Including foreign currency transactions of foreign operations (usually subsidiary companies)—in the financial statements of corporate parent—has already been a complex and labor-intensive work, since long time ago. It’s now become even more challenging doing the same task under the IFRS rules. But there are guidelines for that.
An official guideline about how to include foreign currency transactions and foreign operations in the financial statements of a company, and eventually how to translate financial statements into a presentation currency, is provided by the IAS 21. If you have time, read it. If you don’t, read on.
In the global business environment, having multi-currency transaction is not uncommon at all, especially those companies that have foreign operations or subsidiaries. Basically, a company may present its financial statements in any currencies. But, if the presentation currency differs from the entity’s functional currency, the company should translate its results and financial position into the presentation currency. And if you are its account, then you will have really big big works. There are at least four major activities you would need to perform—depends on certain situations around the subsidiary entity: (1) translating into the presentation currency; (2) translating into the functional currency; (3) translating the foreign currency transactions; and (4) disclose certain situation in the financial footnote. Consider doing the task for three or five foreign operations. Read on for procedures of those translations.
Before discussing the procedure, you would need to understand the concept of function currency, first. This is the key to understanding translation of foreign currency financial statements. So, what is functional currency?
What is Functional Currency?
Functional currency is officially defined (by the IFRS) as: “the currency of the primary economic environment in which an entity operates.” This is usually (but not necessarily) the currency in which that entity principally generates and expends cash.
The opposite of the functional currency, in this context, is called “foreign currency”, a currency other than the functional currency of the reporting entity (e.g., Korean Won is a foreign currency for a US reporting company, a U.S. Dollar is a foreign currency for a reporting company in New Delhi, India.) Therefore, foreign currency financial statements are financial statements that employ as the unit of measure a foreign currency that is not the presentation currency of the entity, and foreign currency transactions are transactions whose terms are denominated in a foreign currency or require settlement in a foreign currency—arise when an entity:
- buys or sells on credit goods or services whose prices are denominated in foreign currency;
- borrows or lends funds and the amounts payable or receivable are denominated in foreign currency;
- is a party to an unperformed foreign exchange contract, or (4) for other reasons acquires or disposes of assets or incurs or settles liabilities denominated in foreign currency.
Is the above definition clear for you? Not really, isn’t it? For example, you’re a U.S reporting entity and has a subsidiary operated in France. The France subsidiary uses franc, poundsterling and euro for its daily operation. Which one is the subsidiary’s functional currency?
Okay. A functional currency is a currency that either:
- mainly influences sales prices for goods and services as well as the currency of the country whose competitive forces and regulations mainly determine the sales prices of the entity’s goods and services; or
- primarily influences labor, material, and other costs of providing those goods or services.
- The currency which influences selling prices is most often that currency in which sales prices are denominated and settled; and
- The currency that most influences the various input costs is normally that in which input costs are denominated and settled.
Note, however, there are many situations in which input costs and output prices will be denominated in or influenced by differing currencies (e.g., a manufacturer that manufactures all of its goods in China, using locally sourced labor and materials, but sells all or most of its output in United States in USD-denominated transactions).
Next question: how do we translate the financial results of a foreign entity’s operations into the presentation currency of its parent?
Two methods are used—depends on : (1) translation into the presentation currency; and (2) translation into the functional currency method. Read on for the details
Translation into the Presentation Currency Method
By saying “presentation currency” means: the currency in which the reporting entity’s financial statements are presented. For example: You’re a UK reporting entity and have a foreign subsidiary operated in Singapore. If your financial statement, in the UK, is denominated (=measured) in GBP, then your presentation currency is the GBP.
Therefore, the essence of “translation into the presentation currency” is converting the foreign entity (subsidiary)’s statements—which uses its functional currency—into the currency used by the parent entity. So, in the above example, if the Singapore subsidiary’s functional currency is SIN$, then you’re converting SIN$ (used on the Singapore Subsidiary’s statements) into the GBP—to get all amounts on the parent’s statements are in GBP.
The key consideration when making foreign currency translations is that, the underlying economic relationships presented in the foreign entity’s financial statements should not be distorted or changed during the translation process into the presentation currency. For example, if the foreign entity’s functional currency statements report a current ratio of 3:1 and a gross margin of 30% of net sales, these relationships should pass through the translation process into the presentation currency.
When the translation is complete, the performance of the foreign entity’s management can be evaluated with the same economic measures used to operate the foreign entity.
Here are three sequential steps you want to take to complete the translation into the presentation currency method:
Step-1. Determine the functional currency of the subsidiary – The subsidiary most likely use a variety of currencies, which makes the job a little bit challenging. In this case, you would then need to determine the functional currency (see the functional currency concept discussed above).
Step-2. Convert all of the subsidiary’s transactions to this functional currency – Note: all entities should 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 parent’s financial results.
Step-3. Convert the results and financial position (balance sheet) of an entity whose functional currency is other than the presentation currency.
Note, however that, in the case of hyperinflationary economy, the third step requires special treatment. Hyperinflation is indicated by characteristics of the economic environment of a country, which include: the general population’s attitude toward the local currency, prices linked to a price index, and the cumulative inflation rate over three years approaching or exceeding 100%.
Here are the procedures to take—extended from the third setep above—in the case of hyperinflationary economic:
- Translate all assets and liabilities at the closing rate of that statement of financial position—including comparatives (Note: “closing rate” = the “spot exchange rate” at the statement of balance sheet date. While “spot exchange rate” = the exchange rate for immediate delivery of currencies exchanged).
- Translate income and expenses for each income statement—including comparatives—at the exchange rate at the dates of the transactions (or at the average rate for the period when this is a reasonable approximation).
- Recognize exchange differences in “Other Comprehensive Income” of the “Statement of comprehensive income.” Note: the cumulative amount of the exchange differences is reported as a separate component of the “Equity” section of the corporate parent’s consolidated Balance Sheet—as “Foreign Currency Translation Reserve”—until disposal of the foreign subsidiary (see next)
- On the disposal of a foreign entity, the cumulative amount of the exchange differences relating to that foreign operation, recognized in other comprehensive income and in a separate component of equity, should be reclassified from equity to profit or loss (as a reclassification adjustment) when a gain or loss on disposal of this entity is recognized.
Before going on the next translation, you may wonder: “To be exact, what exchange rates to use?” If so, read the next snippet.
Exchange Rates Used for Calculations
There is potential confusion regarding the precise exchange rate to be used when conducting foreign currency translations. Here are handy pointer you can follow:
- 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 the presentation currency, 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, which 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.
Translation into the Functional Currency Method
A second method of translating foreign entities’ financial statements is used when the functional currency of the foreign entity is not its local currency. Using the previous example, if the Singapore subsidiary’s functional currency is not SIN$, then you would use “Translation into the Functional Currency” method. Other indicators of when this method is used, is when:
- the subsidiary has close operational integration with its parent (direct production or sales arm of the parent);
- sales prices are influenced by the currency other than the local currency; or most of its financing, sales, and expenses are denominated in the currency other than the local currency, but it uses the local currency to record and report its operations.
Under this method, you translate monetary items (including: cash and any transactions that will be settled in cash—i.e. accounts receivable, payable and any loans) at the spot exchange rate as of the date of the financial statements. All other assets and liabilities (i.e. inventory; prepaid items; property, plant, and equipment; trademarks; goodwill; and equity) will be settled at the historical exchange rate on the date when these transactions occurred.
Monetary items are units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency (IAS 21). Non-monetary items that are measured at fair value in a foreign currency (e.g., property, plant, and equipment) should be translated using the exchange rates at the date when the fair value was determined.
Here are procedures to use for reporting foreign currency items in the functional currency method:
Step-1. Verify that the subsidiary’s functional currency is not local currency—in which transactions were recorded.
Step-2. Use “exchange rates”—according to specific situation—to translate the subsidiary’s financial statements into the functional currency. Here are exchange rates to be used for different accounts:
Use closing exchange rates for: all monetary items (i.e. cash accounts and any accounts that will be settled in cash—e.g. accounts receivable or payable).
- Use historical exchange rates (at the date of transaction) for: all non-monetary items (asset and liability accounts that will not be settled in cash)—that are measured at historical cost in a foreign currency, e.g. depreciation, intangibles, and inventories carried at cost.
- Use exchange rates at the date when the fair value was determined for: non-monetary items that are measured at fair value in a foreign currency.
- Use the weighted-average exchange rate for: all revenues and expenses, except those for which historical exchange rates have already been used.
Step-3. Record any exchange differences in profit or loss.
Step-4. Apply translation into the presentation currency if the functional currency is different than the presentation currency.
