SUMMARY INTERNASIONAL
ACCOUNTINGBy Jonathan T
SESI 1
Worldwide Accounting Diversity: Reasons
Legal systems
Common law
Fewer statutes—more court interpretation
Creation of precedents or case laws
Great Britain and other English-speaking countries
Accounting law is detailed and specific
Sources are nonlegislative organizations
Code law
More statutes
Non-English-speaking countries
Legislated accounting rules
Accounting law is general
Other guidance required
2-3
Worldwide Accounting Diversity: Reasons
Basis for taxation
Published financial statements
Germany—same taxable income and book income
Financial statements adjusted for tax purposes
U.S.—different taxable income and book income
Difference between tax and accounting income gives rise to deferred income taxes
Providers of financing
Accounting and disclosure is less important where major sources are families, banks,
and the government
Accounting and disclosure is more important where major sources are diverse
shareholders
2-4
Worldwide Accounting Diversity: Reasons
Inflation
Some countries have historically high rates of inflation
Necessitates adjustments to offset inflation
Common in Latin American countries
Political and economic ties affect how accounting rules are conveyed
Correlation of factors
Common law countries have domestic listed companies relying on equity for capital.
Code law countries tend to link taxation to accounting statements and rely less on
financing provided by shareholders
2-5
Problems caused by Accounting Diversity
Preparation of consolidated financial statements
Access to foreign capital markets
Comparability of financial statements
Lack of high-quality accounting information
2-6
Preparation of Consolidated Financial Statements
Problems due to:
Local regulations
Books In local currency
Local accounting principles
Requires:
Considerable effort
Additional cost
Expertise in different country’s accounting standards
2-7
Comparability of Financial Statements
Lack of comparability between financial statements from different countries
This adversely affects:
Investment decisions
Lending decisions
Performance analysis
Foreign acquisition decisions
2-8
Accounting Clusters
Accounting models
The Fair Presentation/Full Disclosure Model (Anglo-Saxon or Anglo-American model)
Oriented toward the decision needs of large numbers of investors and creditors
Used in English-speaking countries influenced by the United Kingdom or the United States
The Legal Compliance Model (Continental European model)
Legalistic
Used to provide information for taxation and government-planning
Used in Europe, Japan, and code law countries
The Inflation-Adjusted Model
Resembles the Continental European model
Requires extensive use of adjustments for inflation
2-9
Judgmental Classification of Financial Reporting Systems
Developed by Nobes
Micro-based—Anglo-Saxon model
Macro-uniform—Continental European model
2-10
SESI 2
International Accounting Standard-setting
Evolution of IASC and IASB shows international accounting standard-setting in
the private sector:
With the support of the accounting bodies, standard-setters, capital market
regulators, government authorities, and financial statement preparers
Harmonization allows countries to have different standards as long as they do
not conflict
Accounting harmonization considered in two ways
Harmonization of accounting regulations or standards
Harmonization of accounting practices
3-12
International Accounting Standard-setting
Other factors leading to noncomparable accounting numbers despite similar
accounting standards
Quality of audits
Enforcement mechanisms
Culture
legal requirements
Socioeconomic and political systems
3-13
Harmonization and Convergence
Harmonization
Reduction of alternatives while maintaining a high degree of flexibility in accounting
practices
Convergence
Enforcement of single set of accepted standards by several regulatory bodies
3-14
Harmonization
Can be considered in two ways
Harmonization of accounting regulations and standards
Harmonization of accounting practice
Ultimate goal of international harmonization efforts
Harmonization of standards may or may not result in harmonization of practice
Different from standardization
Standardization involves using the same standards in different countries
Allows for different standards in different countries as long as they do not conflict
3-15
Arguments for Convergence
Facilitate better comparability of financial statements
Easier evaluation of companies
Facilitate international mergers and acquisitions
Reduce financial reporting costs
