This post series will cover the following issues: FASB statement related with foreign currency translation, important term in foreign currency topic you should familiar with, how to determine the functional currency, foreign currency translation, steps to do in foreign currency translation process, Journal entry for foreign currency transactions with case example. Also some additional useful topic related with foreign currency, i.e., forward exchange contract and its journal entry, how to hedge foreign currency exposure to reduce risk with example.
FASB Statement No. 52 (Foreign Currency Translation) applies to foreign currency transactions such as exports and imports denominated in other than a company’s functional currency. It also relates to foreign currency financial statements of branches, divisions, and other investees incorporated in the financial statements of a U.S. company by combination, consolidation, or the equity method.
An objective of translation is to provide information on the expected effects of rate changes on cash flow and equity. Translation also provides data in consolidated financial statements relative to the financial results of each individual foreign consolidated entity.
FASB 52 covers the translation of foreign currency statements and gains and losses on foreign currency transactions.
The translation of foreign currency statements is usually required when the statements of a foreign subsidiary having a functional currency other than the U.S. dollar are to be included in the consolidated financial statements of a domestic enterprise. In general, the foreign currency balance sheet should be translated using the exchange rate at the end of the reporting year. The income statement should be translated using the average exchange rate for the year. The resulting translation gains and losses are shown as a separate component in the stockholders’ equity section.
Any gains or losses arising from transactions denominated in a foreign currency are presented in the current year’s income statement.
Some Important Terms In Foreign Currency
Some key terms that you should be familiar with are:
Conversion: An exchange of one currency for another
Currency Swap: An exchange between two companies of the currencies of two different countries according to an agreement to re-exchange the two currencies at the same rate of exchange at a specified future date.
Denominate: Pay or receive in that same foreign currency. It can only be denominated in one currency (e.g., lira). It is a real account (asset or liability) fixed in terms of a foreign currency regardless of exchange rate.
Exchange Rate: The ratio between a unit of one currency and that of another at a specified date. If there is a temporary lack of exchangeability between two currencies at the transaction date or balance sheet date, the first rate available thereafter is used.
Foreign Currency: A currency other than the functional currency of the business (e.g., the dollar could be a foreign currency for a foreign entity).
Foreign Currency Statements: The financial statements using a functional currency as the unit of measure.
Foreign Currency Transactions: Transactions whose terms are denominated in a currency other than the entity’s functional currency. Foreign currency transactions occur when a business (a) buys or sells on credit goods or services whose prices are denominated in foreign currency, (b) borrows or lends funds and the amounts payable or receivable are denominated in foreign currency, (c) is a party to an unperformed forward exchange contract, or (d) acquires or disposes of assets, or incurs or settles liabilities denominated in foreign currency.
Foreign Currency Translation: The expression in the reporting currency of the company those amounts that are denominated or measured in a different currency.
Foreign Entity: An operation (e.g., subsidiary, division, branch, joint venture) whose financial statements are prepared in a currency other than the reporting currency of the reporting entity.
Functional Currency: What is the functional currency? An entity’s functional currency is the currency of the primary economic environment in which the business operates. It is usually the currency of the foreign country that the company primarily obtains and uses cash.
Before translation, the foreign country figures are re-measured in the “functional currency“. For example: if a company in France is an independent entity and received cash and incurred expenses in France, the franc is the functional currency. However, if the French company was an extension of an Italian parent, the functional currency is the lira. The functional currency should be consistently used except if unusual material economic changes occur.
However, previously issued financial statements are not restated for a change in the functional currency. If a company’s books are not kept in its functional currency, re-measurement into the functional currency is required. The re-measurement process occurs before translation into the reporting currency. When a foreign entity’s functional currency is the reporting currency, re-measurement into the reporting currency obviates translation. The re-measurement process generates the same result as if the company’s books had been kept in the functional currency.
Further worth reading about foreign currency accounting: