Currency translation

What Is Currency Translation?

Currency translation is the process by which a multinational company converts the financial results and operations of its foreign subsidiaries, denominated in their respective local currencies, into the parent company's reporting currency. This crucial aspect of international finance ensures that the financial performance of globally operating businesses can be aggregated and presented in consolidated financial statements, such as the balance sheet, income statement, and cash flow statement. The goal of currency translation is to present a cohesive financial picture for shareholders, regulators, and other stakeholders, despite the multiple currencies involved in a company's global operations. It differs from foreign currency transactions, which involve converting individual transactions, rather than an entire set of financial statements.

History and Origin

The need for standardized currency translation methods arose with the growth of multinational corporations in the mid-20th century. Before comprehensive guidelines, companies employed various ad-hoc approaches, leading to inconsistencies and difficulties in comparing financial performance across different entities. In the United States, significant developments occurred in the 1970s and 1980s. The Financial Accounting Standards Board (FASB) initially issued Statement of Financial Accounting Standards No. 8 (SFAS 8) in 1975, which mandated the temporal method for currency translation. However, SFAS 8 was met with considerable criticism due to its volatile impact on reported earnings, as it required the immediate recognition of translation gains and losses through the income statement. Deloitte provides an overview of the current US standard, ASC 830.

Responding to these concerns, the FASB issued SFAS 52, "Foreign Currency Translation," in 1981, which introduced the current rate method as the primary approach for most foreign operations, significantly changing how currency translation was performed. This standard aimed to better reflect the economic reality of foreign operations and reduce earnings volatility by funneling most translation adjustments through a separate component of equity, known as accumulated other comprehensive income (AOCI), rather than the income statement. Internationally, the International Accounting Standards Board (IASB) later issued IAS 21, "The Effects of Changes in Foreign Exchange Rates," which provides similar guidance for companies reporting under International Financial Reporting Standards (IFRS).

Key Takeaways

• Currency translation converts the financial statements of foreign subsidiaries into the parent company's reporting currency.
• The two primary methods for currency translation are the current rate method and the temporal method.
• Translation adjustments arising from currency translation generally bypass the income statement and are recorded in a separate equity account under the current rate method.
• Currency translation helps provide a consolidated view of a multinational corporation's global financial performance.
• Fluctuations in exchange rate can significantly impact reported financial results, even if underlying operations remain stable.

Formula and Calculation

The choice of currency translation method depends primarily on the functional currency of the foreign subsidiary. The functional currency is the currency of the primary economic environment in which the entity operates.

Current Rate Method (Primary Method for Most Subsidiaries):
This method is typically used when the foreign subsidiary's functional currency is its local currency and it operates relatively independently from the parent company.

• Assets and Liabilities: Translated at the current exchange rate on the balance sheet date.
• Revenues and Expenses: Translated at the average exchange rate for the period (or the rate on the transaction date).
• Equity (except Retained Earnings): Translated at historical rates or current rates depending on the specific component.
• Translation Adjustment: The resulting difference, often referred to as a cumulative translation adjustment (CTA), is reported in other comprehensive income as a separate component of equity.

Temporal Method (Used when Functional Currency is the Parent's Currency or Highly Inflationary Economies):
This method is used when the foreign subsidiary's functional currency is the same as the parent's reporting currency, or in highly inflationary economies where the local currency is not considered stable.

• Monetary Assets (e.g., cash, receivables, payables) and Liabilities: Translated at the current exchange rate on the balance sheet date.
• Non-monetary Assets (e.g., inventory, property, plant, and equipment) and Liabilities: Translated at historical exchange rates (the rates when the assets were acquired or liabilities incurred).
• Revenues and Expenses: Translated at the average exchange rate for the period (or the rate on the transaction date), except for expenses related to non-monetary items (like depreciation), which use historical rates.
• Translation Adjustment: Gains and losses from currency translation are recognized immediately in net income, potentially increasing earnings volatility.

Interpreting the Currency Translation

Interpreting currency translation involves understanding its impact on a company's financial results and assessing the underlying operational performance separate from currency fluctuations. When a company uses the current rate method, the translation adjustment impacts equity but not net income. This can provide a clearer picture of operational profitability but may obscure the economic effects of currency movements on assets and liabilities. For instance, a strengthening reporting currency will reduce the reported value of foreign assets and revenues when translated, even if local operations are thriving.

Conversely, under the temporal method, translation gains and losses flow directly through the income statement. While this method reflects the immediate economic impact of currency changes on certain balance sheet items, it can introduce significant volatility into reported earnings, making it challenging to discern trends in core business operations. Users of financial statements must look beyond the headline numbers to understand the components of income and equity that are attributable to currency translation versus operational performance.

Hypothetical Example

Consider "Global Gadgets Inc.," a U.S.-based company with a subsidiary in Europe, "EuroGadgets GmbH." EuroGadgets GmbH uses the Euro (€) as its functional currency, and Global Gadgets Inc. uses the U.S. Dollar ($) as its reporting currency.

