Module 8: Translation and Consolidation of Foreign Subsidiaries:

Module 8: Translation and Consolidation of Foreign Subsidiaries: Part 1: Foreign currency risk is the net potential gain or loss, which can arise from changes in the exchange rates, to the foreign currency exposure of the firm. Once a foreign subsidiary is acquired, the parent is faced with two accounting questions: What exchange rates are appropriate and how should the resulting foreign exchange gains/losses be reflected in financial statements. There were 4 translation methods, which resulted in different foreign exchange gains and losses due to different foreign exchange exposures. Section 1651 recommends that only the temporal method or the current-rate method be used to translate statements of foreign operations. Which method used depends on the substance of the relationship between the parent and the subsidiary. Subsidiary is integrated or self-sustaining: Whether a subsidiary is integrated or self-sustaining depends on the exposure of the parent to exchange rate changes. The six criteria to consider when determining exposure are: cash flows; sales prices; sales market; labour, material and other costs; financing; and the degree of interrelationship between the parent and the foreign subsidiary (see page 545). An integrated subsidiary is one in which the parent actively participates in the subsidiary s operating, investing, and financing activities. The parent s exposure is as if they had directly undertaken the transactions of the foreign operation themselves. A self-sustaining subsidiary is one that operates fairly independently of the parent. Although the parent controls the subsidiary, it does not actively participate in the subsidiary s operating, investing, and financing activities. The parent s exposure is limited to its investment in the foreign operation. Accounting methods the parent should use to translate the subsidiary s statements: Temporal method: The temporal method is used in translating the financial statements of an integrated subsidiary. The temporal method translates financial statement elements using exchange rates that will preserve the normal basis of valuation of these financial statement elements and presents the results as if the parent itself had entered into these transactions. In module 7, the parent s net monetary position was exposed to changes in the foreign exchange rates because these items were translated to the year-end exchange rate. Any resulting gain or loss was recognized immediately thru net income. Thus, as if the parent itself had entered into these transactions, when translating the integrated subsidiary s foreign financial statements, their net monetary position will be exposed to foreign exchange fluctuations and any resulting gain or loss will be recognized on the translated income statement. 1

For the financial statement elements that would normally be valued at historical cost, historical exchange rate is used. Non-monetary assets and liabilities, share capital and dividends (declared date = historical rate). For the financial statement elements that would normally be valued at market value, current exchange rate is used (ex: monetary assets and liabilities). Also, certain nonmonetary assets and liabilities if valued at market (i.e. inventory at market). Income Statement items: revenue and expenses at average rate except amortization/depreciation and COGS, which are translated at historical cost as they relate to non-monetary items. Retained earnings are translated with the rate in effect when acquired or earned. Temporal method uses the Canadian dollar as the measuring unit and therefore, financial ratios differ because different exchanges rates are used. Current-rate method: The current-rate method is used in translating the financial statements of a selfsustaining subsidiary. Since the parent has little interactions with the subsidiary, only their net investment is exposed. Thus the net assets are exposed to foreign exchange fluctuations. For net assets (assets liabilities) to be exposed, they must be translated at the current rate. Thus the all assets and liabilities are translated at the current rates. Dividends (declared date = historical rate) and share capital at the historical rates. Income statement items: revenues and expenses at the rates in effect when the revenues and expenses were recognized in income (average rate). Retained earnings are translated with the rate in effect when acquired or earned. Since the parent is independent of the subsidiary, any resulting gain or loss from the translation of the subsidiary s statements is not recognized thru net income but held under Other Comprehensive Income (OCI) and closed to Accumulated Other Comprehensive Income (AOCI) on the translated balance sheet. The financial statement relationships remain the same as they were when stated in the foreign currency. Current rate method uses foreign currency as a measuring unit. Since most balance sheet accounts are translated at the current rate there is no change in the underlying relationships and thus the balance sheet financial ratios are the same. Also, the income statement items are translated at the average rate so the relationship remains the same and thus financial ratios are the same. However, ratios between the B/S and I/S are different because different rates used. Exception: Where the economic environment of the foreign operation is highly inflationary, the temporal method should be used regardless of whether the foreign subsidiary is self-sustaining or integrated (because non current assets and liabilities are translated at historical rate so they are not affected by fluctuations in foreign exchange rates). NOTE: Never use a foreign exchange rate prior to the date of acquisition. Thus, the most historic rate for the parent is the foreign exchange rate on the acquisition date. 2

