Excel Assignment

Prepared by Jenelle Conaway, George Mason University (2021)

Translation and Remeasurement

This lesson presents the procedures for restating a foreign entity’s financial statements in order to consolidate that foreign entity with its parent company. Many corporations have multinational operations such as foreign-based subsidiaries or branches. For example, a US auto manufacturer may have manufacturing subsidiaries in Canada, Mexico, Spain, and Great Britain. The foreign subsidiaries often prepare their financial statements in their home currencies. For example, the Mexican subsidiary reports its operations in pesos. The foreign currency amounts in the financial statements of these subsidiaries have to be restated into their US dollar equivalents before they can be consolidated with the financial statements of the US parent company that uses the US dollar as its reporting currency unit. There are two methods used in the process of restating foreign entity financial statements to the parent company reporting currency: translation and remeasurement.

Functional Currency Both US GAAP and IFRS take a functional currency approach, which requires the foreign entity to restate all of its accounts into its functional currency. If an entity has transactions denominated in other currencies, the foreign transactions must be adjusted to their equivalent functional currency value before the company may prepare financial statements (as we learned about in the Foreign Currency Transactions lecture).

Functional Currency is the currency of the primary economic environment in which a company operates. It is normally the currency in which a company primarily generates and spends cash, but not always.

Functional currency is used to determine whether a specific foreign operation is (1) self- contained an integrated with its local economy or (2) an extension of its parent company. A parent company may have multiple foreign affiliates in many different countries. Each affiliate must be analyzed to determine its individual functional currency.

How to Determine Functional Currency? US GAAP: Provides a list of indicators, but no guidance is provided as to how these indicators should be weighted in the functional currency determination.

IFRS: Has a hierarchy of primary and secondary factors to consider the functional currency determination.

There are several differences in the factors that must be considered under IFRS. As a result, it is possible that a foreign subsidiary could have one functional currency under US GAAP and a different functional currency under IFRS.

Comparison of US GAAP & IFRS Determination of Functional Currency

Example 1: Functional Currency A US-based company by the name of Big Blue owns 100% of Big Blue UK. The functional currency of Big Blue is the US Dollar (USD). The USD is also the reporting currency of the consolidated group. Big Blue UK is a leading provider of Tudor-style ceramic pottery replicas, which are sold at the finest tourist shops throughout London. However, with the interest in Henry VIII rising in the US, in 2008, Big Blue UK began exporting its products to the US. Total exports accounted for 10% of the total sales. The ceramic pottery replicas are made in Wales using clay from quarries in northern Scotland. Big Blue UK maintains its accounting records in Brittish Pounds.

Based on the above, what is the functional currency of Big Blue UK?

US GAAP: _____BP_______________ IFRS: __________BP__________

Example 2: Functional Currency A US-based company by the name of Squarebucks Coffee Corp owns 100% of Costa Rica Café. The functional currency of Squarebucks is the US Dollar (USD). The USD is also the reporting currency of the consolidated group. Costa Rica Café is a leading producer of coffee beans, which are sold exclusively to Squarebucks. The coffee beans are grown at a mountainside farm in Costa Rica and harvested by locals. Costa Rica Café also has a small café onsite at the farm where tourists can enjoy the latest Squarebucks flavors. Costa Rica Café maintains its accounting records in Costa Rican Colon currency.

Based on the above, what is the functional currency of Costa Rica Café?

US GAAP: _______USD_____________ IFRS: _____USD_______________

Exchange Rates

Three possible exchange rates may be used in converting financial accounts from one currency to another:

1. The current rate is the exchange rate at the end of the trading day on the balance sheet date (i.e. the spot rate on the balance sheet date; as discussed in the previous lesson on foreign currency transactions.)

2. The historical rate is the exchange rate that existed when a transaction initially took place or on the date the parent company acquired the foreign subsidiary, whichever is more recent.

3. The average rate for the period is usually a simple average for a period of time.

Illustration: Effect of Different Exchange Rates Imagine that you are a US company and on 12/31/2018 you receive payment from a Spanish customer in the amount of 100 euro. You deposit the euro into a bank account in Spain.

