Learning Module 3: Multinational Operations

Learning Module 3 Multinational Operations EXAMPLE 1 Accounting for Foreign Currency Transactions with Settlement before the Balance Sheet Date 1. FinnCo purchases goods from its Mexican supplier on 1 November 20X1; the purchase price is 100,000 Mexican pesos. Credit terms allow payment in 45 days, and FinnCo makes payment of 100,000 pesos on 15 Decem ber 20X1. FinnCo's functional and presentation currency is the euro. Spot exchange rates between the euro (EUR) and Mexican peso (MXN) are as follows: 1 November 20X1 MXNI EURO.0684 15 December 20X1 MXNI EUR0.0703 FinnCo's fiscal year end is 31 December. How will FinnCo account for this foreign currency transaction, and what effect will it have on the 20X1 finan- cial statements? Solution: The euro value of the Mexican peso account payable on 1 November 20X1 was EUR6,840 (MXN100,000 × EUR0.0684). FinnCo could have paid for its inventory on 1 November by converting 6,840 euro into 100,000 Mexican pesos. Instead, the company purchases 100,000 Mexican pesos on 15 De- cember 20X1, when the value of the peso has increased to EUR0.0703. Thus, FinnCo pays 7,030 euro to purchase 100,000 Mexican pesos. The net result is a loss of 190 euro (EUR7,030- EUR6,840). Although the cash outflow to acquire the inventory is EUR7,030, the cost included in the inventory account is only EUR6,840. This cost represents the amount that FinnCo could have paid if it had not waited 45 days to settle its account. By deferring payment, and because the Mexican peso increased in value between the transaction date and settlement date, FinnCo has to pay an additional 190 euro. The company will report a foreign exchange loss of EUR190 in its net income in 20X1. This is a realized loss because FinnCo ac- tually spent an additional 190 euro to purchase its inventory. The net effect on the financial statements, in EUR, can be seen as follows: Balance Sheet Assets Cash -7,030 Inventory Stockholders' =Liabilities + Equity +6,840 -190 Retained Income Statement Revenues and Gains earnings -190 -190 Foreign exchange loss Expenses and Losses EXAMPLE 2 Accounting for Foreign Currency Transaction with Intervening Balance Sheet Date 1. FinnCo sells goods to a customer in the United Kingdom for £10,000 on 15 November 20X1, with payment to be received in British pounds on 15 lan- uary 20X2. FinnCo's functional and presentation currency is the euro. Spot exchange rates between the euro (€) and British pound (E) are as follows: 15 November 20X1 EL = €1.460 31 December 20X1 15 January 20X2 EL€1.475 FinnCo's fiscal year end is 31 December. How will FinnCo account for this foreign currency transaction, and what effect will it have on the 20X1 and 20X2 financial statements? Solution: The euro value of the British pound account receivable at each of the three relevant dates is determined as follows: Date 15 Ναν 20Χ1 31 Dec 20X1 15 Jan 20X2 €/E Exchange Rate €1.460 €1.480 €1.475 Account Receivable (£10,000) Euro Value 14,600 14,800 14,750 Change in Euro Value NIA +200 =50 A change in the euro value of the British pound receivable from 15 Novem- ber to 31 December would be recognized as a foreign currency transaction gain or loss on FinnCo's 20X1 income statement. In this case, the increase in the value of the British pound results in a transaction gain of €200 (£10,000 x (€1.48€1.46)]. Note that the gain recognized in 20X1 income is unre- alized, and remember that this is one of few situations in which companies include an unrealized gain in income. Any change in the exchange rate between the euro and British pound that occurs from the balance sheet date (31 December 20X1) to the transaction settlement date (15 January 20X2) will also result in a foreign currency transaction gain or loss. In our example, the British pound weakened slightly against the euro during this period, resulting in an exchange rate of €1.475/ El on 15 January 20X2. The £10,000 account receivable now has a value of €14,750, which is a decrease of €50 from 31 December 20X1. FinnCo will recognize a foreign currency transaction loss on 15 January 20X2 of €50 that will be included in the company's calculation of net income for the first quarter of 20X2. From the transaction date to the settlement date, the British pound has increased in value by €0.015 (€1.475 - €1.460), which generates a realized foreign currency transaction gain of €150. A gain of €200 was recognized in 20X1 and a loss of €50 is recognized in 20X2. Over the two-month period. the net gain recognized in the financial statements is equal to the actual realized gain on the foreign currency transaction. EXAMPLE 3 Placement of Foreign Currency Transaction Gains/Losses on the Income Statement-Effect on Operating Profit 1. Assume that FinnCo had the following income statement information in both 20X1 and 20X2, excluding a foreign currency transaction gain of €200 in 20X1 and a transaction loss of €50 in 20X2. 