What is Foreign Currency Translation? Adjustment, Process & Method

Introduction 

Currency exchange fluctuations are critical to ensuring accurate financial reporting. If not properly accounted for in financial reporting, exchange rate fluctuations can create unrealized gains or paper profits, inflating values and misrepresenting financial performance. Such inaccuracies impact investment decisions and create tax reporting challenges. 

This is where foreign currency translation comes into play. Using the exchange rate at the end of the accounting period enables businesses operating globally to reconcile their financial statements with their local or functional currency. This blog covers everything you need to know about foreign currency translation – what it is, the currency translation process, methods, and how to automate it. 

What Is Foreign Currency Translation?

Foreign currency translation is an accounting method that converts the results of a foreign subsidiary into its parent company’s functional currency, adjusting for exchange rate differences.  It is an essential practice for businesses operating in many countries, transacting in various currencies, or managing subsidiaries globally. 

The functional currency of a business’s parent country means the currency of the primary economy where the business generates and spends the majority of its cash reserves. If exchange rates are not properly recorded or adjusted, it can lead to unrealized losses or gains, resulting in inaccurate financial statements. 

For businesses operating internationally, different currencies are used to facilitate smooth transactions. However, financial statements must ultimately be presented in a single currency, which makes foreign currency translation more critical than ever.

For instance, if a business has its headquarters in the USA but sells its services in the UK or France, it must translate euros and pounds into the US dollar. This allows the company to estimate its cash reserves in a consistent denomination, making it easier to read and evaluate financial statements. 

Foreign Currency Translation Process

The foreign currency translation process primarily involves three steps:

1. Determining the functional currency of the foreign subsidiary
2. Evaluating the financial statements of the foreign subsidiary into the functional currency 
3. Recording profits and losses derived from translating foreign currency

1. Determining the functional currency of the foreign subsidiary 

Businesses first need to determine the functional currency for reporting. Typically, the functional currency is the one used by the subsidiary for most of its transactions. This can be the currency of the parent country where headquarters are located or where most of the operations happen. 

However, it can become difficult to find currency translation if a business is conducting an equal amount of business in various countries. If businesses choose functional currencies, any changes to them should be made only when there’s significant changes in economic circumstances. 

2. Evaluating the financial statements of the foreign subsidiaries into the functional currency

Businesses must ensure that all their financial statements use functional currency. . The translation of financial statements into domestic currency begins with translating income statements. According to the FASB (Financial Accounting Standards Board), all transactions must be translated at the historical exchange rate that existed when transactions took place.  

Additionally, GAAP (Generally Accepted Accounting Principles) require businesses to convert items in the balance sheet as per the rate of exchange that existed when the balance sheet has been prepared. On the other hand, income statements are converted using the weighted average rate of exchange. 

It is important for businesses to determine the exchange rates based on transaction date. Businesses can do so by utilizing bank statements and income records. 

3. Recording profit losses as derived from translating currency

Businesses must record the gains and losses arising from foreign currency transactions and translate them using a consistent exchange rate. If the business sees any transactions occurring at a later date, it will record the same at different rates in the equity section of the balance sheet. 

Foreign Currency Translation Methods 

Foreign currency translation methods include current rate, temporal rate, and monetary/non-monetary translation. However, as exchange rates are constantly fluctuating, accounting for currency translations can be challenging. Hence, businesses often use various methods instead of solely relying on the current rate.

1. Current rate method 

In the current rate method, businesses translate all the items in the financial statements using the current exchange rate, including the assets and liabilities. However, this method witnesses constant fluctuations in exchange rates compared to other methods. 

Therefore, businesses have to report the profits and losses resulting from the translation method on a reserve account. They will not be recorded on the consolidated net income account. 

2. Temporal rate method 

The temporal rate method, also called the historical method, involves adjusting income-generating assets on the balance sheet and other related income statement items using historic exchange rates. The historical rates are determined based on the transaction dates or the date when a business last assessed the transactions fair market value. 

3. Monetary/Nonmonetary translation method 

This method is used when a business has closely integrated foreign operations with the parent company. Monetary account items, such as cash and accounts receivable are translated at the current exchange rate. On the other hand, nonmonetary transactions like inventories and properties are translated using historical exchange rates.

What Is Foreign Currency Translation Adjustment?

The foreign currency translation accounting adjustment, also known as  the cumulative translation adjustment (CTA), compiles fluctuations caused  due to varying exchange rates. 

Businesses selling goods or services globally must convert transactions, like purchasing assets or services, into their functional currency. Due to fluctuations in foreign exchange rates, the value of these assets and liabilities can change. 

Additionally, businesses must record profits and losses from currency translation in the comprehensive income statement of a translated balance sheet. According to FASB statement no. 52, a cumulative translation adjustment (CTA) is needed to help investors understand operational profits and losses and differentiate them from foreign currency translation. 

Each item in financial statements, viz., assets and liabilities, income statement items, cash flow statements, etc., has different rules for translation. Businesses must consider its complexity and must adhere to the accounting rules for foreign currency translation. 

Foreign currency translation accounting example 

A U.S.-based company, ABC Corp, owns a subsidiary in Europe that operates in euros (EUR). At the end of the fiscal year, ABC Corp needs to translate the subsidiary’s financial results into U.S. dollars (USD).