Part 2: Exchange gain or loss under the temporal and current-rate methods: Foreign exchange gains/losses for integrated foreign operations are accounted for in exactly the same manner as foreign transactions. Monetary balances are translated at current year-end rates. Exchange gains and losses on ALL monetary items are reported in income. Non-monetary balances are translated at historic rates and therefore do not result in gains and losses. Unrealized foreign exchange gains and losses for self-sustaining foreign operations are reported in other comprehensive income (OCI) which is closed to accumulated other comprehensive income (AOCI) shown as a separate component of shareholders equity section of the balance sheet. When all or some of the investment in the subsidiary is sold, the cumulative unrealized foreign exchange gains or losses are removed from AOCI and the realized foreign exchange gain or loss is reported in the income statement. Option: a firm can hedge its net investment in a self-sustaining foreign subsidiary. If the hedge is imperfect, the ineffective portion should be recognized in net income. The effective portion of the net gain or loss would be recognized under OCI. Then this gain or loss under OCI should be recognized in net income in the same period as corresponding exchange gains or losses arising from the translation of the financial statements of the self-sustaining foreign operation. Difference between accounting exposure and economic exposure: Accounting (Translation) exposure is the component of foreign currency risk that results from translating the statements of foreign subsidiaries into Canadian dollars. The amount of foreign exchange gains/losses recognized in the financial statements or under Accumulated OCI varies depending on the translation method used. It does not necessarily represent realized gains or losses. It is not a measure of economic exposure. Economic exposure is the risk that changes to foreign exchange rates have on the earnings and cash flow of foreign operations and the long-term implications this may have to the parent. It is measured in true economic terms, that is, whether the entity is economically better or worse off due to the exchange rate fluctuations. Economic wellness is difficult to measure precisely. Transaction exposure exists between the transaction date and the settlement date (Module 7). 3

Purchase discrepancies and goodwill for a purchased foreign subsidiary: The purchase discrepancy calculation is complicated by having to translate each component of the purchase price into the reporting currency, usually Canadian $. The exchange rate in effect on the date of acquisition is used to translate each of the underlying assets and liabilities. Do not use the exchange rate in effect when the subsidiary acquired the assets/liabilities prior to acquisition. In the years following acquisition, under the temporal method, in the purchase discrepancy amortization and impairment schedule, everything is translated at historic rates and there is no resulting gain/loss from this translation. In the years following acquisition, under the current rate method, in the purchase discrepancy amortization and impairment schedule, amortization/impairment loss is translated at the average exchange rate for the current year and the unamortized/unimpaired amount is translated at the year-end current rate. The resulting gain/loss is included in the other comprehensive income (OCI) which is closed to accumulated other comprehensive income (AOCI) shown as a separate component of shareholders equity section of the balance sheet. None of this gain or loss would relate to the NCI, as they do not participate in the purchase. Review Example 8.6-1: Current-rate method: Purchase price discrepancy amortization and goodwill impairment schedule: Calculation of goodwill in U.S. dollars Purchase price US$50,000 Book value of SF: (US$10,000 + 27,000) US$37,000 CP Co. s ownership 0.8 29,600 Purchase price discrepancy 20,400 Allocation: Building (US$65,000 55,000) 0.8 8,000 Goodwill US$ 12,400 Purchase price discrepancy amortization and goodwill impairment schedule: Jan. 1 Amortization/ 20X3 1.40 Impairment 1.38 Dec. 31 1.39 2003 2003 Building US$8,000 C$11,200 US$800 C$1,104 US$7,200 C$10,008 Goodwill US$12,400 17,360 US$827 1,141 US$11,573 16,087 C$ 28,560 C$ 2,245 C$ 26,095 Translation adjustment on PD amortization and goodwill impairment loss: Jan.1, 20X3 balance C$28,560 Amortization 2,245 Calculated balance, December 31, 20X3 26,315 Actual balance December 31, 20X3 26,095 Accumulated other comprehensive income (loss) C$ (220) 4

