Module 8 considers translation and consolidation of a subsidiary resident in a foreign country and surveys segment disclosures, international disclosure practices, and analysis of financial statements of foreign subsidiaries.
The current-rate method is used to translate self-sustaining operations and the temporal method is used to translate integrated operations.
Accounting exposure is the component of foreign currency risk that results from translating the statements of foreign subsidiaries into Canadian dollars. The amount recognized in the financial statements as foreign exchange gains/losses or as other comprehensive income varies depending on the translation method used. It does not necessarily represent realized gains or losses or economic exposure. Accounting exposure exists only on those financial statement elements translated at the current rate.
Economic exposure is the risk that foreign exchange rate changes have on the earnings of foreign operations and the long-term effects this may have on the parent company. The exposure is measured in true economic terms (that is, whether the entity is economically better or worse off due to the exchange-rate fluctuations), which are difficult to measure precisely.
Financial statements attempt to reflect economic results. Foreign exchange gains/losses recognized in the financial statements should therefore reflect the true economic impact of foreign currency fluctuations. Translation methods based on the parent’s relationship with its foreign subsidiary attempt to reflect the parent’s exposure to exchange rate changes. Financial statements do not always accurately reflect economic reality when historical cost accounting is used as the basis of measurement.
Whether a subsidiary is integrated or self-sustaining depends on the level of exposure of the parent to exchange rate changes. The six criteria to consider when determining the level of exposure are as follows:
An integrated subsidiary is one in which the parent actively participates in the subsidiary’s operating, investing, and financing activities. The parent’s exposure is the same as if it had directly undertaken the transactions of the foreign operation.
A self-sustaining subsidiary is one that operates independently of the parent. Although the parent controls the subsidiary, it does not actively participate in the subsidiary’s operating, investing, and financing activities. The parent’s exposure is limited to its investment in the foreign operation.
The temporal method is used in translating the financial statements of an integrated subsidiary (IT = Integrated Temporal). The current-rate method is used in translating the financial statements of a self-sustaining subsidiary.
The temporal method translates financial statement elements using exchange rates that will preserve the normal basis of valuation of these financial statement elements and presents the results as if the parent itself had entered into these transactions in the first place.
Foreign exchange gains/losses for integrated foreign operations are accounted for in exactly the same manner as foreign transactions. Monetary balances are translated at current year-end spot rates. Exchange gains and losses on monetary balances are reported in net income. Non-monetary balances are translated at historic rates and therefore do not result in gains and losses.
The current-rate method translates most balance sheet items at the current rates and translates revenues and expenses at the rates in effect when the revenues and expenses were recognized in income. However, in practice, revenues and expenses are translated at average rate. Dividends and share capital are translated at the historical rates. Most financial statement relationships remain the same as they were when stated in the foreign currency.
Where the economic environment of the foreign operation is highly inflationary, the temporal method should be used regardless of whether the foreign subsidiary is self-sustaining or integrated.
Translation gains/losses for self-sustaining foreign operations are reported in accumulated other comprehensive income (a separate component of shareholders’ equity) until they are realized when the investment in subsidiary is sold. At that time, the translation gains/losses held in accumulated other comprehensive income will be removed and reported in income.
The hedged item in this case is a net investment in a self-sustaining foreign subsidiary. Section 1530, in the illustrative examples, shows where to locate the "Gains and losses on hedges of unrealized foreign currency translation losses and gains" in the statement of comprehensive income.
Two computer illustrations were presented in order to further your understanding of the translation and consolidation process involving foreign operations.
The purchase discrepancy is calculated in the normal fashion as the difference between the imputed purchase price and the net book value of the subsidiary’s shareholders’ equity.
For the temporal method, the initial calculation is further complicated by the necessity of translating each component of the purchase price into the reporting currency (usually Canadian dollars).
The exchange rate in effect on the date of acquisition is used to translate each of the underlying assets and liabilities, not the exchange rate in effect when the subsidiary acquired the assets/liabilities prior to the parent’s acquisition of the subsidiary.
In the years following acquisition under the current rate method, amortization in the purchase discrepancy amortization schedule is translated at the average exchange rate for the current year and the unamortized amount is translated at the year-end current rate. The resulting translation gain/loss that pertains to the parent is included in the accumulated other comprehensive income on the consolidated balance sheet.
