Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
CHAPTER 13Foreign operations
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Contents Stock exchange requirements Segment reporting Foreign currency transactions and foreign
operations Primary translation – reporting foreign currency
transactions in the functional currency Secondary translation – translating individual
foreign currency financial statements in a group’s presentation currency
Alternative accounting methods for secondary translation
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Stock exchange requirements
Stock exchange listing as a strategic issue Credibility Public awareness Financing flexibility
IFRS accepted by most stock exchanges IFRS not yet fully accepted in the US
SEC requires reconciliation statement on net income and shareholders’ equity
IFRS/US GAAP convergence program (“Norwalk Agreement”)
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Segment reporting
Business and geographical segments may vary significantly in terms of rate of profitability, risks and growth oppportunities
Segment reporting reflects a disaggregation of financial statement data by line of business and/or geographical area.
IAS 14 Segment Reporting
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Reportable segments
Primary reporting format: the company has to identify the dominant source and nature of the risks and returns (business or geographical segments) Analysis will concentrate on the
primary format, with nonetheless some limited information on the other segmentation view
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Reportable segments (cont.)
A segment is identified as a reportable segment if a majority of its revenue is earned from sales to external customers and a 10% threshold of total revenue, total results or total assets is satisfied
Reportable segments should account for at least 75% of total consolidated revenue
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Segment information content Segment information elements:
Segment revenue Segment expense Segment assets Segment liabilities
Top-down approach: elements of consolidated financial statements are systematically disaggregated into segment disclosures Directly attributable elements and the relevant
portion that can be allocated on a reasonable basis to the segment
Some awkward links with consolidation procedures
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Foreign currency effects Foreign currency issues affect two
different areas1. Translation of foreign currency transactions
and related individual assets and liabilities which are denominated other than in the reporting currency (primary translation)
2. Translation of the financial statements of foreign subsidiaries for inclusion in group financial statements (secondary translation)
IAS 21 The Effects of Changes in Foreign Exchange Rates
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Fig. 13.1 Primary and secondary translation
Business transactions,assets and liabilities denominated
in functional currency
Business transactions, assets and liabilities,denominated in
other currency than FC
Individual financial statements in functional
currency
Individual financial statements in (group) presentation currency
PrimaryTranslation
Secondary Translation
Consolidated financial statements in (group) presentation currency
Consolidation
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Functional currency The functional currency concept is
central in the translation requirements Functional currency is defined as “the
currency of the primary economic environment in which the entity operates” (IAS 21, par.8)
It is determined separately for each individual entity within a group and may require considerable professional judgement
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Foreign currency transactions
Foreign currency transactions are business transactions that are denominated or require settlement in a currency other than the functional currency of the company
On initial recognition, the foreign currency transaction will be recorded in the functional currency by applying the spot exchange rate between the functional currency and the foreign currency at the date of the transaction
But which rate to use for subsequent measurement?
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Illustration – Primary translation (table 13.1)
UK company (reporting in £) borrows $5m on 1.1.X1, to be repaid on 31.12.X5
Balance sheet date
Exchange rate £ =
Loan £ equivalent
1.1.X1 $1.60 3.125m
31.12.X1 $1.55 3.226m
31.12.X2 $1.40 3.571m
31.12.X3 $1.25 4.000m
31.12.X4 $1.30 3.846m
31.12.X5 $1.40 3.571m
How should the loan be accounted for after initial recognition?
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Illustration – Primary translation (cont.)
Historical exchange rate or closing rate for subsequent measurement of the loan?
1. Maintain historical rate £3.125m (historical equivalent), stable through time Exchange rate changes have no impact on balance-sheet
value No recognition of value increase of the loan
OR
2. Convert at closing rate £3.226 (on 31.12.X1), variable through time Exchange rate changes have impact on balance sheet
value Recognition of value changes of the loan
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Primary translation – subsequent measurement
The accounting treatment (IAS 21) of foreign currency balance sheet items depends on the type of asset acquired or liability incurred
Monetary items are translated using the exchange rate at balance sheet date
Cash, receivables, payables, loans outstanding etc Non-monetary items are translated using
the historical rate of exchange that was in effect at the time the item was acquired or incurred
Inventory, equipment, land etc
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Primary translation – subsequent measurement (cont.)