Cost-listing would allow access to less expensive capital
Reduce investor uncertainty and the cost of capital
Reduce cost of preparing worldwide consolidated financial statements
Simplify auditing
Easy transfer of accounting staff internationally
3-16
Harmonization Efforts
Several organizations were involved at global and regional levels
International Organization of Securities Commissions (IOSCO)
International Federation of Accountants (IFAC)
European Union (EU)
International Forum on Accountancy Development (IFAD)
International Accounting Standards Committee(IASC)
International Accounting Standard Board (IASB)
3-17
Principles-Based Approach to International
Financial Reporting Standards
IASB follows a principles-based approach to standard setting vs a rules-based
approach
Standards establish general principles for recognition, measurements, and reporting
requirements for transactions
Limits guidance and encourages professional judgment in applying general
principles to entities or industries
3-18
IASB Framework
Created to develop accounting standards systematically
Framework for Preparation and Presentation of Financial Statement adopted
by IASB in 2001 from IASC
Scope of Framework
Objective of financial statements and underlying assumptions
Qualitative characteristics that affect the usefulness of financial statements
Definition, recognition, and measurement of the financial statements elements
Concepts of capital and capital maintenance
3-19
Qualitative Characteristics of Financial Statements
Understandability: Understandable to people with reasonable financial
knowledge
Relevance: Useful for making predictions and confirming existing expectations
Affected by nature and materiality of information
Reliability: Neutral and represents faithfully what it purports to
Reflecting items based on economic substance rather than their legal form
Comparabilty
3-20
Elements of Financial Statements
Definition
Assets, liabilities, and other financial statement elements are defined
Recognition
Guidelines as to when to recognize revenues and expenses
Measurement
Various bases are allowed: historical cost, current cost, realizable value, and present
value
3-21
The Norwalk Agreement
Proposed Changes as per the discussion paper published jointly by two boards:
Decision-useful objective encompassing information relevant to assessing
stewardship
Stakeholder approach (vs. U.S. framework of shareholder approach) — users other
than capital providers explicitly acknowledged
Asset of an entity would be present economic resource to which, through an
enforceable right or other means, entity has access or can limit others’ access
Emphasis on principle and guidance development for fair value measurements in
IFRS—exit price as measurement base, or, if not—develop additional guidance
3-22
Use of IFRS
Evidence of support for IFRS
Adoption by the EU – public companies in the EU were required to begin using IFRS
in 2005
IOSCO has endorsed IFRS for cross-listings
IFAC G20 accountancy summit in July 2009 issued renewed mandate for adoption
of global accounting standards
Latest IFAC Global Leadership Survey—emphasized that investors and consumers
deserve simpler and more useful information
Adoption of IFRS in 2011: Japan, Canada, India, Brazil and Korea
3-23
IASB/FASB Convergence
The Norwalk Agreement reached in 2002 between the IASB and FASB
pledged
For compatible financial reporting standards
Proper coordination of work program to maintain compatibility
3-24
SESI 3
PEOPLE’S REPUBLIC OF CHINA (PRC)
Background
World’s largest country with population of 1.34 billion(2008)
People’s Republic of China (PRC) established in 1949
Politically:
Communist, one-party state
Economically:
Until the 1980s, all firms state-owned
Currently in transformation to socialist market economy
World’s second largest economy (in terms of GDP) and fastest growing
among large economies, and is largest recipient of FDI
6-26
PEOPLE’S REPUBLIC OF CHINA (PRC)
Accounting Profession
Profession less prestigious than in U.S./U.K
Accounting and auditing have developed separately
Chinese Institute of Certified Public Accountants (CICPA) and Chinese
Association of Certified Practicing Auditors (CACPA) merged in1998
Economic reform and the large number of joint ventures with foreign
companies has led to emergence of the audit profession
In October 2007, the ICAEW in the UK and CICPA set up a joint project
for cooperation between the accounting professions in the two countries
6-27
Germany
Background
European Union’s largest country, population 82.2 million