In a few cases, the income statement is impacted by the items on balance sheet that have been translated using historical interest rates. For example, the cost of goods sold will be impacted when inventory that has been translated at a historical exchange rate is liquidated. If that is the case, you would charge the inventory valuation at the historical exchange rate, through the income statement. You can use the same approach for the depreciation of plant and equipment and the amortization of intangible items.
Translation of Foreign Currency Transactions
Basically, you should record foreign currency transactions on initial recognition, in the functional currency. You can do this by applying to the foreign currency amount the spot exchange rate between the ‘functional-currency’ and the ‘foreign-currency’ at the date of the transaction.
Additionally, at the date of each balance sheet—interim as well as annual, you would need to adjust the account balances denominated in a currency other than your presentation currency—to reflect changes in exchange rates during the period since the date of the last statement of financial position (or since the foreign currency transaction date if it occurred during the period.)
Finally, you would need to recognize the exchange differences in profit or loss in the period in which they arise.
Here are the key rules to remember:
1. If your company is directly engaged in foreign exchange transactions that are denominated in foreign currencies, then any translation adjustments to the presentation currency that result in gains or losses should be recognized immediately in the income statement.
Note: You can continue to make such 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.
2. You don’t report gains/losses on transactions of a long-term nature when accounted for by the equity method. These transactions are defined as those with no settlement date planned in the foreseeable future. Instead, you would include these transactions in the standard translation procedure used to translate the financial statements of a subsidiary into the currency of its parent.
3. If a foreign entity has multiple distinct operations, it is possible that some have different functional currencies. If so, you should review your operations regularly—to determine the correct functional currency to use and translate their financial results accordingly.
Note: If the results of a selected operation on the financial reports of a foreign entity are insignificant, there is no requirement to break out its financial statements using a different functional currency.
4. 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 you should itemize the change and its impact on the financial statements, in financial statement footnote.
Note: See some footnotes you need for foreign currency translation.
Accompanying Footnotes for Foreign Currency Translation
Many items (related to foreign currency transactions) that occur in a not-so-straight forward way, and there is no way for accountants to include every bit of calculation and its underlying circumstances in the financial statements or the statements become too long. You would need to disclose them on the financial statement footnote, instead.
Aggregate transaction gains or losses related to foreign exchange must be disclosed in the attached footnotes. Here is an example of such footnote:
“The company conducts business with companies in several Far East countries as part of its ongoing textile import business. This results in a number of payables denominated in the currencies of those countries, with about $250,000 to $500,000 of such payables being outstanding at any one time. The company does not engage in hedging activities to offset the risk of exchange rate fluctuations on these payables. During the reporting period, the company benefited from foreign exchange gains on these accounts payable totaling approximately $7,500.”
Next item is the “Foreign Currency Translation Reserve”—in the equity section of the balance sheet that accounts the exchange different (as a result of the translation of financial statements into the presentation currency) and the cumulative amount of this adjustment. For this item, you would need to accompany footnote describes (a) changes in the amount of this balance; (b) the amount of income taxes allocated to it; and (c) any amounts shifted out of this account and recognized as part of the sale or termination of a company’s investment in a foreign entity. Here is an example of such footnote:
“The company summarizes in the equity section of the statement of financial position all exchange differences resulting from the translation of the financial statements of its three foreign subsidiaries into the consolidated corporate statements. During the reporting period, the balance in this account declined by $50,200 to a new balance of $225,650, reflecting the cumulative impact of translation losses incurred during the period. Approximately 30% of this decline was attributable to the sale of the company’s travel subsidiary located in Indonesia. In addition, 60% of this decline was attributable to the partial write-down on the company’s investment in its Sun Giok Pte Ltd subsidiary.”
Finally, you would also need to make footnote for the impact of change IF there has been a significant change in a foreign currency—in which you have significant outstanding transactions, and this change has occurred subsequent to the financial statement date, the impact of this change should be reported as a footnote to the statements. For example:
“About 20% of the company’s revenue is earned from sales to India. On January 14, subsequent to the date of these financial statements, the exchange rate of the India Rupee dropped 12% from its value on the financial statement date. Since all of the company’s sales to India are denominated in Rupee, this represents a potential loss of 12% when those revenues are eventually paid by customers in Rupees. At this time, the drop in value would represent a foreign exchange loss to the company of approximately $415,000. As of the release date of these statements, no accounts receivable related to the sales had been paid by customers. All receivables related to the sales should be collected by the end of February and so are subject to further fluctuations in the exchange rate until that time.”