Foreign Currency Matters Under ASC 830
Companies that consolidate the results of foreign operations denominated in local currencies must translate the foreign financial statements into U.S. Dollars (USD). ASC 830 (aka FAS 52) provides the accounting and reporting requirements for foreign currency transactions and the translation of financial statements from a foreign currency to the reporting currency. ASC 830 also applies to the translation of financial statements for purposes of consolidation or combination, or the equity method of accounting. 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 ASC 830.
Remeasurement and Translation
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. ASC 830 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. An entity’s functional currency might be the currency of the country in which the entity is located (the home currency), the reporting currency of the entity’s parent or the currency of another country.
- Foreign currency transactions and remeasurement
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 remeasurement process should produce the same result as if the entity’s accounting records had been maintained in the functional currency. Adjustments resulting from the remeasurement process are generally recorded in net income.
- Translation of foreign currency financial statements
After the remeasurement process is complete or if the functional currency is the home currency, the current rate 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 other comprehensive income, a separate component of stockholders’ equity.
- 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 net income. 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.
- Equity method investees
Pursuant to ASC 830-10-15-5, foreign currency financial statements of a foreign investee accounted for by the equity method should be translated to the reporting currency in the same manner as the financial statements of a consolidated foreign investee. First, the functional currency of the equity method investee should be determined and transactions denominated in currencies other than its functional currency should be remeasured. Then, if the functional currency of the equity method investee is different from the reporting currency of the equity method investor, the financial statements of the investee should be translated into the reporting currency at the current rate before determining the balance of the investor’s equity investment.
Foreign currency translation is more than a simple mechanical exercise. A thorough understanding of ASC 830 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.