Part 3: Consolidated financial statements for foreign subsidiaries: First, if necessary, restate the foreign subsidiary financial statements using Canadian accounting principles. Second, translate the financial statements and then consolidate them. Next, consolidate the financial statements From a consolidated viewpoint, the parent indirectly acquired the assets of the subsidiary on the date of acquisition. Use the exchange rate on the date of acquisition as the historical rate. Ignore all exchange rates before the acquisition date. Consolidated financial statements for integrated foreign subsidiaries: Calculate CGS: BI (historical) + P (historical assumed average) EI (historical) Calculate amortization expense match to historical rate of capital asset The gain/loss on translation of all monetary items is calculated. The foreign exchange gain/loss on the income statement is the gain or loss on translation of monetary items. The current year s purchase discrepancy amortization and any impairment loss in the income statement are translated at the historic rate. The NCI on the income statement is the NCI s percentage times the subsidiary s translated income adjusted for any upstream transactions and after the foreign exchange gain or loss has been included. The unamortized purchase discrepancy and unimpaired goodwill translated at the historic rate is included on the balance sheet. NCI on the balance sheet is the NCI s percentage times the subsidiary s translated shareholders equity adjusted for upstream transactions. Calculation of gain or loss from translation of an integrated subsidiary: Net monetary bal., Dec. 31, Yr.1 = Jan. 1 Yr 2 @ historical rate at beg. of year $ Changes over Yr 2: Sales @ average rate Purchases - Inventory @ historical rate (assume average) - Capital assets @ historical rate (transaction date) All expenses except non-cash @ average rate Issuance of shares @ historical rate (transaction date) Dividends @ historical rate (date declared) Net changes $ Calculated position Dec. 31, Yr 2 $ Actual net monetary position Dec. 31, Yr 2: @ current rate (year-end) $ Exchange Gain/Loss on translation thru net income $$ 5

Consolidated financial statements for self-sustaining foreign subsidiaries: Calculate the gain or loss on translation of net assets closed to OCI. The accumulated OCI from translating the subsidiary statements is allocated between the parent and the NCI. The parent s share is added under AOCI on the Consolidated balance sheet. The current year s purchase discrepancy amortization and any impairment loss in the income statement are translated at the average rate for the current year. The unamortized purchase discrepancy and unimpaired goodwill is translated at the current year-end rate and is included on the balance sheet. The gain or loss resulting from the translation of the purchase discrepancy and impairment schedule is allocated all to the parent under cumulative OCI. The parent s total cumulative OCI appear in consolidated shareholders equity. The NCI on the income statement is the NCI s percentage times the subsidiary s translated income adjusted for any upstream intercompany transactions. NCI on the balance sheet is the NCI s percentage times the subsidiary s translated shareholders equity (adjusted for any upstream intercompany transactions), including their share of the AOCI from translating the subsidiary statements. Calculation of gain or loss from translation of a self-sustaining subsidiary: Net assets, Dec. 31, Yr.1 = Jan. 1 Yr 2 @ historical rate at beg. of year $ Changes in net assets, over Yr 2 Capital stock Net income Dividends @ historical rate (transaction date) @ average rate @ historical rate (date declared) Calculated net assets, December 31, Yr 2 $ Actual net assets, December 31, Yr 2 @ current rate (year-end) $ Exchange gain/(loss) from translation thru OCI $$ OCI closed to AOCI and split between the parent s and NCI %s. 6

Part 4: Class example 1: Chapter 12, Problem 11, pages 589-591 in text. The financial statements of Voll Inc. of Germany, as at December 31, Year 11: Balance Sheet Cash DM 105,000 Accounts receivable 168,000 Inventory at cost 357,000 Land 420,000 Buildings 1,470,000 Accumulated deprecation 420,000 1,050,000 Equipment 483,000 Accumulated deprecation 168,000 315,000 DM 2,415,000 Accounts payable 210,000 Miscellaneous payables 105,000 Bonds payable 600,000 Common shares 850,000 Retained earnings 650,000 DM 2,415,000 Retained Earnings Statement Balance, January 1 DM 420,000 Net income 630,000 Dividends 400,000 Balance, December 31 DM 650,000 Income Statement Sales DM 3,150,000 Cost of sales 1,680,000 Depreciation building 105,000 Depreciation equipment 63,000 Other expenses 672,000 Net income DM 630,000 Other information: 1. On January 1, Year 11, Crichton Corporation of Toronto acquired a controlling interest in Voll. 2. Exchange rates were: January 1, Year 11 December 31, Year 11 Average for Year 11 CDN$1 = DM2.05 CDN$1 = DM2.20 CDN$1 = DM2.10 3. The land and buildings were purchased in Year 5 when the exchange rate was DM1.50 7

