How to Translate Foreign Currency on Financial Statements

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Translation of foreign currency is the process of converting the accounting figures denominated in one currency into a second currency using the prevailing exchange rates between the two currencies. Companies that hold ownership rights exceeding 50 percent in their international subsidiaries are considered to have a parent-subsidiary relationship. The financial statements of the foreign subsidiary must be prepared on the basis of country-specific accounting regulations with regards to U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). These accounts should then be consolidated with the parent company’s account and the foreign currencies translated into the local currency of the parent company. There are basically two approaches that are applied in currency translation: temporal rate method, which factors historical movement of the foreign exchange rates; and current rate method, which involves the use of the prevailing exchange rates. These methods are applicable both independently and in combination.

Identify the currency conversion methods that you will use in the foreign currency translation procedure. The methods that will be at your disposal include: currency of books and records (CBR), which is the currency denomination used in the foreign financial statements; functional currency, which is the currency that the subsidiary routinely uses in the buying, selling and borrowing processes; and reporting currency, which is the currency in which the parent company’s financial statements are denominated.

Choose the approach to use in the conversion of the foreign currency. Employ the temporal rate method if the functional currency is exhibiting high levels of inflation, so that you can ignore the functional currency and directly convert the CBR into the reporting currency. Choose the current rate method if the CBR is the same as the functional currency, so that you can convert the functional currency into the reporting currency.

Apply the current rate method to convert fixed assets and liquid items such as cash, receivables, inventories valued at market rates, payables and short-term debt that are denominated in foreign currency using the exchange rate on the balance sheet date.

Apply the temporal rate method to convert the foreign currency exchange rates for capital and long-term liabilities such as long-term debt, as well as dividends, prepaid expenses and inventories valued at cost.

Present any gains and losses resulting from the conversion in the owners' equity section as a separate item. You will have to disclose any material changes in the exchange rates occurring during the period between the financial statement date and the audit report date in the financial statements for the preceding year.

Tips & Warnings

  • Always consider the impact of both the direct rates and indirect rates in the adjustments of the foreign currencies. In the United States, for example, the direct rate would be the cost of a unit of foreign currency per U.S. dollar, whereas the indirect cost is the number of foreign currency units per U.S. dollar.
  • Do not fail to recognize any losses or gains on foreign currency realized by the different items of the income statements, because this will affect the flow and transition of the adjustments.

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