• To report the deposit on your balance sheet in USD at 12/31/2018 you would use the current exchange rate of $1.80 and report cash in USD of $180.

At the end of 2019, the euros are still in the bank in Spain, but now the exchange rate is $1.70. You have to report the cash balance on your 12/31/2019 balance sheet in USD.

· If you restated the currency at the current rate of $1.70, you would report cash of $170. You still have 100 euros in the bank, but now you have to adjust the USD- equivalent value downwards by $10.

· If you restated the currency at the historical rate of $1.80, you would still report $180 and there would be no imbalance.

· If you restated the currency at the average rate (something in-between $1.80 and $1.70), you would have an imbalance smaller than $10.

· Which is the correct rate to use?

The imbalance created by the application of exchange rates must be reflected in the financial statements, as either a component of net income or a component of comprehensive income.

Two major issues related to the restatement of foreign currency financial statements are:

1. Which exchange rate should be used?

2. Where should the resulting adjustment be reported in the financial statements?

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Translation versus Remeasurement

Two possible methods are used to restate foreign entity financial statements into the parent company’s reporting currency: translation and remeasurement.

Translation and remeasurement include different adjustment procedures and may result in significantly different consolidated financial statements. The conceptual reasons for the two different methods come from a consideration of the primary objective of the restatement process: to provide information that shows the expected impact of exchange rate changes on the parent company’s cash flows and equity.

Selecting a Restatement Method

The appropriate restatement method is determined under both IFRS and US GAAP by identifying the functional currency of a foreign operation.

Foreign affiliates fall into two groups.

1. Foreign affiliates that are relatively self-contained entities that generate and spend

local currency units.

1. The local currency is the functional currency for this group of entities.

2. Exchange rate changes do not directly affect the parent company’s cash flows

but do affect the foreign affiliate’s net assets (assets minus liabilities) and,

therefore, the parent company’s net investment in the entity.

3. Translation is appropriate for these firms’ financial statements.

2. Foreign affiliates that are extensions of the parent company. These affiliates operate in a foreign country but are directly affected by changes in exchange rates because they depend on the parent company’s economy for sales markets, production components, or financing.

1. For this group, the parent company’s functional currency is the foreign affiliate’s functional currency.

2. There is a presumption that the effect of exchange rate changes on the foreign affiliate’s net assets will directly affect the parent company’s cash flows, so the exchange rate adjustments are reported in the parent’s income.

3. Remeasurement is appropriate for these firms’ financial statements.

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Three possible scenarios may require the restatement of financial statements from one currency to another via translation and/or remeasurement.

Case 1 : The subsidiary reporting currency is the subsidiary functional currency. Translate the financial statements from the subsidiary functional currency to the parent reporting currency.

Subsidiary Reporting Currency

Subsidiary Functional Currency

Translation

Parent Reporting Currency

Case 2 : The subsidiary reporting currency is not the subsidiary functional currency, but the subsidiary functional currency is the parent reporting currency. Remeasure the financial statements from the subsidiary reporting currency to the subsidiary functional currency.

Subsidiary Reporting Currency

Remeasurement

Subsidiary Parent Functional Reporting

Currency

Currency

Case 3 : The subsidiary reporting currency is not the subsidiary functional currency, and the subsidiary functional currency is different from the parent reporting currency.

Subsidiary Reporting Currency

Remeasurement

Subsidiary Functional Currency

Translation

Parent Reporting Currency

First, remeasure the financial statements from the subsidiary reporting currency to the subsidiary functional currency. Second, translate the financial statements from the subsidiary functional currency to the parent reporting currency so that the consolidation and financial statements can be prepared in the parent reporting currency.

Case 3 is not common in practice but is a consideration for foreign subsidiaries that have very significant business activities in a currency other than the currency of the country in which the subsidiary is physically located. This situation, of having to both remeasure and translate, emphasizes why it is important first to determine the foreign entity’s functional currency before beginning the restatement process.

