After studying this chapter, you should be able to do the following:

1. Contrast an enterprise’s foreign currency accounting exposure with its economic exposure and evaluate how effectively the translation methods capture the economic effects of exchange rate changes.
2. Differentiate between an integrated and a self-sustaining foreign operation, and describe the translation method that is used in the translation of each type.
3. Prepare translated financial statements for integrated foreign operations using the temporal method.
4. Prepare translated financial statements for self-sustaining foreign operations using the current rate method.
5. Use translated financial statements to prepare consolidated financial statements.
6. Analyze and interpret financial statements involving foreign operations.
7. Identify some of the differences between IFRSs and ASPE involving foreign operations.

Consolidated financial statements are required when one entity has control over another entity or when a venturer has joint control over a joint venture. Foreign-currency-denominated financial statements must be translated to the presentation currency of the reporting entity. IAS 27 requires that consolidated financial statements be prepared using uniform accounting policies for like transactions and other events in similar circumstances.

Three major issues are related to the translation process: (1) what is the functional currency of the foreign operation, (2) what is the presentation currency (also known as the reporting currency) of the parent company, and (3) where should the resulting translation adjustment be reported in the consolidated financial statements?

Accounting Exposure versus Economic Exposure
Exposure is the risk that something could go wrong. Foreign-currency exposure is the risk that a loss could occur if foreign-exchange rates changed. Foreign-currency risk can be viewed as having three components: translation exposure (accounting exposure), transaction exposure, and economic exposure.

• Translation (Accounting) Exposure — This exposure results from the translation of foreign-currency-denominated financial statements into dollars. Only those financial statement items translated at the closing rate or the forward rate create an accounting exposure. If an item is translated at the historical rate, the Canadian dollar amount is fixed at historical cost and will not be affected by rate changes. However, if an item is translated at the closing rate or the forward rate, the Canadian dollar amount will change every time the exchange rate changes. Each item translated at the closing rate is exposed to translation adjustment. A separate translation adjustment exists for each of the exposed items. The net translation adjustment needed to keep the consolidated balance sheet in balance is based solely on the net asset or net liability exposure. Net asset exposure means that more assets than liabilities are exposed. The gains and losses that result from the translation are usually unrealized in the sense that they do not represent actual cash flows.



• Transaction Exposure — Transaction exposure exists when there is a lapse in time between the origination of a receivable or payable and the settlement of the receivable or payable. It affects the current cash flows of the enterprise. The resulting cash gains and losses are realized and affect the enterprise’s working capital and earnings.



• Economic Exposure — Economic exposure takes a longer-term view of the situation than either of the others. It arises because of “the possible reduction, in terms of the domestic reporting currency, of the discounted future cash flows generated from foreign investments or operations due to real changes (inflation adjusted) in exchange rates.” It represents a long-term potential threat or benefit to a company carrying out business in foreign countries. Economic exposure exists when the present value of future cash flows would change as a result of changes in exchange rates. Economic exposure is not easy to measure.

Translation Methods
Until the adoption of IFRSs in 2011, two major methods for translating foreign operations were used under Canadian GAAP: (1) the temporal method and (2) the current rate method. IAS 21 uses a similar approach for translating foreign operations but does not refer to the approaches by a particular name. The objective of translation is to express financial statements of the foreign operation in Canadian dollars (or other presentation currency) in the manner that best reflects the reporting enterprise’s exposure to exchange rate changes as determined by the economic facts and circumstances. The translated statements should reflect the reporting enterprise’s exposure to exchange rate changes.

The basic objective underlying the temporal method is to produce a set of translated financial statements as if the transactions had occurred in Canada in the first place.

• Under normal measurement practices, certain financial statement items are reported at historical cost, whereas other items are reported at fair value. The temporal method is designed to maintain this reporting practice when translating the foreign-currency statements into Canadian dollars.



• If the financial statement item is supposed to be reported at fair value, when translating the item into Canadian dollars we need to take the fair value of the item in foreign currency and apply the rate of the date that the fair value was determined.



• Use historical exchange rates to translate revenues and expenses (i.e., use the exchange rate on the date that the transaction giving rise to the revenue occurred).



• Use average rates to approximate exchange rates throughout the period.



• Use historical rates to measure expenses based on the historical cost of the related balance sheet items. Since depreciation expense is directly related to the purchase of a depreciable asset, depreciation expense should be translated using the exchange rate on the date that the depreciable asset was purchased. Similarly, cost of goods sold is based on the cost of the inventory. Therefore, use the exchange rate on the date when the inventory was purchased when translating the cost of goods sold.

