Chapter 9Translation Of Foreign Currency Transactions

The Need For TranslationForeign Currency TransactionBuying or selling goods or servicesBorrowing or lending money denominated in a foreign currencyAcquiring investments that must be paid for in a foreign currencyHedging transaction

The Need For TranslationForeign Currency Financial StatementsSignificantly influenced companiesSubsidiariesIntegratedSelf-sustainingJoint ventures

TerminologySPOT RATE: The term spot rate is used to refer to the exchange rate at a particular point in time. In accounting literature, the most relevant spot rate is the one that prevails at the Balance Sheet date and, in this context, it is generally referred to as the current rate. There are at least two spot rates at any point in timeBid rateAsk rate

TerminologyHISTORIC RATE: This term is used to refer to the exchange rate that prevailed at the time a particular Balance Sheet item was: - acquired (asset) or - incurred (liability).

Alternative Methods of TranslationCurrent / Non-Current MethodMonetary / Non-Monetary Method

Temporal MethodCurrent Rate MethodCompletelyDiscredited

The Temporal MethodThe ConceptItems valued at current values are translated using current exchange rates.Items valued at historic values are translated using historic exchange rates.

The Temporal MethodExampleInventories carried at cost would be translated at historic ratesInventories carried at net realizable value would be translated at current rates

Temporal As Per CICA HandbookParagraph 1651.03(c)(i) The temporal method is a method of translation that translates assets, liabilities, revenues and expenses in a manner that retains their bases of measurement in terms of the Canadian dollar (i.e., it uses the Canadian dollar as the unit of measure). In particular:monetary items are translated at the exchange rate in effect at the balance sheet date;non-monetary items are translated at historical exchange rates, unless such items are carried at market, in which case they are translated at the exchange rate in effect at the balance sheet date;revenue and expense items are translated at the exchange rate in effect on the dates they occur;depreciation or amortization of assets translated at historical exchange rates is translated at the same exchange rates as the assets to which it relates.

Temporal As Per CICA HandbookMonetary Items DefinedParagraph 1651.03(b) Monetary items are money and claims to money the value of which, in terms of the monetary unit, whether foreign or domestic, is fixed by contract or otherwise. Future Income tax liabilities and assets are classified as monetary items.

Temporal As Per CICA HandbookItems specified as non-monetaryInvestments in equity instruments carried at costInventories carried at costPrepaid itemsProperty, plant and equipment and accumulated amortizationPatents, trademarks, licenses and formulasGoodwillOther intangible assets (including deferred charges)Deferred incomeShare capital (see Paragraph 9-31)Revenue and expenses related to non-monetary items, including:Cost of goods soldDepreciation and amortization (including amortization of deferred income)

Temporal As Per CICA HandbookOther Guidance On Monetary ItemsParagraph 1651.47 Preference shares of a foreign operation held by the reporting enterprise are translated in the same manner as common shares (i.e., at historical rates) unless redemption is either required or imminent, in which case the current rate is used. ...Paragraph 1651.52 Future income tax liabilities and assets are monetary items and, as such, are translated at the current rate.

Conceptual Definition Vs. CICAThe two approaches provide identical results

References to monetary confuse temporal with monetary vs. non-monetary

Temporal Method and FC TransactionsParagraph 1651.14 At the transaction date, each asset, liability, revenue or expense arising from a foreign currency transaction of the reporting enterprise should be translated into Canadian dollars by the use of the exchange rate in effect at that date. [October, 2006]

Use Of Averages IfTransactions occur uniformly over the periodExchange rate changes uniformly over the period

Temporal Method and FC TransactionsParagraph 1651.16 At each balance sheet date, monetary items denominated in a foreign currency should be adjusted to reflect the exchange rate in effect at the balance sheet date. (July, 1983)

Paragraph 1651.18 At each balance sheet date, for non-monetary assets of the reporting enterprise that are carried at market, the Canadian dollar equivalent should be determined by applying the exchange rate in effect at the balance sheet date to the foreign currency market price. (July, 1983)

Exchange Gains And LossesSourceSome items are translated at current rates

As the rate changes, gains and losses arise

Exchange Gains And Losses

Balance Sheet ItemExchange Rate MovementEffect on IncomeAssetIncreaseGainAssetDecreaseLossLiabilityIncreaseLossLiabilityDecreaseGain

