SUMMARY INTERNASIONAL ACCOUNTING By Jonathan T

Transcription

1 SUMMARY INTERNASIONAL ACCOUNTING By Jonathan T

2 SESI 1

3 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

4 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

5 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

6 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

7 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

8 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

9 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

10 Judgmental Classification of Financial Reporting Systems Developed by Nobes Micro-based Anglo-Saxon model Macro-uniform Continental European model 2-10

11 SESI 2

12 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

13 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

14 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

15 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

16 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

17 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

18 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

19 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

20 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

21 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

22 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

23 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

24 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

25 SESI 3

26 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

27 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

28 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

29 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

30 Japan Background Population 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

31 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

32 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

33 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

34 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

35 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

36 SESI 4

37 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

38 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

39 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

40 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

41 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

42 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

43 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

44 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

45 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

46 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

47 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

48 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

49 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

50 SESI 5

51 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

52 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

53 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

54 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

55 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

56 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

57 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

58 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

59 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

60 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

61 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

62 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

63 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

64 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

65 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

66 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

67 SESI 6

68 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

69 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

70 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

71 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

72 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

73 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

74 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, Assume spot rate as of February 1, 2011 is $0.10 per peso. 7-74

75 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,

76 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

77 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

78 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 $0.09. The loss was ($ $0.09) x 1,000,000 pesos. Joe could have purchased a foreign currency forward contract on December 1,

79 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, 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

80 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

81 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

82 SESI 7

83 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

84 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

85 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

86 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

87 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

88 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

89 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

90 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

91 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

92 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

93 Hedging Balance Sheet Exposure Companies can hedge against gains and losses by using foreign currency forward contracts, options, and borrowings 8-93