20X1 20X2 Revenues €20,000 €20,000 Cost of goods sold 12,000 12,000 Other operating expenses, net 5,000 5,000 Non-operating expenses, net 1,200 1,200 FinnCo is deciding between two alternatives for the treatment of foreign currency transaction gains and losses. Alternative I calls for the reporting of foreign currency transaction gains/losses as part of "Other operating expenses, net." Under Alternative 2, the company would report this informa- tion as part of "Non-operating expenses, net." FinnCo's fiscal year end is 31 December. How will Alternatives 1 and 2 affect the company's gross profit margin, operating profit margin, and net profit margin for 20X1? For 20X2? Solution: Remember that a gain would serve to reduce expenses, whereas a loss would increase expenses. 20X1-Transaction Gain of €200 Alternative 1 Alternative 2 Revenues €20,000 €20,000 Cost of goods sold (12,000) (12,000) Gross profit 8,000 8,000 Other operating expenses, net (4,800) incl. gain (5,000) Operating profit 3,200 3,000 Non-operating expenses, net (1.200) (1,000) incl. gain Net profit €2,000 €2,000 Profit margins in 20X1 under the two alternatives can be calculated as follows: Gross profit margin Alternative 1 €8,000/€20,000 = 40.0% Alternative 2 €8,000/€20,000 - 40.0% Alternative 1 Operating profit 3,200/20,000 = 16.0% Alternative 2 margin 2,000/20,000 10.0% 3,000/20,000 15.0% Net profit margin 20X2-Transaction Loss of €50 2,000/20,000 = 10.0% Alternative 1 Alternative 2 Revenues €20,000 €20,000 Cost of goods sold (12,000) (12,000) Gross profit 8,000 8,000 Other operating expenses, net (5,050) (5,000) Operating profit 2,950 3,000 Non-operating expenses, net (1,200) (1,250) incl. loss Net profit €1,750 €1,750 Profit margins in 20X2 under the two alternatives can be calculated as follows: Alternative 1 Alternative 2 Gross profit margin €8,000/€20,000 - 40.0% Operating profit 2,950/20,000 = 14.75% margin Net profit margin 1,750/20,000= 8.75% €8,000/€20,000 - 40.0% 3,000/20,000 15.0% 1,750/20,000 8.75% Gross profit and net profit are unaffected, but operating profit differs under the two alternatives. In 20X1, the operating profit margin is larger under Alternative 1, which includes the transaction gain as part of "Other oper- ating expenses, net." In 20X2, Alternative 1 results in a smaller operating profit margin than Alternative 2. Alternative 2 has the same operating profit margin in both periods. Because exchange rates do not fluctuate by the same amount or in the same direction from one accounting period to the next, Alternative 1 will cause greater volatility in operating profit and operating profit margin over time. incl. loss EXAMPLE 4 Foreign Currency Translation in a Highly Inflationary Economy 1. Turkey was one of the few remaining highly inflationary countries at the beginning of the 21st century. Annual inflation rates and selected exchange rates between the Turkish lira (TL) and US dollar during the 2000-2002 period were as follows: Date Exchange Rates Year Inflation Rate (%) 01 Jan 2000 TL542,700 LUSSI 31 Dec 2000 TL670,800 US$1 2000 38 31 Dec 2001 TL1.474,525 US$1 2001 69 45 31 Dec 2002 2002 TL1,669,000USSI Assume that a US-based company established a subsidiary in Turkey on 1 January 2000. The US parent sent the subsidiary US$1,000 on 1 January 2000 to purchase a piece of land at a cost of TL542,700,000 (TL542.700/ USS US$1,000 TL542,700,000). Assuming no other assets or liabilities, what are the annual and cumulative translation gains or losses that would be reported under each of three possible translation approaches? Solution: Approach 1: Translate Using the Current Rate Method The historical cost of the land is translated at the current exchange rate, which results in a new translated amount at each balance sheet date. Date Carrying Value 01 Jan 2000 TL542,700,000 31 Dec 2000 542,700,000 31 Dec 2001 542,700,000 5-42,700,000 31 Dec 2002 Current Exchange Rate 542,700 Translated Amount in USS Annual Translation Gain (Loss) Cumulative Translation Gain (Loss) $1,000 809 N/A N/A 670,800 ($191) ($191) 1.474,525 368 (441) (632) 1,669,000 325 (43) (675) At the end of three years, land that was originally purchased with US$1,000 would be reflected on the parent's consolidated balance sheet at US$325 (and remember that land is not a depreciable asset). A cumulative translation loss of US$675 would be reported as a separate component of stock holders' equity on 31 December 2002. Because this method accounts for adjustments in exchange rates but does not account for likely changes in the local currency values of assets, it does a poor job of accurately reflecting the economic reality of situations such as the one in our example. That is the major reason this approach is not acceptable under either IFRS or US GAAP Approach 2: Translate Using the Temporal Method (US GAAP ASC 830) The historical cost of land is translated using the historical exchange rate, which results in the same translated amount at each balance sheet date. Annual Translation Gain (Loss) Cumulative Translation Gain (Loss) Historical Exchange Rate Date 01 Jan 2000 Carrying Value Translated Amount in USS TL542,700,000 542,700 $1,000 N/A N/A 31 Dec 2000. 