chapter 13 foreign operations. contents stock exchange requirements segment reporting foreign...

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts

CHAPTER 13Foreign operations


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


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”)


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


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


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


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


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


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


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


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?


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?


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


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


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


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


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


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


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?


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


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


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


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


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


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


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



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.


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


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


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 %



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


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)


(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


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)


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


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

chapter 13 foreign operations. contents stock exchange requirements segment reporting foreign...

Documents

segment reporting slide

segment reporting business

secondary translation

functional currency

segment disclosures

foreign exchange rates

total assets

primary format