PRESENTATION CURRENCY AND FUNCTIONAL CURRENCY CHAPTER 15 MULTINATIONAL OPERATIONS CHANGES IN EXCHANGE RATES IMPACT ON SALES: EXAMPLE 1

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1 Presenter s name Presenter s title dd Month yyyy CHAPTER 15 MULTINATIONAL OPERATIONS PRESENTATION CURRENCY AND FUNCTIONAL CURRENCY Presentation currency: In which the company presents its financial statements. Functional currency: In which the company conducts its primary activity. Local currency: Used within the country in which the company operates. Often, presentation currency = functional currency = local currency. Often, functional currency of sub functional and presentation currency of parent. Copyright 2013 CFA Institute 2 IMPACT ON SALES: EXAMPLE 1 FinnCo sells goods to a customer in the United Kingdom for 10,000 with payment to be received in British pounds. Credit terms allow 45 days for receipt of payment. FinnCo s functional and presentation currency is the euro. rate on the date of the transaction: 1 = rate on the date of payment: 1 = Question: What is FinnCo s foreign exchange gain or loss? IMPACT ON SALES: EXAMPLE 1 FX Rate Euro value of FinnCo s receivable on transaction date 10, ,600 Euro value of FinnCo s receivable on receipt date 10, ,750 FinnCo s foreign exchange gain 150 Copyright 2013 CFA Institute 3 Copyright 2013 CFA Institute 4

2 IMPACT ON SALES: EXAMPLE 2 IMPACT ON SALES: EXAMPLE 2 FinnCo sells goods to a customer in the United Kingdom for 10,000 with payment to be received in British pounds. Credit terms allow 45 days for receipt of payment. rate on the date of the transaction: 1 = rate on the date of payment: 1 = Assume that the transaction date was in November Year 1, the payment date was in January Year 2, and the company has a 31 December year-end. rate on 31 December, Year 1: 1 = Question: What is FinnCo s foreign exchange gain or loss for Year 1? And for Year 2? Transaction date rate: 1 = Value of receivable: 14,600 Balance sheet date rate: 1 = Value of receivable: 14,800 Gain of 200 Payment receipt date rate: 1 = Overall actual realized foreign currency gain = 150 Value of receivable: 14,750 Loss of 50 Copyright 2013 CFA Institute 5 Copyright 2013 CFA Institute 6 IMPACT ON SALES AND PURCHASES Foreign Currency Transaction Type of Exposure Strengthens Weakens : IMPACT ON SALES: EXAMPLE 2 Where will FinnCo report the foreign currency transaction gain in Year 1? Export sale Asset (account receivable) Gain Loss Import purchase Liability (account payable) Loss Gain Report transaction gain as part of other operating expenses, net. Gross profit margin: no impact Operating profit margin: higher Net profit margin: no impact Report transaction gain as part of nonoperating expenses, net. Gross profit margin: no impact Operating profit margin: lower Net profit margin: no impact Copyright 2013 CFA Institute 7 Copyright 2013 CFA Institute 8

3 IMPACT OF : EXAMPLE DISCLOSURE Our exposure to foreign currency transaction gains and losses is the result of assets and liabilities, (including inter-company transactions) that are denominated in currencies other than the relevant entity s functional currency... Transaction gains and losses on these foreign exchange contracts are recognized each period in other income, net included on the consolidated statements of income. During the years ended December 31, 2011, 2010, and 2009, we recorded net realized and unrealized foreign currency transaction gains of $9 million and $13 million, and a transaction loss of $1 million, respectively. Yahoo! Inc., Annual Report (2011) TRANSLATING FOREIGN CURRENCY FINANCIAL STATEMENTS INTO THE PARENT COMPANY S PRESENTATION CURRENCY Two questions must be addressed: 1. What exchange rate should be used for each line item? 2. Where should the translation be reported? Copyright 2013 CFA Institute 9 Copyright 2013 CFA Institute 10 WHAT EXCHANGE RATE SHOULD BE USED FOR EACH LINE ITEM? WHAT EXCHANGE RATE SHOULD BE USED FOR EACH LINE ITEM? Current rate method: Use spot exchange rate on balance sheet date for all assets and liabilities. Temporal method: - Use spot exchange rate on balance sheet date for all monetary assets and liabilities (and for all nonmonetary assets and liabilities that are measured at their current value). - Use historical exchange rate for nonmonetary assets and liabilities that are measured at historical cost. When the subsidiary s functional currency is different from the parent s All assets and liabilities: Translate at current exchange rate (current rate method). Equity accounts: Translate at historical exchange rates. Revenues and expenses: Translate at average exchange rate, which approximates exchange rate on transaction date. When the subsidiary s functional currency is the same as the parent s Monetary assets and liabilities: Translate at current exchange rate. Nonmonetary assets and liabilities: - Historical cost at historical exchange rates. - Current value at valuation date exchange rate. Equity accounts: Translate at historical exchange rates. Revenues and expenses: - Not related to nonmonetary assets, translate at average exchange rate. - Related to nonmonetary assets, use historical. Copyright 2013 CFA Institute 11 Copyright 2013 CFA Institute 12

