Foreign Currency Translation in Financial Reporting
(Shortened URL: bit.ly/FCtranslation)
When a multinational corporation based in the U.S. owns more than 50 percent of the voting stock of a foreign company, a parent-subsidiary relationship exists. The parent company is usually required to prepare consolidated financial statements. Before this can be done, the financial statements of the foreign subsidiary must be recast using U.S. generally accepted accounting principles (GAAP). Next, the foreign accounts must be remeasured (translated) from the foreign currency into U.S. dollars. To make the translation, the first step is to identify three currencies: (a) currency of books and records (CBR) -- the CBR is the currency in which the foreign financial statements are denominated; (b) functional currency (FC) -- the FC is the one in which the subsidiary generally buys, sells, borrows, repays, etc.; and (c) the reporting currency (RC) -- the RC is the one in which the consolidated financial statements are denominated. There are three approaches to foreign currency translation in financial reporting (preparing financial statements): (1) temporal rate method, (2) current rate method, and (3) use of both methods. The following three rules are used to determine the method of translation:
Rule 1: If the FC is hyper-inflationary (i.e., 100% cumulative inflation within three years), then ignore the FC and remeasure the CBR into the RC using the temporal rate method.
Rule 2: If the CBR is different from the FC, then remeasure the CBR into the FC using the temporal rate method.
Rule 3: Translate from the FC into the RC using the current rate method.
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Over 90 percent of the time, Rule 1 and Rule 2 do NOT apply and you go directly to Rule 3.
You must apply the rules in sequence, stopping when the subsidiary's financial statements have been converted into the parent's reporting currency (RC). For example, when the functional currency (FC) is hyper-inflationary, then Rule 1 applies; that is, the financial statements which are denominated in the CBR are translated into the RC using the temporal rate method, and Rules 2 and 3 aren't used. A second example is as follows: The CBR is British pounds, the FC is Japanese yen (not hyper-inflationary), and the RC is U.S. dollars; then you skip Rule 1 and apply Rule 2, translating the CBR (pounds) into
the FC (yen) using the temporal rate method. Since the FC (yen) is not the RC (dollars), you would then apply Rule 3 to translate the FC (yen) into the RC (dollars) using the current rate method. A third example is as follows: When the FC is not hyper-inflationary and CBR is the same as the FC, then you go directly to Rule 3. The great majority of the time, over 90 percent, the translation process uses only Rule 3 because the the FC is not hyper-inflationary and the FC equals the CBR.
Using the current rate method, all assets and liabilities are translated using the current rate (i.e., exchange rate on the balance sheet date). Owners' equity and dividends are translated at historical rates (exchange rate at the time the asset was acquired, liability incurred, or element of paid-in capital was issued or reacquired). Income statement items can be translated using the average exchange rate (the average of the exchange rate at the beginning of the accounting period and the current rate).
Under the temporal rate method, the objective is to measure each subsidiary transaction as though the transaction had been made by the parent. Monetary items (e.g. cash, receivables, inventories carried at market, payables, and long-term debt) are remeasured using the current exchange rate. Other items (e.g. prepaid expenses, inventories carried at cost, fixed assets, and stock) are remeasured using historical exchange rates.
EXAMPLE FILES:
Current Rate Method - click filename at bottom of page
Temporal Rate Method - click filename at bottom of page