Initial Scenario

The subsidiary’s balance sheet shows total assets of €1,000,000.

The exchange rate at the time of consolidation is 1 EUR = 1.10 USD.

Thus, the total assets in USD = Assets * USD currency rate

Total assets in USD = €1,000,000 * 1.10 = $1,100,000.

Prior Year Comparison

The previous year, the exchange rate was 1 EUR = 1.20 USD.

Last year’s assets value = Asset * USD currency rate

Last year’s assets value = €1,000,000 * 1.20 = $1,200,000.

Translation Adjustment:

Current year assets in USD: $1,100,000.

Prior year assets in USD: $1,200,000.

The translation adjustment is: $1,100,000 – $1,200,000 = -$100,000.

The business will report this adjustment in the equity section of the balance sheet under “Accumulated Other Comprehensive Income” as a reduction. This reflects the impact of exchange rate changes on the value of foreign assets and does not affect net income but will change the equity position of the business. 

How Does Automated Financial Consolidation And Reporting Software Help Streamline Foreign Currency Translation?

An advanced, fully automated financial consolidation and reporting software not only helps ensure complete accurate and consolidated reporting with real-time visibility but also offers 99% currency conversion automation along with efficient automated data extraction. 

1. Automated currency conversion 

The software automates the conversion of foreign currencies to the base currency, reducing manual errors and saving time during the financial consolidation process. Moreover, solutions like organizational structure management offer multi-currency consolidation that imports exchange rates and stores historical rates for audit trail purposes.

2. Real-time exchange rate updates 

It integrates real-time exchange rate data, ensuring that all transactions are recorded at the most accurate rates and improving the reliability of financial statements. Additionally, with a consolidated financial reporting solution, businesses can use numerous features to make foreign currency translation more accurate and efficient. This includes 

• Currency exchange rate sync is designed to automate extraction of currency exchange rate information from ERPs
• Aggregated currency reporting for accurate financial reporting and combining group currency info using the appropriate conversion.
• Group currency conversion and calculation that converts any local currency to a group currency.

3. Centralized data management 

By centralizing financial data from multiple currencies and entities, the software streamlines the reconciliation and consolidation process, making it easier to track and report gains and losses. AI-enabled consolidated management reporting helps businesses with robust features like group currency management to ensure unmatched fraud prevention and monitor the financial report’s source data throughout. It also offers variance analysis that helps track currency fluctuations every minute and drive informed decision-making. 

Use HighRadius’ Record-to-Report Software To Improve Foreign Currency Translation Accounting

HighRadius offers a cloud-based Record to Report Software that helps accounting professionals streamline and automate the financial close process for businesses. We have helped accounting teams from around the globe with month-end closing, reconciliations, journal entry management, intercompany accounting, and financial reporting.

Our Financial Close Software is designed to create detailed month-end close plans with specific close tasks that can be assigned to various accounting professionals, reducing the month-end close time by 30%. The workspace is connected and allows users to assign and track tasks for each close task category for input, review, and approval with the stakeholders. It allows users to extract and ingest data automatically, and use formulas on the data to process and transform it. 

Our Account Reconciliation Software provides an out-of-the-box formula set that can configure matching rules and match line-level transactions from multiple data sources and create templates to automate various transaction processing required for month-end close. Our solution has the ability to prepare and post journal entries, which will be automatically posted into the ERP, automating 70% of your account reconciliation process. 

Our AI-powered Anomaly Management Software helps accounting professionals identify and rectify potential ‘Errors and Omissions’ throughout the financial period so that teams can avoid the month-end rush. The AI algorithm continuously learns through a feedback loop which, in turn, reduces false anomalies. We empower accounting teams to work more efficiently, accurately, and collaboratively, enabling them to add greater value to their organizations’ accounting processes.

FAQs

1. How is foreign currency translation gain/loss calculated?

Foreign currency translation gains/losses arise from changes in exchange rates during transaction processing. This includes realized gains/losses, recorded when a customer pays an invoice before the accounting period ends, and unrealized gains/losses, calculated when a reversing journal entry is created.

2. Is foreign currency translation adjustment for an asset?

Yes, the foreign currency translation adjustment, also known as the CTA, is an equity account that impacts all balance sheet items, including assets. It compiles all the fluctuations in the asset values caused by exchange rate differences and is calculated by comparing the values of assets acquired in another country to the value in the business’s functional currency. 

3. How to account for foreign currency translation?

Businesses can account for foreign currency translation in three steps: 

• Select a functional currency for reporting, that is, the currency of the primary economy where it generates and spends cash reserves
• Translate the financial statements items into functional currency 
• Record gains and losses resulting from translation

4. What is a foreign currency translation reserve?

The foreign currency translation reserve means the accumulated profit or loss arising from translating financial statements items denominated in a foreign currencies into a business’s reporting or functional currency. Currently, the  US dollar and euro are regarded as reserve currencies.

5. Does a foreign currency translation gain affect net income? 

No, a foreign currency translation gain does not impact net income or the bottom line of a business’s income statement. It is reported as other comprehensive income under the equity section in the balance sheet. Moreover, gains and losses fro