BA606 FINANCIAL ACCOUNTING

1
BA606 FINANCIAL ACCOUNTING

• Professor Garry Carnegie
• Lectures 17 18

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Lectures 17 18 Foreign currency translation

• Introduction
• Unit of measurement
• Currency translation
• Foreign currency translation
• Accounting standards
• Hedging of transactions

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Introduction

• Many Australian entities engage in international
  activities
• Such activities include exporting or importing
  goods and services, operating a foreign entity in
  another country and borrowing from, or lending
  to, entities located in other countries
• Foreign transactions and foreign currency
  financial statements are required to be
  translated into the currency of the reporting
  entity

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Introduction

• This topic deals with the accounting issues that
  result from transactions with entities that are
  located overseas and from the overseas operations
  of local entities
• Two preliminary matters require attention
• Unit of measurement
• Currency translation

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Unit of measurement

• Transactions and other past events are to be
  expressed in financial statements in a common
  unit of measurement, such as the Australian
  dollar (AU) as required for entities that are
  incorporated under the Corporations Act 2001
• The currency of the country in which the entity
  is incorporated is known as the domestic
  currency
• Domestic currency, as the unit of measurement, is
  generally used in preparing financial statements

6
Unit of measurement

• Two other related terms are relevant
• AASB 121 The Effects of Changes in Foreign
  Exchange Rates introduces the following terms
• - Functional currency
• - Presentation currency

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Unit of measurement

• Functional currency is defined as the currency
  of the primary economic environment in which the
  entity operates (para. 8)
• Presentation currency is defined as the
  currency in which the financial report is
  presented (para. 8)

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Unit of measurement

• Each entity must determine its functional
  currency and measure its financial performance
  and financial position in accordance with that
  currency
• The presentation currency is then selected
• AASB 121 states for the purpose of reporting
  under the Corporations Act, entities are only
  permitted to present a financial report which
  purports to be drawn up in accordance with the
  Corporations Act in one presentation currency
  (para. AUS 38.1)

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Unit of measurement

• When an entity chooses a presentation currency
  other than its functional currency, AASB 121
  prescribes the procedures for translating (or
  converting) from the functional currency to the
  presentation currency (paras. 38 and 39)

10
Currency translation

• Transactions in a foreign currency are to be
  translated (that is, converted) into the
  domestic currency
• A foreign exchange rate is to be ascertained and
  applied for this purpose
• A foreign exchange rate is the price at which one
  countrys currency can be converted into the
  currency of another country in the foreign
  exchange market

11
Currency translation

• The exchange may be immediate or at some future
  (that is, forward) moment
• The immediate rate is known as the spot rate
• On Wednesday, 17 September 2008, the following
  retail exchange rates are stated in the
  Australian Financial Review (page 51)
• - Buying rate US0.7977 (2007 0.8909)
• - Selling rate US0.7829 (2007 0.8816)

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Currency translation

• The terms buying and selling refer to buying
  and selling Australian dollars
• The difference between these two rates is the
  foreign currency dealers margin
• Where the exchange rate is determined now but the
  currency is delivered later, such as in three or
  six months time, the rate is known as the
  forward rate

13
Currency translation

• Exchange rates are determined by the supply of
  and demand for the respective currencies
  concerned
• Changes in exchange rates can lead, of course, to
  exchange gains or losses
• An entity can protect itself against the risk of
  exchange loss in three main ways

14
Currency translation

• An entity may borrow foreign currency equal in
  amount and maturity to its overseas accounts
  receivable
• An entity may simultaneously sell goods and
  purchase goods in a foreign currency for
  identical amounts
• An entity may enter a forward exchange
  agreement (that is, a written agreement) to
  cover its transactions

15
Currency translation

• A forward exchange agreement is entered into with
  a bank or another party to exchange currencies of
  different countries one or two months in the
  future at a price (the forward exchange rate)
  that is specified at the time of the agreement
• The entitys bank or other party charges a
  commission for entering into this commitment

16
Currency translation

• Such agreements enable domestic sellers or
  purchasers of goods and services to establish, at
  the time of sale or purchase, the actual amount
  in AU that will be received or paid for a
  specific foreign currency amount
• Accordingly, the agreement insulates the entity
  against the effects of exchange rate fluctuations

17
Foreign currency translation

• Foreign currency translation may be classified
  broadly as relating to
• - Foreign currency transactions
• - Foreign-based operations

18
Foreign currency translation

• Foreign currency transactions
• Foreign sales and purchases that are made on
  credit give rise to accounts receivable and
  accounts payable respectively
• The effects of changes in exchange rates on
  short-term monetary items dominated in a foreign
  currency are reflected in the entitys accounts

19
Foreign currency translation

• Short-term monetary items include the following
  two categories
• - Foreign sales
• - Foreign purchases

20
Foreign currency translation

• Foreign sales
• Where an entity sells goods or services on credit
  with settlement in a fixed amount of foreign
  currency, the entity will incur foreign exchange
  gains and losses if there is a change in exchange
  rates between the date of sale and the settlement
  date
• Study Example 29.2 (H, P H, pp. 953-955)

21
Foreign currency translation

• Foreign purchases
• Where an entity purchases goods or services on
  credit with settlement in a fixed amount of
  foreign currency, the entity will incur foreign
  exchange gains and losses if the exchange rates
  between the date of purchase and the date of
  settlement changes
• Study Example 29.3 (H, P H, pp. 955-956)

22
Foreign currency translation

• Long-term monetary items
• Entities that borrow or lend in a foreign
  currency are also susceptible to foreign exchange
  gains and losses
• Such gains and losses are to be recognised in the
  income statement on the same basis, as outlined,
  for foreign sales and foreign purchases (that is,
  in the period in which they arise)

