Multinational Operations

Question 1

What is the definition of local currency
How about funcitonal currency
How about presentation currency
What is the other name of the presentation currency

Answer 1

Local currency is the national currency of the country where the subsidiary is located
Functional currency is the currency of THE PRIMARY ECONOMIC ENVIRONMENT.
The presentation currency is the currency in which the parent company prepares its consolidated financial statements.

Question 2

What are some of the ways that ownership firms use to work out which functional currency to use, and when might the local currency and the functional currency be different. Give two examples.

Answer 2

Management will assess both primary and secondary factors.
Sales Prices, which currency mainly influences the sales price of goods and services
Cost drivers what currency influences labor materials and other costs
Financing. What currency are funds from financing activities generated
Cash retention what currency are receipts paid.
Example 1 is when there is a well integrated subsidary, like a Japanese’s firm who is part of a large us organisation that is just used as a sales vehicle, they might choose to make the functional currency different to the local currency.
Example two might be when a Canadian firm that has a French subsidiary, sells most goods in the us. This example is called a third country example. The key with this example that they expend and receive cash mainly in the us.

Question 3

What is the hyperinflation rule and is it applicable under US GAAP or IFRS
Do you use the current rate or the temporal rate

Answer 3

Under US GAAP if a country operates in an economy with over 100% inflation over 3 years, then the local currency cannot be used as the functional currency. Therefore the PARENT’S presentation currency is automatically considered the functional currency. You use the temporal rate here

Question 4

What is the difference in how strict management must be regarding the choice of the functional currency under IFRS and USGAAP

Answer 4

Under IFRS there is a hierarchical structure, where management must look at primary indicators like sales and cost drivers first, and then if they are mixed they look at secondary indicators, like financing and cash retention.
Under US GAAP there is not a hierarchical structure, as management will look at all indicators together and work out what the best currency to use is.
Under IFRS the hyperinflation rule is slightly different. Under IFRS the functional currency is actually retained regardless of the inflation level, however the financial statements must be restated for local inflation using a general price index before being translated at the exchange rate.

Question 5

What is the definition of foreign currency transaction exposure?

Answer 5

Foreign currency transaction exposure is when a company has transactions that are denominated in a currency other than the functional currency.
Transactions are measured in the firms reporting currency using the spot exchange rate

Question 6

How do you work out if there are gains and losses on transaction exposure and what do you do if it exists

Answer 6

Foreign currency risk exists when there is a difference between the transaction date and the payment date.
If the exchange rate changes between the date the transaction was recorded and the date the payment was made the firm has to recognise a realised gain or loss. This is recorded on the income statement.

Question 7

What are the three basic steps of transaction exposure?

Answer 7

The transaction date - this is the date that you initially record the purchase.
The balance sheet date - if the transaction has not been settled by the time the firm prepares the financial statements, then the firm must adjust the balance sheet amount. Based on the exchange rate on the balance sheet DATE
And change int he cake between he transaction date and the balance sheet date is recognised as an unrealised gain or loss on the income statement.
The settlement date - when the transaction is settled int he new period oyu recognise and additional gain or loss based ont he exchange rate change since the LAST BALANCE SHEET DATE.

Question 8

What are the analyst issues with the transaction exposure and how do the accounting standards deal with these.

Answer 8

Accounting standards do not say whether these gains and losses should be recorded as Operating income, or non operating income.
You therefore have to be able to work out if the company includes these as operating income or non operating income, and be able to work out the impact on financial ratios depending on where they are classified.
You also have to realise that on the balance sheet these are not realised gains or losses, they are just holding values based on an unrealised receivable, they could get worse or they could get better.

Question 9

What is meant by the assymetry of transaction risk

Answer 9

This type of risk only affects companies whose transaction is denominated in a currency other than their functional currency. For example a us company selling to an Italian firm in Eur, the American company is exposed to exchange rate risk. If the exchange rate fluctuates then it’s only the American firm which has to recognise a gain or loss.

Question 10

What is the classification of an export sale and what happens when the currency strengthens and depreciates

Answer 10

It’s a receivable in both cases and when it strengthens you get a gain and when it weakens you get a loss

Question 11

What is the classification of an import purchase and what happens when the currency strengthens and weakens

Answer 11

It’s a payable and when the currency strengthens the income statement records a loss and when it weakens you record a gain.

Question 12

What are the two methods of translation

Answer 12

The current rate method (translation) - this is used when the functional currency is different from the parent’s presentation currency.
The temporal method (re measurement) - used when the functional currency is the same as the parents presentation currency. This is usually applied when the subsidary is more well integrated with the parent.

Question 13

What do you do if the local, functional and presentation currency all differ?

Answer 13

You must first use the temporal method to move from the local currency to the cuntional currency and then use the current rate method to move from the functional to the presentation.

Question 14

Explain the current rate method (translation) in full and when you should use it.

Answer 14

Translation is used when the functional currency is DIFFERENT from the parent’s presentation currency

Under this method the basic premise is to translate the accounts while maintaining the original financial relationships (ratios).
On the balance sheet all assets and liabilities are translated at the CURRENT exchange rate. (The rate on the balance sheet date). The capital stock is translated at the HISTORICAL rate.
On the income statement all revenues and expenses are translated and the average exchange rate for the reporting period.
The resulting gain or loss is reported in shareholders equity as a separate component called the CUMULATIVE TRANSLATION ADJUSTMENT CTA
The exposure is the subsidiary’s net asset position.

Question 15

Explain the temporal method (re measurement) and when it would be used

Answer 15

Under the temporal method the subsiday’s books are effectively and extension of the parent’s funcitonal currency.
There is a distinction here on the balance sheet between monetary and non monetary items
Monetary items are cash receivables and payables (all time frames) are translated at CURRENT RATES
Non Monetary items like assets and pre are translated at HISTORICAL RATES Non

On the income statement revenues and expenses are translated at the AVERAGE RATE however expenses related to non monetary assets COGS AND DEPRECIATION are translated at the historical assets used for the underlying assets.

The resulting gain or loss is reported directly in the income statement.

The balance sheet exposure is the net monetary asset or liability position.

Question 16

What is the accounting treatment under IFRS and US GAAP for hyperinflation

Answer 16

For both the definition of hyperinflation is 100% price growth over 3 years
Under IFRS the foreign statement must be restated for LOCAL INFLATION using a general price index. And then translated into the presentation currency using the CURRENT EXCHANGE RATE.
Under US GAAP the TEMPORAL METHOD must be usd where the parents presentation currency is automatically treated as the functional currency.

Question 17

What is the economic impact of holding monetary assets or monetary liabilities under hyperinflation

Answer 17

Under hyperinflation if oyu hold monetary assets you see a purchasing power loss whereas if oyu hold monetary liabilities you receive a purchasing power gain.

Question 18

What is the definition of a pure ratio + mixed ratio

Answer 18

Pure ration si where the numerator and the denominator come from the income statement or the balance sheet and they are not affected but the current rate method however they are affected by the temporal method.
Mixed ratios are ratios that combined the items from both statements. ROA/Turnover. They will differ from local currency ratios undue to current rate method because the numerator and the denominator use different methods, one uses the average rate and the other uses the historical rate.

Question 19

What is the directional impact of a subsidary’s currency depreciating, will mixed ratios appear larger or smaller

Answer 19

After translation under the current rate method the mixed ratios will look larger because the denominator (current rate) is smaller than the average rate.

Question 20

When do you use the 3 step method

Answer 20

When the local currency and the functional currency and the presentation currency are all different

Question 21

What are the steps that oyu must go through using the 3 step method for converting financial statements.

Explain this for a US parent company which has a German Subsidary that conducts its Business in Switzerland

Answer 21

Step 1
Remeasure the financial statements from he local currency into the functional currency. Using the TEMPORAL METHOD.
Step 2
Translate the financial statements from the fuinctional currency to the presentation/reporting currency. Using the current rate method.
Step 3
Consolidate the results into the parents financial statements

The PC = USD
The LC = EUR
The FC = CHF

Question 22

What is the effect of exchange rates on sales

Answer 22

Under both methods sales are generally translated using the average exchange rate for the period.
This means that if the currency appreciates during the period (the Functional currency appreciates agains the presentation currency) then the company will report higher translated sales.

Question 23

Where is the translation adjustment reported under the current rate method and the temporal method

Answer 23

Under the current rate method, the translation adjustment us reported in Equity (CTA) whereas under the temporal method it is reported under NI (income statement)

Question 24

How do you find the exposure under hte current rate method versus the temporal method?

Answer 24

The exposure under the current rate method is shown by the net asset position, and under the temporal method it’s show under the net monetary asset/liability position.

Question 25

How can a firm limit exposure to currency fluctuations under the temporal method

Answer 25

It can limit exposure by balancing the monetary assets and the liabilities under the temporal method. This is much harder to do under the current rate method because it requires eliminating shareholder equity.

Question 26

How do you calculate retained earnings under the current method How do you calculate the Cumulative translation adjustment

Answer 26

You translate assets and liabilities at the year end rate, then translate the common stock at the current rate (rate when the stock was issued) then you take the beginning retained earnings and add the current period’s translated net income, and subtract the translated dividends The CTA is the plug in the formula that forces the assets = liabilities + equity. And it is reported in shareholders equity. Have to remember that the translation gain or loss does not hit the income statement.

Question 27

What is the exception to the rule of non monetary items under the temporal method

Answer 27

Non monetary items are translated at historical rates, however if it is carried at fair value it is remeasured at the current rate.

Question 28

How do you calculate the re measurement gain or loss on the temporal method

Answer 28

Reported directly in the income statement. The re measurement gain or loss is the difference between the earnings before and after the translation effect is considered.

Question 29

Will net income be more volatile under the temporal method or the current rate method and why Is it possible for one method to show a gain and another a loss

Answer 29

The temporal method because the translation adjustment is recognised in the income statement rather than hidden in equity. Yes

Question 30

What is the difference between a net asset position and a net monetary position. What method shows what and why does each occur Give an example of when the firm would report a translation gain in the financial statements

Answer 30

Net asset position is shown in the current rate method, and is when the total assets of the firm exceed the total liabilities. Because this is the definition of equity this is what is at risk under the current rate method. The net monetary position is based on the difference between monetary assts and its monetary liabilities. This shows up under the temporal method. Most firms are in net monetary liabilities because they have relatively little cash and have significant debt. They would report a translation gain when the firm has a net monetary liability and the currency depreciates. This is because it is now cheaper to pay off in the parent’s currency. Given that non monetary items are translated at historical exchange rates, they’d annoy create a translation gain or loss. However monetary items are translated at the current rate, the exchange rate fluctuations can create a translation gain or loss. If everything ont he balance sheet was translated at the current rate, the exposure would be the company’s entire net asset position. By locking in the non monetary assets the temporal method shifts the exposure strictly to the net monetary items.

Question 31

What is the definition of a pure ratio

Answer 31

A pure ratio is where all the components come from the same set of financial statements

Question 32

What is the definition of a mixed ratio?

Answer 32

A mixed ratio combines inputs from both the income statement and the balance sheet.

Question 33

What is the impact on pure ratios under the current rate method and the temporal method what method does the current ratio use on the income statement and the balance sheet

Answer 33

Under the current rate method pure balance sheet and putter income statement ratios are unaffected by translation. Because the method uses the SAME METHOD for all items in the statements. It uses the current rate for the balance sheet and the average rate for the income statement. Under the temporal method pure ratios are almost always distorted. This is because different components within the same statement are translated at different rates. (Monetary and non monetary assets for example)

Question 34

What is the impact on mixed ratios of the current method and the temporal method. Explain the impact of the fixed asset turnover in a depreciating local currency environment under both methods

Answer 34

Mixed ratios combine inputs from the different financial statements, and as such the current rate methods will always differ from local currency ratios because the numerator and the denominator are translated using different methods. The directional impact when the currency is weakening (depreciating) relative to the parent’s currency is that the average rate (numirator) will be larger than the ending current rate. This means that mixed ratios will be larger than the original currency ratios. When it’s appreciating this relationship is the other way round. The choice of method significantly impacts the final ratio value.

Question 35

Is net income more volatile under the current or temporal method and why

Answer 35

Usually more volatile under the temporal method because the re measurement gain is reported directly in the income statement. Under the current rate method it is hidden in equity

Question 36

Are total assets higher or lower in a depreciating currency environment

Answer 36

Total assets will be lower under the current rate method because they are measured at the fully depreciated rate whereas under the temporal method the non monetary assets are locked at the higher historical rate resulting in higher reported assets.

Question 37

Is gross profit margin higher under the temporal or the current method.

Answer 37

Under the temporal method gross profit depends on LIFO OR FIFO if a firm uses Fife and the fur rent is depreciating the temporal method results in higher cogs. The current rate cogs are lower because Fife cogs uses higher historical rates.

Question 38

what is the definition of hyperinflation, and what does the annual compounded inflation rate need to be over this period to acchieve this rate

Answer 38

over 100% inflation over 3 years, with an annual compounded inflation rate of 26% per year.

Question 39

what is the treatment of hyperinflation under US GAAP, and why is this a concern

Answer 39

concern because using the current rate method would cause the subsidiary to basically disappear because the exchange rate would effectively be 0. Under US GAAP you have to use the TEMPORAL METHOD. becuase the temporal method requires that non monetary assets are translated at the historical exchange rate, it means that their values are locked in. This preserves them from being affected by hyperinflation. on the income statement the resulting translation gain or loss is reported directly in net income.

Question 40

Under US GAAP and Hyperinflation which currency is used as the subsidiary's functional currency and why

Answer 40

the functional currency is automatically considered to be the parent's presentation currency. (rather than the currency of the primary economic environment.) because you have chosen the parent's presentation currency as the functional currency you are effectively mandating the use of the temporal method, rather than the current method.

Question 41

What is the accounting treatment of Hyperinflation under IFRS

Answer 41

IFRS retains the local currency as the functional currency but requires a two step adjustment process. step one is to restate for inflation. all non monetary items must be RESTATED FOR INFLATION using a general price index from the acquisition date to the balance sheet date step two you translate translate the inflation restated financial statements are translated into the parent's presentation currency using the ENDING exchange rate for ALL ITEMS

Question 42

where and what is the Net purchasing power gain and loss recognized under hyperinflation? is this under IFRS or US GAAP

Answer 42

under IFRS the net purchasing power gain and loss is because monetary items are not restated for inflation. This is recognised directly in the income statement.

Question 43

Where is the information regarding foreign currency disclosure located

Answer 43

Usually located in the footnotes and MD&A

Question 44

What is the clean-surpluss analytical method

Answer 44

This is when analysts take the change in the cumulative translation adjustment from the balance sheet and add it to net income. By moving these surpluses from the balance sheet over to the income statement, you make it easy to compare the financial statements of a company using the current method and one using the temporal method.

Question 45

What is the difference between the statutory tax rate and the effective tax rate

Answer 45

Statutory tax rate is the specific rate implied by the tax rate of the home country Effective tax rate is the calculated figure which is the TAX EXPENSE divided by the PRETAX PROFIT You have to provide disclosure which reconciles these two rates.

Question 46

What are some of the ways that being a multinational co-operation affects the effective tax rate

Answer 46

If the profit mix changes, where the proportion of profits shifts between countries with different tax codes. Changes in the local tax rates, when the actual tax rates of the different countries change, it can affect the effective tax rate.

Question 47

What is the meaning of a foreign tax credit

Answer 47

Foreign tax credits are credits for foreign taxes paid which result int he company being taxed at the home countries rate regardless of where the income was earned

Question 48

What is the full process of moving from a statutory tax rate to an effective tax rate. Explain the full reconciliation

Answer 48

You start with the statutory tax rate, and add and subtract reconciling items to arrive at the ETR If a company operates in a company that has a higher statutory tax rate this creates a positive adjustment, by the amount that is the foreign operations times by their tax rate minus what that tax rate would have been if they were operating in the home country. Permanent differences, these are items like non deductible expenses that are recognised for accounting purposes but not for tax purposes.

Question 49

What is meant by the sustainability of sales growth as it relates to multinational corporations How do they measure sustainable growth, what is the metric

Answer 49

This relates to weather the earnings growth of a company is actually due to a growth in earnings, or if it is actually just down to currency movements. Sustainable growth is growth which is predominantly driven by a growth in volume or prices. Organic growth excludes the effects of acquisitions divestures and currency movements

Question 50

What does foreign exchange risk also encapsulate and how could you mitigate the risks What is the difference between a paper risk and fundamental risks

Answer 50

It impacts the translation of the balance sheet but also the competitiveness of future sales, and the cost of foreign denominated debt. You could use hedging tools and currency swaps Fundamental risks to the firm are those which affect the price and volume at which they are able to sell their goods, whereas paper risks are the risks that the values of balance sheet and income statement numbers are not the same when they get translated from one currency to another