In the years following acquisition under the temporal method, everything in the purchase discrepancy amortization/impairment schedule is translated at historic rates in effect on the date of acquisition, and there is no resulting gain/loss from this translation.
First, translate the financial statements using the principles and techniques learned in Modules 7 and 8. Then, consolidate using the principles and techniques learned in Modules 3 through 6.
The investment account is replaced with the assets and liabilities of the subsidiary, the unamortized purchase discrepancy, and the NCI. From a consolidated viewpoint, the parent indirectly acquired the assets of the subsidiary on the date of acquisition. Use the exchange rate on the date of acquisition as the historical rate. The non-controlling interest (NCI) shares in values recorded on the subsidiary’s books, the unamortized PPD and unimpaired goodwill, and in adjustments arising from unrealized gains/losses on upstream transactions.
The purchase discrepancy is not recorded on the subsidiary’s books but is used only for the purpose of consolidation. Translation gains/losses pertaining to the purchase discrepancy are not recorded on the subsidiary’s books but are included only on the consolidated financial statements; they are then credited/charged fully to the parent.
The unamortized purchase discrepancy translated at the historic rate is included on the balance sheet. The current year’s purchase discrepancy amortization and any impairment loss in the income statement are translated at historical rates.
NCI on the balance sheet is the NCI’s ownership percentage times the subsidiary’s translated shareholders’ equity, adjusted for their share of the unamortized PPD and unimpaired goodwill, and for any unrealized gains or losses on upstream transactions. The foreign exchange gain/loss on the translated income statement is the gain/loss on translation of all monetary items, both current and non-current. The NCI on the income statement is the NCI’s ownership percentage times the subsidiary’s translated income after allowing for amortization of the PPD, impairment of goodwill, and adjustments for unrealized gains or losses on upstream transactions after the foreign exchange gain/loss has been included.
The unamortized purchase discrepancy is translated at the current
NCI on the balance sheet is the NCI’s percentage times the subsidiary’s translated shareholders’ equity including accumulated other comprehensive income, adjusted for their share of the unamortized PPD and unimpaired goodwill and for any unrealized gains or losses on upstream transactions.
The NCI on the income statement is the NCI’s ownership percentage times the subsidiary’s translated income statement after allowing for amortization of the PPD, impairment of goodwill, and adjustments for unrealized gains or losses on upstream transactions.
Consolidated statements combine and summarize results, making it difficult to assess the different types of businesses and economic environments in which the entity operates.
Segmented financial reporting is useful to users in assessing the entity’s performance and the amount, timing, and certainty of future cash flows. If a company has various operating segments and these segments have varying degrees of risk, profitability, and capital investment requirements, the users would want to see financial information for these operating segments.
Segmented financial information must be provided to external users for those segments that are regularly provided to and reviewed by the entity’s chief operating decision maker for internal purposes.
An operating segment should be reported if the segment’s revenues, profits or losses, or assets are greater than 10% of the combined revenues, profits, and assets of all operating segments. At least 75% of a firm’s external revenues must be reported by segment disclosures. Customers and related revenues that constitute greater than 10% of the reporting firm’s total revenues must be disclosed.
Segmented information includes the following:
The goodwill impairment test needs to be conducted for each reporting unit. A reporting unit is either an operating segment or one level below, referred to as a component.
A component of an operating segment is a reporting unit when discrete financial information is available for management review.
In order to be able to conduct the impairment test at the reporting unit level, assets and liabilities need to be assigned to each reporting unit so that fair values of each reporting unit can be determined.
Once the fair value of each reporting unit is determined, the fair value of goodwill can be determined and compared to its carrying value to determine whether impairment has occurred.
If a subsidiary has goodwill, it must also test its reporting units for goodwill impairment. When the parent consolidates this subsidiary, it must conduct its own reporting unit goodwill impairment test. Only if goodwill is impaired at this level would a goodwill impairment loss be recognized by the parent. Thus, if the subsidiary reported goodwill impairment on its reporting units, that does not necessarily imply the parent will record an impairment loss as well.