CFA 2: FRA: Multinational Operations

when analyzing the effect on the financial ratios based on the choice of accounting method, what procedures do you follow?

- Determine whether the foreign currency is appreciating or depreciating? - Determine which rate (historical, average rate, or current rate) is used to convert the numerator under both methods. Determine whether the numerator of the ratio will be the same, larger, or smaller under the temporal method vs. the current rate method. - Determine which rate (historical, average rate, or current rate) is used to convert the denominator under both methods. Determine whether the denominator of the ratio will be the same, larger, or smaller under the temporal method vs. the current rate method. -Determine whether the ratio will increase, decrease, or stay the same based on the direction of change in the numerator and denominator.

What are the two methods used to remeasure or translate the financial statements of a foreign subsidiary to the parent's presentation (reporting) currency?s

- Remeasurement - Translation

Changes in effective tax rate on account of foreign operations can be due to:

- changes in the mix of profits from different countries with varying tax rates. - changes in the tax rate.

Foreign currency transactions occur when....

1) a company makes an import purchase or an export sale that is denominated in a foreign currency 2) borrows or lends funds where the amount to be repaid or received is denominated in a foreign currency.

Two approaches for translating the foreign subsidiary's assets and liabilities

1. All assets and liabilities are translated at the current exchange rate(the spot exchange rate on the balance sheet date) 2. Only monetary assets and liabilities are translated at the current exchange rates. Non-monetary assets and liabilities are translated at historical exchange rates (the exchange rates that existed when the assets and liabilities were acquired.

Explain the temporal method procedures

1. Monetary assets and liabilities are translated at the current exchange rate. 2. Non-monetary assets and liabilities measured at historical cost are translated at historical exchange rates. 3. Non-monetary assets and liabilities measured at current value are translated at the exchange rate at the date when the current value was determined. 4. Stockholders' equity accounts are translated at historical exchange rates. 5. 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). 6. 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.

Factors Considered in Determining the Functional Currency

1. The currency that mainly influences sales prices for goods and services. 2. The currency of the country whose competitive forces and regulations mainly determine the sales price of its goods and services. Other Factors: 3. the currency that mainly influences labor, material, and other costs of providing goods and services 4. The currency in which funds from financing activities are generated 5. The currency in which receipts from operating activities are usually retained.

Purchasing Power Gain

A gain in value caused by changes in price levels. Monetary liabilities experience purchasing power gains during periods of inflation. Holding payables during inflation results in purchasing power gain. A net purchasing power gain will arise when a company holds a greater amount of monetary liabilities than monetary assets.

Purchasing Power Loss

A loss in value caused by changes in price levels. Monetary assets experience purchasing power loss during periods of inflation. Holding cash and receivables during a period of inflation results in a purchasing power loss A net purchasing power loss will arise when a company holds a greater amount of monetary assets than monetary liabilities .

Clean surplus accounting

Accounting that satisfies the condition that all changes in the book value of equity other than transactions with owners are reflected in income. The bottom-line income reflects all changes in shareholders' equity arising from other than owner transactions. In the absence of owner transactions, the change in shareholders' equity should equal net income. No adjustments such as translation adjustments bypass the income statement and go directly to shareholders equity.

Explain the Current rate method procedures

All Income statement accounts: translated at the average rate. 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. 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: translated at the rate that applied when they were declared Translation gain or loss is reported in shareholders equity as part of the cumulative translation adjustment (CTA) 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 Total assets > Total liabilities → Net asset balance sheet exposure

Average rate

Average exchange rate over reporting period

Mixed Ratio

Combines inputs from both the income statement and balance sheet Current rate method: mixed ratios calculated from financial statements translated using the current rate method will be different than the same ratio calculated from the local currency statements before translation. Depreciating foreign currency: translated mixed ratios (with the income statement item in the numerator and an end of period balance sheet item in the denominator) will be larger than the original ratio Appreciating foreign currency: 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.

Remeasurement

Converting local currency into functional currency using temporal method. (Exchange rate values are based on the time assets and liabilities are acquired or incurred, which makes it possible to convert the numbers on the books of an integrated foreign entity into the parent company's currency.) Monetary assets and liabilities are converted using the exchange rate in effect as of the balance sheet date. Non-monetary assets and liabilities are converted using the exchange rate in effect on the date of the transaction. Gains and losses due to foreign exchange are reported in net earnings

Local Currency

Currency of the country being referred to

Inventory and COGS under the temporal method

Ending inventory reported on the balance sheet is translated at the exchange rate that existed when the inventory's acquisition is assumed to have occurred Inventory Method: - FIFO Inventory: FIFO ending inventory (most recently acquired items) is remeasured based on more recent exchange rates. - FIFO COGS: the exchange rates used to remeasure COGS that are older. - LIFO Inventory: Ending Inventory (older items) is measured at older exchange rates - LIFO COGS: is remeasured based on more recent exchange rates. - Weighted average Cost: The weighted-average exchange rate for the year is used when inventory is carried at weighted-average cost.