542,700,000 542,700 1.000 N/A N/A 31 Dec 2001 542,700.000 542,700 1,000 NIA N/A 31 Dec 2002 542,700,000 542,700 1,000 N/A N/A Under this approach, land continues to be reported on the parent's consolidated balance sheet at its original cost of US$1,000 each year. There is no translation gain or loss related to balance sheet items translated at historical exchange rates. This approach is required by US GAAP and ensures that non-monetary assets do not disappear from the translated balance sheet. Approach 3: Restate for Inflation/Translate Using Current Exchange Rate (IAS 21) The historical cost of the land is restated for inflation, and then the inflation-adjusted historical cost is translated using the current exchange rate. Date Inflation Rate (%) Restated Carrying Value Current Exchange Rate 01 fan 00 TL542,700,000 Translated Amount in USS Annual Translation Gain (Loss) Cumulative Translation Gain (Loss) 542,700 $1,000 N/A N/A 31 Dec 00 38 748,926,000 670,800 1116 $116 $116 31 Dec 01 69 1,265,684,940 1,474,525 858 (258) (142) 31 Dec 02 45 1,835,243,163 1,669,000 1.100 242 100 Under this approach, land is reported on the parent's 31 December 2002 consolidated balance sheet at US$1,100 with a cumulative, unrealized gain of US$100. Although the cumulative translation gain on 31 December 2002 is unrealized, it could have been realized if (1) the land had appreciated in TL value by the rate of local inflation, (2) the Turkish subsidiary sold the land for TL1,835,243,163, and (3) the sale proceeds were converted into US$1,100 at the current exchange rate on 31 December 2002 This approach is required by IAS 21. It is the approach that, apart from doing an appraisal, perhaps best represents economic reality, in the sense that it reflects both the likely change in the local currency value of the land as well as the actual change in the exchange rate. EXAMPLE 5 Effects of Different Balance Sheet Exposures under the Temporal Method (Canadaco's functional currency is the parent's functional currency) 1. Canadaco begins operations on 1 January 20X1, with cash of C$1,500,000 and property and equipment of C$3,000,000. In Case A, Canadaco finances the acquisition of property and equipment with a long-term note payable and begins operations with net monetary liabilities of C$1,500,000 (C$3,000,000 long-term note payable less C$1,500,000 cash). In Case B, Canadaco finances the acquisition of property and equipment with capital stock and begins operations with net monetary assets of C$1,500,000. Το isolate the effect that balance sheet exposure has on net income under the temporal method, assume that Canadaco continues to have C$270,000 in interest expense in Case B, even though there is no debt financing. This as- sumption is inconsistent with reality, but it allows us to more clearly see the effect of balance sheet exposure on net income. The only difference between Case A and Case B is the net monetary asset/liability position of the company- ny, as shown in the following table: Canadaco Balance Sheet, 1 January 20X1 Case A Case B Assets Cash Property and equipment Liabilities and Equity Long-term note payable Capital stock C$1,500,000 CS1,500,000 C$4,500,000 CS4,500,000 C$3,000,000 C50 1,500,000 4,500,000 C$4,500.000 CS4,500,000 Canada purchases and sells inventory in 20X1, generating net income of CSI, 180,000, out of which dividends of C$350,000 are paid. The com- pany has total assets of C$5,780,000 as of 31 December 20X1. Canadaco's functional currency is determined to be the euro (the parent's presentation currency), and the company's Canadian dollar financial statements are translated into euro using the temporal method. Relevant exchange rates are as follows: Date 1 January 20X1 Average, 20X1 € per C$ 0.70 0.75 Weighted-average rate when inventory was acquired 0.74 1 December 20X1 when dividends were declared 0.78 31 December 20X1 0.80 What effect does the nature of Canadaco's net monetary asset or liability position have on the euro-translated amounts? Solution: Translation of Canadaco's 31 December 20X1 balance sheet under the temporal method in Case A and Case B is shown in the following table: EXAMPLE 6 Effect of Direction of Change in the Exchange Rate on Translated Amounts Canadaco's Canadian dollar (CS) financial statements are translated into euro (€) under three scenarios: (1) the Canadian dollar remains stable against the euro, (2) the Canadian dollar strengthens against the euro, and (3) the Canadian dollar weakens against the euro. Relevant exchange rates are as follows: € per CS Date Stable Strengthens Weakens 1 January 20X1 0.70 0.70 10.70 Average, 20X1 0.70 0.75 0.65 Weighted average rate when inven 0.70 0.74 0.66 tory was acquired Rate when dividends were declared 0.70 0.78 0.62 31 December 20X1 0.70 080 0.60 What amounts will be reported on the parent's consolidated financial statements under the three different exchange rate assumptions if Canadaco's Canadian dollar financial statements are translated using the 1. current rate method? Solution: Current Rate Method: Using the current rate method, Canadaco's Canadian dollar financial statements would be translated into euro as follows under the three different exchange rate assumptions: