The current rate method is a method of foreign currency translation where most financial statement items are translated at the current exchange rate. 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.
The current rate method is a method of foreign currency translation where most items in the financial statements are translated at the current exchange rate. When a company has operations in other countries, it may need to exchange the foreign currency earned by those foreign operations into the currency used when preparing the company’s financial statements — the presentation currency. IAS 21 The Effects of Changes in Foreign Exchange Rates outlines how to account for foreign currency transactions and operations in financial statements, and also how to translate financial statements into a presentation currency. An entity is required to determine a functional currency (for each of its operations if necessary) based on the primary economic environment in which it operates and generally records foreign currency transactions using the spot conversion rate to that functional currency on the date of the transaction. Income statement items are translated at the weighted average rate for the accounting period.
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.
The change in foreign currency translation is a component ofaccumulated other comprehensive income, presented in a company’s consolidated statements of shareholders’ equity and carried over to the consolidated balance sheet under shareholders’ equity. Currency translation is the process of converting the financial results of a parent company’s foreign subsidiaries into its functional currency, the primary economic environment in which an entity generates and expends cash. For transparency purposes, companies with overseas ventures are, when applicable, required to report their accounting figures in one currency.
Translation adjustments are an inherent result of the process of translating a foreign entity’s financial statements from the functional currency to U.S. dollars. Translation adjustments are not included in determining net income for the period but are disclosed and accumulated in a separate component of consolidated equity until sale or until complete or substantially complete liquidation of the net investment in the foreign entity takes place.
ASC 830 also applies to the translation of financial statements for purposes of consolidation or combination, or the equity method of accounting. Companies reporting under International Financial Reporting Standards (IFRS) are subject to International Accounting Standard No. 21, The Effects of Changes in Foreign Exchange Rates (IAS 21), which is substantially similar to ASC 830. Remeasurement is the process of “remeasuring” or converting financial statement amounts that are denominated in another currency to the entity’s functional currency. And, that change in expected currency cash flows is required to be recorded as foreign currency transaction gains or losses that should be reflected in net income for the period in which the exchange rate changes.
A business unit may be a subsidiary, but the definition does not require that a business unit be a separate legal entity. Pursuant to ASC , foreign currency financial statements of a foreign investee accounted for by the equity method should be translated to the reporting currency in the same manner as the financial statements of a consolidated foreign investee. First, the functional currency of the equity method investee should be determined and transactions denominated in currencies other than its functional currency should be remeasured. Then, if the functional currency of the equity method investee is different from the reporting currency of the equity method investor, the financial statements of the investee should be translated into the reporting currency at the current rate before determining the balance of the investor’s equity investment.
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After the remeasurement process is complete or if the functional currency is the home currency, the current rate method is used. The current method translates all assets and liabilities at the current spot rate at the date of translation. Equity items, other than retained earnings, are translated at the spot rates in effect on each related transaction date (specific identification). Retained earnings are translated at the weighted-average rate for the relevant year, with the exception of any components that are identifiable with specific dates, in which case the spot rates for those dates are used. Income statement items are translated at the average rate for the period, except where specific identification is practicable.
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. It is vital that you keep a close eye on the dates in which any of the above transactions occurred.
Keeping accounting records in multiple currencies has made it more difficult to understand and interpret the financial statements. For example, an increase in property, plant and equipment (PP&E) may mean that the company invested in more PP&E or it may mean that the company has a foreign subsidiary whose functional currency strengthened against the reporting currency.
- Companies that consolidate the results of foreign operations denominated in local currencies must translate the foreign financial statements into U.S.
- ASC 830 (aka FAS 52) provides the accounting and reporting requirements for foreign currency transactions and the translation of financial statements from a foreign currency to the reporting currency.
