The foreign entity’s financial statements in a highly inflationary economy is not sufficiently stable and should be re-measured as if the functional currency were the reporting currency. Thus, the financial statements of those entities should be re-measured into the reporting currency. (The U.S. dollar becomes the functional currency) In effect, the reporting currency is used directly. A highly inflationary environment is one that has cumulative inflation of about 100 percent or more over a three-year period. In other words, the inflation rate must be increasing at a rate of about 35 percent a year for three consecutive years.
Translation of Foreign Currency Statements When the Foreign Currency Is the Functional Currency
- The balance sheet accounts are translated using the current exchange rate.
- Assets and liabilities are converted at the exchange rate at the balance sheet date.
- If a current exchange rate is not available at the balance sheet date, use the first exchange rate available after that date.
- The current exchange rate is also used to translate the statement of cash flows except for those items found in the income statement, which are translated using the weighted-average rate. The income statement items are translated using the weighted-average exchange rate.
- A significant change in the exchange rate between year-end and the audit report date should be disclosed as a subsequent event. Disclosure should also be made of the effects on unsettled balances applicable to foreign currency transactions.
What Are the Steps in the Translation Process?
The four steps in translating the foreign country’s financial statements into U.S. reporting requirements are:
- Conform the foreign country’s financial statements to U.S. GAAP.
- Determine the functional currency of the foreign entity.
- Re-measure the financial statements in the functional currency, if necessary. Gains or losses from re-measurement are includable in re-measured current net income.
- Convert from the foreign currency into U.S. dollars (reporting currency).
Some Important Notes About Foreign Currency Translation
- If a company’s functional currency is a foreign currency, translation adjustments arise from translating that company’s financial statements into the reporting currency.
- Translation adjustments are unrealized and should not be included in the income statement but should be reported separately and accumulated in a separate component of equity. However, if re-measurement from the recording currency to the functional currency is required before translation, the gain or loss is reflected in the income statement.
- Upon sale or liquidation of an investment in a foreign entity, the amount attributable to that entity and accumulated in the translation adjustment component of equity is removed from the stockholders’ equity section and considered a part of the gain or loss on sale or liquidation of the investment in the income statement for the period during which the sale or liquidation occurs.
- As per Interpretation 37, a sale of an investment in a foreign entity may include a partial sale of an ownership interest. In that case, a pro rata amount of the cumulative translation adjustment reflected as a stockholders’ equity component is includable in arriving at the gain or loss on sale. For example, if a business sells a 40 percent ownership interest in a foreign investment, 40 percent of the translation adjustment applicable to it is included in calculating gain or loss on sale of that ownership interest.