In today’s global economy, entities transact in multiple currencies which can create reporting difficulties, as one unit of a currency is not typically equivalent to one unit of another currency. In addition, the values of currencies are constantly changing. This could cause financial reporting headaches since it is not possible to combine, add, or subtract measurements expressed in different currencies. So, how should an entity make sure that it can summarize and present results in more than one currency in its financial statements?
ASC 830 provides principles to ensure financial statements are presented in one uniform currency and properly reflect the economics and financial impacts of operating in multiple economic environments. The objective of a financial statement is to present financial results and relationships that are measured with the greatest degree of relevance and reliability. The ultimate currency used to present financial information should faithfully portray the economic results of the entity’s operations.
There are a number of key concepts relevant to foreign currency matters that are important to understand.
Let’s begin with the reporting entity, which is an entity or group for which financial statements are prepared. These financial statements reflect any of the following:
- The financial statements of one or more foreign entities by combination, consolidation, or equity accounting; or
- Foreign currency transactions.
A reporting entity prepares its financial statement in its reporting currency. The reporting currency usually aligns with a reporting entity’s overall functional currency. The functional currency is the currency of the primary economic environment in which the entity generates and expends cash.
A reporting entity may or may not have one or more foreign entities. A foreign entity is defined as an operation (e.g., subsidiary, division, branch, joint venture) whose financial statements are both
- Prepared in a currency other than the reporting currency of the reporting entity, and
- Combined or consolidated with or accounted for on an equity basis in the financial statement of the reporting entity
All entities within an enterprise should summarize financial results in their functional currency, which is the currency of the primary economic environment in which an entity operates. ASC 830 requires all entities to determine their functional currency.
Last (but certainly not least), there’s the star of the show: foreign currency. A foreign currency is defined as a currency other than the functional currency of an entity. A foreign currency must be addressed by an entity in situations where an entity enters into foreign currency transactions, holds an investment in another entity with a different functional currency, or a combination thereof.
Now that you have an understanding of the key concepts, let’s review some of the most significant accounting issues specific to foreign currency matters.
Issue #1: Identification of a Functional Currency
As noted above, the functional currency is based on an entity’s primary economic environment. In some cases, this determination is relatively straightforward! However, over the years, businesses find themselves operating in an increasingly global economy. Because of this, the determination of an entity’s functional currency becomes increasingly complex.
For example, if a global entity conducts significant business in two or more currencies, the functional currency might not be clearly identifiable! In those instances, the economic facts and circumstances pertaining to a particular foreign operation should be assessed in relation to the objectives of foreign currency.
While U.S. GAAP includes a framework of various considerations to identify an entity’s functional currency, there is no unequivocal criteria. This, in turn, results in management applying judgment to determine the functional currency in which financial results and relationships are measured with the greatest relevance and reliability. Since there is so much judgment, it is important to document the decision-making process!
Keep in mind, changes to the functional currency designation are expected to be relatively rare. The only time the functional currency should be changed is if significant changes in economic facts and circumstances clearly indicate it has changed. This is a source of SEC comment letters for U.S. publicly traded companies.
Issue #2: Accounting for Foreign Currency Transactions
Accounting issues arise with the identification, classification, and measurement of foreign currency transactions. Let’s walk through each of these considerations.
Foreign currency transactions arise when an entity does any of the following:
- Buys or sells on credit goods or services the prices of which are determined in a foreign currency
- Borrows or lends funds and the amounts payable or receivable are denominated in a foreign currency
- Is a party to an unperformed forward exchange contract
- For other reasons acquires or disposes of assets, or incurs or settles liabilities denominated in a foreign currency
Once a foreign currency transaction is identified, it is important to classify the transaction as monetary or nonmonetary. This classification impacts the measurement and recognition of exchange rate gains and losses specific to the transaction. Foreign currency transactions are measured and recognized in an entity’s functional currency through the process of remeasurement.
