In order to consolidate or combine financial statements prepared in different currencies, a reporting entity must have financial statements of its foreign entities in its reporting currency to produce single currency, consolidated financial statements. This process is referred to as translation and is different from remeasuring foreign entity financial statements. A foreign entity remeasures its financial statements into its functional currency when its books and records are maintained in a currency other than its functional currency.
The steps needed to translate a foreign entity’s financial statements depend on whether the foreign entity’s books and records are maintained in the foreign entity’s functional currency or another currency.
As discussed in ASC 830-10-45-17, when a foreign entity’s books and records are not maintained in its functional currency, the reporting entity must first remeasure the financial statements into its functional currency and then translate the foreign entity’s financial statements into the reporting currency.
Foreign currency remeasurement – This is the process by which an entity expresses transactions whose terms are denominated in a foreign currency in its functional currency. Changes in functional currency amounts that result from the measurement process are called transaction gains or losses; transaction gains and losses are included in net income.
Foreign currency translation – This is the process of expressing a foreign entity’s functional currency financial statements in the reporting currency. Changes in reporting currency amounts that result from the translation process are called translation adjustments; translation adjustments are included in the cumulative translation adjustment (CTA) account, which is a component of other comprehensive income:
The application of the remeasurement and translation processes starts with an understanding of the following concepts and definitions used in ASC 830.
Reporting Currency: The currency in which a reporting entity prepares its financial statements
Foreign Currency: Any currency other than the functional currency of the referenced distinct and separable operation
Foreign Entity: A distinct and separable operation whose financial statements are prepared in a currency other than the reporting currency, and that is consolidated, combined or accounted for on the equity method. A reporting entity must identify its foreign entities to determine which financial statements have to be translated. Distinct and separable operations whose financial statements are prepared in the reporting currency are domestic entities which, by definition, do not need to be translated.
Distinct and separable operation: An operation that can be clearly distinguished operationally and for financial reporting purposes, from the rest of the reporting entity for which a meaningful set of financial statements are routinely prepared.
Functional Currency: Definition from ASC 830-10-20 - An 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 cash.
Framework for the application of ASC 830
The figure below summarizes the key steps in the application of ASC 830. An understanding of the various defined terms is critical to navigating the ASC 830 framework.
Determining Whether an Entity is a Distinct and Separate Operation and Determining the Functional Currency (Step 3)
ASC 830-10-45-5 states that an entity might have more than one distinct and separable operation, such as a division or branch, in which case each operation may be considered a separate entity. If those operations are conducted in different economic environments, they might have different functional currencies.
ASC 830-10-20 defines a Foreign Entity as “an operation” (for example, subsidiary, division, branch, joint venture, and so forth) whose financial statements are both:
Prepared in a currency other than the reporting currency of the reporting entity
Combined or consolidated with or accounted for on the equity basis in the financial statements of the reporting entity
ASC 830-10-55 provides further guidance regarding what factors to consider when determining the functional currency. Below are factors that should be considered both individually and collectively when determining the functional currency:
1. Cash flow indicators:
Foreign currency: Cash flows related to the foreign entity’s individual assets and liabilities are primarily in the foreign currency and do not directly affect the parent entity’s cash flows
Parents currency: Cash flows related to the foreign entity’s individual assets and liabilities directly affect the parent’s cash flows currently and are readily available for remittance to the parent entity
2. Sales price indicators:
Foreign currency: Sales prices for the foreign entity’s products are not primarily responsive on a short-term basis to changes in the exchange rates but are determined more by local competition or local government regulation
Parents currency: Sales prices for the foreign entity’s products are primarily responsive on a short-term basis to changes in exchange rates: for example, sales prices are determined more by worldwide competition or by international prices
3. Sales market indicators:
Foreign currency: There is an active local sales market for the foreign entity’s products, although there also might be significant amounts of exports.
Parent’s currency: The sales market is mostly in the parent’s country or sales contracts are denominated in the parent’s currency
4. Expense indicators:
Foreign currency: Labor, materials, and other costs for the foreign entity’s products or services are primary local costs, even though there also might be imports from other countries
Parent’s currency: Labor, materials, and other costs for the foreign entity’s products or services continually are primary costs for components obtained from the country in which the parent is located
5. Financing indicators:
Foreign currency: Financing is primarily denominated in foreign currency, and funds generated by the foreign entity’s operations are sufficient to service existing and normally expected debt obligations
Parent’s currency: Financing is primarily from the parent or other dollar-denominated obligations, or funds generated by the foreign entity’s operations not sufficient to service existing and normally expected debt obligations without the infusion of additional funds from the parent entity. Infusion of additional funds from the parent entity for expansion is not a factor, provided funds generated by the foreign entity’s expanded operations are expected to be sufficient to service that additional financing
6. Intra-entity transactions and arrangements indicators:
Foreign currency: There is a low volume of intra-entity transactions and there is not an extensive interrelationship between the operations of the foreign entity and the parent entity. However, the foreign entity’s operations may rely on the parent’s or affiliates’ competitive advantages, such as patents and trademarks
Parent’s currency: There is a high volume of intra-entity transactions and there is an extensive interrelationship between the operations of the foreign entity and the parent entity.
7. Long-Term considerations:
Per the KPMG Foreign Currency Handbook, paragraph 2.019 “Long-term considerations are more important than short-term considerations in determining the functional currency because the functional currency, once determined, should not change unless significant changes in facts and circumstances occur. For example, a newly established foreign entity, economic factors during the start-up phase may point towards the parent’s functional currency as the entity’s functional currency, but the foreign entity is anticipated to be relatively self-contained and integrated within the foreign economic environment once it is fully operational. In this case, the foreign currency should be the foreign entity’s foreign currency from inception.”
Remeasure foreign currency transactions (Step 4)
When an operation has transactions denominated in a currency other than its functional currency, they must be measured in the functional currency. Changes in the expected functional currency cash flows caused by changes in exchange rates are included in net income in the period. ASC 830-10-20 defines foreign currency transactions.
Foreign currency transactions are initially recorded in an operation’s functional currency. Subsequent measurement of foreign currency transactions will depend on whether the transaction gives rise to an account balance that is monetary or non-monetary.
Monetary assets and liabilities
Monetary assets and liabilities, such as cash, accounts receivable, accounts payable, and long term debt, create foreign currency exchange rate risk as they represent amounts that will be settled with counter-parties in a currency other than an operation’s functional currency. Monetary assets and liabilities are measured at the end of each reporting period based on the then current exchange rates. This measurement gives rise to foreign currency gains and losses, which are recorded in current period net income.
Non-monetary assets and liabilities
Non-monetary assets and liabilities, such as inventory and property, plant, and equipment, do not require future settlement or adjustment. Non-monetary assets and liabilities are initially measured using historical exchange rates. All aspects of the ongoing accounting for these items (e.g., depreciation, impairment, lower of cost or market) should be measured in terms of the operation’s functional currency.
Translate financial statements of foreign entities (Step 5)
Foreign currency translation is the process of expressing a foreign entity’s financial statements in the reporting currency of the reporting entity. The purpose of translation is to express a foreign entity’s functional currency financial statements in terms of the reporting currency. Thus, when a reporting entity’s financial statements include the results of foreign entities, the reporting entity must translate the foreign entity’s financial statements before they can be consolidated. The financial statements of a foreign entity should be translated into the functional currency of its immediate parent company based on the nature of the account as follows:
The period-end spot rate for assets and liabilities
The weighted average exchange rate for income statement accounts
Historical exchange rates for equity accounts (except for the change in retained earnings)
Once the reporting entity has translated its foreign entity financial statements, it should record these amounts in its consolidated financial statements. We refer to the “immediate” parent, as ASC 830 should be applied to each individual layer of a consolidation, beginning with the lowest level of the consolidated reporting entity’s organizational structure. Gains and losses (and the associated tax effect) from the effect of exchange rate differences in translation are recorded in the CTA account. CTA is a separate component of accumulated other comprehensive income (OCI) in shareholders’ equity.