Chapter 11 Slide 1

Introduction

Translation and Consolidation of
Foreign Operations

Chapter 11 Slide 2
Introduction
Two major accounting questions are posed by the
translation to Canadian dollars of subsidiary financial
statements presented in a foreign currency:

What exchange rates are appropriate for each balance?
How should the resulting exchange gains and losses be
reflected in the Canadian dollar financial statements?

The answers depend on the type of foreign currency
exposure the parent faces with the foreign subsidiary
Chapter 11 Slide 3
Accounting Exposure Versus
Economic Exposure
Foreign currency exposure is the risk that a loss
(or gain) could occur as a result of changes in foreign
exchange rates

Foreign currency exposure has three components:
Translation exposure (accounting exposure)
Transaction exposure
Economic exposure
Chapter 11 Slide 4
Accounting Exposure Versus
Economic Exposure
Translation exposure accounting exposure results
from the translation of foreign-currency-denominated
financial statements into Canadian dollars, giving rise to
exchange gains and losses
Only those financial statement items translated at the closing
rate or forward rate create an accounting exposure since the
Canadian dollar value of those items changes every time the
exchange rate changes (these changes are referred to as
translation adjustments)
The value of items translated using the historical rate is fixed
and does not fluctuate with rate changes
Positive translation adjustments increase shareholders
equity; negative adjustments decrease shareholders equity

Chapter 11 Slide 5
Accounting Exposure Versus
Economic Exposure
Transaction exposure this exposure represents the
foreign exchange loss or gain that can occur between the
the time of entering a transaction (e.g. sale or purchase)
involving a foreign currency-denominated receivable or
payable, and the time of settling it in cash with the
customer or vendor
Refer to discussion and examples in Chapter 10

The resulting cash gains and losses are realized and affect the
enterprises cash flow, working capital, and earnings
Chapter 11 Slide 6
Accounting Exposure Versus
Economic Exposure
Economic exposure represents a longer-term risk to
the parent that the overall value of its investment in a
foreign subsidiary will change (decrease or increase) as a
result of exchange rate fluctuations (the PV of future cash
flows changes as a result of changes in exchange rates)

Economic exposure varies depending on how closely
linked the activities of the parent are to the subsidiary


Chapter 11 Slide 7
Functional Currency
IAS 21 provides two methods of translating subsidiary
financial statements, depending on the functional currency
of the foreign operation
Functional currency is the currency of the primary
economic environment in which the entity operates
Normally the currency in which the entity primarily
generates and expends cash


Chapter 11 Slide 8
Functional Currency
Factors to consider in determining functional currency
a) The currency:
i. that mainly influences sales prices for goods and
services (this will often be the currency in which
sales prices for its goods and services are
denominated and settled); and
ii. of the country whose competitive forces and
regulations mainly determine the sales prices of its
goods and services
b) The currency that mainly influences labour, material
and other costs of providing goods or services (this
will often be the currency in which such costs are
denominated and settled)


Chapter 11 Slide 9
Functional Currency
Other factors to consider in determining functional
currency
a) the currency in which funds from financing
activities (i.e., issuing debt and equity
instruments) are generated
b) the currency in which receipts from operating
activities are usually retained

Chapter 11 Slide 10
Functional Currency
Additional factors to consider in determining
functional currency
a) whether the activities of the foreign operation are carried out as
an extension of the reporting entity, rather than being carried
out with a significant degree of autonomy
b) whether transactions with the reporting entity are a high or a
low proportion of the foreign operation's activities
c) whether cash flows from the activities of the foreign operation
directly affect the cash flows of the reporting entity and are
readily available for remittance to it
d) whether cash flows from the activities of the foreign operation
are sufficient to service existing and normally expected debt
obligations without funds being made available by the reporting
entity

Chapter 11 Slide 11
Translation Methods
The translation method used should reflect the
parents exposure to exchange rate changes
If the functional currency is the same as the functional
currency of the reporting entity there is transaction
exposure
This is referred to as an integrated foreign operation in the
Hilton text
If the functional currency is different from the
functional currency of the reporting entity there is
economic exposure
This is referred to as a self sustaining foreign operation in
the Hilton text
Chapter 11 Slide 12
Translation Methods
Functional currency is the same as the functional
currency of the reporting entity (integrated foreign
operation)
F/S prepared as if the transactions had been
transacted by the reporting entity
Functional currency is different from the functional
currency of the reporting entity (self sustaining foreign
operation)
Preserves the foreign operations F/S relationships
Chapter 11 Slide 13
Translation Under IAS 21
Same functional currency (integrated foreign
operation)
Temporal method
Different functional currency (self-sustaining operation)
Current rate method
Exception exists for self-sustaining subsidiaries in highly
inflationary economies where temporal method is more
relevant
IAS 29 requires judgment to determine when an economy is highly
inflationary by examining such factors as whether the population
maintains its wealth and financial transactions in more stable
foreign currencies

