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Capitalized interest Intercorporate investments
Employee compensation: post-employee and sharebased
Multinational operations
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When a firm constructs an asset for its own use or, in limitedcircumstances, for resale, the interest that accrues during theconstruction period is capitalized as a part of the assetscost. Theobjective of capitalizing interest is to accurately measure the cost ofthe asset & to better match the cost with the revenues generated bythe constructed asset. The treatment of capitalizing interest is similarunder US GAAP & IFRS.
The interest rate used to capitalize interest is based on debtspecifically related to the construction of the asset. IF no constructiondebt is outstanding, the interest rate is based on existing unrelatedborrowing. Interest costs on general corporate debt is excess ofproject construction costs are expensed.
Capitalized interest is not respond in the income statement asinterest expense. Once construction interest is capitalized, theinterest cost is allocated to the income statement throughdepreciation expense (if the asset is held for use), or COGS (if theasset is held for sale).
Generally, capitalized interest is reported in the cash flow statementas an outflow from investing activities, while interest expense is
reported as an outflow from operating activities.
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Securities that are purchased by corporations rather thanindividual investors. Intercorporate investments allow acompany to achieve higher growth rates compared to keepingall of its funds in cash. These investments can also be usedfor strategic purposes like forming a joint ventures or making
acquisitions. Companies purchase securities from othercompanies, banks and governments in order to takeadvantage of the returns from these securities. Marketablesecurities that can readily be exchanged for cash, such asnotes and stocks, are usually preferred for this type ofinvestment.
Intercorporate investments are accounted for differently thanother funds held by a company. Short-term investments thatare expected to be turned into cash are considered currentassets, while other investments are considered non-currentassets. When companies buy intercorporate investments,dividend and interest revenue is reported on the income
statement.
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Financial assets - an ownership interest of lessthan 20% is considered as passive investment .There 3 types of financial assets under IFRS &US GAAP
1. Held to maturity - are debt securities acquiredwith the intent & ability to be held to maturity .
2. Held for tradingare debt & equity securities forthe purpose of profiting in the near term .
3. Available for saleare debt & equity securitiesthat neither held to maturity nor held for trading .
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Investments in associatesownership interestbetween 20% & 50% is typically a non controllinginvestment . The investor can usually significantlyinfluence the investees business operations .
Business combinationsownership interest ofmore than 50% is usually a controlling investment .
Joint venturesis a entity where control is shared
by 2 or more investors.
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Under US GAAP , a security is considered impaired if its decline in
value is determined to be other than temporary.
Under IFRS impairment of a debt security is indicated if at least one
loss event has occurred and its effect on the securitys future cash
flow can be estimated .
An equity security can be considered impaired if its fair value has
experienced a substantial or extended decline below its carrying
value . Held to maturity become impaired when its carrying value is
decreased to the present value of its estimated future cash flows.
Under IFRS , impairments of available for sale debt securities may
be reversed under the sane conditions as impairments of held tomaturity securities . Reversals of impairments are not permitted for
equity securities . Under US GAAP , impairments on available for
sale may not be reversed for either debt or equity. Impairment of held
for trading securities are not allowed under US GAAP & IFRS
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Held-to-Maturity Held-for-Trading Available-for-
sale
Balance Sheet Amortized cost Fair value Fair Value with
unrealized G/L
recognized in
equity
Income Statement Interest (including
amortization)
Realized G/L
Interest Dividends
Realized G/L
Unrealized G/L
Interest Dividends
Realized G/L
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Investment ownership of between 20% & 50% is considered
investment in associates . Equity method is used for reporting
Equity method
Income statement treatment
Proportionate share of investee earnings is recognized
Additional, depreciation from excess of purchase price allocated to
investee assets & liabilities
Balance sheet treatment Proportionate share of investee earnings increases investment
account
Dividends decreases investment account
Equity income from income statement increases investment
account
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At the acquisition date, the excess of the purchaseprice over the proportionate share of the investeesbook value is allocated to the investeesidentifiable assets & liabilities based on their fair
values . Any remainder is considered as goodwill .
Impairment of investment of associates
If the fair value of the investment fall below the
carrying value . The investment is written down tofair value & loss is recognized in the incomestatement
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Under IFRS, business combinations are not differentiated based on thestructure of the surviving entity. Under US GAAP, business combinations arecategorized as:
Merger - The combining of two or more companies, generally by offering thestockholders of one company securities in the acquiring company inexchange for the surrender of their stock.
