Question

On 1 January 2019, Umi Bhd, a company incorporated in Malaysia, acquired 80% interest in Adeq Ltd, a company incorporated in Singapore whose functional and presentation currencies are Singapore Dollar (S$). At this date, Adeq Ltd’s net assets were represented by share capital of S$3,000,000; revaluation reserve of S$1,000,000, and retained profit of S$1,000,000. The functional and presentation currencies of Umi Bhd are Ringgit Malaysia (RM).

Required:

a) Advise the directors of UMI Bhd of how they should consolidate and translate the foreign subsidiary’s statement of comprehensive income for the year ended 31 December 2019 and the statement of financial position as at 31 December 2019 into the presentation currency of parent company.

b) Explain whether or not UMI Bhd (reporting entity) should be allowed to present its financial statements in a currency which is different from its functional currency.

c) Assume that on 1 April 2019, UMI Bhd has spent $10million on acquiring a US trading subsidiary, Zoro Ltd and at the year-end the net assets of the US trading subsidiary are also $10m. On consolidation by UMI Bhd, the $10million net assets of the US subsidiary are translated into RM and any foreign exchange differences are taken to reserves. This means that the group’s consolidated shareholders’ funds will fluctuate up and down as exchange rates move. Advise the directors of UMI Bhd on how to reduce the risk of translation differences. Give an example if necessary.

Answer 1

Foreign currency translation is the accounting method in which an international business translates the results of its foreign subsidiaries into domestic currency terms so that they can be recorded in the books of account.

The foreign entities owned by your business keep their accounting records in their own currencies. To apply the appropriate method of these investments, one must translate the financial statements from the foreign currency into domestic currency.

The three steps in the foreign currency translation process are as follows:

DETERMINE THE FUNCTIONAL CURRENCY OF THE FOREIGN ENTITY

Businesses must determine a functional currency for reporting. The functional currency is the one which the company uses for the majority of its transactions. You can choose the currency of the country where your main headquarters are located or where your major operations are.

This can be difficult to determine when you conduct an equal amount of business in multiple countries. However, once you choose the functional currency, changes to it should be made only when there is a significant change in circumstances and economic facts.

REMEASURE THE FINANCIAL STATEMENTS OF THE FOREIGN ENTITY INTO THE FUNCTIONAL CURRENCY

You need to ensure that all your financial statements use the reporting currency.

The translation of financial statements into domestic currency begins with translating the income statement. According to the FASB ASC Topic 830, Foreign Currency Matters, all income transactions must be translated at the rate that existed when the transaction occurred.

The GAAP regulations require the items in the balance sheet be converted in accordance with the rate of exchange as on the date of balance sheet while the income statement items are converted according to the weighted average rate of exchange.

It is vital that you keep a close eye on the dates in which any of the above transactions occurred. Although most currency translation occurs at the financial year-end, the exchange rates are determined by the transaction date in some instances. Bank statements and income records help you to determine the right rates.

RECORD GAINS AND LOSSES ON THE TRANSLATION OF CURRENCIES.

The gains and losses arising from foreign currency transactions that are recorded and translated at one rate and then result in transactions at a later date and different rate are recorded in the equity section of the balance sheet.

Foreign Currency Translation Methods

Since exchange rates are constantly fluctuating, it can cause difficulty while accounting for foreign currency translations. Instead of simply using the current exchange rate, businesses may look at different rates either for a specific period or specific date.

CURRENT RATE METHOD

Using this method of translation, most items of the financial statements are translated at the current exchange rate. The assets and liabilities of the business are translated at the current exchange rate.

Since this can lead to volatility associated with changes in the exchange rate, gains and losses associated with this translation are reported on a reserve account instead of the consolidated net income account.

TEMPORAL RATE METHOD

The temporal rate method, also known as the historical method, is applied to adjust income-generating assets on the balance sheet and related income statement items using historical exchange rates from transaction dates or from the date that the company last assessed the fair market value of the account.

MONETARY-NONMONETARY TRANSLATION METHOD

The monetary-nonmonetary translation method is used when the foreign operations are highly integrated with the parent company.

The method translates monetary items such as cash and accounts receivable using the current exchange rate and translates nonmonetary assets and liabilities including inventories and property using the historical exchange rate.

What Is Foreign Currency Translation Adjustment?

The foreign currency translation adjustment or the cumulative translation adjustment (CTA) compiles all the fluctuations caused by varying exchange rate.

Businesses with international operations must translate their transactions like the acquisition of assets or the purchase of services into their functional currency. With foreign exchange fluctuations, the value of these assets and liabilities are also subject to variations.

The gains and losses arising from this are compiled as an entry in the comprehensive income statement of a translated balance sheet. According to the FASB Summary of Statement No. 52, a CTA entry is required to allow investors to differentiate between actual day-to-day operational gains and losses and those caused due to foreign currency translation.

There are different rules for translating items in financial statements including assets and liabilities, income statement items, cash flow statement items, etc. Considering its complexity, it may be best to consult an accountant regarding the rules of accounting for foreign currency translation.

a)As per the question UMI Bhd should consolidate the subsidiary's financial statements by translating Singapore Dollar into Ringgit Malaysia because UMI BHd is incorporated in Malasyia.

According to the FASB ASC Topic 830, Foreign Currency Matters, all income transactions must be translated at the rate that existed when the transaction occurred.

The GAAP regulations require the items in the balance sheet be converted in accordance with the rate of exchange as on the date of balance sheet while the income statement items are converted according to the weighted average rate of exchange.

b)A reporting currency is the currency in which an entity's financial statements or other financial documents are reported. Choosing one currency for reporting makes it easier to understand the financial documents across the board. Most often the currency used is the currency of the country in which the parent company is legally registered.In preparing financial statements, each entity—whether a stand-alone entity, an entity with foreign operations (such as a parent) or a foreign operation (such as a subsidiary or branch)—determines its functional currency in accordance with paragraphs.The entity translates foreign currency items into its functional currency and reports the effects of such translation.Many reporting entities comprise a number of individual entities (eg a group is made up of a parent and one or more subsidiaries). Various types of entities, whether members of a group or otherwise, may have investments in associates or joint ventures. They may also have branches. It is necessary for the results and financial position of each individual entity included in the reporting entity to be translated into the currency in which the reporting entity presents its financial statements. This Standard permits the presentation currency of a reporting entity to be any currency (or currencies). The results and financial position of any individual entity within the reporting entity whose functional currency differs from the presentation currency are translated in accordance with paragraphs.This Standard also permits a stand-alone entity preparing financial statements or an entity preparing separate financial statements in accordance with IAS 27 Consolidated and Separate Financial Statements to present its financial statements in any currency (or currencies). If the entity’s presentation currency differs from its functional currency, its results and financial position are also translated into the presentation currency in accordance with paragraphs.AS per IAS 21 Umi BHD is allowed to present its financial statements in a currency other than its functional currency.

c)A variety of mechanisms are in place that allow a company to use hedging to lower the risk created by translation exposure.Companies can attempt to minimize translation risk by purchasing currency swaps or hedging through futures contracts. In addition, a company can request that clients pay for goods and services in the currency of the company's country of domicile.

In addition, a company can request that clients pay for goods and services in the currency of the company's country of domicile. This way, the risk associated with local currency fluctuation is not borne by the company but instead by the client who is responsible for making the currency exchange prior to conducting business with the company.

This occurs when a firm denominates a portion of its equities, assets, liabilities or income in a foreign currency. For instance, assume the domestic division of a multinational company incurs a net operating loss of $3,000. ... Now the company as a whole must report a loss. This is an example of translation exposure