Foreign Currency Translation, A Need-to-Know in International Accounting
It is a frequent practice for most organizations or entities to engage in transactions that use and involve foreign money. While generally a wise business move, operating this way sometimes presents complications, as the methods of handling foreign and local currencies may vary. Specifically, the issue lies in consolidating the organization’s financial statements.
With foreign currency regularly flowing through a company’s system, accurate conversion is the biggest concern, as using the wrong exchange rates could lead to discrepancies in accounting. A scenario of this, for example, is using different exchange rates for the same set of data. Should a similar instance happen repeatedly, the result would be a large buildup of inaccurate numbers on file. Eventually, this leads to bigger problems, especially when filing for more official purposes, such as for annual taxes or when appealing to potential investors.
This is the exact reason why international companies must make themselves familiar with the fundamental concepts in international accounting. In this particular case, the applicable process is foreign currency translation. Find out more about this basic international accounting method below.
What is Foreign Currency Translation?
Foreign currency translation is, quite literally, the method of translating foreign money into the currency of the primary economic environment. This is one of the basic tenets of international accounting; any entity dealing with foreign currency must convert said money in a way that is suitable to their existing financial accounts. Failure to properly translate the amounts involved could possibly lead to bigger accounting problems in the future.
In this case, “foreign” refers to any countries, territories, and businesses that are outside of the organization’s main area of operation. This includes business deals done with foreign companies or business conducted by an overseas branch of the parent company. Additionally, having an international business means that while a branch may record their finances in the functional currency of their location, the main branch still must translate those figures for accounting.
As a side note, although some words in currency translation accounting seem daunting and technical, it is very easy to understand. To help you out, here are a few basic words to add to your accounting vocabulary:
- Parent Company
This is the “original” or main company that subsequently launched branches or subsidiaries. Parent companies are the ones to mitigate the issues for foreign currency translation. They translate currency data from their branches and subsidiaries to combine the organization’s overall financial statement.
- Functional Currency
Functional currency is the main currency used by a business for most of its transactions. For example, a British company with subsidiaries in the United States would have the US dollar as its functional currency for the said subsidiary. This is despite the parent company’s financial statement being recorded in British pounds.
- Reporting Currency
Following functional currencies, a reporting currency is that which entities use to report their financial statement. Once the functional currency is established, this data must be consolidated for translation into the company’s reporting currency. The transition between this and functional currency is where some adjustments happen according to exchange rates and other factors.
- Constant Currency
Since the translation of currency is affected by multiple external variables (e.g., exchange rates), fluctuating numbers cannot be helped. Organizations try to circumvent the impact on their financial performance by publishing both the outright financial report (which reflects fluctuations), and the data without these fluctuations. This information is vital for potential and existing investors because it is a more accurate representation of the company’s performance, and thus a better judge for its future.
Speaking of external variables and fluctuations, translation risk is the risk that comes with transacting in foreign currencies. Companies face a problem when the exchange rates fluctuate before they are able to fully consolidate their financial statements. Even accounting for company assets is tricky since their value is also dependent on different factors, including the flow of exchange rates.
Typically, it is the big corporations that are most affected by translation risks. Nevertheless, this risk applies to small businesses that deal in foreign currencies as well. This means that the income they gained from foreign transactions must also be accordingly translated and included in the financial reports.
Foreign Currency Translation Process
The procedure for foreign currency translation is relatively simple and can be done in three moves:
- Identify the functional currency of the foreign party. This applies to all sources, whether it’s from a subsidiary, branch, or individual client based overseas. For example, if a client from Canada pays an Australian business in Canadian dollars, the functional currency is CA dollar and not AU dollar.
- Translate the foreign functional currency into the parent/main branch’s functional currency. This step is where a foreign subsidiary’s functional currency turns into the company’s reporting currency. It is important to align and use a uniform currency for financial statements to avoid discrepancies in accounting.
- Consolidate and record all data to find profit gained and lost in the currency translation process. Translation risk comes to play because of the volatile exchange rates. This is also where companies make use of constant currencies to avoid rate fluctuations from affecting their financial performance on paper.
Foreign Currency Translation Methods
To mitigate currency translation risks and effects, companies make use of different foreign currency translation methods. Rather than solely relying on current exchange rates, some organizations may opt to use another rate, depending on different factors.
- Current Rate Method
This is a straightforward way of converting foreign business assets and liabilities. It simply goes off of the current exchange rate, exposing finances more to fluctuating exchange rates. Because of the risks present, the effect of this currency translation method is often detailed on a separate account, apart from the rest of the company’s consolidated income report.
- Temporal Rate Method
The temporal rate method can also be called the “historical method” because it is used based on varying time factors. Typically, this means applying exchange rates according to either of two time-based events. One is the date of transaction; the other is the date of the company’s most recent assessment of the asset’s fair market value.
- Monetary-Nonmonetary Translation Method
Monetary-nonmonetary translation entails combining the two other foreign currency translation methods. This technique is most useful for entities with regular and heavily ingrained foreign transactions. It is particularly beneficial for parent companies with active branches and subsidiaries abroad.
This method separates an organization’s monetary assets from the nonmonetary. The money is then translated using the current rate method, basing on the present exchange rate. All nonmonetary items (e.g., equipment, inventories, properties) are then converted through the temporal rate method.
What is Foreign Currency Translation Adjustment?
Also known as cumulative translation adjustment (CTA), foreign currency translation adjustment pertains to the combination of all the fluctuations from exchange rates. This accounts for the gains and losses inflicted by the fluctuating exchange rate and thereby helps in showing a company’s true financial abilities. Along with the organization’s foreign profits, assets and services acquired internationally are also subject to translation, and consequently, exposed to the risks of exchange rate variations.
In compliance with the Financial Accounting Standards Board (FASB), CTAs must enable investors to discern the difference in the company’s actual financial performance without the impact of gains and losses caused by foreign currency translation. Currency translation accounting can be a complicated and grueling task. Because of this, it is recommended to have a licensed accountant go over the necessary financial statements.