Required Treatment of Gains and LossesParagraph 1651.120 An exchange gain or loss of the reporting enterprise that arises on translation or settlement of a foreign currency-denominated monetary item or a non-monetary item carried at market should be included in the determination of net income for the current period. (January, 2002)

Required Treatment of Gains and LossesAn ExceptionChanges in fair value on available-for-sale investments to Other Comprehensive Income

Exchange gains and losses receive comparable treatment

Required Treatment of Gains and LossesForeign Currency Financial Statements receive different treatment (see Chapter 10)

Disclosure

Paragraph 1651.37 The amount of exchange gain or loss included in net income should be disclosed (see paragraphs 1651.20, 1651.24 and 1651.31). An entity may exclude from this amount those exchange gains or losses arising on financial instruments classified as held for trading in accordance with "Financial Instruments Recognition And Measurement", Section 3855. An entity may also exclude from this amount exchange gains or losses on available-for-sale financial assets and cash flow hedges (see "Hedges", Section 3865) included in any gains or losses removed from accumulated other comprehensive income and included in net income for the period. (October, 2006)

Disclosure

Paragraph 1520.03 contains an identical recommendation

Foreign Currency Purchases and SalesTwo transaction approach requiredTransaction recorded at current rate

Exchange gains and losses into income as they arise

Foreign Currency Purchases and SalesOn December 12, 2007, a Canadian company purchases Inventory in Switzerland for 100,000 Swiss Francs (SF, hereafter). At this time SF1 = $0.94. When the company closes its books on December 31, 2007, the Inventory is still on hand and the Accounts Payable has not been paid. On this later date SF1 = $0.96.

Foreign Currency Purchases and Sales

December 12, 2007Inventory [(SF)($100,000)($0.94)]$94,000 Accounts Payable$94,000

December 31, 2007Exchange Loss [(SF100,000)($0.96 - $0.94)]$2,000 Accounts Payable$2,000

Foreign Currency Capital TransactionExampleOn December 31, 2008, a Canadian Company with a December 31 year end borrows 1,000,000. At this time 1 = $1.40.On December 31, 2009, the rate for the Euro is 1 = $1.50 and on December 31, 2010, the rate is 1 - $1.55. On this latter date the loan is repaid.Ignore interest payments.

Foreign Currency Capital Transaction

Foreign Currency Capital Transaction

Held-To-Maturity InvestmentsExampleOn January 1, 2008, Empire Inc. acquires 200,000 in long-term debt of a British company. At this time 1 = $2.15.

On December 31, 2008, when Empire Inc. closes its books, the exchange rate is 1 = $2.25.

Held-To-Maturity Investments

Available-For-Sale At Cost InvestmentsExampleOn January 1, 2008, Empire Inc. acquires 200,000 in equity securities of a British company.

At this time 1 = $2.15. The investment is classified as available for sale and the shares do not have a quoted market price.

On December 31, 2008, when Empire Inc. closes its books, the exchange rate is 1 = $2.25.

Available-For-Sale At Cost Investments

Held-For-Trading InvestmentsExampleOn January 1, 2008, Empire Inc. acquires 200,000 in equity securities of a British company.

At this time 1 = $2.15. The investment is classified as held for trading.

On December 31, 2008, when Empire Inc. closes its books, the market value of the securities has increased to 215,000 and the exchange rate is 1 = $2.25.

Held-For-Trading Investments

Available-For-Sale At Fair Value InvestmentsExampleOn January 1, 2008, Empire Inc. acquires 200,000 in equity securities of a British company.

At this time 1 = $2.15. The investment is classified as available for sale.

On December 31, 2008, when Empire Inc. closes its books, the market value of the securities has increased to 215,000 and the exchange rate is 1 = $2.25.

Available-For-Sale At Fair Value Investments

Available-For-Sale At Fair Value InvestmentsReclassificationIf investments are sold, the Other Comprehensive Income amounts will be reclassified into Net Income

HedgingAn extremely complex area

Our coverage is limited to simple applications in the area of foreign exchange risk

HedgingParagraph 3865.02 Hedging is an activity designed to modify an entity's exposure to one or more risks by creating an offset between changes in the fair value of, or the cash flows attributable to, the hedged item and the hedging item (or changes resulting from a particular risk exposure relating to those items).

Hedged Items In GeneralParagraph 3865.07(c) A hedged item is all or a specified portion of a recognized asset, a recognized liability, an anticipated transaction, or a net investment in a self-sustaining foreign operation, or a group of similar recognized assets, recognized liabilities or anticipated transactions, having an identified risk exposure that an entity has taken steps to modify.