Under the current rate method, all of the assets and liabilities of a foreign entity are translated at the closing rate on the date of the balance sheet; this preserves the relationship in dollars between all balance sheet items that formerly existed in the foreign currency. Share capital is translated at historical rates. All revenues and expenses are translated using the exchange rate in effect on the dates on which such items are recognized in income during the period. If the revenues or expenses were recognized in income evenly throughout the period, the average rate for the period is used to translate these items.

• The current rate method preserves the relationship of balance sheet items.
• Under the current rate method, the net assets of the foreign entity (and therefore the Canadian parent’s investment) are exposed to foreign exchange fluctuations.
• A peculiarity resulting from this method is that a property carried at historical cost in the foreign entity’s statements will be translated into differing Canadian dollar values if exchange rates fluctuate over some time frame.
• The IASB recognizes that the exchange adjustments under the current rate method have little or no direct effect on the present and future cash flows from operations. Accordingly, the exchange adjustments are not recognized in profit or loss; they are included in other comprehensive income.

Translation under IAS 21 IAS 21 establishes accounting standards for the translation of the financial statements of a foreign operation (a subsidiary, joint venture, associate, or branch) for use by a reporting enterprise (a Canadian investor). A foreign operation is viewed as either integrated or self-sustaining for translation purposes depending on whether the functional currency of the foreign entity is the same as or different from the functional currency of the Canadian reporting entity. To determine whether a specific foreign operation is integrated with its parent or self-sustaining, IAS 21 created the concept of the functional currency. As discussed in Chapter 10, the functional currency is the primary currency of the entity’s operating environment.

The interrelationship of the functional currency, the classification of the foreign entity, and the translation method can be depicted as follows:

Functional currency of foreign	Classification of entity foreign entity	Translation method	Translation adjustment reported in
Same as parent’s	Integrated	Temporal method	Net income
Different from parent’s	Self-sustaining	Current rate method	Other comprehensive income
Currency of a country other than parent’s country and other than country where it resides	Self-sustaining	Current rate method	Other comprehensive income

The exchange adjustments for the self-sustaining subsidiary are not recognized in net income because the changes in exchange rates have little or no direct effect on the present and future cash flows from operations. They merely serve to keep the balance sheet in equilibrium and are a mechanical by-product of the translation process. The cumulative amount of the exchange differences is presented in a separate component of equity until disposal of the foreign operation.

When the parent sells all or part of its self-sustaining foreign operations, or receives a liquidating dividend, a proportionate portion of the accumulated exchange gains and losses is taken out of other comprehensive income, and the realized exchange gains or losses are reported in net income. If the parent hedges its investment in a self-sustaining foreign operation with a forward exchange contract, the exchange gains or losses on the forward contract are also reported in other comprehensive income to offset the unrealized losses or gains on the investment.

Exhibit 10.3 (page 563) and Exhibit 11.1 (page 620) provides a detailed list of indicators for evaluating a foreign operation to determine whether the foreign operation is integrated or self-sustaining.

The two methods of translation actually use different currencies as the underlying unit of measure. The temporal method uses the Canadian dollar as the functional currency and the measuring unit, while the current rate method uses the foreign currency as the functional currency and the measuring unit. Under both methods, the presentation currency for the Canadian reporting entity is the Canadian dollar.

Exhibit 11.5 provides an excellent summary of the exchange rates to be used for self-sustaining operations (the current rate method) and integrated operations (the temporal method). Translation of the numerous revenues, expenses, gains, and losses at the historical rates is generally impractical. A weighted-average exchange rate for the period would normally be used to translate such items.

Some points to remember about translation and consolidation:

• When the parent acquires the subsidiary, the parent indirectly buys all of the net assets of the subsidiary.



• With no acquisition differential and the subsidiary wholly owned, the investment account is equal to the subsidiary’s shareholders’ equity.



• Note that the translation of a subsidiary on the date of acquisition is the same regardless of whether the entity is integrated or self-sustaining. However, there produce different results subsequent to the date of acquisition.



• For consolidation purposes, we never use an exchange rate older than the rate at the date of acquisition.



• All items within shareholders’ equity are translated using the historical rate applicable for each item.



• Dividends are translated at the historical rate on the date of declaration.



• Revenue and expenses, with the exception of depreciation and cost of goods sold, are translated at the average rate for the year. Cost of goods sold and depreciation are translated at the historical rates used to translate the related balance sheet asset accounts.