Monetary assets and liabilities have amounts that are fixed in terms of units of currency by contract or otherwise. Examples include cash-, short- or long-term accounts receivable, short- or long-term accounts payable, and debt instruments. Monetary assets and liabilities are initially measured on the transaction date using the exchange rate in effect at that date. At each subsequent balance sheet date and through the date of settlement or derecognition, monetary assets and liabilities are remeasured at the current exchange rate with transactions gains and losses reflected as a component of the income statement.
So, what are nonmonetary assets and liabilities? Anything that falls outside the definition of a monetary asset or liability would be nonmonetary in nature. Examples include inventories, prepaid expenses, fixed assets, goodwill, common stock, and preferred stock. Nonmonetary assets and liabilities are also initially measured on the transaction date using the exchange rate in effect on that date. However, at each balance sheet date and through settlement or derecognition, nonmonetary assets and liabilities are remeasured using the same exchange rate in effect as of the date of the initial transaction. This, in turn, produces the same result in terms of functional currency that would have occurred if these transactions had been initially recorded in the functional currency!
Issue #3: Accounting for Foreign Currency Translations
Foreign currency translation is the process of expressing in the reporting currency of the reporting entity those amounts that are denominated in a different currency. When a reporting entity presents its consolidated financial statements, it must include its subsidiaries' financial results upon consolidation in the same reporting currency. This results in a single currency used to report the results of the entity.
While it seems relatively straightforward, there are certain matters to consider. Foreign currency translation adjustments are typically recorded in other comprehensive income, a component of stockholders’ equity. The measurement process of translation, known as the current rate method, depends on the financial statement classification:
Translation adjustments resulting from changes in exchange rates do not affect reporting currency cash flows until the related foreign entity is sold, exchanged, or liquidated. ASC 830 includes special considerations for the parent’s accounting for currency translation adjustments (CTA) to determine whether full or partial recognition of CTA in earnings is appropriate. ASC 830 includes guidance on determining whether transactions are “within” a foreign entity or whether the transactions involve investments “in” a foreign entity.
We also explored a common mistake when preparing the statement of cash flows in our plumber pun of a blog. When consolidated financial statements are prepared for an entity that has foreign subsidiaries, the statement of cash flows must be translated to the reporting currency and the effect of the foreign exchange rates shown. There is a proper “flow” involved when preparing the consolidated statement of cash flows:
- Prepare cash flow statements for all subsidiaries, including foreign subsidiaries (in their functional currency)
- Translate the foreign subsidiary cash flow statements using the average rate(s) as required by ASC 830
- Combine the individual cash flow statements, and with elimination entries, this creates the consolidated statement of cash flows
Issue #4: Volatility in Foreign Currency
Sometimes, changes in exchange rates impact the income statement, as is the case with foreign currency transactions. Other times, changes in exchange rates may impact equity, as is the case with foreign currency translation adjustments. The geography of currency volatility is heavily dependent on an entity’s functional currency. Hyperinflationary economies continue to exist around the world, as we highlighted a number of years ago in one of our blogs.
As uncertainty continues across the globe related to monetary policy, political environments, and economic and national stability, companies will need to proactively manage their foreign currency translation risk exposures. This often results in entities managing risk using derivative instruments and applying hedge accounting. Check out our topic page on derivatives for more information!
Presentation and Disclosure
ASC 830 requires entities to disclose the aggregate foreign currency transaction gains or losses included in determining net income for the period either on the face of or in the notes to the financial statements. In addition, entities should include an analysis of changes in cumulative translation adjustments within the financial statement footnotes. Financial statements should not be modified for significant changes in exchange rates after the balance sheet date. However, if there are significant fluctuations that may impact an entity in future periods, such information should be disclosed within the footnotes to the financial statements. U.S. GAAP also encourages management to supplement required disclosures with an analysis and discussion of the effects of rate changes on the reported results of operations.
Accounting Differences: ASC 830 vs. IAS 29
While there are many similarities between ASC 830, IAS 21, and IAS 29, there are some notable differences between these standards. Let’s review some of the more common differences noted in practice:
Determination of Functional Currency
As discussed above, ASC 830 includes several indicators of an entity’s functional currency. However, there is no stated hierarchy for these indicators. In contrast, IFRS does include a hierarchy of factors for entities to consider. The two primary factors cited in IAS 21 are:
- The currency that mainly influences the entity’s pricing of goods and services; and
- The currency that mainly influences the cost of providing goods or services
There are also secondary factors identified in IAS 21.