23
Foreign currency translation

• Foreign-based operations
• Such operations include foreign branches,
  subsidiaries or other reporting entities whose
  financial statements are expressed in the
  currency of the country in which they conduct
  business
• For an Australian entity, such financial
  statements are to be translated into Australian
  dollars

24
Foreign currency translation

• The prime purpose of translation is to
  incorporate the results of foreign operations
  into the economic entitys financial reports
• Alternatively, in evaluating the actual
  performance of foreign based operations, the
  foreign currency financial reports should be used
  for financial statement analysis purposes

25
Foreign currency translation

• Translation involves no accounting entries in the
  books of either the parent entity or of the
  overseas operation
• On translating the results of an overseas
  operation into the domestic currency, the
  statements will probably not balance due to the
  nature of the adjustments to be made, hence an
  exchange difference, as a balancing item, will
  arise

26
Foreign currency translation

• Four methods are available for translating
  foreign currency financial statements
• - Historical method
• - Closing-rate method
• - Temporal method
• - Current-rate method

27
Foreign currency translation

• Historical method
• Known as the traditional approach, this method,
  in general, requires that balance sheet and
  income statement items be translated at the
  historical rate appropriate for each respective
  item
• The historical rate is the one that was current
  when the transaction or other event occurred

28
Foreign currency translation

• There are two variations of the historical method
• The first involves the translation of current
  assets and current liabilities at the exchange
  rate on reporting date, while non-current assets
  and non-current liabilities are translated at
  relevant historical exchange rates

29
Foreign currency translation

• The second variation distinguishes between
  monetary assets and liabilities (whose amounts
  are fixed in terms of a foreign currency) and
  non-monetary assets and liabilities (whose
  amounts are not fixed in terms of a foreign
  currency)
• Monetary items are translated at the exchange
  rate current on the reporting date, while
  non-monetary items are translated at relevant
  historical exchange rates

30
Foreign currency translation

• Under both historical methods, income statement
  items are translated at the exchange rate
  prevailing at the time the income and expenses
  were recognised
• Components of equity are also translated at
  relevant historical exchange rates

31
Foreign currency translation

• Closing-rate method
• Under this method, all balance sheet and income
  statement items, including depreciation, are
  translated at the exchange rate current on the
  reporting date
• All items in the foreign operations financial
  statements are translated using the same exchange
  rate, thus resulting in no translation gain or
  loss (that is, exchange difference)

32
Foreign currency translation

• Under AASB 121, exchange difference is defined
  as the difference resulting from translating a
  given number of units of one currency into
  another currency at different exchange rates
  (para. 8)

33
Foreign currency translation

• Temporal method
• Under this method, items in the income statement
  and items recorded in the balance sheet at
  historical cost are translated at the appropriate
  historical exchange rate
• Assets and liabilities that are stated at current
  replacement cost or net market value are
  translated at the exchange rate current on the
  reporting date

34
Foreign currency translation

• Under the temporal method, where marketable
  securities are shown in a foreign currency at
  historical cost, the historical rate is used for
  translation, while the same asset, if instead was
  recorded in the accounts in a foreign currency at
  current market price, would be translated at the
  exchange rate current on the reporting date
• The translation gain or loss for the period is
  included in the income statement

35
Foreign currency translation

• Current-rate method
• This method is a variation of the closing-rate
  method
• In its pure form, balance sheet items are
  translated at the exchange rate current on the
  reporting date, while income statement items are
  translated at the appropriate historical exchange
  rate

36
Foreign currency translation

• Under the current-rate method, translation gains
  or losses are not recognised in the income
  statement but are accumulated in the balance
  sheet as a foreign currency translation reserve
  (that is, as a component of equity)

37
Accounting standards

• Key provisions of AASB 121 Foreign currency
  transactions
• Foreign currency receivables and payables are to
  be recognised by applying the spot rate on date
  of the transaction (para. 21)
• On subsequent reporting dates, such items must be
  translated at the spot rate at the reporting
  date or closing rate (as defined in para. 8)
  in accordance with para. 23(a)

38
Accounting standards

• Exchange differences, both realised and
  unrealised, are to be recognised as income and
  expenses in the reporting period in which the
  exchange rate changes (para. 28)
• The procedures required by AASB 121 are
  illustrated in examples 29.2 and 29.3 as
  previously addressed

39
Accounting standards

• In the case of non-monetary items, at each
  reporting date non-monetary items that are
  measured in terms of historical cost in a foreign
  currency shall be translated using the exchange
  rate at the date of the transaction (para.
  23(b))
• Read Example 29.4 (H, P H, pp. 957-959)

40
Accounting standards

• On the other hand non-monetary items that are
  measured at fair value in a foreign currency
  shall be translated using the exchange rates at
  the date when the fair value was determined
  (para. 23(c))

41
Accounting standards

• Key provisions of AASB 121 Foreign-based
  operations
• The basic features for translating financial
  statements from one currency to another are
  detailed in para. 39
• The required procedure is very similar to the
  current-rate method, except that AASB 121 does
  not indicate how equity items should be
  translated, although it seems reasonable, for
  consistency purposes, to translate equity items
  using the closing rate at balance sheet date
• Read Example 29.5 (H, P H, pp. 962-965)

42
Hedging of transactions

• Entities may hedge their exposure to risks of
  exchange losses in three main ways as previously
  outlined
• Hedging of financial instruments is addressed in
  AASB 139 Financial Instruments Recognition and
  Measurement (see, in particular, paras. 85-89)

43
Hedging of transactions

• Para. 89 of AASB 139 requires that any gains and
  losses arising from changes in the fair value of
  the hedged item be offset (in the income
  statement) by losses and gains arising from
  changes in the fair value of the hedging
  instrument
• Read Example 29.7 (H, P H, pp. 973-976)