West Germany and East Germany established in 1949, were reunified
in 1990
Historically, banks have been primary source of finance via both loans
and equity
Since reunification, the economy has been affected by
internationalization
German companies increasingly listing on foreign exchanges, e.g., New
York Stock Exchange
Most common business forms are Aktiengesellschaft (AG) and
Gesellschaft mit beschrankter Haftung (GMBH)
6-28
Germany
Accounting Profession
Profession has traditionally been less influential than in U.S./U.K
Auditing is dominant part of profession and certified auditors title of
Wirtschaftsprufer (WP) was created in 1931
Institut der Wirtschaftsprufer similar to the AICPA
Obtaining WP title is extremely rigorous
Wirtschaftspruferkammer (WPK) is a state-sponsored group that
oversees auditing profession
6-29
Japan
Background
Population 127.2 million, world’s third largest economy
Banks are primary source of finance via both loans and equity, and
cross-corporate equity ownership is also common
Keiretsu (and predecessor Zaibatsu) emphasize close business ties and
reflect cultural value of collectivism
1990s recession led to an increase in Japanese firms’ attempts to obtain
capital internationally
6-30
Japan
Accounting Profession
Certified Public Accountants Law (1948) established the profession
JICPA is one of the nine founding members of the IASC
Profession is significantly less influential than in U.S./U.K. and is also much
smaller in numbers than U.S
Obtaining CPA title is extremely rigorous, as in Germany
Low status within Japanese society vs. engineers and scientists
Collectivism leads to lack of trust of auditors
Tax advising is a much larger, separate, profession
6-31
Mexico
Background
History of significant inflation:
Government control of business is partially blamed
Significant changes in1990s, including privatization of state-owned firms
and NAFTA
Historically, most businesses family-owned--even the very large:
Prefer to raise capital via debt vs. equity
Gradually changing
Mexico’s one stock exchange, the Bolsa Mexicana de Valores, is
privately-owned
Represents one of the largest U.S. trading partners (three-quarters of
Mexico’s imports, more than 80% of her exports, and 60% of all FDI)
6-32
Mexico
Accounting Profession
The Asociacion de Contadores Publicos, first professional accountant
organization, established in 1917
This group was succeeded by the Mexican Institute of Public Accountants
(MIPA) in 1964
MIPA establishes accounting and auditing principles
In order to practice public accounting in Mexico, one needs a
“professional diploma” Contador Publico Certificado (CPC) is equivalent of U.S. CPA:
Can have reciprocal privileges in U.S. and Canada based on passing certain
exams
6-33
United Kingdom
Background
Population of about 62 million, comprised of England, Northern Ireland,
Scotland, and Wales
Among the five countries in this chapter, its financial structure is closest to
the U.S
15,000 Private Limited Companies (PLCs) with about 2,500 of these
listed on the London Stock Exchange
6-34
United Kingdom
Accounting Profession
World’s first association of professional accountants:
The Society of Accountants in Edinburgh, established in 1853
Six professional chartered bodies coordinated through Consultative
Committee of Accountancy Bodies (CCAB)
The profession developed in response to the needs of industry and has
influenced the development of professions in a number of other countries
Compared to the U.S. the certification requirements focus more on work
experience and less on university education
6-35
SESI 4
Types of Differences Between IFRS and U.S. GAAP
Definition differences
Recognition differences
Measurement differences
Alternatives
Lack of requirements or guidance
Presentation differences
Disclosure differences
4-37
IFRS and U.S. GAAP
IFRS more flexible in many cases
Choice between alternative treatments in accounting
IFRS generally have less bright-line guidance
More judgment is required in applying IFRS
IFRS is a principles-based accounting system:
whereas U.S. GAAP is a rules-based system
4-38
IAS 2, Inventories
Provides more extensive guidance than U.S. GAAP
Cost of inventories include:
Costs of purchase
Costs of conversion
Other costs
design, interest if takes time to bring to saleable condition
Cost of inventories exclude:
Abnormal waste
Storage unless necessary for the production process
Administrative overhead
Selling costs
4-39
IAS 16, Property, Plant, and Equipment
Recognition of initial costs
Probable future benefits
Can be measured
Recognition of subsequent costs
