Question

Wahl Company’s consolidated financial statements include two wholly owned subsidiaries. One subsidiary is located in Australia and the other is located in France. The functional currency for the Australian subsidiary is the U.S. dollar. The European euro is the functional currency for the subsidiary located in France. Given this scenario, address the following with research to support your opinions: What are the objectives of translating a foreign subsidiary’s currency? Why? How do gains and losses arise from the translation or measurement of each subsidiary’s financial statements? How are these measured? The indicators listed in FASB ASC 830 which identifies economic factors to be considered, individually and collectively, in determining the functional currency for a particular subsidiary. Why are these important to consider?

Answer 1

A) What are the obejectives of translatin a foreign subsidiary's currency? Why?

The translation of the financial statements of each component entity of a reporting entity should accomplish both of the following objectives:

i. Provide information that is generally compatible with the expected economic effects of a rate change on a reporting entity’s cash flows and equity

ii. Reflect in consolidated statements the financial results and relationships of the individual consolidated entities as measured in their functional currencies in conformity with U.S. generally accepted accounting principles (GAAP).

B) How do gains and losses arise from the translation or measurement of each subsidiary’s financial statements? How are these measured?

How to translate financial statements into a Presentation Currency

When an entity presents its financial in the presentation currency different from its functional currency, then the rules depend on whether the entity operates in a non-hyperinflationary economy or not.

Non-hyperinflationary economy

When an entity’s functional currency is NOT the currency of a hyperinflationary economy, then an entity should translate:

• All assets and liabilities for each statement of financial position presented (including comparatives) using the closing rate at the date of that statement of financial position.
  Here, this rule applies for goodwill and fair value adjustments, too.
• All income and expenses and other comprehensive income items (including comparatives) using the exchange rates at the date of transactions.
  GAAP also permits using some period average rates for the practical reasons, but if the exchange rates fluctuate a lot during the reporting period, then the use of averages is not appropriate.

All resulting exchange differences shall be recognized in other comprehensive income as a separate component of equity.

However, when an entity disposes the foreign operation, then the cumulative amount of exchange differences relating to that foreign operation shall be reclassified from equity to profit or loss when the gain or loss on disposal is recognized.

Hyperinflationary economy

If the economy qualifies as hyperinflationary, the financial statements are remeasured as if the reporting parent company’s reporting currency were the functional currency. Any exchange differences are reported in income.

C) ASC 830-10-55-5 states the following economic factors, and possibly others, should be considered both individually and collectively when determining the functional currency:

i) Cash flow indicators

1. Foreign currency. Cash flows related to the foreign entity’s individual assets and liabilities are primarily in the foreign currency and do not directly affect the parent entity’s cash flows.

2. Parent’s currency. Cash flows related to the foreign entity’s individual assets and liabilities directly affect the parent’s cash flows currently and are readily available for remittance to the parent entity.

ii) Sales price indicators

1. Foreign currency. Sales prices for the foreign entity’s products are not primarily responsive on a short-term basis to changes in exchange rates but are determined more by local competition or local government regulation.

2. Parent’s currency. Sales prices for the foreign entity’s products are primarily responsive on a short-term basis to changes in exchange rates; for example, sales prices are determined more by worldwide competition or by international prices.

iii) Sales market indicators

1. Foreign currency. There is an active local sales market for the foreign entity’s products, although there also might be significant amounts of exports.

2. Parent’s currency. The sales market is mostly in the parent’s country or sales contracts are denominated in the parent’s currency.

iv) Expense indicators

1. Foreign currency. Labor, materials, and other costs for the foreign entity’s products or services are primarily local costs, even though there also might be imports from other countries.

2. Parent’s currency. Labor, materials, and other costs for the foreign entity’s products or services continually are primarily costs for components obtained from the country in which the parent entity is located.

v) Financing indicators

1. Foreign currency. Financing is primarily denominated in foreign currency, and funds generated by the foreign entity’s operations are sufficient to service existing and normally expected debt obligations.

2. Parent’s currency. Financing is primarily from the parent or other dollar-denominated obligations, or funds generated by the foreign entity’s operations are not sufficient to service existing and normally expected debt obligations without the infusion of additional funds from the parent entity. Infusion of additional funds from the parent entity for expansion is not a factor, provided funds generated by the foreign entity’s expanded operations are expected to be sufficient to service that additional financing.

vi) Intra-entity transactions and arrangements indicators

1. Foreign currency. There is a low volume of intra-entity transactions and there is not an extensive interrelationship between the operations of the foreign entity and the parent entity. However, the foreign entity’s operations may rely on the parent’s or affiliates’ competitive advantages, such as patents and trademarks.

2. Parent’s currency. There is a high volume of intra-entity transactions and there is an extensive interrelationship between the operations of the foreign entity and the parent entity. Additionally, the parent’s currency generally would be the functional currency if the foreign entity is a device or shell corporation for holding investments, obligations, intangible assets, and so forth, that could readily be carried on the parent’s or an affiliate’s books.