Acquisition- A corporate action in which a company buys most, if not all, ofthe target company's ownership stakes in order to assume control of thetarget firm. Acquisitions are often made as part of a company's growthstrategy whereby it is more beneficial to take over an existing firm'soperations and niche compared to expanding on its own. Acquisitions areoften paid in cash, the acquiring company's stock or a combination of both.
Consolidation - A stage in the life of a company or an industry in whichcomponents in the company or industry start to merge to form fewer
components. These components can include product lines at the companylevel or companies themselves at the industry level. The consolidation ofcompanies differs from mergers in that consolidations create new entitieswhile mergers do not.
Special Purpose Entities It is a legal entity created to fulfill narrow,specific or temporary objectives. SPEs are typically used by companies toisolate the firm from financial risk.
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There are 2 approaches for accounting
Pooling of interest method (or uniting of interestunder IFRS)
Purchase method (acquisition method)acquisition methodthree major accounting issues .
1. Recognition and measurement of assets andliabilities of the combined entities
2. Goodwill : initial recognition & subsequent treatment3. Minority interest : recognition and measurement of
non controlling interest
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Identifiable assets and liabilities
To be measured at the fair value on the date of acquisition
Contingent liabilities
The parent must recognize any contingent liabilities whichcan create an obligation due to past action of the subsidiary .
Financial assets
Reclassification can be done by the parent at the time of
acquisition
Goodwill is equal to the excess of purchase consideration paid
over the fair value of identifiable net assets acquired
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Add each asset and liability of the subsidiary (100%) with the parent
company
Dont add equity accounts
Remove the investments in shares of subsidiary from parents
B/sheet
Remove all inter company balances
Equity of subsidiary doesnt figure into parents balance sheet
SBI SBH
Owns 100%SBH is a wholly owned
subsidiary of SBI
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There are two methods of recognizing goodwill at the time ofacquisition
Full goodwill method (compulsory under US GAAP) Partial goodwill method ( preferred under IFRS)
1. Full goodwill methodgoodwill = fair value of the subsidiaryfair value oftotal identifiable net assets.
1. Partial goodwill methodgoodwill = acquisition pricefair valueproportionate identifiable net assets .
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Add each line item of subsidiary (100%) with the parent company .Dont add equity accounts
Remove the investments in shares of subsidiary from parents
B/sheet
Remove all inter company balances
Equity of subsidiary does not figure into parents balance sheet Minority interest is share of the other investors in the net assets of
the subsidiary and shown in equity
SBI
SBH
Owns 60%
HDFC will be called as minority
Interest in the books of SBI when it
consolidates the books of SBH
SBH Owns 40%
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Value of minority interest depends upon
the method of recognizing goodwill
1. Full goodwill method
MI = shareholding% x fair value of
subsidiary
1. Partial goodwill methodMI = share holdings x fair value of net
assets of subsidiary
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Steps
Add each line of subsidiary (100%) with the parent company
Remove all; inter company transactions
Arrive at the consolidated profit before minority interest Subtract minority interest after calculating PAT
Notes
If the subsidiary has incurred profits >>the value of its equitygoes up>> value of minority interest will also go up
Value of consolidated income is not dependent of the method
of goodwill valuation
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Important points Goodwill to be recognized only when purchased Goodwill is neither depreciated nor amortized Goodwill is tested for impairment at least annuallyImpairment (US GAAP)
1. Recoverability testwhether to impair?Goodwill to be impaired when net book value of reporting unit > FVof reporting unit
2. Loss impairmenthow much to impair?Impairment loss = Book value of goodwill (less)Implied fair value
of goodwill
Under IFRS
Impairment loss = Book value of cash generating unitfair valueof cash generating unit
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SPE is an legal structure created tom isolate certainliabilities from the main company . It is created by theprimary sponsor and finances its activities .
