There are two accounting events in which an entity must deal with foreign currency translation:
- Purchases, sales, cash receipts, cash payments, investments and other (individual) financial transactions in a currency other than the functional currency of the entity accounting for these transactions,
- Conversion of financial statements of a foreign (currency) subsidiary or branch upon consolidation in the consolidated financial statements.
A company needs to decide on its presentation currency. This is a currency that is functionally (logically) based on the economic environment in which this company is operating.
– Foreign currency remeasurement
A foreign currency denominated transaction must be recorded initially as per the exchange rate applicable on the transaction date. Thereafter, at every balance sheet date when this foreign currency denominated transaction is not settled yet, the translation of the balance sheet amount must be adjusted to the new balance sheet date FX rate. The translation differences resulting from such FX remeasurements are recorded in profit or loss.
Foreign currency translation is also about converting the financial statements of a subsidiary presented in the subsidiary’s functional currency to another currency for consolidation into the parent company’s consolidated financial statements. This situation arises if and when the parent company’s functional currency (or presentation currency) is not the same as the functional currency of the subsidiary.
As per IAS 21 The Effects of Changes in Foreign Exchange Rates, the items in the balance sheet are converted in accordance with the FX rate as on the date of balance sheet (closing FX rate), whereas items in the income statement and cash flow statement are converted in accordance with the average FX rate for that particular period (year/quarter).
– Steps involved in the translation process
The process of foreign currency translation involves the following four steps:
- Adjust the financial statements of the foreign subsidiary to IFRS (if necessary).
- Determine the functional currency of the foreign entity.
- Re-assess the financial statements in the functional currency, if required. Profits and losses arising from the re-assessment are countable in re-assessed current profit or loss.
- Convert the foreign currency into the required foreign currency, like USD, EUR or YEN of the parent company at closing or average FX rate.
– Presentation (accumulating) FX translation results
The FX translation results (losses or profits) that result from the translation upon consolidation are recorded in the equity component in the consolidated financial statements of the parent company in the form of a separate reporting line, called ‘Translation reserve’ or something similar.
Upon liquidation or sale of an investment in a foreign currency entity, the amount attributable to this entity and accumulated in the ‘Translation reserve’ component of equity is reclassified to retained earnings/other reserves in the equity section. In addition, it is considered as a part of the profit or loss on liquidation or sale of the investment in the foreign currency entity in the income statement for the period of occurrence of the sale or the liquidation.
Translation adjustments should not be included in the income statement before being realised. However, if re-assessment from the recording currency to the functional currency is requisite before translation, the profit or loss is replicated in the income statement.
Other movement schedules
(Consolidated) financial statements include movement schedules for non-current financial components in the consolidated financial position. Upon translation and consolidation of subsidiaries with functional currencies different from the consolidation currency such movement schedules also show a separate reporting line, called ‘Translation difference’ or something similar. Here the difference between the opening FX rate and closing FX rate is recognised.
– High inflationary countries
IAS 29 Financial reporting in hyperinflationary economies requires a change in the functional currency of a reporting entity (in this case a subsidiary that is consolidated) when a country becomes highly inflationary because a reasonably stable measuring unit is necessary to provide meaningful financial reporting using historical cost accounting. For example, in a highly inflationary economy, assets carried at historical cost become relatively smaller when compared with assets acquired recently at higher price levels due to inflation. See ‘Hyperinflation in Argentina‘ for further details on this accounting issue.