110.

309 Advanced Financial Accounting

Accounting for Foreign Currency (FC) Transactions;
and
Translation of Financial Statements (F/S) of Foreign Entities

Deegan 9th Edition – Ch. 30 and Ch. 31

Learning objectives

1 2 3
Explain need to Differentiate Apply NZ IAS 21 to
translate FC Functional v account for FC
transactions & F/S’s. Presentation transactions; F/S’s
currency. and FX gains/losses.

2
Foreign Exchange
Markets
 FX market is the largest and most liquid market with
more than $US 6.6 trillion traded every day, an
average of $250 billion per hour.

 Currencies are traded among banks in inter-bank

market, through foreign exchange brokers and
securities brokers, and over-the-counter

3
 2/3 of FX transactions are carried out by commercial banks
 Most widely traded currency is the US$ (88%)

4
The New Zealand Dollar
Introduced in 1967 and replaced the NZ pound.
The NZ $ was initially pegged to the US $ at US$1.62 = NZ$1.
This changed in November 1967 to US$1.12 = NZ$1 after the
devaluation of the British pound.
In 1971 the US devalued its dollar relative to gold, leading NZ to
peg its dollar at US$1.216.
The NZ$ was floated on 4 March 1985 at an initial rate of
US$0.4444. Since then, the NZ$ value has been determined by
the financial markets and has ranged between US$0.39 - 0.88.
The NZ$ value is often strongly affected by currency trading and
is among the 11 most-traded currencies.

5
NZ$ (cont.)
 Between $NZ 5 and $9 billion is traded every day:

http://www.interest.co.nz/charts/exchange-rates/foreign-exchange-trading-volume
s

 It is one of the most volatile currencies:

http://www.xe.com/currencycharts/?from=NZD&to=USD&view=1Y

http://www.xe.com/currencycharts/?from=NZD&to=AUD&view=1Y

6
 Foreign Exchange
What determines/influences Exchange Rates
• Variety of political and economic factors that influence exchange rates
• Purchasing power parity
• Interest rates
• Trade balance
• Capital flows
• Foreign exchange reserves
• Economic growth and employment
• Confidence -- Political and Economic
• Government interventions and reactions

7
 Purchasing power parity
Big Mac index
The Economist's Big Mac index is based on the theory of
purchasing-power parity (PPP), the idea that exchange rates
should move to equalise the prices of a basket of goods and
services across different countries.
The basket in this case is the Big Mac.

http://www.economist.com/content/big-mac-index

8
http://www.economist.com
/content/big-mac-index

9
Foreign Exchange
Basic Foreign
Currency
Markets

Forward
Spot Market
Market

Spot rate: the exchange Forward rate: the exchange

rate available today rate that be locked in today for
an expected future exchange
transaction
10
Spot market
rates Bid (buy) and offer (sell) rates

Direct quote (1 FCU = $NZ)

Indirect quote (1 $NZ = FCU)

https://www.asb.co.nz/business/international/foreign-exchange/f
oreign-exchange-rates

Forward rates
https://www.asb.co.nz/markets/exchangerates.asp

11
 NZ IAS 21 prescribes
NZ IAS 21 how to account for FC transactions of an entity;
and
The Effects of how to translate F/S’s from Functional Currency
Changes in to Presentation Currency.
Foreign NZ IAS 21 does not apply to FC derivatives and
Exchange hedge accounting of FC items (covered by NZ
IFRS 9 Financial Instruments).
Rates

12
 Definitions
• Exchange rate is the ratio of exchange for two currencies.
• Spot exchange rate is the exchange rate for immediate delivery.
• Closing rate is the spot exchange rate at the end of the reporting period.
• Monetary items are units of currency held and assets and liabilities to be
received or paid in a fixed or determinable number of units of currency.
• Functional currency is the currency of the primary economic environment
in which the entity operates.
• Presentation currency is the currency in which the F/S’s are presented.