Let's assume the following exchange rates:

• Average exchange rate for the year: $1.10/€
• Current exchange rate at year-end: $1.15/€
• Historical exchange rate for EuroGadgets' initial equity investment: $1.05/€

EuroGadgets GmbH's simplified financial statements (in Euros) are:

Income Statement (for the year)

• Revenue: €1,000,000
• Expenses: €700,000
• Net Income: €300,000

Balance Sheet (Year-end)

• Assets: €2,000,000
• Liabilities: €800,000
• Equity: €1,200,000

Translation using the Current Rate Method:

1. Income Statement:

   • Revenue: €1,000,000 * $1.10/€ = $1,100,000
   • Expenses: €700,000 * $1.10/€ = $770,000
   • Translated Net Income: $330,000

2. Balance Sheet:

   • Assets: €2,000,000 * $1.15/€ = $2,300,000
   • Liabilities: €800,000 * $1.15/€ = $920,000
   • Equity (translated):
     • Initial Investment: €1,200,000 (assuming this is part of initial equity) * $1.05/€ = $1,260,000 (This is a simplified assumption for initial equity, in reality, retained earnings are from translated net income and translation adjustments build up).
     • Translated Net Income (from above): $330,000

The difference between the translated assets and liabilities and the translated equity (including retained earnings) forms the cumulative translation adjustment, which is reported in other comprehensive income as part of consolidated equity. The process ensures that the consolidated financial statements maintain balance after incorporating all foreign subsidiary figures.

Practical Applications

Currency translation is fundamental for any multinational corporation that prepares consolidated financial statements. It allows investors, analysts, and management to gain a holistic view of the company's global performance by bringing together financial data from operations spanning different currencies. For example, a U.S. company with significant European operations needs to translate its euro-denominated results into U.S. dollars to present a unified financial picture.

Beyond mere reporting, currency translation highlights the impact of foreign currency fluctuations on a company's reported financial health. While not directly affecting cash flows from existing foreign operations, significant currency movements can materially alter reported revenues, expenses, assets, and liabilities, thereby influencing financial ratios, debt covenants, and even dividend decisions. The ongoing strength of the U.S. dollar, for instance, has required many global companies to navigate significant currency headwinds that affect their reported earnings. Reuters reported on how global companies navigated these currency challenges in 2022 earnings calls. This process is distinct from managing foreign currency transactions, which relates to specific cross-border deals. It also contributes to a company's overall economic exposure to currency risk.

Limitations and Criticisms

While essential for financial reporting, currency translation has limitations and faces criticisms. One significant drawback is that the reported translated figures may not always reflect the true underlying economic performance of the foreign subsidiary, particularly under the current rate method where translation adjustments bypass the income statement. A strong reporting currency can make a profitable foreign subsidiary appear less successful in dollar terms, even if its local currency performance is robust. This can obscure operational insights and make comparisons across periods difficult if exchange rates fluctuate significantly.

Another criticism relates to the volatility introduced by currency translation. While the current rate method generally reduces income statement volatility compared to the temporal method, the cumulative translation adjustment can still lead to substantial swings in the equity section of the balance sheet, affecting key financial ratios and potentially signaling financial instability to some stakeholders. The choice of functional currency also presents a challenge, as determining the primary economic environment can be subjective and impact the method applied. EY discusses various considerations in accounting for foreign currency translation, highlighting the complexities involved. Moreover, in periods of high inflation, the application of standard translation methods can further distort financial reporting. The IMF has also published research on the broader effects of exchange rate volatility on firm performance.

Currency Translation vs. Exchange Rate

Currency translation is often confused with simply looking at an exchange rate. An exchange rate is the value of one currency in terms of another. For example, if the exchange rate is $1.10 per Euro, it means one Euro is worth $1.10. This is a single point in time conversion.

Currency translation, however, is a comprehensive accounting process that applies various exchange rates (current, historical, average) to an entire set of foreign subsidiary financial statements (balance sheet, income statement, cash flow statement) over an accounting period to convert them into the parent company's reporting currency. While currency translation uses exchange rates as its inputs, it's a much broader and more complex financial reporting activity, dealing with how all accounts are systematically converted to present consolidated financial results.

FAQs

What is the main purpose of currency translation?

The main purpose of currency translation is to combine the financial results of a multinational company's foreign subsidiaries, which operate in various local currencies, into a single, cohesive set of financial statements for the parent company, typically in its reporting currency.

What are the two main methods of currency translation?

The two main methods of currency translation are the current rate method and the temporal method. The choice depends on the functional currency of the foreign subsidiary and whether its operations are largely independent or highly integrated with the parent.

Does currency translation affect a company's cash flow?

Currency translation itself does not directly affect a company's cash flows. It is an accounting adjustment for reporting purposes. However, changes in exchange rates, which are the basis for currency translation, can significantly impact the U.S. dollar equivalent of future foreign currency cash flows when those flows are eventually remitted to the parent company.

Where do translation adjustments appear on financial statements?

Under the most common method (current rate method), translation adjustments generally appear in a separate component of equity on the balance sheet, often referred to as Accumulated Other Comprehensive Income (AOCI) or a cumulative translation adjustment (CTA). They bypass the income statement.