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