13
 Foreign Currency
(FC) Transactions

Foreign Currency Transaction

Transaction Balance Settlement

date date date

14
 Four accounting
issues
1. Initial recording of transaction
2. Presenting FC balances at subsequent balance
dates
3. The treatment of FC gains/ losses
4. Recording of settlement of FC receivables/
payables

15
 Three conceptual accounting
approaches
I. Two transactions, recognise gains and losses
II. Two transactions, defer gains and losses
III. One transaction, no exchange gains or losses

NZ IAS 21 adopts the two transactions approach

and recognises gains and losses

16
 FC Transactions - NZ IAS 21
 At Transaction date:
• FX transaction is recorded in Functional currency, by applying spot rate at date of
transaction.
• For practical reasons, a rate that approximates the actual rate at date of transaction is
often used (eg. Av. weekly or monthly rate).
 At each balance sheet date:
• Monetary items - translated using closing rate;
• Non-monetary items measured at historical cost - translated using rate at date of
transaction; and
• Non-monetary items that are measured at fair value - translated using rate at the
date FV was determined.
 Exchange differences:
May arise on:
• settlement of monetary items, or
• translating monetary items at rates different from those at initial recognition
• They are recognised in profit or loss.

17
 Akl Co. purchased machinery from a French firm
for €100,000 on Dec. 10, with payment due on
Feb. 8. Akl's fiscal year ends on Dec. 31. Direct
spot rates were:
Example Dec. 10 $1.70
Dec. 31 (year end) $2.00
Feb. 8 $1.90

18
10 Dec.
Equipment 170,000
Accounts Payable (€) 170,000
Y1
100,000 x 1.70 = 170,000
31 Dec.
FC Loss 30,000
Accounts Payable (€) 30,000
(100,000 X 2.00)- 170,000 = 30,000
8 Feb.
Accounts Payable (€) 200,000 Y2
FC Gain 10,000
Cash 190,000
(100,000 X 1.90) – 200,000 = 10,000

19
 Translation of F/S’s
of Foreign Operations

(1) To the functional (2) To a presentation currency

currency (not the functional currency)

20
21
Identifying the Functional

NZ Ltd (NZL) owns a subsidiary in Hong Kong, Dragon Ltd (D)

 Case 1 – NZL manufactures all goods in New Zealand, sells them to D, who in turn
sells to Hong Kong local customers, based on a sales price determined by NZL. D
has a long-term loan from NZL which was advanced when the subsidiary was
established. All profits made by D are remitted back to NZL.
 Case 2 – D manufactures all goods in Hong Kong using local labour and sells them
to Hong Kong local customers. Selling prices are based on a 25% mark-up on cost.
The company has no long-term loans. All profits made by D are reinvested back
into the business for expansion purposes. The only remittances made to NZL are
in the form of dividends.
 Case 3 – D assembles all goods in Hong Kong using a combination of locally
sourced materials and materials manufactured by NZL. All goods are then
exported and sold in Thailand, based on selling prices determined by NZL. The
company has a small loan from a Thai bank.

22
 Case 1 Case 2 Case 3
Sales prices
HK$ HK$ Baht
Sales market
NZ$ HK$ NZ$
Expenses
NZ$ HK$ NZ$/HK$
Financing
NZ$ - Baht
Intragroup transactions
High Low Medium
Conclusion: functional
currency NZ$ HK$ ?

In Case 3, need to determine underlying economic substance of transactns/events to decide functional currency

23
 1) Translation of F/S’s
into Functional Currency
When translating a foreign operation’s F/S’s from local to
functional currency, principles used earlier in accounting
for FX transactions apply:
Foreign currency monetary amts are translated at closing rate
Non-monetary amounts are translated at appropriate historical
rates (date of transactions or re-measurement at FV, if any)

Equity and related items, Incomes and expenses* are translated

at rates on the dates of transactions.

Exchange differences are recognised in profit and loss

* = Exception for Depreciation – use rate used for associated asset
24
25
 Example 1: Vista – pg.1

On 1 Jan. 2022 Kiwi Co. established a subsidiary, Vista, in Spain. The NZ$ is the functional
currency of Vista. The following is the balance sheet of Vista at 1 Jan. 2022 in €:
Vista
Statement of Financial Position at 1 January 2022
Assets Liabilities & shareholders’ Equity
Cash 100,000 Liabilities 200,000
Plant Assets, Net 300,000 Share capital 200,000
Total Assets 400,000 Total L + E 400,000

On 31 December 2022, the subsidiary reported the following trial balance:

Amount (€)
Dr Cr
Cash 200,000
Plant Assets, Net 250,000
Liabilities 220,000
Share capital 200,000
Sales 500,000
Expenses (including $50,000 depreciation) 470,000
920,000 920,000

26
 Example 1: Vista – pg.2

Relevant exchange rates are:

1 Jan. 2022 € 1 = $NZ 2.00
Average for 2022€ 1 = $NZ 1.80
31 Dec. 2022 € 1 = $NZ 1.60

Required:
Assume that the $NZ is the functional currency of Vista and prepare:
• a translated statement of financial position as at Dec 31, 2022, and
• a translated statement of financial performance for 2022 for the foreign
subsidiary.
• include an analysis of the foreign currency exchange difference.