• The amount required to balance the balance sheet is the unrealized exchange loss from the translation of the subsidiary’s financial statements. An independent calculation of the translation gain or loss can also be calculated as a “proof”.



• Net equity earnings should be equal to the subsidiary’s net income when there is no acquisition differential or non-controlling interest.



• Consolidated retained earnings are the same as the parent’s retained earnings under the equity method.



• Accumulated translation adjustments are reported separately from retained earnings. The exchange gain or loss is reported in net income under the temporal method (for integrated foreign operations) and in other comprehensive income under the current rate method (for self-sustaining foreign operations).



• The investment account under the equity method should be equal to the subsidiary’s shareholders’ equity when there is no acquisition differential or non-controlling interest.



• The three components of cost of goods sold are each translated at the rate when these goods were purchased.



• The translated income (i.e., the equity earnings) of the foreign-currency subsidiary is quite different under the temporal method than under the current rate method. The exchange gains or losses are based on the accounting exposure, which is based on the translation method.

Under the current rate method (used for self-sustaining foreign operations), the net assets position of the foreign entity is at risk from currency fluctuations, while under the temporal method (used for integrated foreign operations) it is the monetary position that is at risk. As a general rule of thumb, integrated subsidiaries usually have a net liability exposure, whereas self-sustaining subsidiaries usually have a net asset exposure.

Complications with an Acquisition Differential

• The acquisition differential is translated at the exchange rate on the date of acquisition.
• The subsidiary’s separate-entity financial statements are the same regardless of the parent’s percentage ownership in the subsidiary.
• Amortization expense for the acquisition differential is translated at the average rate.
• Non-controlling interest on the balance sheet is based on the subsidiary’s shareholders’ equity plus the unamortized patent at the end of the year.

Other Considerations

• Lower of Cost and Net Realizable Value (LCNRV) – Certain items, such as inventory, will be valued at the LCNRV. If the subsidiary is self-sustaining, the method of valuation used is of no consequence in the translation because all of the assets are translated at the closing rate regardless of whether they are carried at cost or net realizable value. If the foreign operation is integrated, assets carried at cost are translated at historical rates, while assets carried at net realizable value are translated at the closing rate. Remember that the temporal method remeasures, in Canadian dollars, transactions that have been incurred by the foreign operation. Therefore, the translated financial statements should reflect the LCNRV in Canadian dollars as if the parent itself had carried out the inventory acquisitions of its foreign subsidiary. When assets are valued at the LCNRV, a write-down to net realizable value may be required in the translated financial statements even though no write-down is required in the foreign-currency financial statements.



• Intercompany Profits — The historical rate should be used in determining the intercompany profit to be eliminated. This eliminates the same profit that was recorded in the first place.



• Cash Flow Statement — A cash flow statement is easier to prepare by analyzing the change in a non-cash item on the balance sheet after it has been translated into Canadian dollars (i.e., ignore the cash flow statement of the foreign subsidiary and the translated cash flow statement of the foreign subsidiary, and simply create a new one from the translated balance sheet and translated income statement of the foreign subsidiary).



• Tax Effects of Exchange Adjustments — Exchange differences arising from translating the financial statements of a foreign operation into Canadian dollars are usually not taxable or deductible until the gains or losses are realized. Since these differences were recognized for accounting purposes but not for tax purposes, a temporary difference occurs and deferred income taxes should be recognized in the financial statements of the reporting entity. (We ignored the tax impact on the acquisition differential and for the foreign-exchange adjustments in the illustrations in this chapter to avoid complicating the discussions and illustrations.)



• Disclosure requirements — IAS 21 indicates many disclosure requirements, including that an entity must disclose the exchange adjustments reported in profit and other comprehensive income.

ASPE Differences

• As mentioned in Chapter 3, private companies can either consolidate their subsidiaries or report their investments in subsidiaries under the cost method or the equity method or at fair value if the securities are traded in an active market. Under the cost method or the fair value method, the financial statements of a foreign subsidiary do not have to be translated.
• The exchange rate at the end of the reporting period is called the current rate, not the closing rate.
• The functional currency is not used to classify foreign operations. Instead, the foreign operation is classified as either integrated or self-sustaining using similar, but not exactly the same, factors to those used under IFRSs to determine the functional currency.
• The translation gains and losses from translating self-sustaining foreign subsidiaries do not go through OCI but are reported as a separate component of shareholders’ equity because OCI does not exist under ASPE.
• When the foreign operations are located in a highly inflationary environment, the temporal method is used regardless of whether the operation is integrated or self-sustaining. No adjustments are made for inflation prior to translation.