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Translation, also known as “Current Rate Method”

The fundamental concept is that a parent’s entire investment in a foreign operation is exposed to foreign exchange risk, and translation of the foreign operation’s financial statements should reflect this risk. • Translation is the most common method; Translation converts the functional

currency into the reporting currency.

o E.g. US company’s French subsidiary uses the euro as its recording currency and functional currency, but needs to report in USD to consolidate with the US parent company.

Financial Statement Item	Translation Exchange Rate
Assets and Liabilities	Current rate
Equity (except Retained Earnings, see note below)	Historical rate
Beginning of period Retained Earnings	Historical rate (from prior year translated calculation). For our purposes, assume the Historical Rate is an accurate calculation of translated Beginning RE.
Revenues and Expenses	Average rate – revenues and expenses are assumed to occur uniformly over the period

Example 3: Translation Process Restate the financial statements using translation. The relevant exchange rates are as follows.

Current Historical Average

$1.25 $1.35 Assume all line items were generated on the same day. $1.30 Average for the year 2019.

Step 1: Translate the Income Statement. INCOME STATEMENT, 2019

Balance Sheet Exposure Exposure to translation adjustments is referred to as “balance sheet exposure” or accounting exposure. As exchange rates change, balance sheet items restated using the current rate change in value from period to period (as the current rate fluctuates). Balance sheet items restated using historical rates do not change in parent currency equivalent value from one period to another (because the historical rate is based on the one point in time when the transaction initially took place).

Balance sheet exposure is different from transaction exposure:

· Transaction exposure gives rise to foreign exchange gains and losses that are ultimately realized in cash. o Transaction exposure was discussed in the prior lesson on foreign currency transactions; i.e. when companies have foreign currency denominated receivables or payables.

· Balance sheet exposure adjustments do not directly result in cash inflows or outflows.

Each balance sheet item restated using a current exchange rate is individually exposed. However, positive adjustments are offset by negative adjustments. The net adjustment needed to keep the consolidated balance sheet in balance is based solely on the net asset or net liability exposure.

Net Asset Balance Sheet Exposure means Assets > Liabilities

Net Liability Balance Sheet Exposure means Assets < Liabilities

Remeasurement, also known as “Temporal Method” The basic objective is to produce a set of financial statements as if the foreign subsidiary had actually used the parent’s reporting currency in conducting its operations.• Remeasurement converts recording currency into the functional currency.

o For example, a Canadian foreign subsidiary that primarily manufactures a part and ships it to a US plant for inclusion in a product that is sold to US customers might use the Canadian dollar as its recording currency and USD as its functional currency, but needs to report in USD to consolidate with the US parent company.

Monetary items include: cash, short-term or long-term receivables and payables, marketable securities (equity, trading, and available for sale; because they are marked to market at each reporting date, they are considered monetary assets).

Nonmonetary items include: inventory, prepaids, fixed assets, long-term investments, intangibles, deferred income, and equity (except Retained Earnings). Another way to differentiate between Monetary and Nonmonetary items is that Nonmonetary items are usually carried on the balance sheet at historical cost.

Complicating Aspects of Remeasurement

1. The use of historical exchange rates to remeasure nonmonetary items makes the restatement more complicated than translation. It is necessary to keep a record of historical exchange rates for each nonmonetary item.

2. Cost of Goods Sold is more complicated to remeasure than translate. When remeasuring COGS, you must decompose it into its individual components and remeasure each one separately.

For our purposes, calculations in this class will assume that COGS×Historical rate is an accurate calculation of remeasured COGS. You will not be asked to remeasure the individual components of COGS.

Example 4: Remeasurement Process Restate the financial statements using remeasurement. The relevant exchange rates are as follows.

Current Historical Average $1.25 $1.35 Assume all nonmonetary line items were generated on the same day.

$1.30 Average for the year 2019.

1119000 – 357,500 = 761,500 ……. 1231750-761,500= 470,260

It is important to note that the remeasurement method does not always result in larger balances; that was just a function of this example. For example, if the euro had appreciated (instead of depreciated) or it had net liability balance sheet exposure, the remeasurement method would have resulted in lower balances.