4 WHERE SHOULD THE TRANSLATION ADJUSTMENT BE REPORTED? FACTORS CONSIDERED IN DETERMINING THE FUNCTIONAL CURRENCY When the subsidiary s functional currency is different from the parent s Unrealized translation gain/loss is accumulated as a separate component of the parent s equity. When the subsidiary s functional currency is the same as the parent s reported as a gain or loss in the parent s net income. The functional currency is 1. The currency that 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. 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. Copyright 2013 CFA Institute 13 Copyright 2013 CFA Institute 14 TRANSLATING FOREIGN CURRENCY TRANSLATING FOREIGN CURRENCY Worksheet for Amerco (U.S. subsidiary), 31 December 20X1 rate is 1.00 = US$1.00 Worksheet for Amerco (U.S. subsidiary), 31 March 20X2 No transactions. Current exchange rate is 0.80 = US$1.00. Balance sheet item USD Rate ( ) EUR Cash $3, ,000 Inventory 12, ,000 Total $15,000 15,000 Notes payable $5, ,000 Common stock 10, ,000 Total $15,000 15,000 Balance sheet item USD Rate ( ) EUR Cash $ 3,000?? Inventory 12,000?? Total $15,000? Notes payable $5,000?? Common stock 10, ,000 Total $15,000? Copyright 2013 CFA Institute 15 Copyright 2013 CFA Institute 16

5 TRANSLATING FOREIGN CURRENCY Worksheet for Amerco (U.S. subsidiary), 31 March 20X2 No transactions. Current exchange rate is 0.80 = US$1.00. TRANSLATING FOREIGN CURRENCY Worksheet for Amerco (U.S. subsidiary), 31 March 20X2 No transactions. Current exchange rate is 0.80 = US$1.00. U.S. Dollar Rate ( ) Euro Change in Euro Value since 31 Dec 20X1 Cash $3, C 2, Inventory 12, C 9,600 2,400 Total $15,000 12,000 3,000 Notes payable $5, C 4,000 1,000 Common stock 10, H 10,000 0 Subtotal $15,000 14,000 1,000 2,000 2,000 Total 12,000 3,000 Change in Euro U.S. Dollar Rate ( ) Euro Value since 31 Dec 20X1 Cash $ 3, C 2, Inventory 12, H 12,000 0 Total $15,000 14, Notes payable $5, C 4,000 1,000 Common stock 10, H 10,000 0 Subtotal $15,000 14,000 1, Total 14, Copyright 2013 CFA Institute 17 Copyright 2013 CFA Institute 18 IMPACT ON TRANSLATION ADJUSTMENT EFFECTS OF TRANSLATION METHOD ON FINANCIAL RATIOS Foreign Currency (FC) Balance Sheet Exposure Strengthens Weakens Net asset Net liability Positive translation Negative translation Negative translation Positive translation Receivables turnover (sales/receivables) is the same under both current and temporal methods. - Sales are translated at the average exchange rate under both. - Receivables are translated at the current exchange rate under both. Current ratio (current assets/current liabilities) differs. - Inventory is translated at the current exchange rate under the current method, but the historical exchange rate under the temporal method. - If the subsidiary s currency appreciates relative to the parent, the current ratio will be higher under the current method than the temporal. Copyright 2013 CFA Institute 19 Copyright 2013 CFA Institute 20

