CA Garima Mittal

In this article, author attempts to highlight the basic concept of foreign currency translation and its impact on financial statement as per FASB 52. Please note this article is for giving the overview of its basic concept and it is not the exhaustive view for taking any opinion. For any queries, author can be reached at garimamittal@live.in .

Introduction& related concepts

Financial Aspect

Financial reporting of most companies operating in foreign countries is affected due to this statement. This statement replaces FASB Statement No. 8, “Accounting for Translation of Foreign currency Financial Statements”. This statement is replaced in order to provide information that is generally compatible with the expected economic effects of rate change on an enterprise’s cash flow and equity and reflect in consolidated financial statements the financial results and relationships as measured in the primary currency in which each entity conducts its business (referred to as its “functional currency”).

FASB 52 introduces the concept of “functional currency” to determine the recognition of foreign currency translation gain, losses and adjustments.

In order to understand this concept, we must be aware of definition of functional currency & foreign currency translation gains/loss.

As per FASB, entity’s functional currency is the currency of the primary economic environment in which the entity operates; normally that is the currency of the environment in which an entity primarily generates and expends the cash. A foreign entity’s functional currency might not be the currency of the country in which it is located. Cash flow indicators, sales price indicators, sales market indicators, expense indicators, financing indicators & intercompany transactions and arrangements indicators are some economic factors which should be considered both individually and collectively when determining the functional currency.

Foreign currency translation gain/loss: Foreign currency transactions are transactions denominated in currency other than entity’s functional currency. A change in the exchange rates between the functional currency and the currency in which a transaction is denominated increases or decreases the expected amount of functional currency cash flows upon settlement of the transaction. That increase or decrease in the expected functional currency cash flows is a foreign currency transaction gain or loss that generally shall be included in determining net income for the period in which exchange rate changes.

Coming back to Statement 52, management must designate a functional currency for each foreign subsidiary. If the functional currency is determined to be dollar, then temporal method is used. If the functional currency is the local currency, then all-current method is used.

Now question is what is temporal/all-current method?

Under all current method, all the assets and liabilities are translated at current rate & translation gains and losses must be excluded from income and accumulated in the new component of owner’s equity. All the income statement events must be translated at the weighted average rate for the year that prevails when the revenue or expense was recognized.

Under temporal method, gains or loss resulting from translation are included in income for the period.

But, what happens if the foreign entity’s accounting records are maintained in currency other than its functional currency, how will we translate the account balances? If this will be the case, account balances must be remeasured to the functional currency before its translation. The remeasurement process should produce the same results as if the entity’s book of record had been initially recorded in the functional currency.

A special remeasurement rule is necessary for inventory where cost, or market value, whichever is lower, is applied. Before the rule is applied, the inventory cost and market amounts must be expressed in functional currency. A possible result is for an inventory write-down to occur in functional currency, even if no write-down is suggested in the books of record currency. It is also possible for a write-down in the books of record currency to be no longer appropriate in the functional currency.

Disclosure in Financial Statements:

  • Aggregate transaction gain or loss included in determining net income for the period shall be disclosed in the financial statements or notes thereto.
  • An analysis of change during the period in the separate component of equity for cumulative translation adjustments shall be provided in the separate financial statements, in notes to financial statements, or as part of statement of changes in equity.

Analyst should at least disclose the beginning and ending amount of cumulative translation adjustment, amount transferred from cumulative adjustment and included in determining net income for the period & amount of income tax for the period allocated to translation adjustments.

Income Tax Consequences:

Translation adjustment shall be accounted in the same way as timing difference under the provision of Accounting Principles Board (‘APB’) Opinions 11, 23 & 24.

In accordance with Opinion 11, any income tax related to those transactions gains and losses and translation adjustments which are reported in a separate component of equity shall be allocated to that separate component of equity.

APB Opinion No. 23 “Accounting for Income Taxes-Special Areas” provides that deferred tax shall not be provided for unremitted earnings of a subsidiary in certain instances which includes the case that deferred tax shall not be provided on translation adjustments.

Conclusion

We can predict that the Statement 52 adoption will lead to small fluctuation in operating income and much smaller fluctuation in net income in response to change in exchange rates, but much greater changes in equity because of translation adjustments. All who use financial ratios and income and equity numbers must know the effect of this statement.

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