Foreign Currency Translation – Lesson 5 Summary Problem

Problem Overview

• International Inc. – a wholly-owned foreign subsidiary of Local Ltd.; both entities prepare financial statements under IFRS.
• Functional currency of International Inc. is the foreign currency unit (FCU).
• Lesson 5 illustrates foreign currency translation through a single, comprehensive case that requires conversion of Year 6 financial statements to Canadian dollars (C$) under two distinct translation models:
  • Integrated (Temporal Method) – assumes the parent’s currency is the functional currency.
  • Self-Sustaining (Current-Rate Method) – assumes the subsidiary’s currency is the functional currency.
• Technical competency targeted: 1.2.3 – Evaluate treatment for non-routine transactions.
• Learning outcome: Determine the translation of foreign operations.

Key Data: International Inc. (FCU)

• Statement of Financial Position (SFP) at December 31
  • Cash & receivables – 100\,000
  • Inventory (cost) – 650\,000
  • Capital assets (net) – 1\,250\,000
  • Patents – 250\,000
  • Total assets – 2\,100\,000
  • Accounts payable – 350\,000
  • Long-term debt – 900\,000
  • Share capital – 100\,000
  • Retained earnings – 750\,000

• Comparative Year 5 balances supplied for trend analysis.

• Statement of Comprehensive Income (SCI) – Year 6
  • Sales – 2\,500\,000
  • Cost of goods sold (COGS) – 2\,100\,000
  • Gross profit – 400\,000
  • Expenses: Depreciation 50\,000; G&A 75\,000; Selling 75\,000.
  • Profit – 200\,000.

• Statement of Changes in Equity (FCU) – Year 6
  • Opening retained earnings 600\,000.
  • Profit 200\,000.
  • Dividends declared 50\,000.
  • Closing retained earnings 750\,000.

Exchange-Rate Schedule (C$ per FCU)

• Opening (Jan 1, Year 6) – 1.05
• Average Year 6 – 1.10
• Year-end (Dec 31, Year 6) – 1.15
• Additional specific rates:
  • Capital-asset purchase (Yr 6) – 1.16
  • Patent acquisition (Yr 2) – 0.90
  • Opening inventory – 0.98
  • Ending inventory purchase – 1.18
  • Dividend declaration – 1.22
  • Date of investment (Jan 1, Yr 1) – 0.80.

Additional Narrative Notes

• Capital assets existing at Jan 1, Yr 6 were bought Jan 1, Yr 1.
• New capital assets purchased Yr 6: cost 470\,000 FCU; depreciation on the new assets 20\,000\ \text{FCU}.
• Patents deemed to have an indefinite life – no amortisation.
• Inventory purchased evenly throughout the year; sales also evenly spread.
• Functional-currency assessments drive choice of translation method:
  • Integrated → Temporal;
  • Self-Sustaining → Current rate (IAS 21, IFRS).

Required Translations

1. Integrated Operation
   • Translate SCI and SFP using the temporal method.
   • Opening retained earnings assumed translated at C\$391\,100.
2. Self-Sustaining Operation
   • Translate SCI and SFP using the current-rate method.
   • Opening translated retained earnings C\$500\,000.
   • Opening AOCI C\$155\,000.

Translation Mechanics & Conceptual Rules

• Temporal Method (Integrated)
  • Monetary assets & liabilities → year-end rate.
  • Non-monetary items at historical cost → historical rate.
  • Non-monetary items at FV → rate when FV determined.
  • Revenues & most expenses → average rate.
  • COGS → blend of historic rate for opening inventory, average for purchases, historic for ending inventory.
  • Depreciation/Amortisation → same historic rate applied to the related asset.
  • Translation difference recognised in SCI as \text{Foreign exchange gain/loss}.
  • Plug retained earnings to balance.

• Current-Rate Method (Self-Sustaining)
  • All assets & liabilities → closing rate.
  • Share capital → historical rate of initial investment.
  • Revenues & expenses → average rate.
  • Translation difference taken to \text{OCI} and accumulated in \text{AOCI}.

Solution – Integrated Operation (Temporal)

Translated SCI (C$)

• Sales: 2\,500\,000 \times 1.10 = 2\,750\,000.
• COGS (Note 1): 2\,237\,600.
• Gross profit: 512\,400.
• Depreciation (Note 2): 47\,200.
• G&A: 75\,000 \times 1.10 = 82\,500.
• Selling: 75\,000 \times 1.10 = 82\,500.
• Foreign-exchange loss (Note 3): 55\,800.
• Profit & comprehensive income: 244\,400.

Translated SFP (C$)

Assets
• Cash & A/R: 100\,000 \times 1.15 = 115\,000 (monetary).
• Inventory (cost): 500\,000 \times 1.18 = 590\,000 (historic rate of purchase).
• Capital assets (net) – composite (Note 2) 1\,162\,000.
• Patents: 250\,000 \times 0.90 = 225\,000.
• Total assets: 2\,092\,000.

Liabilities & Equity
• A/P: 350\,000 \times 1.15 = 402\,500.
• Long-term debt: 900\,000 \times 1.15 = 1\,035\,000.
• Share capital: 100\,000 \times 0.80 = 80\,000.
• Retained earnings (Note 4): 574\,500.
• Total: 2\,092\,000.