Hedged Items: Foreign Currency ApplicationsForeign currency denominated monetary assets or monetary liabilitiesAnticipated TransactionsFirm commitmentsForecasted transactionsInvestments in self-sustaining foreign operations

Hedging Items In General

Paragraph 3065.07(d) A hedging item is all or a specified percentage of a derivative, or all or a specified percentage of a group of derivatives offsetting a risk exposure identified in the hedged item. All or a specified percentage of:(i) a non-derivative financial asset;(ii) a non-derivative financial liability; or(iii) a group of non-derivative financial assets or non-derivative financial liabilities, provided that all non-derivative items in a group are similar;may be designated as a hedging item only for a hedge of a foreign currency risk exposure.

Hedging Items: Foreign Currency ApplicationsExampleOn July 1, 2008, a Canadian company purchases merchandise in France for 200,000.

At this time 1 = $1.40.

The merchandise must be paid for on December 31, 2008.

Hedging Items: Foreign Currency ApplicationsPurchase Euros on July 1, 2008Effective but costly (no return on funds)Purchase financial asset denominated in EurosSome rate of returnLow rates on short term investments

Hedging Items: Foreign Currency ApplicationsPurchase non-financial assets denominated in EurosInconvenientMay or may not be effectiveForward contract to take delivery of Euros on December 31, 2008EffectiveRequires no investment of funds

A Derivatives PrimerParagraph 3855.19(e) A derivative is a financial instrument or other contract within the scope of this Section with all three of the following characteristics:(i) its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or other variable (sometimes called the "underlying"), provided in the case of a non-financial variable that the variable is not specific to a party to the contract;(ii) it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and(iii) it is settled at a future date.

A Derivatives Primer

TypesContractsForwardsFuturesBoth parties must performOptionsOnly one party required to perform

A Derivatives Primer

Accounting proceduresInitial recognition at fair value (often nil)Subsequent measurement at fair valueGains and losses to Net Income (in general)

Forward Exchange ContractsExample (From Text Paragraph 9-99)

On January 1, 2007, Sandor Inc., a Canadian public company, enters into a forward exchange contract to take delivery of 100,000 on December 31, 2007 at a rate of 1 = $2.30.

On January 1, 2007, the exchange rate is 1 = $2.26.

Forward Exchange ContractsInitial RecognitionNo consideration for contractFair value = nilNo recognition in the financial statements

Forward Exchange ContractsSettlement on December 31, 2007 when rate is 1 = $2.33.

Forward Exchange ContractsIf Balance Sheet date occurred prior to settlement of the contract, the fair value of the contract would have to be recorded in the Balance Sheet. This would result in a gain or loss to be included in Net Income.

Hedge AccountingObjective

Hedge accounting is a method for recognizing the gains, losses, revenues and expenses associated with the items in a hedging relationship such that those gains, losses, revenues and expenses are recognized in net income in the same period when they would otherwise be recognized in different periods.

Hedge AccountingIts use is optionalOften not necessary (e.g., contract hedging a monetary asset)

Sometimes cannot qualify

Management may decide not to use

Hedge AccountingQualificationDesignation

Documentation

Evaluation for effectiveness (Beyond the scope of this text)

Fair Value HedgesUnder this approach, gains and losses on the hedging item must be included in Net Income. Gains and losses on the hedged item that are attributable to the hedged risk must also be included in Net Income.

Fair Value HedgesFair value hedge accounting can be used when the hedge is a hedge of the exposure to changes in the fair value of:a recognized asset or liability;an unrecognized firm commitment; oran identified portion of such an asset, liability, or firm commitment.

Cash Flow Hedge AccountingCash Flow Hedge Accounting Under this approach, gains and losses on the hedging item are treated as items of Other Comprehensive Income, rather than as items to be included in the determination of Net Income.

Cash Flow Hedge AccountingCash flow hedge accounting can be used when the hedge is a hedge of the exposure to variability in cash flows associated with:a recognized asset or liability;a forecasted transaction; orthe foreign currency risk in an unrecognized firm commitment.

Hedge Of Exposed Monetary BalanceExampleOn November 1, 2008, Torcan Ltd. a Canadian company with a December 31 year end, sells merchandise in Switzerland for 1,000,000 Swiss Francs (SF, hereafter). Assume that, at this time, the exchange rate is SF1 = $0.90. On December 31, 2008, the exchange rate is SF1 = $0.92.The merchandise is paid for on February 1, 2009 when the exchange rate is SF1 = $0.95.

