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RESOURCE STUDY NOTES

In this issue:
Paper E1 Paper F2
Enterprise
Operations Financial
Management
Paper T4 part B Many businesses have to deal with multiple
Test of Professional currencies, so F2 students are expected to be
Competence in able to explain currency translation principles
Management
and consolidate a group’s foreign subsidiaries –
Accounting
an area that’s always challenging in the exam
By Eric Leung

Every entity should have its functional or home currency


– ie, the currency of the economic environment in which it
mainly generates and expends cash. In order to determine
the functional currency, you first need to consider the
following set of primary factors:
– The currency in which the entity’s goods are priced or
the sales revenues are collected.
– The currency of the country whose competitive forces
and regulations most influence the price of the goods.
– The currency in which costs such as labour and materials
are denominated and settled, or the currency that
influences such costs.
If you can’t make a definitive conclusion based on these,
you’ll need to consider the following secondary factors:
– The currency in which funds from financing activities
(debt and equity) are generated.

STUDY NOTES

– The currency in which receipts from operating activities


are retained – ie, the currency in which the entity maintains
its excess working capital balances.
Tap to reveal a These factors will normally need to be considered when
chart on how the primary factors don’t point to a single currency – eg,
to account for
when the “sales” factor shows euros to be the functional
foreign currency
currency while the “cost” factor indicates dollars.
transactions for
a single entity
Foreign currency transactions in one entity
In essence, there are two steps to dealing with a foreign
currency transaction: initial recognition and subsequent
measurement. On the initial recognition, the amount of
foreign currency involved has to be converted to the entity’s
functional currency by applying the spot exchange rate
between the currencies at the transaction date.
The subsequent measurement step is more complicated
because monetary items and non-monetary items require
different accounting treatments. Monetary items are
defined by IAS21 as “money held, and assets and liabilities
to be received or paid, in a fixed or determinable number
of units of currency”. Examples include cash, accounts
receivable and accounts payable. Non-monetary items
are characterised by the “absence of the right to receive,
or obligation to deliver, a fixed or determinable number
of units of currency”. Examples include inventories, plant
and equipment, and investments in equity instruments.
Tap the button at the top of this page to see a chart
illustrating how to account for each type of item.

The consolidation of foreign subsidiaries


In a group context, when an entity determines the
functional currency of a foreign operation – eg, an overseas
subsidiary – the relationship between the two organisations
need to be considered. There are two possible scenarios.
One is that the overseas operation has a significant degree
of autonomy – eg, inter-company transactions are

STUDY NOTES

infrequent. In this case, the functional currency of the


foreign subsidiary is that entity’s local currency. The
alternative scenario is that the foreign operation is an
extension of the parent – eg, inter-company transactions
are frequent – and it depends on the parent company for
financing. In this case, the subsidiary takes the parent’s
functional currency.
The essence of consolidating foreign subsidiaries is
that their financial statements are presented in a different
currency from that of their parent’s presentation currency.
An important first step in the consolidation process is to
translate the statements of the foreign operation into the
parent’s presentation currency. The method to use is
determined as shown in the diagrams below.

Scenario 1: foreign subsidiary has significant autonomy

Foreign operation’s Foreign operation’s Presentation currency


financial statements:
local currency
= ≠ functional currency:
local currency
of parent company’s
financial statements: £

Translation
process (closing
rate method)

Scenario 2: foreign subsidiary is an extension of the parent’s operation

Foreign operation’s Foreign operation’s Presentation currency


financial statements:
local currency
≠ = functional currency:
parent’s currency (£)
of parent company’s
financial statements: £

Remeasurement
process (temporal
or historical
rate method)

STUDY NOTES

In this article I shall focus on illustrating the rules for


translation using the closing rate method in the first
scenario – ie, that of a subsidiary with significant autonomy.
These are as follows:
– Items on the statement of profit or loss and other
comprehensive income are translated using the rate on the
transaction date, although average rates are acceptable.
– Assets and liabilities are translated using the closing rate.
– Dividends paid during the year are translated using the
rate on the date of payment.
– Share capital and pre-acquisition reserves are translated
using the rate on the date of acquisition.
– The remaining balance in equity is the “plug-in” figure
for post-acquisition reserves.
You would be well advised to master basic
consolidation techniques such as goodwill calculations
under IFRS 3 (revised) and the implication behind non-
controlling interests (NCI), together with how the NCI
figures should be determined. On top of these methods,
there are two key “top-ups” for the consolidation of
foreign subsidiaries:
– Goodwill and fair-value adjustments to the carrying
amounts of net assets are treated as net assets of foreign
operations, so they will be translated in the same way
as any other net assets of the acquired subsidiary. If the
closing rate method is applied, goodwill and fair-value
adjustments have to be retranslated every year-end at
the closing rate, giving rise to a translation gain or loss.
– If the closing rate method is applied, the translation
gain or loss is reported in the other comprehensive income
(OCI) section of the consolidated financial statements.