Detailed Supporting Notes

Note 1 – COGS Breakdown

\begin{aligned}
\text{Opening inventory} &:\ 270\,000\times0.98=264\,600\
\text{Purchases} &:\ (2\,100\,000-270\,000+500\,000)=2\,330\,000\times1.10=2\,563\,000\
\text{Ending inventory} &:\ 500\,000\times1.18=590\,000\
\text{COGS} &= 264\,600+2\,563\,000-590\,000 = 2\,237\,600
\end{aligned}

Note 2 – Capital-Asset Translation & Depreciation
Old assets NBV 830\,000 @ 0.80 → 664\,000 less dep’n 24\,000.
New assets cost 470\,000 @ 1.16 → 545\,200; dep’n 20\,000\times1.16=23\,200.
Net translated NBV 1\,162\,000.
Total dep’n translated 47\,200.

Note 3 – Monetary-Item Translation Adjustment
Formula: \text{FX gain/loss}=\text{(closing NA – opening NA translated at opening rate)}-\text{net cash flows translated at spot dates}.
Computed loss 55\,800.

Note 4 – Retained Earnings Reconciliation
\begin{aligned}
\text{Opening RE}&=391\,100\
+\text{Profit}&=244\,400\
-\text{Dividends}&=50\,000\times1.22=61\,000\
\text{Closing RE}&=574\,500
\end{aligned}

Solution – Self-Sustaining Operation (Current-Rate)

Translated SCI (C$)

• Sales: 2\,500\,000\times1.10 = 2\,750\,000.
• COGS: 2\,100\,000\times1.10 = 2\,310\,000.
• Gross profit: 440\,000.
• Depreciation: 50\,000\times1.10 = 55\,000.
• G&A: 75\,000\times1.10 = 82\,500.
• Selling: 75\,000\times1.10 = 82\,500.
• Profit: 220\,000.
• OCI (translation): 83\,500.
• Comprehensive income: 303\,500.

Translated SFP (C$)

Assets
• Cash & A/R: 100\,000\times1.15 = 115\,000.
• Inventory: 500\,000\times1.15 = 575\,000.
• Capital assets: 1\,250\,000\times1.15 = 1\,437\,500.
• Patents: 250\,000\times1.15 = 287\,500.
• Total assets: 2\,415\,000.

Liabilities & Equity
• A/P: 350\,000\times1.15 = 402\,500.
• Long-term debt: 900\,000\times1.15 = 1\,035\,000.
• Share capital: 100\,000\times0.80 = 80\,000.
• Retained earnings (roll-forward): 659\,000.
• AOCI: 238\,500.
• Total: 2\,415\,000.

Equity Roll-Forwards

1. Net assets reconciliation (in FCU then translated): Opening net assets 700\,000\text{ FCU} → 700\,000\times1.05=735\,000.
   • Profit 220\,000 – Dividends 61\,000 = Closing net assets 894\,000 (FCU) → 894\,000\times1.15=1\,028\,100.
     Difference vs carrying values booked to OCI 83\,500.
2. Retained earnings:
   500\,000 + 220\,000 - 61\,000 = 659\,000.
3. AOCI:
   155\,000 + 83\,500 = 238\,500.

Conceptual Take-Aways & Exam Triggers

• Identifying functional currency (IAS 21) is the first, critical step.
• Temporal vs current-rate methods affect:
  • Where translation gains/losses are reported (SCI vs OCI).
  • Which historical vs current rates apply.
• Items measured at historical cost retain historical exchange rates under temporal translation.
• Weighted-rate approach required for COGS when purchases are periodic.
• Monetary assets & liabilities always exposed to closing-rate changes under the temporal method, producing translation gains/losses.
• Dividends translate at the rate on declaration date.
• Share capital translates at the initial investment rate and is never re-measured.

Numerical Shortcuts & Exam Tips

• Keep a table of all known spot rates; annotate each asset/liability/transaction with its correct rate before calculating.
• Reconcile retained earnings (or AOCI) last – it often becomes the balancing figure that confirms accuracy.
• Show all units and exchange-rate multipliers to pick up partial-credit marks.

Ethical & Practical Implications

• Transparent disclosure of translation method & impact on equity satisfies IAS 1 presentation and IAS 21 requirements.
• Consistent application period-to-period prevents earnings manipulation through opportunistic method switching.
• Analysts must adjust for translation effects when comparing multi-national results.

Quick Formula Sheet

• Average-rate translation: \text{FC} \times \text{Average FX}.
• Historical-rate translation (temporal): \text{FC} \times \text{Rate at transaction date}.
• Current-rate translation: \text{FC} \times \text{Closing FX}.
• COGS (temporal): \text{(Opening Inv @ hist)} + \text{(Purchases @ avg)} - \text{(Ending Inv @ hist)}.
• FX Gain/Loss (temporal): change in net monetary items measured at closing rate.

Suggested Study Strategy

1. Memorise the decision tree for selecting functional currency.
2. Practise mechanical translation steps under both methods until rate selection is reflexive.
3. Re-work the provided numbers independently; verify your totals match 244\,400 profit (integrated) and 220\,000 profit plus 83\,500 OCI (self-sustaining).
4. Anticipate follow-up questions on hyper-inflationary economies, partial disposals, or re-measurement of fair-value inventories.