Foreign Currency Financial Statements
1. Define the functional currency concept and briefly describe how a foreign entity’s functional currency is determined. Why is this definition critical from a financial reporting perspective?
A company’s functional currency is the currency of the primary economic environment in which it operates. It is normally the currency in which it receives most of its payments from customers and in which it pays most of its liabilities. Other factors that are considered in determining the functional currency include whether its sales prices are determined primarily by local competition or local government regulation instead of short-run exchange rate changes or worldwide markets.
The functional currency determination (local currency or parent currency or some other currency) is critical in determining what approach to converting financial statements to the ultimate reporting currency is used: the current rate or the temporal method. If the functional currency is the local currency, the current rate method is used. If it is the parent currency, the temporal method is used. If it is some other currency, then both approaches may need to be used.
2. How does ASC Topic 830 define a highly inflationary economy? If the economy is deemed to be highly inflationary, which method for converting the financial statements to the reporting currency is used? How does the use of this method improve the economic representational faithfulness of the financial statements?
A highly inflationary economy under GAAP is one that has cumulative inflation of approximately 100 percent or more over a three-year period. The functional currency is assumed to be the reporting currency (for U.S. companies, the dollar) which means that the foreign currency financial statements must be remeasured into the dollar using the temporal method. The effect of the hyperinflation is then reflected in the current year’s consolidated income statement which would not be the case if the current rate method were used. Judgment must be exercised in applying this rule to avoid changing functional currencies frequently due to minor differences in the inflation rate.
3. What procedure is used to allocate the investment purchase price at the date of acquisition of a foreign subsidiary?
The functional currency of a foreign subsidiary does not affect the original recording of the business combination. This is because all assets, liabilities, and equities of the foreign subsidiary are converted into U.S. dollars at the current exchange rate in effect on the date of consummation of the business combination. As a result, no special procedure must be applied at the date of original recording of a foreign subsidiary.
4. Describe what the current rate method is and under what circumstances it should be used.
The current rate method is used when the foreign subsidiary’s local currency is determined to be the subsidiary’s functional currency. The subsidiary’s financial statements must be translated using the current rate method into the reporting entity’s currency (typically the parent’s currency).
5. Describe what the temporal method is and under what circumstances it should be used.
The temporal method is used when the foreign subsidiary’s currency is determined to be the reporting entity’s currency (typically the parent’s currency). The temporal method is used when the functional currency of the foreign subsidiary is the U.S. dollar. The subsidiary’s financial statements must be remeasured using the temporal method into the reporting entity’s currency.
6. If the current rate method is used, the gain or loss on translation is included under other comprehensive income. Explain why this makes sense economically.
Since the functional currency is not the parent’s currency, no direct impact on the reporting entity’s (parent’s) cash flows is expected due to exchange rate changes. The effects of exchange rate changes are reflected in the consolidated statement’s accumulated comprehensive income account instead of being included in the income statement.
7. The gain or loss on remeasurement is included in net income each year if the temporal method is used. Explain why this makes sense economically.
Since the functional currency is assumed to be the reporting entity’s (or parent’s) currency, a direct impact on the parent’s cash flows is expected due to exchange rate changes. The effects of exchange rate changes are reflected in the consolidated income statement.
8. Under what circumstances would a foreign entity’s financials statements need to be both remeasured and translated? Would this process have an effect on both the income statement and other comprehensive income? Explain.
A foreign subsidiary’s financial statements could be both translated and remeasured if the entity’s books are maintained in a different currency than the functional currency and the functional currency is not the reporting entity’s local currency. In this case, the entity’s financial statements must be remeasured into the functional currency using the temporal method. The gain or loss on remeasurement is included in income. The functional currency financial statements are then translated into the reporting entity’s currency using the current rate method. The gain or loss on the translation is included in accumulated other comprehensive income. In this situation, the consolidated financial statements would include both a remeasurement gain or loss in income and the a translation adjustment included in accumulated other comprehensive income.
9. If a company’s sales were very seasonal—for example, a holiday-tree grower—would it be appropriate to use the annual average exchange rate to translate and remeasure sales and other expenses? Why or why not?
No, it would not be appropriate to use the annual average exchange rate. Theoretically, the exchange rate at the date each transaction occurs should be used. Given that this is not practical, reasonable assumptions are made concerning what exchange rate to use. The use of an average exchange rate is appropriate when sales are earned evenly during the year and expenses are incurred evenly during the year. A reasonable assumption for a holiday tree grower would be to use the average exchange rate during the quarter from October through December since those are the month’s that trees are typically sold. For expenses, examining the months that are the most labor intensive (such as planting, fertilizing and harvesting) and using a reasonable weighting of those months exchange rates would be a reasonable way of determining the rate for those costs.
10. In the current-rate-method example in the chapter, the parent’s other comprehensive income adjustment related to its investment in the subsidiary was larger than the other comprehensive income adjustment on the subsidiary’s translated financial statements. Why?
The parent purchased the subsidiary for an amount in excess of book value. This excess was attributable to an unrecorded patent. Recall that the excess amount would not be included on the subsidiary’s books. The consolidated financial statements, however, would include both the amortization of the patent and the patent. Since the current rate method is being used, the impact of the change in exchange rates on the patent and the amortization is included in the translation adjustment to be included in consolidated comprehensive income. The subsidiary’s translation adjustment would not include this because the patent was not included in the books. Thus, the consolidated translation adjustment is larger than the subsidiary’s translation adjustment.
11. Under the current rate method, all the expenses are translated using some form of current-period exchange rate. Under the temporal method, some expenses such as salaries and utilities are translated using current rates but others, such as cost of goods sold and depreciation expense, use historical rates. Why are different rates used between the two methods? After all, they are all expenses.
The temporal method requires remeasuring expenses of a foreign subsidiary. Expenses related to monetary items are remeasured at appropriately weighted average exchange rates for the period. Those types of expenses are either paid in cash or recorded as liabilities which will require the eventual payment of cash. Those that relate to nonmonetary items are remeasured at historical exchange rates. Expenses related to nonmonetary items would be those related to inventory and plant assets. Under the current rate method, all accounts are translated at the weighted average rate.
12. How does the choice of functional currency affect how the gain or loss on a hedge of a net investment in a foreign subsidiary is reported in the financial statements?
If the functional currency is a subsidiary’s local currency, the current rate method is used, and the gain or loss on the hedge of a net investment in a foreign subsidiary is reported in other comprehensive income. If the functional currency is the parent’s currency, the temporal method is used, and the gain or loss is included in current period income.
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