###### Valuation of a Convertible Bond in an ...

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In a hyperinflationary environment, the local currency rapidly depreciates against the parent’s presentation currency. This is as a result of a **deterioration of purchasing power**. In this case, using the current rate to translate all of the balance sheet accounts will result in much lower translated assets and liabilities. Using the lower values, the subsidiary seems to disappear in the parent’s consolidated financial statements.

The local currency-denominated values increase to offset the impact of inflation. This implies that the real value of the non-monetary assets and liabilities is not affected by hyperinflation. Unfortunately, US GAAP does not allow the adjustment of non-monetary items. As a result, IFRS and US GAAP differ significantly when dealing with a subsidiary operating in a highly inflationary environment.

According to FASB, a hyperinflationary environment is one where the cumulative inflation exceeds 100% over 3 years. Compounding at an inflation rate of more than 26% per annum over three years will result in cumulative inflation of over 100%, i.e., \((1.26^{3})\) is approximately 100%). The IASB does not give a specific definition of hyperinflation. However, cumulative inflation of over 100% over 3 years is one indication of the existence of inflation.

The accounting applied to a foreign operation changes significantly when the economy in which it operates is highly inflationary. US GAAP requires the financial statements of such foreign operations to be translated using the temporal method as if the parent currency is the functional currency. The resulting translation gain/loss is reported in net income.

On the other hand, IFRS requires the foreign financial statements to be first restated for foreign inflation using rules in IAS 29. The financial statements are then translated into parent company currency using the current rate method. Restating inflation involves the following approach:

Monetary assets and liabilities are not restated as they are already expressed in the current monetary unit at the balance sheet date. However, non-monetary assets and liabilities are restated for changes in the general purchasing power of the monetary unit. Recall that non-monetary are carried at historical cost. Therefore, the restated cost is determined by applying the historical cost, the change in the general price index from the acquisition date to the balance sheet date. Property, plant, and equipment are restated from their date of revaluation. Finally, all the components of stockholder’s equity are restated by applying the change in the general price level from the start of the period or, if later, from the date of contribution to the balance sheet date.

All income statement items are restated by multiplying by the change in the general price index. The applicable dates are from when the items were initially recorded to the balance sheet date. The net gain or loss in purchasing power that arises from monetary assets and liabilities during the inflation period is included in net income.

Since monetary items are not restated for inflation, they are **exposed to inflation risk. **This suggests that holding **cash and receivables **during a period of inflation results in a **purchasing power loss,** whereas holding **payables** results in a **purchasing power gain. **For example**, **assume that a basket of goods can be purchased at £50 on 1 January 2017. At the end of the year, the same basket costs £75. The same £50 can only purchase 63.67% of the basket of goods. Therefore, there is a purchasing power loss of £25. Borrowing money during a period of inflation increases the purchasing power. If a company borrows £75 on January 1, 2017, when the general price index is £50, it can acquire 1.5 baskets of goods. The result is a purchasing power gain of £25. However, the interest cost of borrowing offsets this gain.

A net purchasing power gain arises when the monetary liabilities are higher than the monetary assets, and a net purchasing loss will arise when the opposite case exists. If the exchange rate change by the same proportion as the change in the general price index in a highly inflationary country, both IFRS and US GAAP will produce similar results.

Delight company is US based and established a wholly-owned subsidiary, ABC, on January 1, 2016. Delight presents its financial statements in the US dollar. ABC’s financial statements for its first year of operations in foreign currency units (FC) are as shown below:

$$ \textbf{ABC’s Income Statement for the year ended 31 December 2016} $$

$$\begin{array}{l|r} {}& \textbf{Amount in FC}\\ \hline\text{Sales} & 2,000\\ \hline \text{Interest expense} & (500)\\ \hline\text{Net income} & 1,500\\ \end{array}$$

