What is Currency Translation?
Currency translation is the process of converting the financial results of a parent company's foreign subsidiaries into its functional currency, the primary economic environment in which an entity generates and expends cash. For transparency purposes, companies with overseas ventures are, when applicable, required to report their accounting figures in one currency.
How Currency Translation Works
Many companies, particularly big ones, are multinational, operating in various regions of the world that use different currencies. If a company sells into a foreign market and then sends payments back home, earnings must be reported in the currency where its corporate headquarters is based. Alternatively, in the rare case that a company has a foreign subsidiary, say in Brazil, that does not transfer funds back to the parent company, the functional currency for that subsidiary would be the Brazilian real.
Before a foreign entity's financial statements can translate into the reporting currency, the foreign unit's financial statements must be prepared in accordance with General Accepted Accounting Principles (GAAP) rules.
- Assets and Liabilities: Exchange rate between the functional currency and reporting currency at the end of the period
- Income Statement: Exchange rate on the date that income or an expense was recognized; a weighted average rate during the period is acceptable
- Shareholder Equity: Historical exchange rate at the date of entry to shareholder equity; the change in retained earnings uses historical exchange rates of each period's income statement
Gains and losses resulting from currency conversions are recorded in financial statements. The change in foreign currency translation is a component of accumulated other comprehensive income, presented in a company's consolidated statements of shareholders' equity and carried over to the consolidated balance sheet under shareholders' equity.
If a company has operations abroad that keep books in a foreign currency, it will disclose the above methodology in its Notes to Consolidated Financial Statements under "Note 1 - Summary of Significant Accounting Policies" or something substantially similar.
The Financial Accounting Standards Board (FASB) Accounting Standards Codification Topic 830, entitled "Foreign Currency Matters," offers a comprehensive guide to measurement and translation of a foreign entity's functional currency financial statements.
- Currency translation is the process of converting the financial results of a parent company's foreign subsidiaries into its functional currency.
- Companies must report using the currency of the environment in which it primarily generates and expends cash.
- Currency translations use the exchange rate at the end of the reported period for assets and liabilities, the exchange rate on the date that income or an expense was recognized for the income statement and a historical exchange rate at the date of entry to shareholder equity.
- Gains and losses resulting from currency conversions are recorded in a company's consolidated statements of shareholders' equity.
A Real World Example of Currency Translation
International sales accounted for 62 percent of Apple Inc.’s (AAPL) revenue in the quarter ending Dec. 29, 2018. In 2018, a recurring theme for the iPhone maker and other big multinationals has been the adverse impact of a rising US dollar. When the greenback strengthens against other currencies it subsequently weighs on international financial figures once they are converted into US dollars.
The likes of Apple seek to overcome adverse fluctuations in foreign exchange rates by hedging their exposure to currencies. Foreign exchange derivatives, such as forward contracts, futures contracts, and options, are acquired to enable companies to lock in a currency rate and ensure that it remains the same over a specified period of time.
Constant currencies is another term that often crops up in financial statements. Companies with overseas operations often choose to publish reported numbers alongside figures that strip out the effects of exchange rate fluctuations. Investors generally pay a lot of attention to constant currency figures as they recognize that currency fluctuations can mask the true financial performance of a company.
In its fiscal 2019 third-quarter ending Feb. 28, 2019, Nike Inc. (NKE) reported a 7 percent increase in revenues, adding that sales rose 11 percent on a constant currency basis.