What is Foreign Currency Translation?
Foreign currency translation refers to the accounting method in which companies having international businesses translate the financials of their international subsidiaries into its domestic or the functional currency with the motive of meeting the financial reporting requirements, where any gains or losses arising out of such translation are to be recorded in the consolidated financial statements.
Explanation
In the present world, many of the companies operate in different areas of the world having different currencies, but in order to present a better picture of the company financial statementCompany Financial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more of the foreign subsidiary should be presented in the same reporting currency as of parent company. Here, foreign currency translation comes into the picture, which is used in accounting to re-measure the financial statements of a foreign subsidiary. As per US GAAP, the balance sheet items are converted at the rate of exchange prevailing on balance sheet date, and the company’s income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more items are converted at the weighted-average exchange rate for the particular year. All the profits and losses arising from such currency translation will form part of the other comprehensive incomeOther Comprehensive IncomeOther comprehensive income refers to income, expenses, revenue, or loss not being realized while preparing the company's financial statements during an accounting period. Thus, it is excluded and shown after the net income.read more.
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Process
- To translate the foreign subsidiary’s financial statement into the reporting currency of the parent company, it is to be ensured that the subsidiary’s financial statement is prepared according to GAAPGAAPGenerally accepted accounting principles (GAAP) are the minimum standards and uniform guidelines for the accounting and reporting. These standards prohibit firms from engaging in unethical business activities and enable for a more accurate comparison of financial reports to investors.read more. So, the foreign currency translation process’s first step involves matching the foreign entities’ financial statements to US GAAP.
- After that, the foreign entity’s functional currency is to be determined, i.e., identifying the currency in which financial statements of the foreign currency are reported.
- In the next step, foreign entities’ financial statements will be reassessed in the functional currencyFunctional CurrencyThe term functional currency represents the currency of the location in which business operates primarily, earns a significant portion of revenue, and incurs the cost to generate such profits. In short, it is the home currency of that country where the corporate headquarter is situated.read more of the parent company, which is generally its domestic currency.
- Lastly, all the profits and losses arising from such currency translation will be recorded in the financial statements.
This process will be followed at each of the balance sheet dates.
Foreign Currency Translation Methods
#1 – Current Rate Translation
According to this method of currency translation, all the assets and liabilities of the foreign subsidiary are translated into the parent company’sParent Company'sA holding company is a company that owns the majority voting shares of another company (subsidiary company). This company also generally controls the management of that company, as well as directs the subsidiary's directions and policies.read more functional currency at the current rate or the exchange rate prevailing on the balance sheet date of the company. However, the equity section items are translated using the historical rates, and items of Income statements are translated using the actual exchange rates, i.e., rates prevailing on dates of actual recognition of revenues and expenses.
#2 – Temporal Rate Translation
This method is also known as the historical method, and according to this method, all the balance sheet itemsBalance Sheet ItemsAssets such as cash, inventories, accounts receivable, investments, prepaid expenses, and fixed assets; liabilities such as long-term debt, short-term debt, Accounts payable, and so on are all included in the balance sheet.read more are not recognized at a single exchange rate, and rather both the current rate as well as historical rate, is considered based on how the same are carried on books of the entity.
#3 – Monetary-Nonmonetary Translation
This method makes a distinction between the monetary and non- monetary assets and the liabilities of the company where the monetary accounts are translated at the current exchange rate because they are readily convertible into cash and values of which fluctuate over the time and all the non-monetary accounts are translated at the historical rates.
Adjustment of Foreign Currency Translation
The company’s cumulative translation adjustment (CTA) should include all the translation adjustments arising from foreign currency translation. This CTA is shown under the translated balance sheet’s comprehensive income section (part of shareholders’ equity), which compiles all the gains or losses arising out of exchange rate fluctuations.
Advantages
- In case of the multiple operations of a company in different countries, the company will be using different currencies for their business operationsBusiness OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation.read more, but from an accounting point of view, financial statements should be presented in a single currency, and for this, foreign currency translation is required.
- This process of the currency translation analyzes financial statements in a better manner as if more than a single currency is used; then it makes the analysis difficult.
Disadvantages
- If there is a major change in the exchange rate, then considering them in income statements may significantly fluctuations in the current year’s earnings.
- It ignores the changes in the exchange rates, and translation gains and losses are recognized in the income statement as soon as it occurs.
Foreign Currency Transaction vs. Foreign Currency Translation
Foreign Currency transaction refers to the operations that are conducted by the business entity in a currency which is different than its functional currency, whereas the foreign currency translation refers to the conversion of the foreign currency transaction into the functional currency as the same is done in the currency other than its functional currency.
Important Considerations
- In case the company’s functional currency is foreign currency, then there arises the translation adjustment by translating the company’s financial statements into reporting currency.
- Unrealized translation adjustments are not included in the income statements and are shown separately as a component of equity.
- At the time of liquidationLiquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order.read more or at the time of sale of the investment in a foreign company, the translation adjustment amount in the equity section is eliminated from there and considered as part of an income statement.
Conclusion
Businesses with international operations are required to translate their transactions to their functional currency, which is generally their domestic currency. With the fluctuation in the foreign exchange, the value of the company’s assets and liabilities is also subject to variations. All the translation adjustments arising due to foreign currency translation are recorded in the shareholders’ equity section in the parent company’s consolidated balance sheet.
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