The method used to translate the financial statements of a foreign operation depends on the way in which it is financed and operates in relation to the reporting enterprise. For this purpose, foreign operations are classified as either ‘integral foreign operations’ or ‘non-integral foreign operations’.
An integral foreign operation carries on its business as if it were an extension of the reporting enterprise’s operations. For example, such an operation might only sell goods imported from the reporting enterprise and remits the proceeds to the reporting enterprise. In such cases, a change in the exchange rate between the reporting currency and the currency in the country of foreign operation has an almost immediate effect on the reporting enterprise’s cash flow from operations. Therefore, the change in the exchange rate affects the individual monetary items held by the foreign operation rather than the reporting enterprise’s net investment in that operation.
In contrast, a non-integral foreign operation accumulates cash and other monetary items, incurs expenses, generates income and perhaps arranges borrowings, all substantially in its local currency. It may also enter into transactions in foreign currencies, including transactions in the reporting currency. When there is a change in the exchange rate between the reporting currency and the local currency, there is little or no direct effect on the present and future cash flows from operations of either the non-integral foreign operation or the reporting enterprise. The change in the exchange rate affects the reporting enterprise’s net investment in the non- integral foreign operation rather than the individual monetary and non- monetary items held by the non-integral foreign operation.
Translation of Foreign Integral Operations
The individual items in the financial statements of the foreign operation are translated as if all its transactions had been entered into by the reporting enterprise itself. The cost and depreciation of tangible fixed assets is translated using the exchange rate at the date of purchase of the asset or, if the asset is carried at fair value or other similar valuation, using the rate that existed on the date of the valuation. The cost of inventories is translated at the exchange rates that existed when those costs were incurred. The recoverable amount or realisable value of an asset is translated using the exchange rate that existed when the recoverable amount or net realisable value was determined. For example, when the net realisable value of an item of inventory is determined in a foreign currency, that value is translated using the exchange rate at the date as at which the net realisable value is determined. The rate used is therefore usually the closing rate.
Translation of Non-Integral Foreign Integral Operations
The translation of the financial statements of a non-integral foreign operation is done using the ‘closing rate method’ in which the following procedures are used:
- The assets and liabilities, both monetary and non-monetary, of the non-integral foreign operation should be translated at the closing rate;
- Income and expense items of the non-integral foreign operation should be translated at exchange rates at the dates of the transactions; and
- All resulting exchange differences should be accumulated in a foreign currency translation reserve until the disposal of the net investment.
- For practical reasons, a rate that approximates the actual exchange rates, for example an average rate for the period is often used to translate income and expense items of a foreign operation.
- Any goodwill or capital reserve arising on the acquisition of a non-integral foreign operation is translated at the closing rate.
- A contingent liability disclosed in the financial statements of a non-integral foreign operation is translated at the closing rate for its disclosure in the financial statements of the reporting enterprise.
- The incorporation of the financial statements of a non-integral foreign operation in those of the reporting enterprise follows normal consolidation procedures, such as the elimination of intra-group balances and intra-group transactions of a subsidiary (AS 21 and AS 27). However, an exchange difference arising on an intra-group monetary item, whether short-term or long-term, cannot be eliminated against a corresponding amount arising on other intra-group balances because the monetary item represents a commitment to convert one currency into another and exposes the reporting enterprise to a gain or loss through currency fluctuations.
- When the financial statements of a non-integral foreign operation are drawn up to a different reporting date from that of the reporting enterprise, the non-integral foreign operation often prepares, for purposes of incorporation in the financial statements of the reporting company, statements as at the same date as the reporting enterprise (AS 21).
- The exchange differences are not recognised as income or expenses for the periodbecause the changes in the exchange rates have little or no direct effect on the present and future cash flows from operations of either the non-integral foreign operation or the reporting enterprise. When a non-integral foreign operation is consolidated but is not wholly owned, accumulated exchange differences arising from translation and attributable to minority interests are allocated to, and reported as part of, the minority interest in the consolidated balance sheet.
- An enterprise may dispose of its interest in a non-integral foreign operation through sale, liquidation, repayment of share capital, or abandonment of all, or part of, that operation. The payment of a dividend forms part of a disposal only when it constitutes a return of the investment. In the case of a partial disposal, only the proportionate share of the related accumulated exchange differences is included in the gain or loss. A write-down of the carrying amount of a non-integral foreign operation does not constitute a partial disposal. Accordingly, no part of the deferred foreign exchange gain or loss is recognised at the time of a write-down.
The following are indications that a foreign operation is a non-integral foreign operation rather than an integral foreign operation:
- While the reporting enterprise may control the foreign operation, the activities of the foreign operation are carried out with a significant degree of autonomy from those of the reporting enterprise.
- Transactions with the reporting enterprise are not a high proportion of the foreign operation’s activities.
- The activities of the foreign operation are financed mainly from its own operations or local borrowings rather than from the reporting enterprise.
- Costs of labour, material and other components of the foreign operation’s products or services are primarily paid or settled in the local currency rather than in the reporting currency.
- The foreign operation’s sales are mainly in currencies other than the reporting currency.
- Cash flows of the reporting enterprise are insulated from the day-to-day activities of the foreign operation rather than being directly affected by the activities of the foreign operation.
- Sales prices for the foreign operation’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.
- There is an active local sales market for the foreign operation’s products, although there also might be significant amounts of exports.
