When I was a junior, one of the toughest area of accounting, for me, is the accounting for foreign currency and translation. It is not really because of a complex subject—at least it is not as complex as cost accounting. It was merely because of I have less interest in foreign currency accounting matter, until I joined a multi-national group of company that involves multi-currency transactions with customers and across the group.
The night before dealing with multi-currency transactions for the first time, I went to a bookstore, grabbed a GAAP book and read it overnight. Hoahh… so tired and still got no clear picture (what should someone expect from a ‘night-GAAP-book-reading’?).
I did not even have a clue what ‘functional currency’ is. It was not because of my professor did not teach me well—she is the most smart (and strict) professor I ever knew. I just didn’t remember what really it is. Well, that is not a cool story at all, I just want to try to be honest so that you won’t do the same. Seriously. Accounting for foreign currency and translation is an important area that every accountant should be able to do it, correctly. But incase if any of you have similar issue right now, Let me hand you a brief summary of what accounting for foreign currency really is and how to account it.
All companies are said to have a functional currency. That is the currency in which most transactions are denominated.
If in doubt as to identity of functional currency, several factors should be examined:
- the currency of primary sales markets;
- the currency used for major financing;
- the currency used to acquire materials and pay labor, etc.
The US Dollar will be viewed here as the functional currency because it almost always is for US companies. If you’re in India, then Rupee most likely be your functional currency, or Singapore Dollar for Singaporean, Peso for Philippine, Rupiah for Indonesian, Won for Korean, Pound sterling for the UK, and etc.
Note: For the rest of this article, I use USD as the functional currency.
Foreign Currency Prior To Reporting in Financial Statements
Prior to being reported in financial statements, figures denominated in foreign currencies must be stated at their equivalent US dollar values. Two different approaches have been established for this purpose:
Approach-1. Financial statements of foreign subsidiaries of US companies are translated into US dollars for consolidation purposes if the functional currency of the sub is other than the dollar (which it normally is).
Approach-2. Individual transactions of a US company made in a foreign currency are re-measured into US dollars. Although not as frequent, re-measurement is also used for the statements of a foreign sub-subsidiary if its functional currency is the US dollar.
Foreign Currency Translation and Re-measurement
Both translation and re-measurement are based on multiplying the reported foreign currency balance times a fraction which is the value of desired currency/equivalent value of the foreign currency.
In either case, there are two accounting problems to address:
1. Should the restatement be based on historical exchange rates or current exchange rates (called spot rates)?
2. If a balance is updated using the current rate, a change occurs in the reported figure. How is this effect measured and reported?
Translation Of The Financial Statements Of A Foreign Subsidiary
All accounts in the asset and liability sections (no exceptions) are translated into the functional currency (US dollars in my case) at the current exchange rate in effect on the date of the balance sheet.
All other accounts (revenues, expenses, paid-in capital, dividends, etc.) are translated into US dollars at the historical exchange rate in effect at the time of the original recording of the account. Common stock, for example, is translated at rate in effect when stock was issued; dividends use the rate at the date of declaration.
Since many income statement items (such as sales and rent expense) occur throughout the year, an average rate for the year can often be used. And, because the date of recording is used, cost of goods sold and depreciation expense are translated at the average rate for the current year and not when the asset was bought.
Assets and liabilities use current exchange rates; thus, their balances will continually change. The effect of these changes is accumulated and reported in a ‘Translation Adjustment’ account that appears within stockholders’ equity.
There is no income effect created by a translation.
The translation adjustment is computed as follows:
1. The January 1 balance of net assets (or the equivalent stockholders’ equity) is translated at the rate on that day;
2. Any change in net assets during the year is translated at the rate on the date of the change. Dividends, income, and stock transactions are about the only possible changes in the net asset total;
3. The above two translated figures are added;
4. The December 31 balance of net assets is translated at the rate on that date;
5. The value of the assets as they entered the company during the year (3) is compared to the ending value of the net assets (4). Difference is the change in value which is the translation adjustment for the year.
Remeasurement and Translation of Individual Transactions
Remeasurement of individual transactions (such as purchases and sales) denominated in a foreign currency. Remeasurement is also appropriate for a subsidiary that has the same functional currency as its parent.
At the time of the original transaction, all balances are remeasured at the exchange rate on that date. Subsequently, any foreign currency monetary balances (cash, receivables, payables, and assets and liabilities reported at market value) must be remeasured at new current exchange rates.
Monetary accounts could be remeasured every day but for convenience they are remeasured at the time of subsequent transactions (a payable is collected, for example) and at the end of the fiscal period. Any time that a monetary account is remeasured and the value changes a gain or loss is computed that is reported on the income statement (and not within the stockholders’ equity).
All other accounts (such as inventory, buildings, common stock, revenues, etc.) remain at historical rates and never change. For a remeasurement, that rate is the date of the initial transaction. Thus, depreciation uses the historical rate when the asset was bought; cost of goods sold is based on the rate when the inventory was acquired.
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