CFA Level 2: FRA

Net Asset vs Net Liability Exposure

A foreign operation will have a net asset balance sheet exposure when assets translated at the current exchange rate are greater than liabilities translated at the current exchange rate. A net liability balance sheet exposure exists when liabilities translated at the current exchange rate are greater than assets translated at the current exchange rate.

Translating Retained Earnings

net income is obtained from TRANSLATED income statement dividends (which are subtracted from NI before NI is added to RE) should be translated at the date at which they are declared

Temporal Method (Remeasurement)

A variation of the monetary/non-monetary translation method; used when parent's presentation currency and the functional currency of the subsidiary are the same; Monetary assets and liabilities are translated at the current exchange rate. Non-monetary assets and liabilities measured at historical cost are translated at historical exchange rates. Non-monetary assets and liabilities measured at current value are translated at the exchange rate at the date when the current value was determined. Stockholders' equity accounts are translated at historical exchange rates. Revenues and expenses, other than those expenses related to non-monetary assets (as explained in 3.b. below), are translated at the exchange rate that existed when the transactions took place (for practical reasons, average rates may be used). Expenses related to non-monetary assets, such as cost of goods sold (inventory), depreciation (fixed assets), and amortization (intangible assets), are translated at the exchange rates used to translate the related assets. when the temporal method is used, the translation adjustment is reported as a gain or loss in net income. US GAAP refer to these as re-measurement gains and losses. The basic assumption underlying the recognition of a translation gain or loss in income relates to timing. Specifically, if the foreign entity primarily uses the parent company's currency in its day-to-day operations, then the foreign entity's monetary items that are denominated in a foreign currency generate translation gains and losses that will be realized in the near future and thus should be reflected in current net income.

Current Rate Method

Approach to translating foreign currency financial statements for consolidation in which all assets and liabilities are translated at the current exchange rate. The current rate method is the prevalent method of translation. When a foreign entity has a functional currency that differs from the parent's presentation currency, the foreign entity's foreign currency financial statements are translated into the parent's presentation currency using the following procedures: All assets and liabilities are translated at the current exchange rate at the balance sheet date. Stockholders' equity accounts are translated at historical exchange rates. Revenues and expenses are translated at the exchange rate that existed when the transactions took place. For practical reasons, a rate that approximates the exchange rates at the dates of the transactions, such as an average exchange rate, may be used. Note that the CTA is presented as a plug figure inthe stockholder's equity section of the BS Note that the net translation gain or loss that results from this procedure is unrealized, however, and will be realized only when the entity is sold. In the meantime, the unrealized translation gain or loss that accumulates over time is deferred on the balance sheet as a separate component of stockholders' equity. When a specific foreign entity is sold, the cumulative translation adjustment related to that entity is reported as a realized gain or loss in net income. The current rate method results in a net asset balance sheet exposure (except in the rare case in which an entity has negative stockholders' equity):

placement of foreign currency gains/losses on income statement

Both IFRS and US GAAP require foreign currency transaction gains and losses to be reported in net income (even if the gains and losses have not yet been realized), but neither standard indicates where on the income statement these gains and losses should be placed. The two most common treatments are either (1) as a component of other operating income/expense or (2) as a component of non-operating income/expense, in some cases as a part of net financing cost. The calculation of operating profit margin is affected by where foreign currency transaction gains or losses are placed on the income statement.

Where do you recognize a change in value of a foreign currency asset or liability that has been settled BEFORE reporting date? At what rate do you recognize the change?

Both IFRS and US GAAP require the change in the value of the foreign currency asset or liability resulting from a foreign currency transaction to be treated as a gain or loss reported on the income statement. The basic principle is that all transactions are recorded at the spot rate on the date of the transaction. The foreign currency risk on transactions, therefore, arises only when the transaction date and the payment date are different. the original asset/liability account is recorded when the account is created (when the parties agree to the receivable/payable) the difference between the amount paid using spot rate on actual transaction date and the amount recorded on balance is the gain/loss that shows up on the income statement

Where to find notes related to foreign currency translation

Disclosures related to foreign currency are commonly found both in the Management Discussion & Analysis (MD&A) and the Notes to Financial Statements sections of an annual report

Where do you recognize a change in value of a foreign currency asset or liability that has been opened BEFORE a reporting date and settled AFTER?

Foreign currency transaction gains and losses are reported on the income statement, creating one of the few situations in which accounting rules allow, indeed require, companies to include (recognize) a gain or loss in income before it has been realized. Subsequent foreign currency transaction gains and losses are recognized from the balance sheet date through the date the transaction is settled. Adding together foreign currency transaction gains and losses for both accounting periods (transaction initiation to balance sheet date and balance sheet date to transaction settlement) produces an amount equal to the actual realized gain or loss on the foreign currency transaction.

Monetary vs Non-Monetary Assets

Monetary items are cash and receivables (payables) that are to be received (paid) in a fixed number of currency units. Non-monetary assets include inventory, fixed assets, and intangibles, and non-monetary liabilities include deferred revenue.

Cumulative Translation Adjustment (CTA)

The cumulative translation adjustment will be the sum of the translation adjustments that arise over successive accounting periods Single period net translation adjustment result from translating individual assets and liabilities at the current exchange rate and can be viewed as the net foreign currency translation gain or loss caused by a change in the exchange rate:

Functional Currency Approach to Translation

The following three steps outline the functional currency approach required by accounting standards in translating foreign currency financial statements into the parent company's presentation currency: 1) Identify the functional currency of the foreign entity. 2) Translate foreign currency balances into the foreign entity's functional currency. 3) Use the current exchange rate to translate the foreign entity's functional currency balances into the parent's presentation currency, if they are different.

Translation under hyperinflation: IFRS

When a foreign entity is located in a highly inflationary economy (defined as 100% inflation in 3 years aka 26% annually compounded rate for 3 years), the entity's functional currency is irrelevant in determining how to translate its foreign currency financial statements into the parent's presentation currency. IFRS require that the foreign entity's financial statements first be restated for LOCAL inflation (this means that commodity-like assets, such as land, will gain in local currency value). Then, the inflation-restated foreign currency financial statements are translated into the parent's presentation currency using the current exchange rate.

Translation under hyperinflation: GAAP

When a foreign entity is located in a highly inflationary economy, the entity's functional currency is irrelevant in determining how to translate its foreign currency financial statements into the parent's presentation currency. US GAAP do not allow restatement for inflation but instead requires the use of the temporal method (so the assets will not see any changes in value) hyperinflation is defined as 3 year inflation rate of 100%; this translated to a 26% annually compounded rate

2 factors that determine whether a transaction will result in a foreign currency gain or loss on income statement:

Whether a change in exchange rate results in a foreign currency transaction gain or loss (measured in local currency) depends on (1) the nature of the exposure to foreign exchange risk (asset or liability) and (2) the direction of change in the value of the foreign currency (strengthens or weakens). Note that some companies may choose not to disclose either the location or the amount of their foreign currency transaction gains and losses, presumably because the amounts involved are immaterial. There are several reasons why the amount of transaction gains and losses can be immaterial for a company: