Accounting for foreign currency: Will you get lost in translation?

Introduction

Figures from the World Trade Organization show that since the 1980’s global trade has more than quadrupled in volume and has grown with an average of almost 5% per annum. International trading relationships increasingly make countries more interdependent and this globalization process poses some interesting questions from an accounting perspective regarding accounting for foreign currency. It is therefore relevant to note that the accounting guidance for company transactions and business operations conducted in foreign currency has not significantly changed since FASB Statement 52 was issued in 1981 and became effective in 1983 (principles currently included under FASB Accounting Standards Codification 830). This blog provides a brief refresher course of the methodology to follow in order to properly account for foreign currencies under U.S. Generally Accepted Accounting Principles (US GAAP).

Three-step process

Fundamentally, accounting for foreign currencies entails a three-step process:

  1. Determination of the reporting currency of the consolidating enterprise, and determination of the functional currency of each business entity which is separately accounted for (i.e. a foreign subsidiary or an international business unit);
  2. Remeasurement of transactions executed in a foreign currency; recalculating transactions done in a currency other than the functional currency from the foreign currency to the functional currency of the business entity – this will provide insight into the translation gains and losses incurred resulting from transactions executed in foreign currencies, and these results will be recognized in the income statement;
  3. Translation and restatement of the business entities’ accounts into the reporting currency of the consolidating enterprise – this will enable consolidation and show the required adjustment to equity as a result of consolidating an entity with a functional currency different from the company’s reporting currency, and this adjustment will be accounted for as Cumulative Translation Adjustment (CTA) as part of equity under the Other Comprehensive Income (OCI) account.

To illustrate this process we will make use of a simplified example of a listed U.S. company selling shoes domestically and abroad through a Dutch subsidiary that operates as a global sales office.

Functional and reporting currency

The reporting currency of the company is the currency in which the enterprise as a whole publishes its consolidated financial statements. In the case of our example this will be the US Dollar as it concerns a U.S. registrant.

The functional currency is determined following ASC 830-10-45-2: “An entity’s functional currency is the currency of the primary economic environment in which the entity operates; normally, that is the currency of the environment in which an entity primarily generates and expends cash.”

That this requires some judgement shows our example below. Management needs to determine the functional currency of its Dutch subsidiary, which is reporting as follows:

As the significant cash flows of receipts and expenditures in Dollars and in Euros equal to USD 18,000,000 each, there seems to be no clear answer here. However, as the functional currency is regarded as a matter of fact, management should weigh other factors as well in determining the functional currency. Other variables that influence the economic environment can include, for example, the financing structure of the subsidiary (i.e. permanent or impermanent dollar nominated intra-company funding) or the requirements to file statutory reports and pay taxes in the local currency. Further to some additional analysis and taking a long-term view of the business entity, management eventually chooses the Euro as the functional currency of this business entity. Such decision should be documented and recorded properly for future referral and periodic evaluation.

Foreign currency transactions and remeasurement

Foreign currency transactions arise when a business entity buys or sells goods or services where prices are stated in a foreign currency. For example, a currency other than the functional currency of the entity, or borrows or lends funds and the amounts payable or receivable are denominated in such foreign currency.

ASC Topic 830 requires that all income transactions are translated at the rate that existed at the time the transaction occurred. This can be impractical in certain instances, and therefore the ASC allows for the use of a weighted average rate, for example by making use of monthly or quarterly exchange rates consistent with the company’s periodic management reporting cycle.

Let’s illustrate this process by following the entity previously used in our example. As the weighted average rate for the USD during the year amounted to $ 1.10 per EUR, sales in US Dollars of USD 8,000,000 and purchases in US Dollars in the amount of USD 10,000,000 are converted to the functional currency of the business unit at that rate. This results in sales of EUR 7,273,000 and cost of goods sold of EUR 9,091,000. Sales, purchases and other operating costs transacted in Euros do not need translation and can be stated as originally recorded.

Now that we have recorded all transactions in the operation’s functional currency, including the transactions in a foreign currency, subsequent measurement of foreign currency transactions will depend on whether the transaction gave rise to an account balance that is monetary or nonmonetary. We can distinguish as follows:

Monetary assets and liabilities

Monetary assets and liabilities, such as cash, accounts receivable, accounts payable, and long-term debt, create foreign currency exchange rate risk as they represent amounts that will be settled with counterparties in a currency other than an operation’s functional currency. Monetary assets and liabilities are measured at the end of each reporting period based on the then current

exchange rates. This measurement gives rise to foreign currency gains and losses, which are recorded in current period net income.

Nonmonetary assets and liabilities

Nonmonetary assets and liabilities, such as inventory and property, plant, and equipment, do not require future settlement or adjustment. Nonmonetary assets and liabilities are initially measured using historical exchange rates. All aspects of the ongoing accounting for these items (i.e.,depreciation, impairment, lower of cost or market) should be measured in terms of the operation’s functional currency.

Again, let’s take a look at what this means for the remeasurement of the Dutch subsidiary’s balance sheet at the end of the reporting period:

As the period-end conversion rate amounts to $1.15 per EUR, the monetary assets of Cash, Accounts Receivable and Accounts Payable are remeasured against this rate, with the differences resulting from the change in the exchange rate between the time the transaction occurred and the end of the reporting period recorded in the income statement as translation gains and losses from foreign currency. The non-monetary assets are not impacted, and therefore Inventory and Property, Plant and Equipment are stated at the EUR balance as originally (historically) recorded.

Translating the reporting entity’s financial statements

In case the functional currency of the foreign business unit is the same as the reporting currency of the consolidated enterprise, no further translation is necessary. In all other cases, income statement and balance sheet of the operating entity need to be translated into the reporting currency of the parent company so that consolidation can take place.

For this translation the following exchange rates should be used:

  • The period-end spot rate for assets and liabilities
  •  The weighted average exchange rate for income statement accounts
  •  Historical exchange rates for the equity accounts (except for the change in retained earnings during the year, which is the result of the income statement translation process.

This gives the following translation for our example case, with a weighted average rate of USD 1.15 per EUR for the current year and a period-end spot rate of USD 1.10 per EUR:


And finally, the gains and losses from translating the entity’s financial statements from its functional currency to the company’s reporting currency due to exchange rate changes are recorded as cumulative translation adjustments (CTAs) in the CTA account, which is a separate component of Other Comprehensive Income (OCI) in shareholder’s equity:

Conclusions

The longevity of the guidance seems to imply that there really is no need to get lost in translation. The methodology provides a logical framework that has proven its value in ensuring that foreign operations and transactions in foreign currency are dealt with in a consistent and effective manner.

Remarkably, but not shown in our example, following the prescribed guidance can lead to translation gains and losses resulting from converting transactions in foreign currency at one set of rates (for example daily spot rates) for purposes of translation and remeasurement during the year, but then subsequently using a uniform ‘weighted’ exchange rate for translating (back) the period income statement, including the same transactions, at the end of the year for purposes of consolidation and reporting. This as a uniform weighted rate will generally not exactly match a ‘true’ weighted rate, which would require the obvious impracticality of taking into account the exact volume of the transactions individually to calculate.

However, as the Financial Accounting Standards Board (FASB) considered, such effects will generally be immaterial and will not impact total shareholder’s equity, but only the classification within shareholders’ equity between Retained Earnings and the Cumulative Translation Adjustment account.

Nevertheless, as the field of international accounting can be vast indeed, please do not hesitate to contact Marcus Bergen at (650) 285 8656 if and when other specific accounting issues would arise.

 


 

Marcus is the Co-Lead for CFOs2GO’s International Practice Group. His background and skill set provides for valuable and dynamic support to set up effective country organizations, create proper company structures, implement timely and accurate management reporting and budgeting processes, ensure adequate frameworks of internal controls, provide interim CFO functionality, and support internal audit functions and projects when and where needed, in the U.S. or anywhere around the world.

If you would like to speak with Marcus, please use the Comments section to make a request.

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