What’s in the net investment?

by John Hughes

Sherritt International Corporation and Northland Power Income Fund provide examples of an issue that’s come up from time to time in the IFRS changeover disclosures:

The significance of the foreign currency ”net investment” in a self-sustaining foreign operation, as CICA 1651 puts it, is that while translating the net investment into the reporting currency generates exchange gains and losses from one period to the next, “it is inappropriate to incorporate this exchange gain or loss in net income of the reporting enterprise in the period in which it arises.” Instead, it’s recognized as a separate component of shareholders’ equity. On the other hand, if (say) a loan to a foreign subsidiary isn’t part of the net investment, then gains and losses arising on the intercompany balance are treated in the same way as gains and losses on normal foreign currency trade balances, affecting net income. The notion is that if a foreign operation is “financially and operationally independent of the reporting enterprise,” then the periodic translation gains and losses really aren’t relevant to assessing current performance, because (in the words of IAS 21) they “have little or no direct effect on the present and future cash flows from operations.” However, a short-term loan does have a direct effect, because settling the loan will involve one side or the other (or conceivably both) raising or receiving funds in a currency that isn’t its measurement currency, and therefore incurring a gain or loss.

There’s a lot of space on the spectrum, of course, between an obvious short-term loan and an equally obvious long-term equity investment, and this is where IFRS and Canadian GAAP differ. Canadian GAAP says the net investment includes “intercompany balances of a long-term nature that are related to the acquisition or financing of the foreign operation.” The phrase “long-term” is often used in Canadian GAAP just to denote longer than one year, so one can at least imagine arguments being made for treating various non-current balances as part of the net investment, regardless that they’re scheduled for repayment (and that the related exchange gains or losses will therefore crystallize) in the not-too-distant future.

IAS 21 states in contrast that the treatment applies to items “for which settlement is neither planned nor likely to occur in the foreseeable future,” and specifies that while this may include long-term receivables or loans, it doesn’t include trade receivables or trade payables. As written, this might still seem to allow some scope for murkiness, depending on how people approached the terms “planned,” “likely,” and “foreseeable.” The basis for conclusions to IAS 21 should shut this down by stating: “The Board noted that the nature of the monetary item referred to (in the Standard) is similar to an equity investment in a foreign operation i.e. settlement of the monetary item is neither planned nor likely to occur in the foreseeable future.” The “i.e.” is perhaps a little shaky, because of course there’s more to an equity investment than that. But the intention is clear – if gains or losses on a loan or other intercompany monetary item might plausibly crystallize faster than those attaching to the investor’s other interests in that foreign operation, then it’s very probably not a part of the net investment.

It’s also worth noting the difference in how the gains and losses arising from translating the net investment, and accumulated in equity, are ultimately realized in profit or loss. CICA 1651 requires including “an appropriate portion” of these gains and losses in net income “when there is a reduction in the net investment,” and provides as examples not just selling part or all of the interest in the foreign operation, but also reducing the equity in the operation “as a result of capital transactions (for example, dividend distributions, capital restructuring).” IAS 21 only envisages recognizing these amounts in net income on actually disposing of a foreign operation, including (for a subsidiary) losing control.

The IFRS standard specifies that writing down a foreign operation’s carrying amount isn’t a partial disposal – this is consistent with the Canadian GAAP conclusion reached in EIC-26. There’s a little quirk attached though. EIC-26 addresses a situation where an entity commits to a plan of disposal for a self-sustaining foreign operation, and says the deferred gain or loss  is “included as part of the carrying amount of the investment when evaluating that investment for impairment.” Depending on whether an impairment loss is recognized, and the amount of it, this inclusion could effectively result in reclassifying deferred gains to profit or loss at that time, prior to actually disposing of it. The basis for conclusions to IAS 21 addresses this possible treatment (which derives from US GAAP), but concludes by not permitting any exchange differences to be recycled when an asset/disposal group is classified as held for sale.

When a foreign operation is going to be disposed, it seems to me investors are already viewing it under a different spotlight, separate from ongoing operations, so it’s unlikely it has much practical consequence for them whether you reclassify the deferred gain or loss at the earlier or the later date. That aside though, it’s likely the greater focus in IFRS on the degree of permanence underlying the “net investment” concept will generally produce a more logical segregation of exchange gains and losses.

The opinions expressed are solely those of the author.