It can take following forms : corporation, joint venture
or trust VIE is a category of SPE that meets any or both of the
following conditions :1. Risk-equity is insufficient to finance the entities
activities without additional financial support .2. Equity investors that lack anyone of the following . Decision making right Obligation to absorb expected loss Right to receive residual return
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Equity Method ProportionateConsolidation
AcquisitionMethod
Leverage LowerLiabilities
are lower & equity
is the same
In-between Higher
Net profitmargin
Higher-sales arelower & net income
is the same
In-between Lower
ROE Higher-equity is
lower & net incomeis the same
Same as Equity
Method
Lower
ROA Higher-net income
is the same &
assets are lower
In-between Lower
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Present value calculation need to be understood in
detailRule of pension accounting for income statement
and balance sheetRules of adjustment in US GAAP and IFRS need to
be differentiated
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Defined contribution plan
1. Firm make a periodic contribution to the retirement fund2. Based on factors like no of years service , last drawn salary , employee
age , profits etc3. No assurance by the firm for the final placement of the liability4. Fund managed by the employees5. No assurance by the firm for the future value plan assets6. Pension expense = contribution made each year7. No liability recognized on the balance sheet
Defined benefit plan
1. Firm makes a periodic contribution to the retirement fund2. Fund managed by the firm through an independent trust3. Payment to be made to each employee after the retirement till his / her
death4. Approximation of several factors involved to estimate the total pension
obligation5. Investment risk of fund assets lies with firm which has responsibility for the
discharge of the retirement obligation
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Balance sheet impact Assetsfair value of plan assets in pension fund Liabilitypresent value of amount owed to employee for their services till date ( define
benefit obligation)
Fund assets are compared against fund liabilities
In case the status is overvalued ( assets more than liabilities)- difference is shown on
assets side
In case the status is undervalued ( liability more than assets)- difference is shown on
liability side
Income statement impact : pension expense include the following Service costPV of benefits earned by employee due to their service in the current period
Interest costclosing PV of obligation estimated at beginning of year (less) opening PV of
obligation estimated at beginning of the year
Actuarial gain or lossPV of any change in future obligation caused because of changes in
assumptions used by actuarial
Prior service costretroactive benefits awarded to employees when a plan is initiated or
amended
Expected return on fund assetsit reduced the pension expense . Expected return is used
in price of actual return to reduce the volatility
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IT is the actuarial present value (at an assumeddiscount rate) of all future pension benefits earnedto date, based on expected future salaryincreases.
The assumptions here are of going concern andthat the employees will work until retirement .
It is the actuarial present value (at an assumeddiscount rate) of all future pension benefit earnedto date, based on current salary levels, ignoringfuture salary increases.
It is on current basis and shows the liability thatwill be payable if the firm expects to liquidate andsettle pension obligation.
This is the amt of ABO that is not contingent onfuture service. For example, the minimum tenureof the employee for being eligible to receivepension benefits.
Present value of Cash outflow required to satisfythe pension obligation (Less) Fair Value ofPension Plan assets.
Under US GAAP
Projected Benefit
Obligation (PBO)
Accumulated Benefit
Obligation (ABO)
Vested Benefit
Obligation (VBO)
Funded Status
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Opening Obligation
Current Service Cost
Interest Cost
Plan Amendments
Actuarial gains and losses
Benefit Paid
Closing Obligation
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It is the PV of benefits earned by theemployees during the current.
It is the increase in the PBO that is theresult of the employees working onemore period.
For PBO, it includes an estimate ofcompensation growth It is immediately recognized as a
component of pension expense .
Increase in the obligation due to passage
of time It is equal to beg. Pension obligation xdiscount rate
It is immediately recognized as acomponent of pension expense.
Current Service
Cost
Interest Cost
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It is the change in PBO as a result of the firm
adopting or amending its pension plan.
Charged immediately in Income Statement; or
Report in OCI and amortize over remaining
average service life
Gains and losses arising as a result of changes
in variables such as mortality, employee turnover,retirement age and the discount rate.
This also includes any difference between actual
and estimated return on plan assets.
Charged immediately in Income Statement; or
Report in OCI and follow Corridor method for
recognition
Pension paid to employees during the current
year.
It reduces the pension obligation (treat it like a
liability that has been paid)
Past (prior) ServiceCosts
Change in ActuarialAssumptions
Benefits Paid
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It is the interest rate used to calculate the PV of benefit
obligation
It affects all measures of benefit viz., ABO, PBO & VBO and
Pension expense.
It is not risk free rate. It is based on interest rates of high quality
fixed income investments with maturity profile similar to the
future obligation
It is the expected average annual rate of compensation increase. It affects PBO and Pension expense but has no impact on ABO
and VBO
It is the assumed long term rate of return on the investments in
the plan
Its treatment is similar to any other actuarial assumptions
Expected return on plan assets is recognized as part of pensionexpense (-ve)
Treatment of difference between Expected and Actual Return is
same as that of actuarial gains/losses. Such amount is clubbed
with Actuarial gains/losses and treated accordingly
Discount
(Settlement)Rate
Rate ofCompensation
growth
Expected
Return on planAssets
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Current Service Cost
Interest Cost
Expected Return on Assets
Amortization of Deferred (gains) and
Losses
Amortization of past service cost
Pension Expenses
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Used to recognized AGL that were taken to
OCI (and not to income statement)
Take the opening balance of PBO and FV of
plan assets
Take the one which is higher Take 10% of it
This is the corridor (max range available to
the company )
If the unrecognized AGL exceed this range ,
then this excess needs to be amortized
The amortized will be over expected average
remaining service lives of the employees
When It is Used ?