Changes in Functional Currency
Although it is expected to be rare, changes do occur with an entity’s functional currency. Under ASC 830, the effect of a change in functional currency depends on whether the change is from the reporting currency to a foreign currency or vice versa. Changes from the reporting currency to a foreign currency are accounted for prospectively, while changes from a foreign currency to the reporting currency are accounted for on the basis of the translated amounts at the end of the previously reported period. IAS 29 does not make such a distinction and instead accounts for all changes to functional currency on a prospective basis. In practice, these modifications are effective as of the first day of an entity’s latest reporting period, whether interim or annual.
Treatment of CTA for Partial Disposals
ASC 830 provides guidance on the sale or liquidation of the net assets within a foreign entity. Partial sales may be recognized but only apply when there is a change in ownership interest. If an entity determines that a partial sale occurred, there would be no release or reattribution of CTA. On the other hand, IAS 29 does not include considerations related to partial disposals. IAS 29 instead includes an election for an entity to apply either a proportionate or absolute reduction approach for the release or reattribution of CTA.
Join the Revolution with GAAP Dynamics!
GAAP Dynamics training courses are designed to help leading accounting firms and multinational companies move beyond the training status quo. Our courses are continually updated, and new courses are constantly being added, so check back often! Below are our courses related to foreign currency matters.
Unlocking the Puzzle of Accounting for Foreign Currency – Volatility has brought renewed focus to the accounting for foreign currency. Take a tour of the world with Joe America as you learn all about foreign currency transactions and translations in accordance with ASC Topic 830.
There are numerous resources available on accounting for foreign currency matters under both ASC 830 under U.S. GAAP, and IAS 21 and IAS 29 under IFRS Standards. To save you time searching, we have compiled a list of resources below to assist you in your research and quest to master foreign currency accounting.
Resources from GAAP Dynamics:
We have written several blogs on a variety of foreign currency accounting topics which are listed below. Click on the links to view the full blog post.
Overview of Foreign Currency Translation under ASC 830
To better understand how currency fluctuations impact financial statements, let’s dive into ASC 830 (FAS 52) and foreign currency translation.
Unlock the Puzzle of Accounting for Foreign Currency (ASC 830)
Volatility in currency markets has brought accounting for foreign currency into the spotlight. This post provides a nice overview of rules under U.S. GAAP (ASC 830).
Foreign Currency Translation (ASC 830) and Cash Flows - Plug the Flow?
Having trouble accounting for foreign currency translation under ASC 830 in the statement of cash flows? You're not alone! This post discusses the issue.
Identification of Hyperinflationary Economies: IAS 29 and ASC 830
This post covers the identification of hyperinflationary economies under IFRS (IAS 39) with comparisons to U.S. GAAP (ASC 830).
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Resources From the FASB and IASB:
- ASC 830, Foreign Currency Matters – This link will take you to the authoritative guidance.
- IAS 21 The Effects of Changes in Foreign Exchange – This link will take you to the authoritative guidance (professional subscription required).
- IAS 29 Financia Reporting in Hyperinflationary Economies – This link will take you to the authoritative guidance (professional subscription required).
Resources From Accounting Firms:
The Big 4 accounting firms have informative, in-depth guides on foreign currency matters. To save you time and effort in your research, we have linked to them below.
- Deloitte: A roadmap to foreign currency transactions and translations (2020)
- EY: Financial reporting developments - Foreign currency matters (2020)
- KPMG: Foreign currency handbook (2018)
- PwC: Foreign Currency Accounting Guide (2019)
- Deloitte: A roadmap to foreign currency transactions and translations (2020)
- EY: IFRS Core Tools: IFRS Update of Standards and Interpretations in Issue (2020); IFRS Developments - Hyperinflationary economies (IAS 29) (2018)
- KPMG: The Effects of Changes in Foreign Exchange Rates (2021)
- PwC: IFRS Overview (2019)