This article helps you to understand some basic concepts around currency translation, the need for currency translation, steps involved in currency translation and rules and methods related to Currency Translation. The subsequent articles to this will also help you to get a better understanding of how currency translation can be done in SAP BPC 10.1 (Classic).
What is Foreign Currency Translation?
Currency translation is the process of converting one currency value in the denomination of another currency based on the exchange rates defined. Companies which operate in different countries have the need to translate their financial reports from different local currencies to one common reporting currency or group currency. It is about converting the amounts related to accounting stated as per one particular currency to another currency to meet the finance reporting related requirements.
As per the United States Generally Accepted Accounting Principles regulations, the items in the balance sheet are converted in accordance with the rate of exchange as on the date of balance sheet, whereas items in the income statement are converted in accordance with the weighted-average rate of exchange for that particular year. The losses and profits that are derived as a result of the converting are showcased in the equity category of the owner in the form of a separate item.
The International Accounting Standard 21 ‘The Effects of Changes in Foreign Exchange Rates’ lays down the manner in which foreign currency transactions as well as operations should be accounted in the finance related statements. It also suggests the manner in which statements should be translated into a reporting currency.
Need for Currency Translation
- Currency translations help a company create financial statements that feature a single currency
- Governing tax authority often requires companies to only use one denominated currency as part of their recording procedure
- For multinational companies having cross-border operations, currency translation will be essential
- Single currency as part of financial statements will make these statements easier to read and analyse
- It is near impossible to draw rational conclusions from a statement, which features more than one currency
Key Concepts explained around Currency Translation
The functional currency is the primary currency of the business or business unit for a multinational company.
According to International Accounting Standards (IAS) and U.S. GAAP “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.
For example: An Australian company with bulk of its operations in United States would consider the U.S. dollar as its functional currency, even if the financial figures on its Balance Sheet and Income Statement are expressed in Australian Dollars.
This is the currency which is used to report an entity’s financial statements. So, for a multinational company accountant must convert foreign currencies into a single reporting currency at the specified exchange rate.
The primary currency used by a company on its consolidated financial statement. This involves a currency translation from all foreign currencies into the single group currency. A group currency is important to those companies that generates revenues in more than one currency or that have subsidiaries or divisions in foreign countries.
This is the currency used in a particular country for it’s the transactions happening in that country, so a multinational company can operate in each of the locations in their respective local currency. For example An Australian company having it branch in India will operate in INR as the local currency in India.
Foreign Currency Translation Reserve (FCTR)
Exchange differences arising from translating assets and liabilities at the closing rate of balance sheet date compare to the average rates used by Retained Earnings taken directly to the foreign currency translation reserve.
The average rate for a period refers to a calculated average exchange rate for the specific financial period. This is typically the financial year, as it is the basis for most financial statements.
The average rate should be calculated by checking each rate during the period and dividing it by the number of these different rates.
The average rate for the period is used for translation currencies for income statement accounts.
Closing Rate / End Rate
The ending rate for the period is the exchange rate at the end of the financial period. For example, if the financial year ends on December 31, the currency translation would use the exchange rate of this date.
Liability and asset accounts use the ending rate for the period for currency translation. Nonetheless, fixed assets are not translated with the ending rate.
The original historical rate at the point of acquiring simply uses the exchange rate of the date when the entry was created for the income statements. For example, if the qualifying transaction happened on July 22, even if the financial year ends on December 31, the exchange rate used should be from July 22.
Fixed assets are always translated with the historical rate. It must be noted they also won’t be re-translated later on.
Keys steps involved in Foreign Currency Translation
- Determine the Functional Currency of the foreign entity
- Remeasure the financial statements of the foreign entity into the reporting currency of the parent company
- Record gains and losses on the translation of currencies
Methods of Currency Translation
Rule 11 of the International Accounting Standards Board sets forth an acceptable methodology for currency translation. These rules define “functional” currency as the one that predominates in the foreign subsidiary’s economic environment. The functional currency may differ from the “local” currency, which is the official currency of a nation. Parent companies use the “reporting” currency for financial reporting — it’s normally the home currency. Currency translation is largely a matter of converting the functional currency into the reporting currency.
Current Rate Translation Method
The accounting standards’ methodologies employ the functional currency translation approach, which relies on the current rate method when the functional currency is the same as the local currency — for example, a London subsidiary using the British pound. In the current rate method, assets and liabilities use the current, or “spot,” exchange rate existing on the date of translation — the date on the balance sheet. The method translates equity items excluding retained earnings using the transaction date’s spot rate. Retained earnings and income statements use an average of the period’s translation rates, except when the foreign operation can identify an appropriate specific rate.
Temporal Rate Translation Method
The accounting standards call for foreign operations to use the temporal, or historical, rate method when the local currency differs from the functional one. For example, a subsidiary of a Australian company with foreign operations in a small country in which all business transpires in U.S. dollars, not the country’s local currency, would use the temporal method. When you apply the temporal rate method, you adjust income-generating assets on the balance sheet and related income statement items using historical exchange rates from transaction dates or from the date that the company last assessed the fair market value of the account. You recognise this adjustment as current earnings.
Monetary-Nonmonetary Translation Method
A company uses the monetary-non-monetary translation method when a foreign subsidiary is highly integrated with the parent company. The goal is to represent translated amounts as if they arose from exports sent from the parent company to the subsidiary’s markets. You translate monetary assets and liabilities such as cash, accounts receivable and accounts payable using the current exchange rate. You use the historical rate when you translate non monetary items such as inventory, fixed assets and common stock. For example, you would use the spot rates existing at the time you purchased inventory items.
Rules for Translation of Financial Statements
Assets and liabilities: Translate using the current exchange rate at the balance sheet date for assets and liabilities.
Income statement items: Translate revenues, expenses, gains, and losses using the exchange rate as of the dates when those items were originally recognised.
Allocations: Translate all cost and revenue allocations using the exchange rates in effect when those allocations are recorded. Examples of allocations are depreciation and the amortisation of deferred revenues.
Different balance sheet date: If the foreign entity being consolidated has a different balance sheet date than that of the reporting entity, use the exchange rate in effect as of the foreign entity’s balance sheet date.
Profit eliminations: If there are intra-entity profits to be eliminated as part of the consolidation, apply the exchange rate in effect on the dates when the underlying transactions took place.
Statement of cash flows: In the statement of cash flows, state all foreign currency cash flows at their reporting currency equivalent using the exchange rates in effect when the cash flows occurred. A weighted average exchange rate may be used for this calculation.
If there are translation adjustments resulting from the implementation of these rules, record the adjustments in the shareholders’ equity section of the parent company’s consolidated balance sheet.
Different companies might have slight differences as to which transactions should be recorded with which rate. It is a good idea to check with the responsible jurisdiction prior to currency translation to ensure you use the correct rates.
Please refer to our next blog in this blog series to understand the detailed configurations required in SAP BPC Blog # 7.1.