Treatment underCORRIDOR
METHOD
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PBO at beginning of period
Current service cost
Interest cost
Plan amendments
Actuarial (gains)/lossesBenefits paid
PBO at end of period
Fair value of plan assets at the BegActual return on assets
Employer contributions
Benefits paid
FV of plan assets at the end
Firms are required to disclose reconciliation of PBO and plan assets in the financial
footnotes
PBO
Plan Assets
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Effect on Increase Discount
Rate
Decrease Rate of
compensationIncrease
Increase Expected
Rate of Return
PBO Decrease Decrease No Effect
ABO Decrease No Effect No Effect
VBO Decrease No Effect No Effect
Effect of changing plan assumptions on Benefit Obligation
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Effect of changing plan assumptions on Pension Expenses
Effect on Increase Discount
Rate
Decrease Rate of
compensation
Increase
Increase Expected
Rate of Return
Service Cost Decrease Decrease No Effect
Interest Cost Decrease* Decrease No Effect
Expected Return No Effect No Effect Increase
Pension Expenses Decrease* Decrease Decrease
* For mature plans, a higher discount rate might increase interest
cost. In rate cases, interest cost will increase by enough to offset the
decrease in the service cost, and pension expenses will increase.
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All the actuarial gains or loss AND prior period costs needs tobe recognized as pension liability under the US GAAP
irrespective of the fact whether it has been expensed in
income statement or taken to OCI
That is, Under US GAAP the net pension asset or liability
reported on the balance sheet equals to the funded Pension Accounting under US GAAP does not reduce the
volatility of the FUNDED STATUS (by not eliminating past
service cost and deferred gains and losses that have not yet
been recognized in the income statement).
On the positive side: The net pension asset/liability reportedon the balance sheet represents the economic reality.
Reported Expense, however is still smoothed number that
may not represent economic reality and thus will require
adjustment for analytical purposes
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Adjustments required when transaction takes
place involving currency of two differentcountries
When assets and liabilities are in a currencyother than the reporting currency?
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Meaning: when a company make any operational transaction involvingcurrency of other country
Example: (1) A firm in the US has sold goods to a customer in Europe (2) A
firm in the US has purchased goods from a supplier in Japan
There is no legal entity in FC which need to be consolidated into HC
Since there is no equity investment involved, there is no need to
consolidate any FS
Impact on financial statement
Sales / purchase is initially recognized at the spot rate on the transaction
date.
Balance sheet values (Debtors / Creditors) are re-stated at the closing rate
any realized gain / loss is T/F Income Statement
At the time of payment, Debtors / Creditors are settled at the rate on the
date of cash flow and any gain / loss (from the previous balance sheet
value) is recognized in income statement
Rules of inter-corporate investments do not come into picture
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Currency of the investees country being referred to
Currency of the primary economic environment in which the
entity operates. Usually the currency of cash generation and
spending
Determined by the Management
As per IASB, the management should consider the following
factors while determining the functional currency:
Currency in which the parent company prepares its financial
statements
This is the main concept and the rules / standards learnt will be used to
convert a foreign currency FS into Home Currency
The currency that influences sale prices for goods and services
Currency of the country whose competitive forces and regulations
mainly determine the sale price of goods and services The currency that influences labor, material and other costs
The currency from which funds are generated
The currency in which receipts from operating activities are usually
retained
Local currency
Functional
Currency
Reporting
(Presentation
currency)
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The consolidation of the foreign subsidiary is similar to the
consolidation of a local subsidiary
There are two steps in converting foreign subsidiarys financial
statements:
Conversion from local currency to functional currency This is also called re-measurement
Temporal method is used
Re-measurement usually occurs when a subsidiary is well integrated
with the parent (i.e.; parent takes O,I&F decisions)
Conversion from functional currency to reporting currency This is also called translation Current rate method is used Translation usually involves self contained , independent,
subsidiaries whose operating , investing and financingactivities are decentralized from parent
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The current rateis 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 wads in effect when the original
transaction occurred. For example , if a firm bought machinery on January 2,
2008, the historical rate for that transaction at every balance sheet date in
the future would be the exchange rate on January 2, 2008 Remeasurement involves converting the local currency into functional
currency using the temporal method .