Current rate

Exchange rate on balance sheet date

IASB vs. FASB on what is considered a hyperinflationary environment and the method to be used?

FASB: Cummulative inflation exceeds 100% over a 3 year period so an annual inflation rate of more than 26% over 3 years will result in hyperinflation. When hyperinflation is present, the functional currency is considered to be the parent's presentation hence, the temporal method is used to remeasure the financial statements IASB: does not specify hyperinflation but a cummulative over 100% is one indication

IFRS method for dealing with hyperinflation

Foreign currency financial statements are restated for inflation and then translated using the current exchange rate. Non monetary assets and liabilities: - multiply original cost by the change in the price index from the beginning of the period and the balance sheet date. Monetary assets and liabilities: No need to restate Shareholders equity (not retained earnings) are restated by applying the change in the price index from the beginning of the period or the date of contribution if later. Retained Earnings: Plug figure that balances out the balance sheet. in the statement of retained earnings, net income is the plug figure. Income statement items: restated by multiplying the change in the price index from the date the transactions occur.(use the average) Net purchasing power gain or loss is recognized in the income statement based on the net monetary asset or liability exposure. - net monetary asset- purchasing loss in inflation - net monetary liability- purchasing power gain in inflation. forces net income to be the same as the net income figure that was the plug figure in the statement of retained earnings.

Foreign currency transaction exposure

Foreign currency risk arises when the transaction date and the payment date differ.

How does US GAAP and IFRS treat the change in value of the foreign currency asset or liability resulting from a foreign currency transaction to be treated?

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 arise when the transaction date and the payment date are different.ss

What do both IFRS and US GAAP require regarding disclosures related to foreign currency translations?

IFRS and US GAAP 1. Amount of exchange differences recognized in net income 2. Amount of cumulative translation adjustment classified in a separate component of equity, along with a reconciliation of the amount of cumulative translation adjustment at the beginning and end of the period. US GAAP specifically requires the amount of exchange differences recognized in net income to show the following: - Foreign currency transaction gains and losses - Translation gains and losses resulting from the application of the temporal method

When is Current rate method most often used?

If the functional currency and the parentś presentation currency differ. The current rate method results in a net asset balance sheet exposure Items Translated at Current Exchange Rate Total assets > Total liabilities → Net asset balance sheet exposure When the foreign currency increases in value (i.e., strengthens), the current rate method results in an increase in the positive cumulative translation adjustment (or a decrease in negative cumulative translation adjustment) When the foreign currency decreases in value (i.e., weakens), the current rate method results in a decrease in the positive cumulative translation adjustment (or an increase in the negative cumulative translation adjustment) in stockholders' equity. Translation usually involves self-contained, independent subsidiaries whose operating, investing, and financing activities are decentralized from the parent.

If a subsidiary is operating in a hyperinflationary environment, what method should be used under US GAAP and IFRS?

US GAAP: The functional currency is considered to be the parentś presentation currency, and the temporal method is used. The temporal method must be used with the resulting translation gain or loss reported in net income IFRS: the subsidiaryś financial statements are restated for inflation using IAS 29, and then the inflation adjusted financial statements are translated using the current exchange rate. - (IAS 29)- Monetary Assets and Monetary Liabilities are not restated because they are already expressed in terms of the monetary unit current at the balance sheet. - (IAS 29)- Non-monetary assets and non-monetary liabilities are restated for changes in the general purchasing power of the monetary unit. Apply the change in the general price index from the date of acquisition to the balance sheet date. Some non monetary like PP&E are carried at revalued amount from the date of revaluation. - (IAS 29)- ALL components of stockholders equity are restated by applying the general price level from the beginning of the period or if later, the date of contribution to the balance sheet date. - (IAS 29)- ALL income statement items are restated by applying the change in the general price index from the dates when the items were originally recorded to the balance sheet date - Net gain or loss in purchasing power that arises from holding monetary assets and liabilities during a period of inflation is included in net income.

How does US GAAP and IFRS differ in their handling of non monetary assets in a hyperinflationary environment?

US GAAP: adjusting the non monetary asset and liabilities for inflation is not allowed under US GAAP IFRS: adjusting for inflation is permitted under IFRS.