4. During the year, equipment costing DM 126,000 was purchased for cash. Depreciation totaling DM 21,000 has been recorded on this equipment. The exchange rate on the date of the equipment purchase was DM2.18. The remaining equipment was purchased on the date the subsidiary was acquired and no other changes have taken place since that date. 5. The December 31, Year 11, inventory was acquired during the last quarter of the year, when the average exchange rate was DM2.04. 6. On January 1, Year 11, inventory was DM 525,000 and was acquired when the average exchange rate was DM2.27. 7. Dividends were declared and paid on December 31, Year 11. 8. On January 1, Year 11, monetary liabilities were greater than monetary assets by the amount of DM 1,082,000. 9. The common shares were issued in Year 1 when the exchange rate was DM3.00. Required: a) Assume that Voll is an integrated foreign operation. Translate the financial statements into Canadian dollars. b) Assume that Voll is a self-sustaining foreign operation. Translate the financial statements into Canadian dollars. a) Voll is integrated use temporal method: DM Dollars Cost of sales Inventory Jan. 1, Yr 11 525,000 / 2.05* 256,098 Purchases (derived) 1,512,000 / 2.10 720,000 2,037,000 976,098 Inventory Dec. 31, Yr 11 (357,000) / 2.04 (175,000) 1,680,000 801,098 * The historical rate of 2.27DM (prior to acquisition) is not relevant to Crichton. Crichton s oldest historical rate is the acquisition date. Equipment Purchased Yr 11 126,000 / 2.18 57,798 On hand Jan. 1, Yr 11 357,000 / 2.05 174,146 Equipment balance, Dec. 31, Yr 11 483,000 231,944 Equipment amortization expense Yr 11 purchase 21,000 / 2.18 9,633 On hand Jan. 1, Yr 11 42,000 / 2.05 20,488 63,000 30,121 8

Accumulated amortization Yr 11 purchase 21,000 / 2.18 9,633 On hand Jan. 1, Yr 11 147,000 / 2.05 71,707 168,000 81,340 Net monetary position Balance Jan. 1, Yr 11 (1,082,000) / 2.05 (527,805) Changes Yr 11: Sales 3,150,000 / 2.10 1,500,000 Purchases inventory (1,512,000) / 2.10 (720,000) equipment (126,000) / 2.18 (57,798) Other expense (672,000) / 2.10 (320,000) Dividends (400,000) / 2.20 (181,818) Net changes 440,000 220,384 Calculated position Dec. 31, Yr 11 (307,421) Actual position Dec. 31, Yr 11: net monetary position Cash 105,000 A/R 168,000 273,000 A/P (210,000) Misc. payables (105,000) Bonds (600,000) (642,000) / 2.20 (291,818) Exchange gain on translation Yr 11 15,603 DM Dollars Translated income statement Yr 11 Sales 3,150,000 / 2.10 1,500,000 Cost of sales 1,680,000 calc. 801,098 Amortization building 105,000 / 2.05 51,220 equipment 63,000 calc. 30,121 Other expense 672,000 / 2.10 320,000 Exchange gain (15,603) 2,520,000 1,186,836 Net income 630,000 313,164 Translated retained earnings statement Yr 11 Balance, January 1 420,000 / 2.05 204,878 Net income 630,000 313,164 1,050,000 518,042 Dividends (400,000) / 2.20 (181,818) Balance, December 31 650,000 336,224 9