Translationinvolves converting the functional currency into the parents
presentation (reporting) currency using the current rate method. The current
rate method is also known as the all- current method
Monetary assets and liabilities are fixed in amount of currency to bereceived or paid and includes cash , receivables , payables and short term
and long term debt
All other assets and liabilities such as inventory , fixed assets unearned
revenue etc. are examples of non monetary assets
Clean surplus : taking any unrealized gain/loss into income statement
Dirty surplus : taking any unrealized gain/loss into OCI > equity
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Remeasurement Translation
Functional
Currency
Local
currency
Reporting
currency
Local
currency
Functional = Reporting
currency
Local = Functionalcurrency
Reportingcurrency
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1. Income statement is translated first at the average rate to calculate
the translated profit
2. The translated profit is then taken to the translated balance sheet
which has different assets and liabilities being translated as per table
below
3. The balancing difference in the balance sheet is the currencytranslation gain or loss which is part of OCI (and thus part of Equity)
Parameter Conversion Rate
All income statement A/cs Average Rate
All Balance sheet A/cs (except
common stock)
Current Rate
Common Stock Historical Rate (Date of issue of stock)
Dividends Rate at the time of payment (i.e., Historical
Rate)
Translation Gains / Losses Report under shareholders equity as CTA
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1. Balance sheet is remeasured first as per table below
2.
The net difference in the equity (closing less opening) is the remeasuredPAT during the year
3. Income statement is remeasured as per table below to calculate the PAT
4. Difference in PAT as per step 2 (from Balance sheet) and step 3 (from
Income statement) is the remeasurement gain / loss which has
automatically become part of the Income statement
Parameter Conversion Rate
Balance Sheet A/cs
Monetary Assets & Liabilities Current Rate
All other assets and liabilities i.e., Non Monetary
assets and liabilities
Historical Rate
Income statement A/cs
Expenses related to non monetary assets (Eg.
COGS, D&A)
Historical Rate
Revenues and all other expenses Average Rate
Remeasurement gains / losses Recognise in the income statement
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Current method Temporal method
Exposure is equal to net assets
position of the subsidiary
Exposure is equal to net monetary
assets or liability position
Generally net assets position is
positive
Generally firms have net monetary
liability position as only few assets are
considered monetary
If subsidiary has net assets exposure
and foreign currency is appreciating ,
a gain is recognized
If subsidiary has net monetary assets
exposure and foreign currency is
appreciating , a gain is recognized
Difficult to eliminate exposure by
managing the net assets as it would
result into elimination of share holders
equity
Firms can eliminate the exposure by
managing assets and liabilities
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Since inventory is a non monetary asset, itshould be re measured using the historic rate
FIFO ending inventory and LIFO COGS arere measured based on most exchange rates
FIFO COGS and LIFO ending inventory arere measured using older exchange rates
Under the weighted average method , endinginventory and COGS are re measured at the
weighted average exchange rate for theperiod
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Temporal method All current method
Monetary A&L Current rate Current rate
Non monetary A&L Historical Current rate
Common stock Historical historical
Equity (full) mixed Current rate
Revenue and SG&A Average rate Average rate
COGS Historical Average rate
D&A Historical Average rateNet income mixed Average rate
Exposure Net monetary assets Net assets
Forex gain or loss Income statement Equity (in oci)
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This is the comparison between the original FS in local currency and finally converted
FS in reporting this conversion would have involved either translated or remeasured or both
Current method pure ratios will not be affected
If foreign currency is depreciating , translated mixed ratio will be greater than the
original and vice versa .(assuming mixed ratio has income statement item in thenumerator and b/sheet item in denominator)
Temporal method depends on which item has been converted at what rate and what is the trend in
exchange rates
Pure ratios : both Nr and Dr from the same FAeither from income statementor from the balance sheet
E.g. current ratio, debt to equity , proprietary ratio(from BS), GP/NP margin ,(from
Inc St.)
Mixed ratio : both Nr and Dr are from different FAone from income statementAND one . From the balance sheet
E.g. ROCE, ROE , Turnover ratios
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Hyperinflation= cumulative inflation exceeds 100% over 3 years , defined by FASB(CAGR of over 26%)
IFRS: FS are restated for inflation and then translated using rules of current method non monetary A&L to be restated using price index change since acquisition
Not necessary to restate Monetary A&L
Components of equity (change in PI during the year or post contribution , if that is later )
Income statement items (change in PI from the date of transaction )
Net purchasing power gain/loss is recognized in the income statement (NOT OCI)
Balance sheet is closed first and the difference takes place in income statement
US GAAP : adjusting non monetary assets and liabilities for inflation is not allowed underUS GAAP
We assume that since LC has been severely depreciated , functional currency =
reporting currency
Remeasurement is donetemporal method is used
Value of local currency would have been severely depreciated (PP Theory)
thus converting the values into reporting currency without adjusting for inflation
will reduce their weight significantly in the reporting currency
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