

Tan & Lee Chapter 7 © 2009 12

Evaluation of Translation Approaches

Objective of translation under SFAS 52 in US GAAP:

1. Provide information that is generally compatible with
the expected economic effects of a rate change on
the enterprise’s cashflows and equity; and
2. Reflect in the consolidated statements the financial
results and relationships of the individual
consolidated entities as measured in their functional
currencies

Tan & Lee Chapter 7 © 2009 13

Evaluation of Translation Approaches

• Evaluate the closing rate method against the

objectives:
 An appreciation in the foreign operation currency
will result in a translation gain and a loss when the
currency depreciates
 Financial relationships among items in the original
financial statements are preserved
 A major flaw is that the translated balance sheet is
neither at historical nor current value

Tan & Lee Chapter 7 © 2009 14

Evaluation of Translation Approaches
• Evaluate the remeasurement/temporal method against
the objectives of translation:
– Distorts the original financial ratios (use of mixed rates)
– However, it is argued that if the foreign operation’s functional
currency is the same as the parent’s functional currency:
• The financial ratios should be determined using the functional
currency and not the local currency
– Therefore, this method attempts to “put things right” as though
the foreign operation had been conducted in the parent’s
functional currency

Tan & Lee Chapter 7 © 2009 15

Conclusions
• Functional currency should be determined in relation to the primary
economic environment of the entity but presentation currency is a
“free choice”

• Remeasurement is used to translate the foreign currency

transactions of a stand-alone entity or the financial statements of a
foreign operation to its functional currency

• Apply the closing rate method when translating from the subsidiary’s
functional currency to the parent’s presentation currency

• Special considerations apply to goodwill, intercompany loans that

are quasi-equity and translation in hyper-inflationary economies.

Tan & Lee Chapter 7 © 2009 16