$$ \textbf{ABC’s Balance Sheet of 1-Jan-16 and 31-Dec-16 Respectively} $$

$$\small{\begin{array}{l|rr} \textbf{Assets} & \textbf{Amounts in FC}&{}\\ \hline\text{Cash} & 2,000 & 3,500\\ \hline\text{Fixed assets} & 10,000 & 10,000\\ \hline\textbf{Total assets} & \textbf{12,000} & \textbf{13,500}\\ \hline\textbf{Equity and liabilities} &{} & {}\\ \hline\text{Accounts payable} & 6,500 & 6,500\\ \hline\text{Common stock} & 5,500 & 5,500\\ \hline\text{Retained earnings} & 0 & 1,500\\ \hline\textbf{Total equity and liabilities} & \textbf{12,000} & \textbf{13,500}\\ \end{array}}$$

Suppose that ABC experienced significant inflation during 2016. The general price index during the year is as follows:

$$\begin{array}{l|c} \textbf{Date} & \textbf{General Price Index}\\ \hline\text{1-Jan-16} & 100\\ \hline\text{Average, 2016} & 130\\ \hline\text{31-Dec-16} & 150\\ \end{array}$$

The 2016 inflation rate was 100%, and thus, ABC meets the definition of a highly inflationary economy. Due to the high inflation, ABC’s currency weakened significantly relative to the US dollar. The exchange rates are in the table below:

$$\begin{array}{l|r} \textbf{Date} & \textbf{US\$ per FC}\\ \hline\text{1-Jan-16} & 1.25\\ \hline\text{Average, 2016} & 1.00\\ \hline\text{31-Dec-16} & 0.80\\ \end{array}$$

What amounts will Delight Company include in its consolidated financial statements for the year ended 31 December 2016 related to this foreign subsidiary?

Under the IFRS standard, ABC’s financial statements will be restated for local inflation and then translated into the US dollar using the **current rate method** as follows:

$$\small{\begin{array}{l|r|r|r|r|r} {}& \textbf{FC} & \textbf{Restatement Factor} & \textbf{Inflation-Adjusted FC} & \textbf{Exchange Rate} & \textbf{US\$}\\ \hline\textbf{Assets}& {}& {}&{} &{} &{}\\ \hline\text{Cash} & 3,500 & 150/150 & 3,500 & 0.80 & 2,800\\ \hline\text{Fixed assets} & 10,000 & 150/100 & 15,000 & 0.80 & 12,000\\ \hline\textbf{Total Assets} & 13,500 & & 18,500 & & 14,800\\ \hline\text{Equity and liabilities} &{} &{} &{} &{} &{}\\ \hline\text{Accounts payable} & 6,500 & 150/150 & 6,500 & 0.80 & 5,200\\ \hline\text{Common stock} & 5,500 & 150/100 & 8,250 & 0.80 & 6,600\\ \hline\text{Retained earnings} & 1,500 &{} & 3,750 & 0.80 & 3,000\\ \hline\text{Total equity and liabilities} & 13,500 & & 18,500 &{} & 14,800\\ \hline\text{Sales} & 2,000 & 150/130 & 2,308 & 0.80 & 1,846\\ \hline\text{Interest expense} & (500) & 150/130 & (577) & 0.80 & (462)\\ \hline\text{Subtotal} & 1,500 & & 1,731 &{}& 1,385\\ \hline\text{Purchasing power gain/loss} & {}& {}& 2,019 & 0.80 & 1,615\\ \hline\text{Net income} &{} &{} & 3,750 & {}& 3,000\\ \end{array}}$$

The net purchasing power gain of FC2, 019 can be explained as follows:

$$\begin{align*}\text{Gain from holding accounts payable}&=6500\times\frac{150\times100}{100}\\&=\text{FC3,250}\end{align*}$$

$$\begin{align*}\text{Loss from holding beginning balance in cash}&=-2000\times\frac{150-100}{100}\\&=(1,000)\end{align*}$$

$$\begin{align*}\text{Loss from increase in cash during the year} &=-1500\times\frac{150-130}{130}\\&=(231)\end{align*}$$

$$\begin{align*}\text{Net purchasing power gain (loss)}&=3,250-1,000-231\\&=\text{FC2,019}\end{align*}$$

No translation adjustment is needed since all inflation adjusted FC amounts are translated at the current exchange rate.

In this case, Delight Company will translate ABC’s FC financial statements using the **temporal method.** The resulting translation gain/loss is reported in net income as follows:

$$\small{\begin{array}{l|r|r|r} {}& \textbf{FC} & \textbf{Exchange Rate} & \text{US\$}\\\textbf{Assets} &{} &{} & {}\\ \hline\text{Cash} & 3,500 & \text{0.80 C} & 2,800\\ \hline\text{Fixed assets} & 10,000 & \text{1.25 H} & 12,500\\ \hline\textbf{Total Assets} & \textbf{13,500} &{} & \textbf{15,300}\\ \hline\textbf{Equity and liabilities} &{} &{} &{}\\ \hline\text{Accounts payable} & 6,500 & \text{0.80 C} & 5,200\\ \hline\text{Common stock }& 5,500 & \text{1.25 H} & 6,875\\ \hline\text{Retained earnings} & 1,500 &{} & 3,225\\ \hline\textbf{Total equity and liabilities} & \textbf{13,500} & {}& \textbf{15,300}\\ \hline\text{Sales} & 2,000 & \text{1.00 A} & 2,000\\ \hline\text{Interest expense} & (500) & \text{1.00 A} & (500)\\ \hline\text{Subtotal} & 1,500{} &{} & 1,500\\ \hline\textbf{Translation gain} &{} &{} & \textbf{1,725}\\ \hline\textbf{Net income} & {}& {}& \textbf{3,225}\\ \end{array}}$$

Where: C = Current (period-end) exchange rate; A = Average-for-the-year exchange rate; H = Historical exchange rate

ABC did not issue a dividend, and this translates to US$0. The increase in retained earnings is US$3,225 (from the balance sheet); so, net income is US$3,225, resulting in a translation gain of US$1,725. Under IFRS, the net income is US$3,000, which is different from a net income of US$3,225 when US GAAP is applied. Thus, both standards will result in different translated amounts because there is no one-to-one relationship between the changes in exchange rates and the general price index.

In the previous learning outcome statement, we analyzed all the financial ratios and how they vary according to the translation method used. The same concept applies here. What follows is a summary of the concept of financial ratios discussed in the previous learning outcome statement.

In comparing the ratio effects of the translation methods in a highly inflationary environment, it is necessary to:

- Determine if the local currency is appreciating or depreciating.
- Establish which rate (historical rate, average rate, or current rate) is used to translate the numerator under both methods and examine the effects on the ratio.
- Establish which rate (historical rate, average rate, or current rate) is used to translate the denominator under both methods and examine the effects on the ratio.
- Determine which ratio will increase, decrease, or remain unchanged in the direction of change in the numerator and the denominator.

## Question

Assume that Delight company complies with IFRS to convert ABC’s FC financial statements to US$. Relative to the original net profit margin, the translated return on assets is

most likely:A. Lower.

B. Higher.

C. Unchanged.

## Solution

The correct answer is B.$$\text{Return on assets}=\frac{\text{Net income}}{\text{Total assets}}$$

$$\begin{align*}\text{Original return on assets}&=\frac{1,500}{13,500}\\&=0.11\end{align*}$$

$$\begin{align*}\text{Translated return on assets}&=\frac{3,000}{14,800}\\&=0.20\end{align*}$$

0.20 > 0.11, implying that the translated return on assets is higher than the original return on assets.

This can also be explained without computing the actual amount. In a hyperinflationary environment, the local currency rapidly depreciates against the parent’s presentation currency. The impact is a higher translated ratio than the original ratio. This is because the average rate used in the numerator of the ratio is higher than the end of year rate used in the denominator of the ratio. Note that this is only true for mixed ratios when the current rate method is applied.

Reading 13: Multinational Operations

*LOS 13 (g) Analyze how alternative translation methods for subsidiaries operating in hyperinflationary economies affect financial statements and ratios.*