27
 Workings 1: Vista – pg.3
€ $NZ $NZ $NZ
Exchange rate Income Balance Sheet
statement

Cash 200,000 1.60 320,000

Plant Assets, Net 250,000 2.00 500,000

Liabilities (220,000) 1.60 (352,000)

Share capital (200,000) 2.00 (400,000)

Sales (500,000) 1.80 (900,000)

Expenses 420,000 1.80 756,000
Depreciation * 50,000 2.00 100,000
Exchange difference (24,000) 3
Net Income (68,000) 2 (68,000) 1
28
Soln 1 - Vista Translation difference
€ Exchange $NZ
Net monetary position rate

1 January 2022
- Liabilities (200,000)
- Cash 100,000 (100,000) 2.00 (200,000)

Sales 500,000 1.80 900,000

Exp (420,000) 1.8 (756,000)

Net Monetary position (56,000) *

31 December 2022
-Liabilities
(220,000) (20,000) 1.6 (32,000) **
- Cash
200,000

Gain 24,000
29
Soln 1 - Vista Translated F/S’s
Vista
Statement of financial performance for 2022
Sales $NZ 900,000
Expenses (856,000)
Exchange gain 24,000
Net income 68,000

Statement of Financial Position 31 December 2022

Cash $NZ 320,000
Plant assets, net 500,000
820,000
Liabilities 352,000
Share capital 400,000
Retained earnings 68,000
820,000

30
 (2) Translation of F/S’s from Functional
into Presentation currency
NZ IAS 21. When translating a foreign operation for inclusion in the reporting
entity’s F/S’s (ie translation from the functional to a presentation currency),

Assets and liabilities are translated at the closing rate

Equity and related items, incomes and expenses are

translated at rates at the dates of the transactions (or av.)

All resulting exchange differences are recognised as a

separate component of equity

31
32
33
 Example 2: Vista – pg.1

On 1 Jan. 2022 Kiwi Co. established a subsidiary, Vista, in Spain. The NZ$ is the functional
currency of Vista. The following is the balance sheet of Vista at 1 Jan. 2022 in €:
Vista
Statement of Financial Position at 1 January 2022
Assets Liabilities & shareholders’ Equity
Cash 100,000 Liabilities 200,000
Plant Assets, Net 300,000 Share capital 200,000
Total Assets 400,000 Total L + E 400,000

On 31 December 2022, the subsidiary reported the following trial balance:

Amount (€)
Dr Cr
Cash 200,000
Plant Assets, Net 250,000
Liabilities 220,000
Share capital 200,000
Sales 500,000
Expenses (including $50,000 depreciation) 470,000
920,000 920,000

34
 Example 2: Vista – pg.2

Relevant exchange rates are:

1 Jan. 2022 € 1 = $NZ 2.00
Average for 2022€ 1 = $NZ 1.80
31 Dec. 2022 € 1 = $NZ 1.60

Required:
Prepare the following for the foreign subsidiary:
• a translated statement of financial position as at Dec. 31, 2022, and
• a translated statement of financial performance for 2022, and
• an analysis of the foreign currency translation reserve (FCTR).

35
Workings 2: Vista – pg.3
€ $NZ $NZ $NZ
Exchange rate Income Balance Sheet
statement

Cash 200,000 1.60 320,000

Plant Assets, Net 250,000 1.60 400,000

Liabilities (220,000) 1.60 (352,000)

Share capital (200,000) 2.00 (400,000)

Sales (500,000) 1.80 (900,000)

Expenses 470,000 1.80 846,000
Net Income 54,000 (54,000)
Translation difference 86,000

36
 Solution 2: Vista - pg.4
FCTR Analysis
Opening Net Assets: 200,000 a x (1.6 - 2.0) = - $NZ 80,000
Increase in net assets :30,000 b (1.6 - 1.8) = - $NZ 6,000
Balance - $NZ 86,000

Vista
Statement of financial performance for 2022 ($NZ)
Sales 900,000
Expenses 846,000
Net income 54,000
Statement of Financial Position 31 December 2022 ($NZ)
Cash 320,000 Liabilities 352,000
Plant assets, net 400,000 Share capital 400,000
720,000 Retained earnings 54,000
Translation adjustment (FCTR) (86,000)
720,000

37