Title LM03 Multinational Operations IFT Notes.pdf ✅

LM03 Multinational Operations 2023 Level II Notes © IFT. All rights reserved 1 LM03 Multinational Operations 1. Introduction ........................................................................................................................................................ 2 1.1 Foreign Currency Transactions .......................................................................................................... 2 2. Disclosures Related to Foreign Currency Transaction Gains and Losses ................................... 5 3. Translation of Foreign Currency Financial Statements ..................................................................... 5 3.1 Translation Conceptual Issues ............................................................................................................ 5 4. Translation Methods ....................................................................................................................................... 6 5. Illustration of Translation Methods .......................................................................................................11 6. Translation Analytical Issues ....................................................................................................................13 7. Translation in a Hyperinflationary Economy .....................................................................................15 8. Using Both Translation Methods .............................................................................................................15 8.1 Disclosures Related to Translation Methods .............................................................................. 16 9. Multinational Operations and a Company’s Effective Tax Rate ...................................................16 10. Additional Disclosures on the Effects of Foreign Currency ........................................................17 10.1 Disclosures Related to Sales Growth ...........................................................................................17 10.2 Disclosures Related to Major Sources of Foreign Exchange Risk ....................................17 Summary ................................................................................................................................................................18 This document should be read in conjunction with the corresponding reading in the 2023 Level II CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2022, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute. Version 1.0
LM03 Multinational Operations 2023 Level II Notes © IFT. All rights reserved 2 1. Introduction Many companies engage in transactions outside their national borders. Exporters who will receive foreign currency in the future carry foreign currency receivables on their books. Similarly, importers who will pay in foreign currency in future carry foreign currency payables on their books. As the exchange rate fluctuates over time, the value of the foreign currency receivables and payables also fluctuates. Also, companies may have subsidiaries in foreign countries. The subsidiaries usually keep accounting records in the currency of the country in which they are located. In order to prepare consolidated financial statements, the parent company is required to translate the foreign currency financial statements of its subsidiaries into its own currency. This reading focuses on accounting for these two scenarios: (1) foreign currency transactions and (2) translation of foreign currency financial statements. 1.1 Foreign Currency Transactions Before discussing foreign currency transactions, it is important to understand the following definitions: Presentation currency: This is the currency in which financial statement amounts are presented. Generally, it is the currency of the country where the company is located. Functional currency: This is the currency of the primary economic environment in which an entity operates. Foreign currency transaction: This is a transaction in any currency other than the functional currency of a company. Two types of foreign currency transactions that result in a foreign currency asset or liability are:  Import / Export  Lending / Borrowing Foreign Currency Transaction Exposure to Foreign Exchange Risk Transaction exposure related to imports and exports can be summarized as follows: Import Purchase: Here the importer is required to pay in foreign currency and the settlement date falls after the purchase date. The importer is exposed to the risk that the functional currency may weaken against the foreign currency. This will increase the amount of the functional currency that he is required to pay. For example, consider a US company that imports goods from Mexico and is required to pay in Mexican Pesos. The company is exposed to the risk that the US dollar may weaken against the Mexican Peso. Export Sales: Here the exporter agrees to be paid in foreign currency and the settlement
LM03 Multinational Operations 2023 Level II Notes © IFT. All rights reserved 3 date falls sometime after the sale date. The exporter is exposed to the risk that the functional currency may strengthen against the foreign currency. This will decrease the amount of functional currency that he will receive. For example, consider a US company that exports goods to the UK and agrees to be paid in pounds. The company is exposed to the risk that the US dollar may strengthen against the pound. Both US GAAP and IFRS require the change in the value of foreign currency asset or liability resulting from foreign currency transaction to be treated as a gain or loss reported on the income statement. If the balance sheet date falls between the transaction date and the settlement date, the foreign currency account receivable / account payable is translated at the exchange rate at the balance sheet date. The change in the value of account receivable / account payable is recognized as a foreign currency transaction gain or loss in income. However, these gains and losses are unrealized at the time they are recognized and might or might not be realized when the transactions are settled. Example: Accounting for Foreign Currency Transactions with Settlement before the Balance Sheet Date (This is based on Example 1 of the curriculum.) FinnCo purchases goods from its Mexican supplier on 1 November 20X1; the purchase price is 100,000 Mexican pesos. Credit terms allow payment in 45 days, and FinnCo makes payment of 100,000 pesos on 15 December 20X1. FinnCo’s functional and presentation currency is the euro. Spot exchange rates between the euro (EUR) and Mexican peso (MXN) are as follows: 1 November 20X1 MXN1 = EUR0.0684 15 December 20X1 MXN1 = EUR0.0703 FinnCo’s fiscal year end is 31 December. How will FinnCo account for this foreign currency transaction, and what effect will it have on the 20X1 financial statements? Solution: Amount that FinnCo could have paid for its inventory on the date of purchase, i.e., 1 November 20X1 = MXN100,000 × EUR0.0684 = EUR6,840 Amount actually paid by the company on 15 December 20X1 = MXN100,000 × EUR0.0703 = EUR7,030 By deferring payment, the net result is a loss of EUR7,030 – EUR6,840 = EUR190 Although the cash outflow to acquire the inventory is EUR7,030, the cost included in the inventory account is only EUR6,840. The remaining EUR190 is reported as a foreign exchange loss in net income for 20X1. This is a realized loss.
LM03 Multinational Operations 2023 Level II Notes © IFT. All rights reserved 4 Example: Accounting for Foreign Currency Transaction with Intervening Balance Sheet Date (This is based on Example 2 of the curriculum.) FinnCo sells goods to a customer in the United Kingdom for £10,000 on 15 November 20X1, with payment to be received in British pounds on 15 January 20X2. FinnCo’s functional and presentation currency is the euro. Spot exchange rates between the euro (€) and British pound (£) are as follows: 15 November 20X1 £1 = €1.460 31 December 20X1 £1 = €1.480 15 January 20X2 £1 = €1.475 FinnCo’s fiscal year end is 31 December. How will FinnCo account for this foreign currency transaction, and what effect will it have on the 20X1 and 20X2 financial statements? Solution: The change in value of the accounts receivable from the date of sale to the balance sheet date, i.e., from 15th Nov to 31st Dec is recognized as a foreign currency transaction gain or loss in the 20X1 income statement. So, the company will report a transaction gain of £10,000 × (€1.48 – €1.46) = €200. Note that this is an unrealized gain. The change in value of the accounts receivable that occurs from the balance sheet date to the settlement date, i.e., from 31st Dec to 15th Jan is recorded as a foreign currency transaction gain or loss in the 20X2 income statement. So the company will report a transaction gain of £10,000 × (€1.475 – €1.480) = -€50 (i.e., a transaction loss of €50). The total change from the transaction date to the settlement date = £10,000 ×(€1.475 – €1.460) = €150. This was accounted by showing a gain of €200 in 20X1 and a loss of €50 in 20X2. Impact of Change in Exchange Rate Whether a change in exchange rate results in a foreign currency gain or loss depends on:  The nature of exposure to foreign exchange risk (asset or liability)  The direction of change in the value of the foreign currency (strengthens or weakens) Foreign currency Transaction Type of Exposure Strengths Weakness Export sale Asset (account receivable) Gain Loss Import purchase Liability (account payable) Loss Gain Analytical Issues Both IFRS and US GAAP require FX gains and losses to be reported in net income even if they