To begin with, we would like to tell you why firms translate. First, it facilitates the preparation of consolidated financial statements that allow users to see the performance of a multinational company’s total operations, both domestic and foreign.
Foreign currency translation also facilitates the measurement of a company’s exposure to foreign exchange risk. It helps with the recording of foreign currency transactions, such as foreign currency purchases, sales, borrowing, or lending in the consolidated entity’s reporting currency. Finally, it facilitates reporting domestic accounts to interested foreign entities.
What Is Foreign Currency Translation?
A foreign currency translation is a process of expressing monetary amounts that are stated in forms of foreign currency by a direct exchange rate. The exchange rate is the ratio between a unit of one currency and the amount of the other currency for which that unit can be exchanged for at a particular time.There are three types of translation rates. The first one is a historical rate, which is the exchange rate prevailing when a foreign currency asset was first acquired, or a foreign currency liability was first incurred. The second, a current rate, is the exchange rate prevailing as of the financial statement date. The last one is an average rate. It is a simple or weighted average of either historical or current exchange rate.
Foreign Currency Translation Process
The financial statement translation process would consist of the following steps:
- Determine local currency
The local currency is the currency in which the business maintains its books and records.
- Determine the functional currency of the foreign entity
To determine what the functional currency is, you need to ask yourself, “Where does the business conduct its primary economic activity?”. The primary economic activity indicators are the currency that determines the sales price of goods and services, what country’s regulations affect the selling price and the COGS. The secondary indicators include your financing sources and where you keep your excess funds.
- Determine to report currency
The currency to which you will translate will be your presentation currency or currency that you will write on your financial statements at the end of the financial year.
- Remeasure the financial statements of the foreign entity into the functional currency
Next, you need to convert the financial statements of the foreign subsidiary into the parent company’s functional currency using a temporal method.
- Translate functional currency into reporting currency using a current rate method.
- Record gains and losses that result from the currency translation.
Finally, you would record the gains and losses caused by exchange rate fluctuations over the years (a.k.a. currency translation adjustment) according to the translation method you used.
Foreign Currency Translation Methods
In the current rate method, we take all company’s assets and liabilities and translate them at the year-end rate. If there are different balance sheet dates, use the exchange rate in effect as of the foreign entity’s balance sheet date. The equity will always be calculated at the historical rate, which is the original rate. For example, if you are translating the share capital, the historical rate for share capital would be the exchange rate on the day when those shares were issued.
Since you will translate assets and liabilities and equity at two different exchange rates, you will have an imbalance in your accounting equation. This difference is called translation gain or loss, and it sits in a reoccurring OCI account. All revenues and expenses, COGS, depreciation, and amortization are translated by an appropriate weighted average of currency exchange rates for the period.
In the temporal currency method, everything that is monetary under assets and liabilities is translated at the year-end rate (or foreign entity balance sheet date), and everything that is non-monetary is translated at the historical rate. Just like in the current rate method, the equity is translated at the historical rate. However, the translation gain or loss when using this method will be part of a Net Income.
Monetary means that the amount is fixed in its value by contract. For example, you can have a fixed amount of cash in a different currency, or you might owe a specific amount to suppliers in a different currency. Still, the value of both of these foreign amounts changes depending on the exchange rate. A good example of non-monetary items is PP&E. You will not restate the amount of inventory at the end of the year, and you would just restate the Accounts Payable.
Revenues and expenses, including the cost of sales if inventories are carried at the market, at an average rate. Depreciation, amortization charges, and cost of sales when inventories are carried at cost, at a historical rate in effect when related assets are acquired.
What is Foreign Currency Translation Adjustment?
As was mentioned above, when cash flows are translated from the local currency into the currency used for financial reporting, the translation may result in a gain or loss. Recognizing the gain or loss is commonly referred to as a Currency Translation Adjustment (CTA). To be able to tell the difference between the actual gains or losses and those that arose due to foreign currency translation, a CTA entry is made.
Gains or losses on currency translation make financial forecasting more difficult for the business. They also create more fluctuation in financial results. If translations between currencies are not hedged, they can create large financial losses. Losses occur if there is a large fluctuation in the currency exchange rate.