What Is Currency Translation?
Currency translation is the process of converting one currency in terms of another, often in the context of the financial results of a parent company's foreign subsidiaries into its functional currency—the currency of the primary economic environment in which an entity generates and expends cash flows.
For transparency purposes, companies with overseas ventures are, when applicable, required to report their accounting figures in one currency.
- Currency translation allows a company with foreign operations or subsidiaries to reconcile all of its financial statements in terms of its local, or functional currency.
- 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.
- There are two main methods of currency translation accounting: the current method, for when the subsidiary and parent use the same functional currency; and the temporal method for when they do not.
- Translation risk arises for a company when the exchange rates fluctuate before financial statements have been reconciled. This risk can be hedged with currency derivatives or forex positions.
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 of the place where the majority of cash is primarily earned and spent. 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. When that condition is satisfied, the financial statements expressed in the functional currency should use the following exchange rates for translation:
- Assets and Liabilities: The exchange rate between the functional currency and reporting currency at the end of the period.
- Income Statement: The exchange rate on the date that income or an expense was recognized; a weighted average rate during the period is acceptable.
- Shareholder Equity: The 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 footnotes 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 on the measurement and translation of foreign currency transactions.
Currency Translation Accounting Methods
There are two main accounting standards for handling currency translation.
- The current rate method: A method of foreign currency translation where most items in the financial statements are translated at the current exchange rate. The current rate method is utilized in instances where the subsidiary isn't well integrated with the parent company, and the local currency where the subsidiary operates is the same as its functional currency.
- The temporal method: Also known as the historical method, this technique converts the currency of a foreign subsidiary into the currency of the parent company. The temporal method is used when the local currency of the subsidiary is not the same as the currency of the parent company. Differing exchange rates are used depending on the financial statement item being translated.
Translation risk is the exchange rate risk associated with companies that deal in foreign currencies and list foreign assets on their balance sheets.
Companies that own assets in foreign countries, such as plants and equipment, must convert the value of those assets from the foreign currency to the home country's currency for accounting purposes. In the U.S., this accounting translation is typically done on a quarterly and annual basis. Translation risk results from how much the assets' value fluctuate based on exchange rate movements between the two counties involved.
Multinational corporations with international offices have the greatest exposure to translation risk. However, even companies that don't have offices overseas but sell products internationally are exposed to translation risk. If a company earns revenue in a foreign country, it must convert that revenue into its home or local currency when it reports its financials at the end of the quarter.
Example of Currency Translation
International sales accounted for 64% of Apple Inc.’s revenue in the quarter ending Dec. 26, 2020. In recent years, a recurring theme for the iPhone maker and other big multinationals has been the adverse impact of a rising U.S. dollar. When the greenback strengthens against other currencies, it subsequently weighs on international financial figures once they are converted into U.S. dollars.
The likes of Apple seek to overcome adverse fluctuations in foreign exchange rates by hedging their exposure to currencies. Foreign exchange (forex) derivatives, such as 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 movements can mask the true financial performance of a company.
In its fiscal second-quarter ending Nov. 30, 2020, Nike Inc. reported a 9% increase in revenues, adding that sales rose 7% on a constant currency basis.