Cummulative translation adjustment (CTA)

Under the current rate method, the translation gain or loss is reported in shareholders equity as part of the CTA. CTA is an accumulated balance of the translation gain or loss. The CTA is simply a plug figure that forces the basic accounting equation (A= L+E) to balance

What method would you use if the local, functional, and the parent or reporting currency is different?

Use both the temporal method and the current rate method.

When would the procedures required by IFRS and US GAAP for translating foreign currency financial statements in high inflation countries produce similar results?

When the two currencies change by exactly the same percentage as the change in the general price index in the high inflationary country.

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.

Translation

involves converting the functional currency into the parents presentation (reporting) currency using the current rate method. (aka all current method) The current rate method is a method of foreign currency translation where most items in the financial statements are translated at the current exchange rate.

effective tax rate

is the tax expense in the income statement divided by pretax profit.

Statutory tax rate

provided by the tax code of the home country.

Impact of Changing Exchange Rates on Exposure

summarizes the impact of changing exchange rates on the parents exposure

historical rate

the exchange rate that existed when an initial transaction took place

When is the Temporal method most often used

If the functional currency is the same as the parents presentation currency. Under both IFRS and US GAAP standards, when the temporal method is used, the translation adjustment needed to keep the translated balance sheet in balance is reported as a gain or loss in net income. US GAAP: refers to as "remeasurements" IFRS: "reporting foreign currency transactions in the functional currency" Items Translated at Current Exchange Rate Exposed assets > Exposed liabilities → Net asset balance sheet exposure Exposed assets < Exposed liabilities → Net liability balance sheet exposure Most liabilities are monetary liabilities. Only cash and receivables are monetary assets, and non-monetary assets generally are measured at their historical cost. As a result, liabilities translated at the current exchange rate (exposed liabilities) often exceed assets translated at the current exchange rate (exposed assets), which results in a net liability balance sheet exposure when the temporal method is applied. Remeasurement usually occurs when a subsidiary is well integrated with the parent (the parent makes the operating, investing, and financing decisions)

What is the main difference after translation and remeasurement of the balance sheet?

Income before translation/loss is different between the two methods The translation gain/loss is different between the two methods Net Income is different between the two models - due to where the gain or loss is reported and also the different exchange ranges under the temporal and current rate. Total assets are different between the two methods because inventory and net fixed assets are different.

How is the local currency impacted in a hyperinflationary environment?

It will rapidly depreciate relative to the parent's presentation currency because of the deterioration of purchasing power. Current rate translation: result in lower assets and liabilities after translation Non-monetary assets and liabilities: not affected by hyperinflation because the local currency-denominated values increase to offset the impact of inflation (real estate values rise with inflation) IFRS and US GAAP differ significantly when dealing with a subsidiary operating in a hyperinflationary environment.

Where do disclosures related to foreign currency translation typically found?

MD& A Notes to Financial Statements

IFRS: How to calculate purchasing power loss or gain from inflation results..

Purchasing power loss: Cash as an example would be calculated by adjusting for inflation on the beginning cash balance, the addition of cash and the other monetary liabilities (such as accounts payable) - Monetary assets- Loss of purchasing power - Non monetary assets (accounts payable, etc) is a purchasing power gain. this number is adjusted to the income statement

How does the current rate method affect financial statement ratios?

Pure income and Pure balance sheet ratios are unaffected by the application of the current rate method. (Pure= all of the components of the ratio are from the balance sheet, or all of the components are from the income statement) All profit margin (gross profit, operating profit, net profit, EBIT ratio) measures and measures like current ratio, quick ratio, LTD to capital are preserved.

Translation of Retained Earnings (Current rate and Temporal Methods)

Stockholders Equity Accounts= Translated at historical exchange rates for both current rate and temporal methods. Problem: Translating retained earnings (R/E), which are the accumulation of previous years income (Translated according to method used to translate the income statement) less dividends (exchange rate when dividends declared) over the life of the company.

Presentation Currency

The currency in which financial statement amounts are presented. Most cases, a company's presentation currency will be the currency of the country where the company is located.

Remeasurement gain or loss

The remeasurement gain or loss is also a plug figure and is simply the difference in the earnings before the gain or loss and the earnings after the gain or loss.

Transfer Pricing & Multinational companies

The system of laws and practices used by countries to ensure that goods, services, and intellectual property transferred between related companies are appropriately priced, based on market conditions such that profits are correctly reflected in each jurisdiction. Multinational companies incur income taxes in the country in which the profit is earned. US has a residual income and there is a credit for taxes paid on that same income in other countries. (The effect of the tax credit is that the multinational company owes taxes on the foreign income only to the extent that the US corporate rate exceeds the foreign rate of tax on that income. The explanation is presented as a reconciliation between the average effective tax rate (tax expense divided by pretax accounting profit) and the relevant statutory rate.