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Transaction gains and losses are a result of the effect of exchange rate changes on transactions denominated in currencies other than the functional currency (for example, a U.S. company may borrow Swiss francs or a French subsidiary may have a receivable denominated in kroner from a Danish customer). Gains and losses on those foreign currency transactions are generally included in determining net income for the period in which exchange rates change unless the transaction hedges a foreign currency commitment or a net investment in a foreign entity. Intercompany transactions of a long-term investment nature are considered part of a parent’s net investment and hence do not give rise to gains or losses. Translation risk is often referred to as “accounting risk.” This risk occurs because each “business unit” is required under FASB Statement no. 52, Foreign Currency Translation, to keep its accounting records in its functional currency and that currency may be different from the reporting currency.
The CTA detail may appear as a separate line item in the equity section of the balance sheet, in the statement of shareholders’ equity or in the statement of comprehensive income. The current rate method differs from the temporal (historical) method in that assets and liabilities are translated at current exchange rates as opposed to historical ones.
What Is Foreign Currency Translation?
This can create a high amount of translation risk, as the current exchange rate may change. To help smooth this volatility, gains and losses associated with this translation are reported on a reserve account instead of the consolidated net income account as in the temporal method. Currency translation is the process of converting a foreign entity’s functional currency financial statements to the reporting entity’s financial statements. Constant currencies are exchange rates used by international companies to eliminate the effects of foreign currency fluctuations in financial statements.
Under FAS 52, the temporal method is also used when the subsidiary operates in a highly inflationary environment. Companies reporting under IFRS treat this differently by re-measuring the financial statements at the current balance sheet rate in order to present current purchasing power. GAAP, on the other hand, does not generally permit inflation-adjusted financial statements. Gains and losses resulting from currency conversions are recorded in financial statements.
Using the concept that a picture is worth a thousand words—and a worksheet even more—this article uses Excel and real-world examples to explain why multinational companies are increasingly experiencing and managing what is often referred to as accounting risk caused by foreign currency exchange rate (FX) fluctuations. The article is designed to help the reader create the worksheet shown in Exhibit 3, and then use it to see firsthand how FX fluctuations affect both the balance sheet and income statement, and how currency translation adjustments (CTAs) may be hedged. It is Step 4, Measure Foreign Currency Transactions, and Step 5, Translate Financial Statements of Foreign Entities, that I want highlight. It is important to understand the distinction, as there are different accounting impacts from the remeasurement process of certain foreign currency transactions versus the foreign currency translation of an entity’s financial statements to the reporting currency.
Although most currency translation occurs at the financial year-end, the exchange rates are determined by the transaction date in some instances. the entity reports the effects of such translation in accordance with paragraphs [reporting foreign currency transactions in the functional currency] and 50 [reporting the tax effects of exchange differences].
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The resulting adjustment is not recognized in current earnings, but rather as other comprehensive income, a separate component of stockholders’ equity. If the functional currency of the subsidiary is not its home currency, the temporal (historical) method is used. Under this method, nonmonetary balance sheet accounts and related income statement accounts are re-measured using historical exchange rates. The remeasurement process should produce the same result as if the entity’s accounting records had been maintained in the functional currency. Adjustments resulting from the remeasurement process are generally recorded in net income.
As this worksheet is created, the equations will produce the amounts shown in Exhibit 4. The worksheet includes lines used later, as shown in Exhibit 5, to demonstrate how a parent company can hedge translation risk by taking out a loan denominated in the functional currency of the subsidiary. Hypothetical amounts for the two trial balances and the currency exchange rates are shown in green.
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.
Companies that consolidate the results of foreign operations denominated in local currencies must translate the foreign financial statements into U.S. ASC 830 (aka FAS 52) provides the accounting and reporting requirements for foreign currency transactions and the translation of financial statements from a foreign currency to the reporting currency.
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. 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. CPAs can use Excel to create a basic consolidation worksheet like the one in Exhibit 3 that demonstrates the source of currency translation adjustments and the effects of hedging (download these worksheets here).
This may not seem like a significant issue, but goodwill arising from the acquisition of a foreign subsidiary may be a multibillion-dollar asset that will be translated at the end-of-period FX rate. As shown in Exhibit 1, eBay’s currency translation adjustments (CTA) accounted for 34% of its comprehensive income booked to equity for 2006. General Electric’s CTA was a negative $4.3 billion in 2005 and a positive $3.6 billion in 2006.