In today’s world of multi-national business transactions, even the smallest company may find that it deals with partners in other countries to a large extent. If so, there are a number of transactions, such as accounts receivable and accounts payable, as well as loans and forward exchange contracts that may be denominated in foreign currencies. Larger organizations may also have foreign subsidiaries that deal primarily in foreign currency transactions. In either case, generally accepted accounting principles state that the transactions must be converted back into U.S. dollars when they are accounted for in a company’s financial statements. Since there is some exchange rate risk associated with conducting business in other currencies, this conversion will likely result in the recognition of some gains or losses associated with transactions that are denominated in foreign currencies.
In this post, we will review how foreign currency translation is accomplished in order to meet the objectives of GAAP. For easier illustration, I use U.S as a base [home country] and U.S dollar as the functional currency. To you, who are not in the U.S, you can simply reverse it.
The key consideration when making foreign currency translations is that when the conversion is complete, we will see an accurate translation of accounting performance in a foreign currency into precisely the same performance in U.S. dollars. In other words, a foreign subsidiary whose financial statements have specific current ratios, gross margins, and net profits will see the same results when translated into a report presentation in U.S. dollars.
The Current Rate Translation Method
The current rate translation method is used when a currency besides the U.S. dollar is determined to be the primary currency used by a subsidiary. This approach is usually selected when a subsidiary’s operations are not integrated into those of its U.S.-based parent, if its financing is primarily in that of the local currency, or if the subsidiary conducts most of its transactions in the local currency. However, one cannot use this method if the country in which the subsidiary is located suffers from a high rate of inflation, which is defined as a cumulative rate of 100% or more over the most recent three years. In this case, the re-measurement method must be used (as described in a later section).
To complete the current rate translation method, the first order of business is to determine the functional currency of the subsidiary. In some locations, a subsidiary may deal with a variety of currencies, which makes this a less-than-obvious decision. The functional currency should be the currency that is used in the bulk of the subsidiary’s transactions and financing. Next, convert all of the subsidiary’s transactions to this functional currency. One must continue to use the same functional currency from year to year in order to provide a reasonable basis of comparison when multiple years of financial results are included in the corporate parent’s financial results.
The next step is to convert all assets and liabilities of the subsidiary to U.S. dollars at the current rate of exchange as of the date of the financial statements. The stockholder’s equity accounts are converted at the historical rate of exchange, while revenues and expenses that have occurred throughout the current fiscal year should be converted at a weighted-average rate of exchange for the entire year. Any resulting translation adjustments should be stored in the equity section of the corporate parent’s consolidated balance sheet.
Example Of The Current Rate Method
An extremely simplified example of a corporate subsidiary’s (located in Mexico) balance sheet is shown below:
The peso exchange rate at the beginning of the year is assumed to be 0.08 to the dollar, while the rate at the end of the year is assumed to be 0.10 to the dollar. A highly abbreviated income statement is shown below:
For the purposes of this exhibit, the blended full-year rate of exchange for the peso is assumed to be 0.09 to the dollar. Note that the net income figure derived from the second exhibit is incorporated into the retained earnings statement at the bottom of the exhibit, and is incorporated from there into the retained earnings line item in the first exhibit. For simplicity, the beginning retained earnings figure on the second exhibit is assumed to be zero, implying that the company is in its first year of existence.
The Re-measurement Method
The re-measurement method is used when the U.S. dollar is designated as the primary currency in which transactions are recorded at a foreign location. Another clear indicator of when this method is used is when the subsidiary has close operational integration with its U.S. parent, and has most of its financing denominated into dollars.
Under this method, we translate not only cash, but also any transactions that will be settled in cash (mostly accounts receivable and payable, as well as loans) at the current exchange rate as of the date of the financial statements. All other assets and liabilities (such as inventory, prepaid items, fixed assets, trademarks, goodwill, and equity) will be settled at the historical exchange rate on the date when these transactions occurred.
There are a few cases where the income statement is affected by the items on the balance sheet that have been translated using historical interest rates. For example, the cost of goods sold will be affected when inventory that has been translated at a historical exchange rate is liquidated. When this happens, the inventory valuation at the historical exchange rate is charged through the income statement. The same approach is used for the depreciation of fixed assets and the amortization of intangible items.
Other income statement items primarily involve transactions that arise throughout the reporting year of the subsidiary. For these items, it would be too labor intensive to determine the exact exchange rate for each item at the time it occurred. Instead, one can determine the weighted average exchange rate for the entire reporting period, and apply this average to the income statement items that have occurred during that period.
Example Of The Re-measurement Method
An extremely simplified example of a corporate subsidiary’s (located in Mexico) balance sheet is shown below (which is the same balance sheet shown on the balance sheet shown on the previous section):
The peso exchange rate at the beginning of the year is assumed to be 0.08 to the dollar, while the rate at the end of the year is assumed to be 0.10 to the dollar. The primary difference in calculation from the current rate method shown in the balance sheet is that the exchange rate for the inventory and fixed assets accounts have changed from the year-end rate to the rate at which they are assumed to have been originated at an earlier date. Also, there is no translation adjustment account in the equity section, as was the case under the current rate method.
A highly abbreviated income statement is shown in the next exhibit:
For the purposes of this exhibit, the blended full-year rate of exchange for the peso is assumed to be 0.09 to the dollar. Note that the net income figure derived from the exhibit is incorporated into the retained earnings statement at the bottom of the exhibit, and is incorporated from there into the retained earnings line item in the balance sheet.
A major issue is that, under the current rate translation method, there was a translation loss of $50, while the re-measurement approach resulted in a translation gain of $61. This was caused by a difference in the assumptions used in deriving the exchange rate that in turn was used to convert the inventory and fixed asset accounts from pesos into dollars. Consequently, the choice of conversion methods used will have a direct impact on the reported level of profitability.
Foreign Exchange Sale Transactions
For smaller companies that only rarely deal with foreign exchange transactions, there is no need to formally recall the details of either of the preceding translation methods. Instead, if they only participate in an occasional sale transaction, they can simply record the initial sale and related account receivable based on the spot exchange rate on the date when the transaction is initially completed. From that point forward, the amount of the recorded sale will not change—only the related receivable will be altered based on the spot exchange rate as of the date of the balance sheet on which it is reported, adjusting it up or down to reflect the existence of a potential gain or loss at the time of the eventual collection of the receivable. The final gain or loss will be recorded when the receivable is settled, using the spot rate on that date. This procedure will cover the most common transactions that a small business will encounter.
Recognition Of Translation Adjustments
The gains and losses resulting from various translation adjustments are treated in different ways, with some initially being stored in the balance sheet and others being recorded at once in the income statement. Here are the key rules to remember:
- If a company is directly engaged in foreign exchange transactions that are denominated in foreign currencies, then any translation adjustments to U.S. dollars that result in gains or losses should be immediately recognized in the income statement. The company can continue to make these adjustments for changes between the last reporting date and the date of the current financial statements, and may continue to do so until the underlying transactions have been concluded.
- If a company has a subsidiary whose results must be translated into U.S. dollars, then any translation gains or losses should be recorded in equity until such time as the subsidiary is sold or liquidated. However, if any portions of the subsidiary’s financial statements will have an impact on the reported cash flows of the corporate parent, then any gains or losses on those portions of the subsidiary’s financial statements must be recognized at once in the income statement of the corporate parent.
- If a company is including translated foreign results in its financial statements, and wishes to include its financial results for other years in the same statements, then it must restate the results of the other years to conform to the same foreign exchange calculations and procedures.
- If there has been a material change in an exchange rate in which a company’s obligations or subsidiary results are enumerated, and the change has occurred subsequent to the date of financial statements that are being included in a company’s audited results, then the change and its impact on the financial statements should be itemized in a footnote that accompanies the audited results.
If there are inter-company long-term investment transactions between a U.S.-based parent and a foreign subsidiary, any transaction gains or losses resulting from foreign exchange considerations should not be recognized in the income statement.
Exchange Rates Used For Calculations
There can be some confusion regarding the precise exchange rate to be used when conducting foreign currency translations. Here are some guidelines:
- If there is no published foreign exchange rate available on the specific date when a transaction occurred that requires translation, one should use the rate for the date that most immediately follows the date of the transaction.
- If the date of a financial statement that is to be converted from a foreign currency is different from the date of the financial statements into which they are to be converted into U.S. dollars, then use the date of the foreign currency financial statements as the date for which the proper exchange rate shall be used as the basis for translation.
- If there is more than one published exchange rate available that can be used as the basis for a translation, use the rate that could have been used as the basis for the exchange of funds that could then be used to remit dividends to shareholders.
Alternatively, use the rate at which a settlement of the entire related transaction could have been completed.
This post has described several approaches for converting transactions and financial statements that are denominated in foreign currencies into U.S. dollars. A good knowledge of the rules upon which these conversions are based is essential for determining the correct method of translation. This can have an impact on the recognition or non-recognition of translation gains and losses.