Worked example
TW plc acquired 75 per cent of the equity share capital
of EQ Ltd on 1 January 2012 for $80m when the reserves of

STUDY NOTES

EQ were $80m. The investment is held at cost in the


individual financial statements of TW. No share capital
has been issued since the acquisition.
On the date of the acquisition, it was assessed that EQ
had a brand worth $10m. This was not recorded in EQ’s
financial statements in accordance with IAS 38. The brand
was considered impaired by 31 December 2012 and was
valued at $6m.
It is the group’s policy to measure non-controlling
interests at fair value on the date of acquisition. The fair
value of the NCI in EQ was $26m on the acquisition date.
The goodwill arising on the acquisition was assessed to be
impaired by 10 per cent by 31 December 2012.
The relevant exchange rates are as follows:
– $1:£0.6 on 1 January 2012.
– $1:£0.8 on 31 December 2012.
– $1:£0.75 on average for the year 2012.
The functional currencies of TW and EQ are pounds
and dollars respectively.
Extracts from the financial statements of TW and EQ
are presented below and on the following page.

Summarised statements of profit or loss for the year ended 31 December 2012

TW EQ
£000 $000
Revenue 500,000 180,000
Cost of sales (380,000) (75,000)
Gross profit 120,000 105,000
Operating expenses (70,000) (90,000)
Profit before interest and tax 50,000 15,000
Finance charge (2,000) (1,000)
Profit before tax 48,000 14,000
Income tax (18,000) (4,000)
Profit for the year 30,000 10,000

STUDY NOTES

Statements of financial position at 31 December 2012


TW EQ
ASSETS £000 $000
Non-current assets
Property, plant and equipment 102,000 98,000
Investment in EQ 48,000 –
Current assets 70,000 27,000
Total assets 220,000 125,000
EQUITY AND LIABILITIES
Equity
Share capital (£1 shares/$1 shares) 40,000 10,000
Reserves 130,000 90,000
Total equity 170,000 100,000

Liabilities 50,000 25,000
Total equity and liabilities 220,000 125,000

The first step of the closing rate method is relatively


straightforward: translate EQ’s statements from dollars to
pounds using the five rules stated earlier in the article.

Working 1a: statement of EQ’s profit or loss for the year ended 31 December 2012

EQ Exchange rate EQ
$000 £000
Revenue 180,000 0.75 135,000
Cost of sales (75,000) 0.75 (56,250)
Gross profit 105,000 78,750
Operating expenses (90,000) 0.75 (67,500)
Profit before interest and tax 15,000 11,250
Finance charge (1,000) 0.75 (750)
Profit before tax 14,000 10,500
Income tax (4,000) 0.75 (3,000)
Profit for the year 10,000 7,500

STUDY NOTES

Working 1b: statement of EQ’s financial position at 31 December 2012


EQ Exchange rate EQ
ASSETS $000 £000
Property, plant and equipment 98,000 0.8 78,400
Current assets 27,000 0.8 21,600
Total assets 125,000 100,000
EQUITY AND LIABILITIES
Equity
Share capital ($1 shares) 10,000 0.6 6,000
Reserves – pre-acquisition 80,000 0.6 48,000
Reserves – post-acquisition (balance) 10,000 Balancing figure 26,000
Total equity 100,000 0.6 80,000

Liabilities 25,000 0.8 20,000
Total equity and liabilities 125,000 100,000

The second step is goodwill translation. Calculating


goodwill in dollars should not be a problem, but most

Working 2: translating goodwill


EQ Exchange rate EQ
$000 £000
Consideration paid 80,000 0.6 48,000
Plus fair value of NCI 26,000 0.6 15,600
106,000 63,600
Less fair value of net identifiable assets:
Share capital (10,000) 0.6 (6,000)
Reserves at acquisition date (80,000) 0.6 (48,000)
Fair-value adjustment (brand) (10,000) 0.6 (6,000)
Goodwill on acquisition 6,000 0.6 3,600
Impairment: 10% (600) 0.8 (480)
Gain on translation of goodwill xxxxxx Balancing figure 1,200
Goodwill at 31 December 2012 5,400 0.8 4,320

STUDY NOTES

students who sat F2 in May 2013’s failed to re-translate it.


Working 2 on the previous page provides a template for
calculating any goodwill impairment and the gain or loss on
translation of goodwill. You must ensure that the final
balance of goodwill is re-translated using the closing rate
($1: £0.8). Also, the translated goodwill must be inserted in
the consolidated statement of financial position (SOFP).
The third step is to calculate the translation gain or loss
for the year. This is a unique process in the consolidation of
foreign subsidiaries – and here students have had problems
both in arriving at a correct figure and in incorporating the
figure in the financial statements.
Fair-value adjustment (ie, brand) is considered an asset
of the foreign operation, so it’s subject to translation at the
closing exchange rate. The impairment loss of the brand is
translated using the average rate.

Working 3a: fair-value adjustment (brand) translation


EQ Exchange rate EQ
$000£000
Fair-value adjustment at 1 January 2012 10,000 0.6 6,000
Less impairment (4,000) 0.75 (3,000)
Gain on translation of fair value adjustment xxxxxx Balancing figure 1,800
Fair-value adjustment at 31 December 2012 6,000 0.8 4,800

Working 3b: total translation gain or loss for the year


All workings in $000
Closing net assets at closing rate: 0.8 x $100,000 (per SOFP) 80,000
Less profit for the year: 0.75 x $10,000 (per SOPL) (7,500)
Less opening net assets at opening rate: 0.6 x [$80,000 reserves at
acquisition + $10,000 share capital at acquisition date]  (54,000)
Translation gain on net assets of subsidiary 18,500
Plus translation gain on fair-value adjustment (working 3a) 1,800
Plus translation gain on goodwill (working 2) 1,200
Total translation gain for the year ended 31 December 2012 21,500

STUDY NOTES

A translation gain or loss arises as a result of the


subsidiary’s net assets; fair-value adjustments arising
from acquisition; and goodwill. The translation gain or loss
for the year goes in the consolidated statement of OCI.
IAS 1 (revised) requires an entity to group items in OCI on
the basis of whether they are potentially “reclassifiable”
to profit or loss subsequently. In this example, the exchange
difference should be regarded as an item that may be
reclassified to profit or loss under IAS 21.
The fourth step is to reconcile the NCI for the year. We
start by tackling the basic NCI calculations. Other than the
subsidiary’s profit, impairment of brand has to be shared
with NCI. Impairment of goodwill is shared with NCI in this
case, since the group chose to measure NCI using fair value
on the acquisition date. If it chose to measure NCI using the
proportionate share of net assets on acquisition, there
would be no sharing of such impairment with NCI because
NCI did not initially share any goodwill under this approach.
Specific to the consolidation of a foreign subsidiary, the
translation gain or loss on net assets (including fair-value
adjustment) of subsidiary – a £20,300,000 gain here –
needs to be shared with NCI under any circumstances. But

Working 4: reconciling the NCI for the year


$000 Exchange rate£000
Profit of subsidiary for the year 10,000
Less impairment of brand (4,000)
Adjusted profit 6,000 0.75 4,500
Less impairment of goodwill (working 2) (480)
 4,020

NCI share of profit: 25% x 4,020 1,005


Plus 25% gain on translation: 25% x 21,500 (working 3b) 5,375
NCI share of total comprehensive income 6,380

STUDY NOTES

Working 5: reconciling the consolidated retained reserves at 31 December 2012


All workings in $000 TWEQ
Retained reserves of TW at 31 December 2012 130,000
Post-acquisition retained reserves of EQ (from working 1) 26,000
Less impairment of goodwill (from working 2) (480)
Less impairment of brand (from working 3a) (3,000)
Plus translation gain on goodwill (from working 2) 1,200
Plus translation gain on fair-value adjustment (from working 3a) 1,800
25,520
Group share of adjusted retained reserves: 75% x 25,520 19,140
Consolidated retained reserves 149,140

the translation gain or loss on goodwill – a £1,200,000 gain


here – is shared with NCI only because the group measured
NCI at fair value on acquisition. There would be no sharing
if the group had instead measured NCI using proportionate
share of net assets on acquisition because, again, NCI did
not initially share any goodwill under this approach.
The fifth step is to reconcile the consolidated retained
reserves at 31 December 2012, which should be relatively
straightforward. The consolidated retained reserves include
both the retained reserves of TW and the share of adjusted
post-acquisition retained reserves of EQ.
The final step is to draft the pro-forma statements.
Don’t forget to: insert lines for goodwill and NCI; include
fair-value adjustments in appropriate items; present the
exchange difference as OCI; and attribute profit and total
comprehensive income both to the equity holders of the
parent and to NCI. Tap the button below to reveal TW
group’s consolidated statement of profit or loss and other
comprehensive income, and its consolidated statement of
financial position.
Eric Leung Yiu Wing is a
lecturer at the Chinese
University of Hong Kong.

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