Must follow initial recognition rules
Carrying amount of the replaced part should be de-recognized
Measurement at initial recognition
Purchase price + costs to perform as intended + costs of dismantling and removing
the asset
Measurement subsequent to initial recognition
Can use cost model or revaluation model
4-40
IAS 40, Investment Property
Land or buildings held for rental, capital appreciation, or both
Same general principles as per IAS 16: choice of cost or revaluation model:
Changes in fair value is recognized in current income and not revaluation surplus
U.S. GAAP generally requires use of cost mode
Disclose fair value in notes when using the cost model
4-41
IAS 36, Impairment of Assets
Must test annually for impairment to plant, property and equipment; intangible
assets; goodwill; investments in subsidiaries; associates, and joint ventures
Does not apply to inventory, construction in progress, deferred tax assets, employee
benefit assets or financial assets (eg: accounts and notes receivable)
Impairment under IAS 36 = carrying amount > recoverable amount
Recoverable amount is the greater of net selling price and present value of future
net cash flows
Impairment more likely under IFRS since discounted cash flows are used
U.S. GAAP uses undiscounted future cash flows
4-42
IAS 38, Intangible Assets
Applies to purchased intangibles, intangibles acquired in business combination,
internally generated intangibles
Goodwill is covered separately under IFRS 3
Intangible asset is identifiable, nonmonetary asset without physical substance:
Held for production of goods or services, rental to others, or for administrative
purposes
Controlled by enterprise as result of past events from which future economic benefits
are expected to be realized
Must be expenses immediately if it does not meet the definition
Except when obtained in business combination
4-43
Intangibles Acquired in Business Combination
Patents, trademarks, and customer lists recognized as assets measured at fair
value
Even if not previously recognized by target
Must have finite or infinite life
Special treatments for in-process research and development
Capitalize when certain criteria is met
Otherwise include in goodwill
4-44
Internally Generated Intangibles
Major difference with U.S. GAAP
IFRS allows some development costs to be capitalized
U.S. GAAP expenses all research and virtually all development
4-45
IFRS 3, Business Combinations
Recognize goodwill only in business combinations
Difference between:
Consideration paid by acquirer plus noncontrolling interest
Fair value of net assets acquired
Negative goodwill must be recognized as income
Goodwill depends on the option selected to measure any noncontrolling interest
Measured at either
A proportionate share of the fair value of the acquired firm’s net assets excluding
goodwill
Fair value, including the noncontrolling interest’s share of goodwill
4-46
IAS 23, Borrowing Costs
Revised in 2007 to be similar to U.S. GAAP as part of convergence project
Capitalize all borrowing costs to extent they are attributable to acquisition,
construction, or production of a qualifying asset
Expense all other borrowing costs
Borrowing costs include interest and other costs incurred in connection with
borrowing
IAS 23 includes foreign currency exchange to the extent they related to interest
costs
Under IAS 23, inventories qualify if they require substantial period to
manufacture
4-47
IAS 17, Leases
Distinguishes between finance (capitalized) leases and operating leases
Provides rules for sale-leaseback transactions
Conceptually similar to U.S. GAAP but provides less specific guidance
Finance leases transfer substantially all the risks and rewards of ownership to
lessee
4-48
Disclosure and Presentation Standards
IAS 7, Statement of Cash Flows:
Classified as operating, investing or financing
Operating cash flows may use direct or indirect method
Interest, dividends, and income taxes must be reported separately
Interest and dividends paid may be classified operating or financing
Interest and dividends received may be classified operating or investing
Income taxes are operating unless specifically identified with investing or financing
activities
Can only disclose noncash investing and financing activities outside of this statement
4-49
SESI 5
Current Liabilities
IAS 1, Presentation of Financial Statements, requires classification of liabilities
Current liabilities
Noncurrent liabilities
Current liabilities
Expected to settle in normal operating cycle
Held for trading purpose
