Foreign currency accounting under ASC 830 has received minimal updates from the old FAS 52 days, but it continues to be an area that causes confusion. It is a topic that we continue to receive training requests for, especially since foreign currency volatility has been a concern in the markets for quite some time now – and doesn’t seem to be one that will be going away any time soon.
How does foreign currency volatility impact companies? Well, a strong dollar makes a U.S.-based company’s products and services more expensive compared to those of a foreign competitor, resulting in a loss of profit. And, if companies are operating in foreign countries and are paid in that foreign currency, then when those earnings are converted back to U.S dollars, the earnings are also less.
But, there is more to the story, stemming from the accounting for foreign currency under U.S. GAAP – namely, transaction and translation effects – resulting in the recording of foreign currency gains or losses. To understand the accounting behind currency effects, we need to look to ASC Topic 830 (or, as many us still refer to it as, the old FAS 52), Foreign Currency Matters.
In this post, we provided an overview of the framework for application of the foreign currency accounting guidance.
It is Step 4, Measure Foreign Currency Transactions, and Step 5, Translate Financial Statements of Foreign Entities, that I want highlight. It is important to understand the distinction, as there are different accounting impacts from the remeasurement process of certain foreign currency transactions versus the foreign currency translation of an entity’s financial statements to the reporting currency.
Remeasurement has an earnings impact, whereas translation impacts get recorded to equity. Let’s first take a look at remeasurement, as that process needs to take place prior to translation into the reporting currency if an entity’s books are not maintained in its functional currency.
Remeasurement is the process of “remeasuring” or converting financial statement amounts that are denominated in another currency to the entity’s functional currency. According to the guidance, “the remeasurement process is intended to produce the same results as if the entity’s books of record had been maintained in the functional currency.” So, at each balance sheet date, as exchange rates between the functional currency and the currency in which monetary assets and liabilities are denominated fluctuate, the amount of functional currency cash flows expected upon settlement of those transactions change. And, that change in expected currency cash flows is required to be recorded as foreign currency transaction gains or losses that should be reflected in net income for the period in which the exchange rate changes.
Once an entity has completed the remeasurement process, translation of the financial statements into the reporting currency is required if the functional currency is different from the reporting currency. In other words, translation is necessary for the purposes of preparing consolidated financial statements when an entity’s functional currency is different from its parent.
ASC Topic 830 requires that the current rate method be used in the translation process. Under the current rate method:
- Assets and liabilities should be translated using the exchange rate at the balance sheet date
- Revenues, expenses, gains and losses should be translated using the exchange rate at the dates on which those elements are recognized
Literal application of the guidance may be burdensome and not always practical, as there could be numerous revenue, expense, gain or loss items that need to be translated. The FASB recognized this and permits the use of weighted average exchange rates.
The guidance does not specify the exchange rate to be used to translate a foreign entity’s capital accounts. However, in order for appropriate elimination of capital accounts in consolidation to happen, historical exchange rates should be used.
The adjustments resulting from the translation process are reported in other comprehensive income. The cumulative foreign currency translation adjustments are only reclassified to net income when the gains or losses are realized upon sale or upon complete (or substantially complete) liquidation in the foreign entity. These translation adjustments impact the entity’s net assets and the parent’s net investment in the entity.
Before we close out this discussion, I want to stress that a critical step in the process, which I did not discuss above, is identification or determination of the functional currency of an entity. It is important because the translation reporting requirements in ASC Topic 830 are based on the functional currency. Take a look at the brief video below for a refresher on functional currency:
We can now see that foreign currency volatility can impact both net income and equity of an entity. Foreign currency translation gains or losses are recorded in other comprehensive income (a separate component of stockholder’s equity), while remeasurement or transaction gains or losses are recorded in current net income.
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. The main tool used to manage this risk is the use of derivatives. Because derivatives and hedging is a vast topic, we’ll save further discussion of that topic for a future post! For more information, check out our foreign currency matters topic page.
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