Chapter 11 Slide 14
Translation Methods - Temporal
The temporal method
Reflects parents close involvement with subsidiary and its
cash flows by measuring exposure to monetary assets and
liabilities
Uses Canadian dollar as the underlying unit of measure,
producing the same result as if the transaction had occurred
in Canada in the first place
All monetary items are translated at the balance sheet
closing rate
Items carried at fair value are translated at the closing rate on
the date when the fair value determination was made
Non-monetary items at historical cost are translated at
applicable historical rates (generally, the rate on the date of
acquisition of the item)
Exchange gains and losses are recorded in income

Chapter 11 Slide 15
Translation Methods - Temporal
Monetary items represent 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

Payables and receivables and all other fixed claims to
money are monetary items; inventory is not
Future income tax liabilities and assets are classified
as monetary items
Estimated liabilities (such as provisions for warranties)
are not considered monetary items
Chapter 11 Slide 16
Translation Methods Current Rate
The current rate method
Reflects the exposure of the subsidiarys net assets and
therefore parents investment in subsidiary, to currency
fluctuations
Uses the foreign currency as the underlying unit of measure
All assets and liabilities are translated at closing rate
Only net assets (i.e. equity balances) are translated at the
historical rate
The translated statements retain the same ratios and
relationships that exist in local currency originals, so the
translated financial statements can provide an effective tool for
the evaluation of local management
Exchange gains and losses are recorded in other
comprehensive income

Chapter 11 Slide 17
Exhibit 11.5

Translation Under IAS 21 - Comparison
Exchange Rates
Financial statement items Temporal Method Current Rate Method
Integrated Self-sustaining
Operations Operations
Monetary Closing Closing
Non-monetary at cost or amortized cost Historical Historical Closing
Non-monetary at fair value (Note 1) (Note 1)
Goodwill Historical Closing
Deferred revenues Historical Closing
Common shares Historical Historical
Dividends Historical Historical
Revenues Historical Historical (2)
Depreciation and amortization Historical Historical (2)
Cost of Sales Historical Historical (2)
Opening Inventory Historical --
Purchases Historical --
Ending inventory Historical --

Note 1: The rate of the date that fair value was determined should be used. If fair value was
determined on the last day of the period, then the closing rate should be used
Note 2: If even throughout the year, use Average Rate for Current Rate for Current Rate
Income statement, all items use Average Rate
Chapter 11 Slide 18
Translation Under IAS 21
Same functional currency (integrated subsidiaries):
Because of the interdependent relationship with the parent,
translation gains and losses are reported in income just as
they
would be if the parent itself had conducted the underlying
transactions

Different functional currency (self-staining subsidiaries):
Because of the more independent relationship that exists
between the parent and subsidiary, the parents exposure is
limited to its net investment in the subsidiary
Translation gains and losses are reported in other
comprehensive income in the year they occur, and in
cumulative other comprehensive income in subsequent years
Chapter 11 Slide 19
Translation Under IAS 21
When the parent sells all or part of its self-sustaining
foreign operations, the cumulative exchange gains and
losses on the foreign operation are removed from the
cumulative other comprehensive income section of
shareholders equity and the realized gains or losses
are reported in the regular income statement

Chapter 11 Slide 20
Translation under IAS 21
The interrelationship of the functional currency, the
classification of the foreign entity, and the translation
method can be summarized as follows:

Functional
currency of
foreign entity
Classification of
foreign entity
Translation
method
Translation
adjustment reported
in
Same as parents Integrated Temporal method Net income
Currency of country
where its resides
Self-sustaining Current rate
method
Other comprehensive
income
Currency of a
country other than
parents country and
other than country
where it resides
Self-sustaining Current rate
method
Other comprehensive
income
Chapter 11 Slide 21
Subsequent to Acquisition
Revenues and expenses can be translated at average rates
if they occur evenly

Amortization of allocation differential (AD):
Integrated subsidiaries (temporal method): The translation of
AD amortization is at the historical rate on the date of
acquisition
Self-staining subsidiaries (current rate method): Translate
opening AD at prior year-end closing rate, translate
amortization at average rate, and compare ending result to
ending foreign currency AD translated at the current years
closing rate. The difference represents a translation gain or
loss recorded in OCI


Chapter 11 Slide 22
Subsequent to Acquisition
Calculation of translation gain or loss:

Integrated subsidiaries (temporal method): Calculate
expected net monetary position in foreign currency,
translate result at closing rate and compare to actual
net monetary position
Difference is a translation gain or loss recorded in
income

Self-sustaining subsidiaries (current rate method):
Calculate expected net asset position in foreign
currency, translate result at closing rate and compare to
actual net
asset position
Difference is a translation gain or loss recorded in OCI
Chapter 11 Slide 23
Illustration
Example: At the beginning of the year, parent invests
500 foreign currency units (FCU) in a subsidiary when 1
FCU = 1 Canadian dollar (CAD)
The net assets were held for the entire year, with no
sales or expenses incurred
At the end of the year, the exchange rate has changed
to 1 FCU = 1.5 CAD

Chapter 11 Slide 24
Illustration
FCU Exch. Rate CAD Gain (loss)
Cash and A/R
200 1.5 300 100
Inventory at cost
300 1.0 300 0
Fixed assets at
cost
500 1.0 500 0
Accounts payable
-100 1.5 -150 -50
Long-term debt
-400 1.5 -600 -200
Net assets
500
Translation loss
-150
Net monetary position at end of year = 200 100 400 = - $300
- $300 x (1.5-1.0) change in exchange rate = - $150 exchange loss recorded in income
Chapter 11 Slide 25
Illustration
FCU Exch. Rate CAD Gain (loss)
Cash and A/R
200 1.5 300 100
Inventory at cost
300 1.5 450 150
Fixed assets at
cost
500 1.5 750 250
Accounts payable
-100 1.5 -150 -50
Long-term debt
-400 1.5 -600 -200
Net assets
500
Translation loss
250
Net asset position at end of year = $500
$500 x (1.5-1.0) change in exchange rate = $250 exchange gain recorded in other comprehensive
income
Chapter 11 Slide 26
Illustration
The integrated subsidiary produces a $150
exchange loss recorded in income while the
self-sustaining subsidiary produces a $250 gain
recorded in other comprehensive income
Chapter 11 Slide 27
Comparative Observations
of the Two Translation Methods
Temporal method the monetary position is at risk from
foreign currency fluctuations
Current rate method the net asset position of the foreign
equity is at risk from foreign currency fluctuations
For most companies monetary liabilities are greater than
monetary assets so they are usually in a net monetary liability
position
This will result in exchange losses for integrated subsidiaries
when foreign currency appreciates in value

Most companies have positive net assets
This will result in exchange gains for self-sustaining subsidiaries
when foreign currency appreciates in value
Chapter 11 Slide 28
Other Considerations
Conformity to IFRS: if foreign subsidiary financial
statements are prepared under foreign GAAP they must be
adjusted to IFRS before translation and consolidation

Lower of cost and net realizable value (NRV) if the
foreign currency weakens, NRV of a balance such as
inventory might be lower than the items cost when translated
into Canadian dollars, even though it might still be higher
than cost in the foreign currency
In such cases, if the foreign currency strengthens at a
later date and NRV translated into Canadian dollars
exceeds cost the write-down is reversed


Chapter 11 Slide 29
Other Considerations
Intercompany profits Upstream and downstream
intercompany profits with integrated subsidiaries are
eliminated at historical cost which is the same as their
carrying values in the parent or subsidiary accounting
records
Although assets of self-sustaining subsidiaries are
translated at the closing rate, unrealized intercompany
profits with self-sustaining subsidiaries are still eliminated
at historical cost

Cash flow statement Prepare from consolidated balance
sheet, not from cash flow statement of parent plus translated
subsidiary cash flow statement
Chapter 11 Slide 30
Other Considerations

Tax effects Foreign subsidiary financial statement
exchange translation gains and losses are usually not
taxable or deductible until realized, and are therefore
temporary differences which should be recognized as
deferred income taxes for accounting purposes
Chapter 11 Slide 31
Translation Under ASPE
ASPE - Subsidiaries are classified as either Integrated
or Self-Sustaining
Integrated foreign operation - the foreign operations are more
closely linked to, or integrated with, the parents own operations
since the functional currency of the foreign operation is the same
as the parents functional currency
Temporal method
Self-sustaining foreign operation the foreign operations are
less linked to the parents own operations and more capable of
existing on their own without the parents support, since the
functional currency of the foreign operation is different from the
parents functional currency
Current rate method