Example No Hedge Accounting

Example No Hedge Accounting

Example Hedge With Forward ContractExampleOn November 1, 2008, Torcan Ltd. a Canadian company with a December 31 year end, sells merchandise in Switzerland for 1,000,000 Swiss Francs (SF, hereafter). Assume that, at this time, the exchange rate is SF1 = $0.90. On December 31, 2008, the exchange rate is SF1 = $0.92.The merchandise is paid for on February 1, 2009 when the exchange rate is SF1 = $0.95.HedgeOn November 1, 2008, Torcan enters a contract to deliver SF1,000,000 on February 1, 2009 at a rate of SF1 = $0.92.On December 31, 2008 the one month forward rate is SF1 = $0.93, resulting in a fair value for the contract of $9,950.

Example Hedge With Forward Contract

Example Hedge With Forward Contract

Example Hedge With Forward Contract

Example Hedge With Forward Contract

Hedge Of Exposed Monetary BalanceExampleOn October 1, 2008, Ardin Ltd. commits to purchasing merchandise in Germany at a cost of 500,000. At this time the spot rate for Euros is 1 = $1.57. The merchandise is to be delivered and paid for on May 1, 2009. On October 1, 2008, Ardin also acquires a term deposit with a maturity value of 500,000 (ignore the interest that would accrue on this asset).On December 31, 2008, when Ardin closes its books, the exchange rate has decreased to 1 = $1.55. On May 1, 2009, the rate is 1 = $1.52.

Example No Hedge Accounting

Example No Hedge Accounting

Example No Hedge AccountingThe economic gain on the commitment (i.e., the purchase will now cost less) cannot be recognized.

Hedge Of Exposed Monetary BalanceExampleOn October 1, 2008, Ardin Ltd. commits to purchasing merchandise in Germany at a cost of 500,000. At this time the spot rate for Euros is 1 = $1.57. The merchandise is to be delivered and paid for on May 1, 2009. On October 1, 2008, Ardin also acquires a term deposit with a maturity value of 500,000 (ignore the interest that would accrue on this asset).On December 31, 2008, when Ardin closes its books, the exchange rate has decreased to 1 = $1.55. On May 1, 2009, the rate is 1 = $1.52.Document the hedging relationship and use Cash Flow Hedge Accounting.

Example Cash Flow Hedge Accounting

Example Cash Flow Hedge Accounting

Example Cash Flow Hedge AccountingAlternative 1 Reclassify Immediately

May 1, 2009Merchandise$25,000 OCI Reclassification Adjustment$25,000

Example Cash Flow Hedge AccountingAlternative 2 Reclassify When Merchandise Sold

January 1, 2010Cost Of Goods Sold$760,000 Merchandise$760,000Cost Of Goods Sold$25,000 OCI Reclassification Adjustment$25,000

Hedge Of Net Investment In Self-Sustaining OperationParagraph 3865.58 A hedge of a net investment in a self-sustaining foreign operation, including a hedge of a monetary item that is accounted for as part of the net investment (see Foreign Currency Translation, Section 1651), should be accounted for as follows:(a) the portion of the gain or loss on the hedging item that is determined to be an effective hedge (see paragraphs 3865.08 -.45) should be recognized in other comprehensive income (see Comprehensive Income, Section 1530); and(b) the ineffective portion of the gain or loss on the hedging item should be recognized in net income.

The gain or loss on the hedging item relating to the effective portion of the hedge that has been recognized in other comprehensive income should be recognized in net income in the same period during which corresponding exchange gains or losses arising from the translation of the financial statements of the self-sustaining foreign operation are recognized in net income. (October, 2006)

Hedge Of Net Investment In Self-Sustaining Operation

Hedge Of Net Investment In Self-Sustaining OperationReduction In Net InvestmentParagraph 1651.31 An appropriate portion of the exchange gains and losses accumulated in the separate component of accumulated other comprehensive income should be included in the determination of net income when there is a reduction in the net investment. (October, 2006)

Discontinuance Of Hedge AccountingDiscontinue If:The hedging item ceases to existThe hedged item ceases to existIt becomes probable that an anticipated transaction will not occurThe entity terminates the hedging designationThe hedging relationship ceases to be effective

International ConvergenceHedging covered in IAS No. 39, Financial InstrumentsNo differences that impact on the material covered in this text Other foreign currency issues in Chapter 10