[FINANCIAL REPORTING] CFA II LOS 18

Summary of Temporal & Current Rate Methods (Part 2)

* Net income is remeasured at a "mixed rate" (i.e., a mix of the average rate and the historical rate) under the temporal method because (1) the FX gain or loss is shown in the income statement, and (2) revenues and SG&A are remeasured at the average rate while COGS, depreciation, and amortization are remeasured at the historical rate. Equity is "mixed" because the change in retained earnings (which includes net income) is mixed. ** Under the current rate method, total assets and liabilities are translated at the current rate. The total equity (equity taken as a whole) would then have to be translated at the current rate for the balance sheet to balance.

Applying the Current Rate Method

- All income statement accounts are translated at the average rate. - All balance sheet accounts are translated at the current rate except for common stock, which is translated at the historical (actual) rate that applied when the stock was issued. - Dividends are translated at the rate that applied when they were declared. - Translation gain or loss is reported in shareholders' equity as a part of the cumulative translation adjustment (CTA).

Exposure to Changing Exchange Rates

- Current Rate Exposure: net asset position of the subsidiary. So, if the subsidiary has a net asset exposure and the local currency is appreciating, a gain is recognized. Conversely, a net asset exposure in a depreciating environment will result in a loss. - Temporal Method: only monetary net assets.If the parent has a net monetary liability exposure when the foreign currency is appreciating, the result is a loss. Conversely, a net monetary liability exposure coupled with a depreciating currency will result in a gain.

Applying the Temporal Method

- Monetary assets and liabilities are remeasured using the current exchange rate. Monetary assets and liabilities are fixed in the amount of currency to be received or paid and include: cash, receivables, payables, and short-term and long-term debt. - All other assets and liabilities are considered nonmonetary and are remeasured at the historical (actual) rate. The most common nonmonetary assets include inventory, fixed assets, and intangible assets. An example of a nonmonetary liability is unearned (deferred) revenue. - Just like the current rate method, common stock and dividends paid are remeasured at the historical (actual) rate. - Expenses related to nonmonetary assets such as COGS, depreciation expense, and amortization expense are remeasured based on the historical rates prevailing at the time of purchase. - Revenues and all other expenses are translated at the average rate. - Remeasurement gain or loss is recognized in the income statement. This results in more volatile net income as compared to the current rate method whereby the translation gain or loss is reported in shareholders' equity.

On the exam, remember these key points regarding the original versus the translated financial statements and ratios:

- Pure balance sheet and pure income statement ratios will be the same. - If the foreign currency is depreciating, translated mixed ratios (with an income statement item in the numerator and an end-of-period balance sheet item in the denominator) will be larger than the original ratio. - If the foreign currency is appreciating, translated mixed ratios (with an income statement item in the numerator and an end-of-period balance sheet item in the denominator) will be smaller than the original ratio.

Translating Financial Statements

- Remeasurement involves converting the local currency into functional currency using the temporal method. - Translation involves converting the functional currency into the parent's presentation (reporting) currency using the current rate method. The current rate method is also known as the all-current method The translation method, current rate or temporal, is determined by the functional currency relative to the parent's presentation currency.

Definition of Exchange Rates

- The current rate is the exchange rate on the balance sheet date. - The average rate is the average exchange rate over the reporting period. - The historical rate is the actual rate that was in effect when the original transaction occurred. For example, if a firm bought machinery on January 2, 2016, the historical rate for that transaction at every balance sheet date in the future would be the exchange rate on January 2, 2016.

LOS 18.a: Distinguish among presentation (reporting) currency, functional currency, and local currency.

- The local currency is the currency of the country being referred to. - The functional currency, determined by management, is the currency of the primary economic environment in which the entity operates. It is usually the currency in which the entity generates and expends cash. The functional currency can be the local currency or some other currency. - The presentation (reporting) currency is the currency in which the parent company prepares its financial statements.

Mixed Ratios

A mixed ratio combines inputs from both the income statement and balance sheet. The current rate method results in small changes in mixed ratios because the numerator and the denominator are almost always translated at different exchange rates. The change will likely be small and the direction will depend on the relationship between the exchange rate used to translate the denominator and the exchange rate used to translate the numerator.

Tax Implications of Multinational Operations

Effective tax rate is the tax expense in the income statement divided by pretax profit. Statutory tax rate is provided by the tax code of the home country.

LOS 18.b: Describe foreign currency transaction exposure, including accounting for and disclosures about foreign currency transaction gains and losses.

Foreign currency denominated transactions, including sales, are measured in the presentation (reporting) currency at the spot rate on the transaction date. Foreign currency risk arises when the transaction date and the payment date differ.

Analyst Issues

IFRS requires disclosure of the "amount of exchange rate differences recognized in profit or loss" while U.S. GAAP requires disclosure of "the aggregate transaction gain or loss included in determining net income for the period."

LOS 18.f: Analyze how the current rate method and the temporal method affect financial statements and ratios. Pure Balance Sheet and Pure Income Statement Ratios

Pure income statement and pure balance sheet ratios are unaffected by the application of the current rate method. In other words, the local currency trends and relationships are "preserved." What we mean by "pure" is that all of the components of the ratio are from the balance sheet, or all of the components are from the income statement.

Exam Focus

This topic review covers a detailed discussion of accounting for foreign subsidiaries and operations of multinational firms. The main issue is how to convert the results of a foreign subsidiary into the parent's consolidated financial statements. You have several significant tasks to master. First, you need to become familiar with the terminology of translation. Second, you need to be able to distinguish between and implement the two methods of accounting for foreign operations (i.e., remeasurement via the temporal method or translation via the current rate method). Third, you need to be able to analyze the impact of these two methods on reported earnings, cash flows, and financial ratios for both the subsidiary and the parent. This reading is important and challenging. Begin by concentrating on the examples of each method and then move on to the analysis section.