Exchange differences arising on translating monetary items at rates different from those at which they were translated on initial recognition or in previous balance sheets shall be recognized in the income statement of the period in which they arise
Identical accounting treatment for (unrealised) exchange gains or losses
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Hedging foreign currency transactions
UK company (reporting in £) orders a machine tool for €10,000 in FRance (1£=€1) to be delivered in six months’ time
Risk: exchange rate € might increase leading to an increase in the acquisition cost of the machine in £ (determined at delivery date)
Action: buy €10,000 in advance at order date (to be delivered after 6 months)
Result: machine acquisition cost in £ can be fixed at order date
IAS 21:IAS 21: On recognition of transaction (at delivery date) the acquisition cost of the machine is converted at the forward exchange rate and not at the spot rate on the moment of delivery
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Secondary translation Secondary translation refers to the process of
translating individual foreign currency financial statements in a group’s presentation currency
A logical solution might be to translate all the transactions of the foreign subsidiary as though they had been carried by the parent company (see table 13.2)
A translation difference (gain or loss) will have to be added to keep the translated balance sheet balancing
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Table 13.2 Consolidation exchange rates
Balance sheet item Rate
AssetsFixed assets Rate at time of acquisitionReceivables Rate at balance sheet date (best estimate of likely proceeds)Inventory Rate at time of acquisitionCash Rate at balance sheet date
FinancingEquityShare capital Rate at time of subscriptionRetained profit Rate ruling at successive balance sheet dates when each slice
of retained profit was added to the balance sheetCreditors Rate at balance sheet date (best estimate of likely payments)Long-term debt Rate at balance sheet date
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Illustration - Secondary translationHistorical or closing rate?
Foreign subsidiary (local currency = LC) 1/2/20X1 – Purchase tangible fixed asset for
1m LC Rate 1/2/20X1 – 1 LC = 10 EUR => Acquisition cost of fixed asset in €=
€10m 31/12/20X1 – Full consolidation of subsidiary
Closing rate – 1 LC = 7 EUR => Translated at closing rate = €7m
What will the fixed asset value be in the group accounts?
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Illustration - Secondary translationHistorical or closing rate? (cont.)
1. Maintain historical rate €10m, stable through time Exchange rate changes have no impact on balance sheet No recognition of value decrease Use of different exchange rates in balance sheet
2. Use of closing rate €7m, variable through time Exchange rate changes have impact on balance sheet Recognition of value increases and decreases One (unique) translation rate
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Secondary translation models
1. Which translation rate for which element of financial statements?
Closing rate, historical rate, average rate
2. How are the translation differences treated?
Use of different translation rates always leads to translation differences which have to be accounted for one way or another
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Table 13.3 Exchange rates – temporal method
Balance sheet component Exchange rateFixed assets HistoricalDepreciation Historical
Current assetsInventory HistoricalMonetary assets CurrentCurrent liabilities CurrentLong-term liabilities Current
EquityShare capital HistoricalRetained earnings Historical /Average
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Temporal method Time perspective of measurement
attribute will determine the exchange rate
Rates: Items at historical cost => Historical rate Items at current prices/nominal value =>
Closing rate Earnings => Historical rate / Average rate
Translation differences are recognized in the income statement
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Net investment method Net asset value of the subsidiary is considered
to be the item to which the exchange rate risk pertains
Rates: Closing rate (except for equity) Equity: historical rate Average rate for income statement
Translation differences are taken directly in equity under a separate heading
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Worked example on translation methods
European Trading Co.plc = British parent (reporting in £)
Invests on 1/1/20X1 CHF 3M in Swiss subsidiary Swiss subsidiary locally loans CHF 2M and buys
factory for CHF 5M Subsidiary reports CHF 500,000 as profit for 20X1 Evolution exchange rate £ / CHF:
Rate on 1/1/20X1 : £ 1 = CHF 4 Rate on 31/12/20X1: £ 1 = CHF 3 Average rate during 20X1: £ 1 = CHF 3,5
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Worked example – temporal method
1 Jan 20X1 CHF' 000 31 Dec 20X1 CHF'000
Fixed assets 5,000 5,000 less Depreciation __ -250 Net current assets Inventory __ 500 Monetary assets __ 750 Current liabilities __ -500 __ 750 5,000 5,500 Long-term liabilities -2,000 -2,000 Total net assets 3,000 3,500 Financed by equity Share capital 3,000 3,000 Retained earnings __ 500 Total equity 3,000 3,500
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Worked example – temporal method
1 Jan 20X1 31 Dec 20X1 Rate used £’000 £’000 £ = Fixed assets 1,250 1,250.00 4 less Depreciation — -62.5 4 Net current assets Inventory* — 142.86 3.5 Monetary assets — 250 3 Current liabilities — -166.67 3 — 226.19 1,250 1,413.69 Long-term liabilities -500 -666.67 3 Total net assets 750 747.02 Equity Share capital 750 750.00 4 Retained earnings*** — 142.85 3.5 Translation adjustment** — -145.83 Total equity 750 747.02 *This rate is assumed: the temporal method requires use of the actual rate at the time the inventory was acquired, for simplicity the example assumes that inventory was acquired uniformly throughout the year. **Under the temporal method the translation adjustment is charged against net income and is only shown separately in this example in order to highlight its existence. ***Again to simplify, the depreciation cost in retained earnings is translated at the average rate and not at the historical rate.
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Worked example - closing rate method
1 Jan
20x1 £' 000 31 Dec 20x1
£' 000 Fixed assets 1,250 1,667.67 less Depreciation __ -83.33 Net current assets Inventory __ 166.67 Monetary assets __ 250.00 Current liabilities __ -166.67 __ 250.00 1,250 1,833.34 Long-term liabilities -500 -666.67 Total net assets 750 1,1667.67 Equity Share capital (initial) 750 750.00 (Translation diff.) __ 273.82 Retained earnings __ 142.85 Total equity 750 1,166.67
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Worked example – comparing methods
Temporal Net investment 31 Dec 20X1 31 Dec 20X1
£’000 £’000
Fixed assets 1,250.00 1,666.67 less Depreciation -62.50 -83.33 Net current assets Inventory 142.86 166.67 Monetary assets 250 250 Current liabilities -166.67 -166.67 226.19 250.00 1,413.69 1,833.34 Long-term liability -666.67 -666.67 Total net assets 747.02 1,166.67 Equity Share capital 750.00 750.00 Translation adjustment -145.84 273.82 Retained earnings 142.86 142.85 Total equity 747.02 1,166.67
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Worked example – effect of translation differences
Growth in equity
Opening equity
Percentage growth in year
CHF accounts 500 3,000 16.67 %
Temporal method -2.98 750 -0.40 %
Net investment method 416.67 750 55.56 %
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Worked example – temporal method
1 Jan 20X1 / CHF
31 Dec 20X1 / CHF
Rate OB £=
1 Jan 20X1/ £
Rate CB£=
31 Dec 20X1/ £
Fixed assets 5,000 5,000 4.00 1,250 4.00 1,250.00
Less depreciation
(250) 4.00 (62.50)
Inventory 500 3.50 142.86
Monetary assets 750 3.00 250.00
Current liabilities
(500) 3.00 (166.67)
LT liabilitiesTotals
(2,000)3,000
(2,000)3,500
4.00 (500)750
3.00 (666.67)747.02
Financed by equity
Share capital 3,000 3,000 4.00 750 4.00 750.00
Retained earnings
500 3.50 142.86
Transl. adjustment
P&L (145.84)
Totals 3,000 3,500 750 747.02
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Worked example – net investment method
1 Jan 20X1 / CHF
31 Dec 20X1 / CHF
Rate OB £=
1 Jan 20X1/ £
Rate CB£=
31 Dec 20X1/ £
Fixed assets 5,000 5,000 4.00 1,250 3.00 1,667.67
Less depreciation
(250) 3.00 (83.33)
Inventory 500 3.00 166.67
Monetary assets 750 3.00 250.00
Current liabilities
(500) 3.00 (166.67)
LT liabilitiesTotals
(2,000)3,000
(2,000)3,500
4.00 (500)750
3.00 (666.67)1,166.67
Financed by equity
Share capital 3,000 3,000 4.00 750 4.00 750.00
Retained earnings
500 3.50 142.85
Transl. adjustment
Balance sheet
273.82
Totals 3,000 3,500 750 1,166.67
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Worked example – comparison of methods
Rate CB£=
Temporal method31 Dec 20X1 / ‘000£
Rate CB£=
Net investment method31 Dec 20X1 / ‘000£
Fixed assets 4.00 1,250.00 3.00 1,667.67
Less depreciation 4.00 (62.50) 3.00 (83.33)
Inventory 3.50 142.86 3.00 166.67
Monetary assets 3.00 250.00 3.00 250.00
Current liabilities 3.00 (166.67) 3.00 (166.67)
LT liabilitiesTotals
3.00 (666.67)747.02
3.00 (666.67)1,166.67
Financed by equity
Share capital 4.00 750.00 4.00 750.00
Retained earnings 3.50 142.86 3.50 142.85
Transl. adjustment P&L (145.84) Balance sheet
273.82
Totals 747.02 1,166.67
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Functional currency and type of foreign operation
IAS 21 sets the functional currency of a foreign subsidiary which is heavily integrated with the operations of the parent and for which the temporal method is more appropriate, equal to the functional currency of the parent
IAS 21 only refers to the closing rate method as the method to be used whan translating foreign currency financial statements to the presentation currency of the group
The translation difference (under the net investment method) is treated as a direct adjustment to equity