Foreign Currency Translation: International Accounting Basics
Foreign currency translation is the accounting method in which an international business translates the results of its foreign subsidiaries into domestic currency terms so that they can be recorded in the books of account.
The foreign entities owned by your business keep their accounting records in their own currencies. To apply the appropriate method of these investments, you must translate the financial statements from the foreign currency into domestic currency.
What this article covers:
- What Is Foreign Currency Translation?
- Foreign Currency Translation Process
- Foreign Currency Translation Methods
- What Is Foreign Currency Translation Adjustment?
What Is Foreign Currency Translation?
If your business entity operates in other countries, you will be using different currencies in your business operations. However, when it comes to accounting, your financial statements have to be recorded in a single currency. This is why you need to perform foreign currency translation.
For example, if your company has its headquarters in the US but has operations in the UK, you must translate the British pound into US dollar.
A part of their financial record keeping, foreign currency translation is the process of estimating the amount of money in one currency in the denomination of another currency. The process of currency translation makes it easier to read and analyze financial statements which would be impossible if they were to feature more than one currency.
Foreign Currency Translation Process
The three steps in the foreign currency translation process are as follows:
Determine the functional currency of the foreign entity
Businesses must determine a functional currency for reporting. The functional currency is the one which the company uses for the majority of its transactions. You can choose the currency of the country where your main headquarters are located or where your major operations are.
This can be difficult to determine when you conduct an equal amount of business in multiple countries. However, once you choose the functional currency, changes to it should be made only when there is a significant change in circumstances and economic facts.
Remeasure the financial statements of the foreign entity into the functional currency
You need to ensure that all your financial statements use the reporting currency.
The translation of financial statements into domestic currency begins with translating the income statement. According to the FASB ASC Topic 830, Foreign Currency Matters, all income transactions must be translated at the rate that existed when the transaction occurred.
The GAAP regulations require the items in the balance sheet be converted in accordance with the rate of exchange as on the date of balance sheet while the income statement items are converted according to the weighted average rate of exchange.
It is vital that you keep a close eye on the dates in which any of the above transactions occurred. Although most currency translation occurs at the financial year-end, the exchange rates are determined by the transaction date in some instances. Bank statements and income records help you to determine the right rates.
Record gains and losses on the translation of currencies.
The gains and losses arising from foreign currency transactions that are recorded and translated at one rate and then result in transactions at a later date and different rate are recorded in the equity section of the balance sheet.
Foreign Currency Translation Methods
Since exchange rates are constantly fluctuating, it can cause difficulty while accounting for foreign currency translations. Instead of simply using the current exchange rate, businesses may look at different rates either for a specific period or specific date.
Current rate Method
Using this method of translation, most items of the financial statements are translated at the current exchange rate. The assets and liabilities of the business are translated at the current exchange rate.
Since this can lead to volatility associated with changes in the exchange rate, gains and losses associated with this translation are reported on a reserve account instead of the consolidated net income account.
Temporal Rate Method
The temporal rate method, also known as the historical method, is applied to adjust income-generating assets on the balance sheet and related income statement items using historical exchange rates from transaction dates or from the date that the company last assessed the fair market value of the account.
Monetary-Nonmonetary Translation Method
The monetary-nonmonetary translation method is used when the foreign operations are highly integrated with the parent company.
The method translates monetary items such as cash and accounts receivable using the current exchange rate and translates nonmonetary assets and liabilities including inventories and property using the historical exchange rate.
What Is Foreign Currency Translation Adjustment?
The foreign currency translation adjustment or the cumulative translation adjustment (CTA) compiles all the fluctuations caused by varying exchange rate.
Businesses with international operations must translate their transactions like the acquisition of assets or the purchase of services into their functional currency. With foreign exchange fluctuations, the value of these assets and liabilities are also subject to variations.
The gains and losses arising from this are compiled as an entry in the comprehensive income statement of a translated balance sheet. According to the FASB Summary of Statement No. 52, a CTA entry is required to allow investors to differentiate between actual day-to-day operational gains and losses and those caused due to foreign currency translation.
There are different rules for translating items in financial statements including assets and liabilities, income statement items, cash flow statement items, etc. Considering its complexity, it may be best to consult an accountant regarding the rules of accounting for foreign currency translation.