Settled within 12 months of balance sheet date
Not deferred until 12 months after balance sheet date
5-51
Differences in IFRS and U.S. GAAP: Current Liabilities
Refinanced short-term debt
IFRS: Long-term, if refinanced prior to balance sheet date
U.S. GAAP: Long-term, if refinancing is agreed prior to balance sheet
Accounts payable on demand due to violation of debt covenants
IFRS: Current, unless lender issued waiver of 12 months by balance sheet date
U.S. GAAP: Current, unless lender issued waiver obtained by annual report issuance
date
Bank overdrafts
IFRS: Long-term, if integral part of cash management netted against cash
U.S. GAAP: Always treated as current liabilities
5-52
Provisions, Contingent Liabilities, and Contingent Assets
IAS 37, Provisions, Contingent Liabilities and Contingent Assets, provides
guidance for:
Reporting liabilities and assets of uncertain timing, amount, or existence
Environmental and nuclear decommissioning costs
5-53
Contingent Liability
Recognized under IFRS, when:
There is a present obligations from past events
It is probable that there will be an outflow of resources
A reliable estimate of the obligation can be made
Constructive obligation: arise from past actions or current statements indicating
that a company will accept certain responsibilities
No concept of constructive obligation in U.S. GAAP
5-54
Provisions
IAS 37
The best estimate of the expenditure required to settle the present obligation
Probability-weighted expected value
Discounted to present value
Recognized under U.S. GAAP at the low end of the range of possible amounts
Provision is reversed when outflow of resources is not probable
5-55
Onerous Contract
Unavoidable costs of obligation exceed economic benefits to be received
Recognize provision for lower of
Cost of fulfillment
Penalty from non-fulfillment
If onerous from entity's own action, no recognition until that action happens
5-56
Restructuring
A program planned and controlled by management that changes either:
Scope of business
Manner in which business is conducted
Under IAS 37, a restructuring provision is recognized when:
Formal restructuring plan exists
There is a valid expectation of the restructuring
U.S. GAAP does not allow recognition until liability has been incurred
5-57
Employee Benefits
IAS 19, Employee Benefits, covers all forms of employee compensation and
benefits
Excludes share-based compensation
Four types of employee benefits
Short-term benefits (compensated absences and bonuses)
Post-employment (pensions and medical benefits)
Other long-term benefits (deferred compensation and disability)
Termination benefits (severance and early retirement)
5-58
Post-employment benefits
Net defined benefit liability (asset)
Balance sheet amount calculated as:
+ Present value of the defined benefit obligation (PVDBO)
− Fair value of plan assets (FVPA)
Asset recognized is limited to the larger of
Surplus
Asset ceiling
No asset ceiling under U.S. GAAP
5-59
Other post-employment benefits
IAS 19 does not provide separate guidance for other post-employment
benefits
U.S. GAAP provides more guidance for measurement of post-employment
medical benefits
5-60
Equity-Settled Share-Based Payment
Payments to non-employees for goods and services
IFRS measurement
Fair value of goods or services, if determined
Fair value of the equity instrument
U.S. GAAP measurement
Fair value of instrument at earlier of
Commitment for performance
When performance completed
5-61
Modification of Stock Option Plans
Types of modification
Length
Vesting conditions
Result of fair value change
Increase in fair value
Increase compensation cost by the same amount
Decrease in fair value
No change in compensation cost deducted
U.S. GAAP
Fair value determines compensation expense
No minimum compensation as under IFRS
5-62
Income Taxes
IAS 12, Income Taxes, similar to U.S. GAAP
Asset-and-liability approach
Deferred tax assets and liabilities
For temporary differences
For operating loss tax credit carry forwards
Under IFRS, measure on the basis of tax laws and rates enacted or substantively enacted
Under U.S. GAAP, measure on the basis of actually enacted tax laws and rates
Account for double taxation effects and differences in rates
5-63
Revenue recognition
IAS 18, Revenue covers revenues from
Sale of goods, rendering of services
Interest, royalties
Dividends
U.S. GAAP
200 authoritative pronouncements
General Measurement Principle
Fair value of consideration received or
Receivable
Multiple elements transaction
Split transaction into multiple elements or
Combine multiple transactions into one
5-64