The critical takeaway from this comparison is that the choice of restatement method (translation or remeasurement) can have a significant impact on the amounts reported by a parent company in its consolidated financial statements. Different functional currencies selected by different companies in the same industry would lead to different restatement methods and could have a significant impact on the comparability of financial statements within that industry.

Highly Inflationary Economies

Both US GAAP and IFRS conclude that the volatility of hyperinflationary currencies distorts the financial statements if the local currency is used as the foreign entity’s functional currency. However, the treatment of foreign operations with functional currencies in the currency of a hyperinflationary economy differs significantly between US GAAP and IFRS.

Each approach is intended to prevent the unrealistic asset values and income statement charges that would exist if the hyperinflation is ignored and normal translation procedures are used.

· US GAAP requires foreign subsidiaries located in hyperinflationary economies to assume the parent company’s currency as the functional currency, thus requiring the remeasurement method.

o Under US GAAP, severe inflation is defined as inflation exceeding 100% over a three-year period.

· IFRS requires a restate/translate approach in restating the financial statements of foreign operations located in a hyperinflationary economy.

o The foreign financial statements are first restated for inflation using rules in accordance with IAS 29 (Financial Reporting in Hyperinflationary Economies). This step adjusts the financial statements for the change in general purchasing power of the monetary unit.

o Then the financial statements are “translated” into the parent company’s reporting currency by multiplying all financial statements items by the current exchange rate.

o IAS29doesnotprovideabright-linethresholdfordeterminingwhethera foreign country is experiencing hyperinflation, but suggests the US GAAP definition as one characteristic.

• https://data.oecd.org/price/inflation-cpi.htm#indicator-chart

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Hedge of a Net Investment

Management of multinational companies might wish to avoid reporting remeasurement losses in net income because of the perceived negative impact this has on the company's stock price or the adverse effect on incentive compensation. Likewise, management might wish to avoid reporting negative translation adjustments in stockholders' equity because of the adverse impact on ratios such as the debt-to-equity ratio.

Translation adjustments and remeasurement gains/losses are a function of two factors: (1) changes in the exchange rate and (2) balance sheet exposure. While individual companies have no influence over exchange rates, there are several techniques that parent companies can use to hedge the balance sheet exposures of their foreign operations. Each of these techniques involves creating an equilibrium between foreign currency asset and foreign currency liability balances that are translated at current exchange rates.

Balance sheet exposure can be hedged through the use of a derivative financial instrument such as a forward contract or a foreign currency option, or through the use of a nonderivative hedging instrument such as a foreign currency borrowing.

Both IFRS and US GAAP require the gain or loss on a hedging instrument that is designated and effective as a hedge of the net investment in a foreign operation be reported in the same manner as the translation adjustment being hedged. However, if the gain on the hedging instrument is greater than the translation adjustment being hedged, the excess must be recognized currently in earnings.

Illustration: Hedge of A Net Investment Italy Co's is a subsidiary of Multico USA. ltaly Co's functional currency is the euro and creates a net asset balance sheet exposure for Multico. Multico USA believes that the euro will lose value against the US dollar over the course of the next year, thereby generating a negative translation adjustment that will reduce consolidated stockholders' equity.

· Example 1: Multico USA can hedge this balance sheet exposure by borrowing euros for a period of time, thus creating an offsetting euro liability exposure (notes payable in euro). As the euro depreciates, a foreign exchange gain will arise on the euro liability that offsets the negative translation adjustment.

· Example 2: As an alternative, Multico might have acquired a euro call option to hedge its balance sheet exposure. As the euro depreciates, the fair value of the call option should increase, resulting in a gain.

The foreign exchange gain on the euro borrowing or the gain on the foreign currency option would be included in other comprehensive income along with the negative translation adjustment arising from the translation of ltaly Co's financial statements. You can see that this treatment is an exception to the general rule that foreign exchange gains and losses are taken directly to net income.