Translated balance sheet December 31, Yr 11 DM Dollars Cash 105,000 / 2.20 47,727 Accounts receivable 168,000 / 2.20 76,364 Inventory 357,000 / 2.04 175,000 Land 420,000 / 2.05 204,878 Buildings 1,470,000 / 2.05 717,073 Accumulated amortization (420,000) / 2.05 (204,878) Equipment 483,000 calc. 231,944 Accumulated amortization (168,000) calc. (81,340) 2,415,000 1,166,768 Accounts payable 210,000 / 2.20 95,455 Miscellaneous current payables 105,000 / 2.20 47,728 Bonds payable 600,000 / 2.20 272,727 Capital Stock 850,000 / 2.05 414,634 Retained earnings 650,000 336,224 2,415,000 1,166,768 Part 5: b) Voll is self-sustaining use current-rate method DM Dollars Calculation of translation gain Net assets Jan. 1, Yr 11 (850 + 420) 1,270,000 / 2.05 619,512 Net income Yr 11 630,000 / 2.10 300,000 Dividends Yr 11 (400,000) / 2.20 (181,818) Calculated net assets Dec. 31, Yr 11 736,694 Actual net assets Dec. 31, Yr 11 1,500,000 / 2.20 681,818 Exchange loss from translation (OCI) Yr 11 55,876 Translated retained earnings statement Yr 11 Balances, January 1 420,000 / 2.05 204,878 Net income 630,000 / 2.10 300,000 1,050,000 504,878 Dividends (400,000) / 2.20 (181,818) Balance, December 31 650,000 323,060 10

DM Dollars Translated income statement Yr 11 Translated income statement all items at average rate thus net income divided by average rate of 2.10 equals translated net income. Net income 630,000 / 2.10 300,000 Other Comprehensive Income (loss) (55,876) Comprehensive Income (loss) $244,124 Translated balance sheet December 31, Yr 11 Cash 105,000 / 2.20 47,727 Accounts receivable 168,000 / 2.20 76,364 Inventory 357,000 / 2.20 162,273 Land 420,000 / 2.20 190,909 Buildings 1,470,000 / 2.20 668,182 Accumulated amortization (420,000) / 2.20 (190,909) Equipment 483,000 / 2.20 219,545 Accumulated amortization (168,000) / 2.20 (76,364) 2,415,000 1,097,727 Accounts payable 210,000 / 2.20 95,455 Miscellaneous current payables 105,000 / 2.20 47,727 Bonds payable 600,000 / 2.20 272,727 Shareholders equity Capital Stock 850,000 / 2.05 414,634 Retained earnings 650,000 323,060 Accumulated Other Comprehensive Income (loss) (55,876) 2,415,000 1,097,727 *NOTE: Previous past exam questions may use cumulative translation adjustment 11

Part 6: Segmented financial reporting: Consolidated statements combine and summarize results, making it hard to assess the risks, growth potential and profitability of different segments and to identity different products and services offered by the firm. Segmented financial reporting is useful to users in assessing the entity s performance and the amount, timing, and certainty of future cash flows. Current standards for segment disclosures (Section 1701) Segmented financial information must be provided to external users for those segments that are regularly provided to and reviewed by the entity s chief operating decision maker for internal purposes (insight into management's strategic direction). An operating segment should be reported if the segment s revenues, profits/losses, or assets are > 10% of combined revenues, profits, & assets of all operating segments. See example in text, pages 471 and 472 for application of the quantitative thresholds. At least 75% of a firm s external revenues must be reported by segment disclosures. S1701 provides information about sales in foreign countries and major customers (revenue to a single customer is greater than 10%) Segmented information includes: o Factors to identify the reportable segment o Types of products/services offered by segment o Information about profits/losses and total assets o Reconciliation to total revenues, profits/losses and assets of the entity Goodwill impairment test for reporting units: The goodwill impairment test needs to be conducted for each reporting unit. A reporting unit is either an operating segment or one level below, a component. A component of an operating segment is a reporting unit when discrete financial information is available for management review. In order to be able to conduct the impairment test at the reporting unit level, assets and liabilities need to be assigned to each reporting unit so that fair values of each reporting unit can be determined. If a subsidiary has goodwill, it must also test its reporting units for goodwill impairment. When the parent consolidates this subsidiary, it must conduct its own reporting unit goodwill impairment test. Only if goodwill were impaired at this level would the parent recognize a goodwill impairment loss. Thus, if the subsidiary reported goodwill impairment on their reporting unit that does not necessarily mean the parent will record an impairment loss as well. THE END 12