IAS 18, Revenue
IASB-FASB Revenue Recognition Project
Both boards working since 2002
June 2010—joint Exposure Draft “Revenue from Contracts with Customers”
5 steps:
Identify the contract
Identify separate performance obligations in the contract
Determine the transaction price
Allocate the transaction price to the separate performance obligations
Recognize the revenue allocated to each performance obligation when the entity satisfies
each performance obligation
5-65
Financial Instruments
Standards
IAS 32, Financial Instruments: Presentation
IAS 39, Financial Instruments: Recognition and Measurement
IFRS 7, Financial Instruments: Disclosure
IFRS 9, Financial Instruments—issued in November 2009 to replace IAS 39—
effective 2015
Definitions
IAS 32—a financial instrument is any contract that gives rise to both a financial
asset of one entity and a financial liability or equity instrument of another
entity
5-66
SESI 6
Foreign Exchange Markets
Foreign Exchange Rates
Interbank rates
Wholesale prices
Banks charge one another
Exchange of currencies
Published on the internet and in newspapers
Reflected
Direct quotes (US $ equivalent)
Indirect quotes (currency per US $)
Direct quote reciprocal of indirect quote
Indirect quote reciprocal of direct quote
7-68
Foreign Exchange Markets
Spot rates
Today’s price for purchasing or selling a foreign currency
Forward rate
Today’s price for purchasing or selling a foreign currency
For some future date
Premium
Forward rate is greater than the spot rate
Discount
Forward rate is less than the spot rate
7-69
Foreign Exchange Markets
Option contracts
Foreign currency option
Gives right, no obligation
Trade foreign currency
Trade in future
Put option
Option to sell the foreign currency
Call option
Option to buy the foreign currency
Strike price
Exchange rate at which currency will be exchanged when option is exercised
7-70
Foreign Currency Transactions
Transaction exposure
Exposure to foreign exchange risk
Export sale
Sale to foreign customer
Later payment
In customer’s currency
Import purchase
Purchases from foreign supplier
Payment in the supplier’s currency
Foreign exchange risk
Change in the exchange rate results in
Exporter will receive less
Importer will pay more than anticipated
7-71
Accounting for Foreign Currency Transactions
One transaction perspective
Treats sale and collection as one transaction
Transaction complete when
Foreign currency received and converted
Sale is measured at converted amount
Not allowed under IAS or U.S. GAAP
7-72
Accounting for Foreign Currency Transactions
Two transaction perspective
Two transactions
Sale
Collection
Sale based on current exchange rate
Exchange rate changes
Collection for different amount
Difference considered
Foreign exchange gain
Foreign exchange loss
Concepts are identical for purchase transaction
(IAS) 21 and FASB ASC 830 require two-transaction perspective
7-73
Accounting for Foreign Currency Transactions
Export sale – example 1
February 1, 2012, Joe Inc., a U.S. company, makes a sale and ships
goods to Jose, SA, a Mexican customer.
Sales price is $100,000 (U.S.).
Jose agrees to pay in pesos on March 2, 2012.
Assume spot rate as of February 1, 2011 is $0.10 per peso.
7-74
Accounting for Foreign Currency Transactions
Export sale – example 1
Joe, Inc. records the sale (in U.S. $) on February 1,
2011 as follows:
Accounts Receivable 100,000
Sales 100,000
7-75
Hedging Foreign Exchange Risk
Hedging
Protects from exchange rate fluctuations
Foreign currency forward contracts
Foreign currency options
Foreign currency forward contract
Buy or sell foreign currency
Future date
Foreign currency option
Right to buy or sell foreign currency
For a period of time
7-76
Hedging Foreign Exchange Risk
Derivative
Hedge accounting appropriate if derivative
Used to hedge an exposure
Highly effective In offsetting changes in
Fair value
Cash flows related to the hedged item
Properly documented as a hedge
7-77
Hedging Foreign Exchange Risk
Hedging risk on an export sale – example 1
Previously, Joe Inc. lost $20,000 without hedging as the peso fell from
$0.11 to $0.09.
The loss was ($0.11 - $0.09) x 1,000,000 pesos.
Joe could have purchased a foreign currency forward contract on
December 1, 2010.
7-78
Hedging Foreign Exchange Risk
Hedging risk on an export sale – example 1
Under the contract, Joe would have agreed to sell 1,000,000 pesos for
$0.105 on March 2, 2011.
In this case, Joe would have collected $105,000 rather than $90,000.
Instead of a $20,000 foreign exchange loss, Joe would have paid a
$5,000 premium on the forward contract.
