September 01, 2010
Companies that consolidate the results of foreign operations denominated in local currencies must translate the foreign financial statements into U.S. Dollars (USD). Financial Accounting Statement No. 52, Foreign Currency Translation (FAS 52), sets forth the appropriate accounting treatment under U.S. GAAP. Companies reporting under International Financial Reporting Standards (IFRS) are subject to International Accounting Standard No. 21, The Effects of Changes in Foreign Exchange Rates (IAS 21), which is substantially similar to FAS 52.
Prior to the adoption of FAS 8, U.S. companies generally translated current accounts at current exchange rates and noncurrent accounts at historical rates. This method was known as the current-noncurrent method and had a very short-term focus. FAS 8, adopted in 1975, required use of the temporal method, which uses the rate in effect at the time each item is recorded (different rates for different items). This method was widely criticized due to the wide variation in earnings that resulted. Six years later, FAS 52 was issued, which mandates the functional currency approach. A key feature of this approach is the current rate method, which translates all assets and liabilities at the current rate in effect at the time of translation, equity accounts at historical rates and income statement items at a weighted-average rate for the period.
The entire task of foreign currency translation can be understood as determining the correct exchange rate to be used in converting each financial statement line item from the foreign currency to USD. The translation adjustment is an inherent result of this process, in which balance sheet and income statement items are translated at different rates. FAS 52 establishes these steps:
- Determine the functional currency. The functional currency is defined as the currency of the primary economic environment in which the entity operates. Normally, that is the currency in which the majority of the subsidiary’s business activities are transacted. This task can be more difficult than it seems and may require significant judgment. The functional currency is not necessarily the home currency or the currency in which the subsidiary keeps its books.
- Determine whether the functional currency of the subsidiary is also its home currency.
- If the functional currency is the home currency, the current method is used. The current method translates all assets and liabilities at the current spot rate at the date of translation. Equity items, other than retained earnings, are translated at the spot rates in effect on each related transaction date (specific identification). Retained earnings are translated at the weighted-average rate for the relevant year, with the exception of any components that are identifiable with specific dates, in which case the spot rates for those dates are used. Income statement items are translated at the average rate for the period, except where specific identification is practicable. The resulting adjustment is not recognized in current earnings, but rather as a component of other comprehensive income.
- If the functional currency of the subsidiary is not its home currency, the temporal (historical) method is used. Under this method, nonmonetary balance sheet accounts and related income statement accounts are re-measured using historical exchange rates. The resulting translation adjustment is recognized in current earnings.
- Under FAS 52, the temporal method is also used when the subsidiary operates in a highly inflationary environment. Again, the resulting adjustment is recognized in current earnings. Companies reporting under IFRS treat this differently by re-measuring the financial statements at the current balance sheet rate in order to present current purchasing power. GAAP, on the other hand, does not generally permit inflation-adjusted financial statements. Instead, it requires the use of a more stable currency as the functional currency.
Foreign currency translation is more than a simple mechanical exercise. A thorough understanding of FAS 52 or IAS 21 is required, and many aspects of this process require significant management judgment, especially as it relates to determining the functional currency of the subsidiary.