Hyperinflationary Subsidiary and Foreign Currency Translation
Global plc owns a subsidiary in a country whose cumulative three-year inflation rate is 140%, and the currency is deemed hyperinflationary. The subsidiary's functional currency is the local currency. Its net assets at year-end are LC 900m, and the closing rate is LC 100 = BDT 1. The opening net assets were LC 600m when the rate was LC 80 = BDT 1. Profit for the year was LC 300m earned evenly; the average rate is LC 90 = BDT 1. The parent also has a BDT 200m receivable from the subsidiary that is, in substance, part of the net investment. Management proposes translating all figures at the average rate for simplicity and ignoring the hyperinflation adjustment.
1. Explain the correct translation process for the hyperinflationary subsidiary and compute the exchange difference arising on net assets.
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Step 1 – Restate for inflation first. The subsidiary's financial statements must be restated into the measuring unit current at the balance sheet date before translation: non-monetary items indexed, monetary items unchanged, and the gain or loss on the net monetary position recognised in profit or loss. Only after restatement are the figures translated.
Step 2 – Translate at closing rate. All assets and liabilities, including restated equity components, are translated at the closing rate (LC 100 = BDT 1). Income and expenses are translated at the closing rate (or rates that approximate it). The average rate is not appropriate because it ignores restatement.
Step 3 – Exchange difference.
- Opening net assets: LC 600m at closing rate = BDT 6.0m (comparative restated).
- Profit: LC 300m at closing rate = BDT 3.0m.
- Closing net assets: LC 900m at closing rate = BDT 9.0m.
- Check: 6.0 + 3.0 = 9.0, so the arithmetic difference is nil only because all items use the closing rate. The real exchange difference arises on the opening balance when translated at the opening rate (LC 600m ÷ 80 = BDT 7.5m) versus closing rate (BDT 6.0m): a BDT 1.5m loss taken to OCI and accumulated in a translation reserve. The average-rate shortcut would produce a spurious BDT 1.0m difference and misstate equity.
Step 4 – Net investment receivable. The BDT 200m receivable forming part of the net investment is retranslated, and exchange differences on it are recognised in OCI, offsetting the subsidiary's translation reserve on consolidation.
2. Assess management's proposal to use the average rate throughout and explain the presentation and disclosure consequences.
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Assessment. Using the average rate for all items is not permitted for a hyperinflationary subsidiary. The standard requires restatement into the current measuring unit and translation of all items at the closing rate. The average rate is a convenience for stable economies only. Applying it here would misstate assets, liabilities, and equity, and would fail to recognise the gain or loss on the net monetary position, which can be material in a 140% inflation environment.
Presentation. The translation reserve is a separate component of equity; the exchange difference on the net investment receivable offsets within OCI. The subsidiary's results are consolidated line by line after restatement. Comparatives are restated into the current measuring unit and translated at the current closing rate, so prior-year figures change.
Disclosure. Disclose the fact of hyperinflation, the restatement, the nature and amount of the gain or loss on the net monetary position, the translation reserve movement, and the exchange rates used. The exam point: restate then translate at closing rate; the average-rate shortcut and the omission of the net monetary gain both distort the financial statements and are likely to be audit findings.