7-79
Cash Flow Hedges, Fair Value Hedges, and Hedge Accounting
Hedge accounting
Offsetting gain or loss
Recognized in net income
In same period as
The gain or loss from the hedged item
Cash flow hedge
An accounting designation for hedges
Offset variability in cash flows
Fair value hedge
Accounting designation for hedges
Offset variability in fair value of hedged assets and liabilities
7-80
Hedge Accounting
Hedge accounting examples
FC asset/forward contract/cash flow hedge
FC asset/forward contract/fair value hedge
FC asset/option/cash flow hedge
FC firm commitment/forward contract/fair value hedge
FC firm commitment/option/fair value hedge
Forecasted FC transaction/option/cash flow hedge
7-81
SESI 7
Balance Sheet Exposure
Assets and liabilities translated at the current exchange rate are
exposed to risk of a translation adjustment
When foreign currency appreciates, a net asset exposure results in a
positive translation adjustment
When foreign currency appreciates, a net liability exposure results in a
negative translation adjustment
Assets and liabilities translated at the historical exchange rate are not
exposed to a translation adjustment
8-83
Translation Methods
Current/Noncurrent Method
Current assets and liabilities are translated at the
current exchange rate
Noncurrent assets and liabilities and stockholders’ equity
accounts are translated at historical exchange rates
There is no theoretical basis for this method
Method is seldom used in any countries and is not
allowed by U.S. GAAP or IFRS
8-84
Translation Methods
Monetary/Nonmonetary Method
Concerns with monetary assets and liabilities
Translated at the current exchange rate
Concerns with nonmonetary assets and liabilities and stockholders’ equity
accounts
Translated at historical exchange rates
The translation adjustment measures the net foreign exchange gain or
loss on current assets and liabilities as if these items were carried on the
parent’s books
8-85
Translation Methods
Temporal Method
Objective is to translate financial statements
As if the subsidiary had been using the parent’s currency
Items carried on subsidiary’s books at historical cost
Including all stockholders’equity items, are translated at historical exchange rates
Items carried on subsidiary’s books at current value are translated at current
exchange rates
Income statement items are translated at the exchange rate in effect at the
time of the transaction
8-86
Translation Methods
Current Rate Method
Objective is to reflect that the parent’s entire investment in a foreign
subsidiary is exposed to exchange risk
All assets and liabilities are translated at the current exchange rate
Equity accounts are translated at historical exchange rates
Revenues and expenses are translated at the exchange rate in effect at the
date of accounting recognition
8-87
DISPOSITION OF TRANSLATION ADJUSTMENT
Translation gain or loss in net income
Translation adjustment is considered to be a gain or loss analogous to the
gains and losses arise from foreign currency transaction
Should be reported in income in the period in which the fluctuation in
exchange rate occurs
Cumulative translation adjustment in stockholders’ equity
The alternative to reporting the translation adjustment as a gain or loss in net
income is to include it in stockholders’ equity as a component of other
comprehensive income
This treatment defers the gain or loss in stockholders’ equity until it is realized
in some way
8-88
Temporal and Current Rate Methods
Translation methods illustrated – Summary
Current Rate Method
All assets and liabilities are translated at current rate
This results in net asset exposure
Net asset exposure and devaluing foreign currency results in translation loss
Translation adjustment included in equity
Temporal Method
Primarily monetary assets and liabilities are translated at current rate
This results in net liability exposure
Net liability exposure and devaluing foreign currency result in translation gain
Translation gain included in current income
8-89
U.S. GAAP
FASB ASC 830, Foreign Currency Matters( formerly SFAS 52, Foreign
Currency Translation) is the relevant accounting standard
Requires identification of functional currency
Functional currency is the primary currency of the foreign subsidiary’s
operating environment
The standard includes a list of indicators as guidance for the foreign
currency decision
When functional currency is U.S. Dollar, temporal method is required
When functional currency is foreign currency, current rate method is
required
8-90
IFRS
IAS 21, The Effects of Changes in Foreign Exchange Rates is the relevant
accounting standard
Uses the functional currency approach developed by the FASB
The standard includes a list, similar to the FASB list, of indicators as
guidance for the foreign currency decision
The standard’s requirements pertaining to hyperinflationary economies
are substantially different from U.S. GAAP
8-91
Hedging Balance Sheet Exposure
Companies that have foreign subsidiaries with highly integrated
operations use the temporal method
Temporal method requires translation gains and losses to be recognized in
income
Losses negatively affect earnings, and both gains and losses increase
earnings volatility
These gains and losses result from the combination of balance sheet exposure
and exchange rate fluctuations
Foreign exchange gains and losses on foreign currency borrowings or
foreign currency derivatives employed to hedge translation based
exposure (under the current rate method)
8-92
Hedging Balance Sheet Exposure
Companies can hedge against gains and losses by using foreign currency
forward contracts, options, and borrowings
8-93