6 RATIOS UNDER LOCAL CURRENCY VS. RATIOS IN TRANSLATED CURRENCY: CURRENT METHOD Underlying relationships in a subsidiary s local currency financial statement are preserved when: - Ratios involve only the balance sheet (e.g., current ratio, debt-toassets, debt-to-equity ratios). - Ratios involve only the income statement (e.g., interest coverage ratio, gross profit margin, operating profit margin, net profit margin). Underlying relationships in a subsidiary s local currency financial statement are distorted when ratios involve amounts from both the balance sheet and income statement because - Assets and liabilities are translated using the current exchange rate. - Revenues and expenses are translated using the average exchange rate. - Equity accounts are translated at historical exchange rates. RATIOS UNDER LOCAL CURRENCY VS. RATIOS IN TRANSLATED CURRENCY: TEMPORAL METHOD Underlying relationships in a subsidiary s local currency financial statement are preserved when both numerator and denominator use the historical exchange rate (e.g., Inventory turnover = Cost of goods sold/inventory). Otherwise, underlying relationships in a subsidiary s local currency financial statement are distorted because - Monetary assets and liabilities are translated at current exchange rate. - Nonmonetary assets and liabilities: - Historical cost translated at historical exchange rates. - Current value translated at valuation date exchange rate. - Revenues and expenses: - Not related to nonmonetary asset, translated at average exchange rate. - Related to nonmonetary assets, translated at historical. - Equity accounts are translated at historical exchange rates. Copyright 2013 CFA Institute 21 Copyright 2013 CFA Institute 22 SUBSIDIARIES OPERATING IN HYPERINFLATIONARY ECONOMIES For a subsidiary in a hyperinflationary economy, translating local foreign currency financial statements into the parent s presentation currency requires the following: Under IFRS: First, restate the subsidiary s local currency financial statements for local inflation. Then, translate the inflation-restated foreign currency financial statements into the parent s presentation currency using the current exchange rate. Under U.S. GAAP: Use the temporal method to translate the subsidiary s local currency financial statements. Include the resulting translation as a gain or loss in determining net income. SUBSIDIARIES OPERATING IN HYPERINFLATIONARY ECONOMIES: EXAMPLE Assume a U.S. company established a subsidiary in Turkey on 1 January 2000 (at which time Turkey was highly inflationary). The U.S. parent sent the subsidiary US$1,000 on 1 January 2000 to purchase a piece of land at a cost of TL542,700,000 (TL542,700/US$ US$1,000 = TL542,700,000). Assuming no other assets or liabilities, what are the annual and cumulative translation gains or losses given the following data? Date Rates Year Inflation Rate (%) 01 Jan 2000 TL542,700 = US$1 31 Dec 2000 TL670,800 = US$ Dec 2001 TL1,474,525 = US$ Dec 2002 TL1,669,000 = US$ Copyright 2013 CFA Institute 23 Copyright 2013 CFA Institute 24

7 SUBSIDIARIES OPERATING IN HYPERINFLATIONARY ECONOMIES: EXAMPLE A Turkish subsidiary of a U.S. parent has one asset: a piece of land at an original cost of TL542,700,000. What are the annual and cumulative translation gains or losses under IFRS? Inflation Rate Restated Carrying Value in TL Current Rate Translated Amount in US$ Annual Gain (Loss) Cumulative Gain (Loss) Date 01/01/00 542,700, ,700 $1,000 N/A N/A 31/12/00 38% 748,926, ,800 1,116 $116 $116 31/12/ ,265,684,940 1,474, (258) (142) 31/12/ ,835,243,163 1,669,000 1, SUBSIDIARIES OPERATING IN HYPERINFLATIONARY ECONOMIES: EXAMPLE A Turkish subsidiary of a U.S. parent has one asset: a piece of land at an original cost of TL542,700,000. What are the annual and cumulative translation gains or losses under U.S. GAAP? Date Carrying Value in TL Historical Rate Translated Amount in US$ Annual Gain (Loss) Cumulative Gain (Loss) 01/01/00 542,700, ,700 $1,000 N/A N/A 31/12/00 542,700, ,700 1,000 N/A N/A 31/12/01 542,700, ,700 1,000 N/A N/A 31/12/02 542,700, ,700 1,000 N/A N/A Copyright 2013 CFA Institute 25 Copyright 2013 CFA Institute 26 SUMMARY Fluctuations in foreign exchange rates cause the translated values of foreign currency assets and liabilities to change, giving rise to foreign exchange differences that must be reflected in the financial statements. For export sales (or import purchases), any change in the functional currency value of the foreign currency account receivable (or account payable) that occurs between the transaction date and the settlement date is recognized as a foreign currency transaction gain or loss in net income. For translating foreign subsidiaries financial statements into the parent company s presentation currency, either the current method or the temporal method is used. Copyright 2013 CFA Institute 27