Five must-know elements of foreign currency accounting
While few significant changes to the accounting for foreign currency have occurred in some time, many accountants remain less than comfortable working in this area.
If you’ve not had to handle a real-world transaction denominated in British pounds, nor had the need to convert a subsidiary’s financial statements from euro to U.S. dollars and can only vaguely recall the lessons from advanced accounting classes, these five key aspects of foreign currency transactions may be helpful to keep in mind.
1. Financial statement values are measured using a company’s “functional currency”
Functional currency is normally the currency of the primary economic environment (or country) in which it operates and generates and expends cash. The local country’s currency is not always the functional currency, however. An entity that works closely with a parent or sister company may have its functional currency considered to be that of the parent or sister company.
Examples include obtaining production inputs primarily from the related company, generating sales mostly from the related company or denominated in the related company’s currency, having a high volume of transactions with the related company or relying on financing from the related company to sustain operations. Once determined, a company’s functional currency is generally not changed unless it experiences a significant change in economic facts and circumstances.
2. Statements are remeasured to the functional currency
Once a foreign subsidiary’s statements are converted from local accounting rules to conform to U.S. Generally Accepted Accounting Principles (GAAP), and the functional currency is determined, the statements are remeasured to the functional currency. From there, the statements are translated to U.S. dollars (the reporting currency) by applying the appropriate exchange rate. This is accomplished by:
- Translating assets and liabilities at the current exchange rate as of the balance sheet date
- Translating income statement values at the exchange rates in effect as of the date the transactions were recognized (note that a weighted average or other approximate rate is acceptable)
- Translating stock and additional paid in capital at historical rates (the dates acquired or issued), and recording retained earnings at the amount reported at the end of the prior period plus or minus the amount of translated net earnings for the period
The resulting translation adjustments are not reported in income, but rather accumulated included in other comprehensive income within equity.
3. A contract that gives rise to settling a transaction in a currency other than a company’s functional currency is a foreign currency transaction
Common examples include buying or selling goods or services on credit when the price is denominated in a foreign currency, or borrowing or lending funds with the amounts denominated in a foreign currency.
Accounting for such transactions involves:
- At the transaction date, measure the asset, liability, revenue or expense at the exchange rate currently in effect
- At each subsequent reporting date, adjust balances denominated in the foreign currency to reflect the exchange rate at that date
- Recognize the resulting increase or decrease in expected cash flows upon settlement of the transaction as foreign currency gain or loss in the income statement
4. Certain foreign currency transactions are not included in a company’s net income, and instead are reflected in other comprehensive income
One type is foreign currency transactions designated as, and effective as, an economic hedge of an investment in a foreign entity.
An example would be a U.S. parent company that borrows euro in order to hedge its investment in a French subsidiary. In this arrangement, declines in the value of the subsidiary carrying value due to changes in exchange rates are offset by declines in the value of cash needed to settle the debt. Another type is an inter-company transaction that is of a long-term investment nature when the parties to the intercompany advance are included in consolidated financial statements.
This requires the advance to not be anticipated to be settled in the foreseeable future, which effectively is interpreted to be through the date the investment is liquidated. If the criteria are met, the translation gain or loss recognized on the stand-alone company’s income statement is reclassified to other comprehensive income upon consolidation.
5. GAAP governs how to account for an equity method investment in a foreign entity
After booking the initial investment, the company reports its share of the unconsolidated subsidiary’s translated net income to the profit & loss statement, increasing/decreasing the investment balance. Any translation adjustment arising from translating the foreign subsidiary’s statements from functional to reporting currency is recorded to other comprehensive income and to the investment balance.
Following these steps will provide you the basis for reporting gains and losses on foreign currency transactions as well as incorporating the financial position and operating results of foreign subsidiaries into your company’s consolidated reporting.
How Wipfli can help
Our accounting specialists can help answer your questions and guide you through any reporting challenges with transactions involving foreign currency. No need to take chances with the complexities arising from foreign currency accounting.
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