Current rate method

What Is the Current Rate Method?

The current rate method is an accounting technique used by multinational corporations to translate the financial statements of their foreign operations from a local functional currency into the reporting currency of the parent company. This process falls under the broader category of accounting and financial reporting, specifically foreign currency translation. Its primary application is when a foreign subsidiary is considered self-sustaining and relatively independent of the parent company's day-to-day operations, meaning its primary economic environment is the local one. The current rate method ensures that the financial position and results of foreign entities are accurately presented in consolidated financial statements.²²

History and Origin

The need for standardized foreign currency translation methods arose with the increasing internationalization of business. Accounting for foreign currency transactions and operations has been a focus of standard-setting bodies throughout the 20th century. In the United States, the Financial Accounting Standards Board (FASB) significantly addressed this area, culminating in the issuance of Statement of Financial Accounting Standards (SFAS) No. 52, "Foreign Currency Translation," in December 1981. This standard largely mandated the use of the current rate method for foreign entities whose functional currency was their local currency, replacing previous, more complex methods like the temporal method for most situations.²⁰, ²¹ Globally, the International Accounting Standards Committee (IASC) initially issued IAS 21, "Accounting for the Effects of Changes in Foreign Exchange Rates," in December 1983, which was later revised by the International Accounting Standards Board (IASB) in December 2003 as IAS 21, "The Effects of Changes in Foreign Exchange Rates." This standard, like its U.S. counterpart, provides guidance on how to account for foreign currency transactions and operations in financial statements, including the application of the current rate method.¹⁸, ¹⁹

Key Takeaways

• The current rate method translates the financial statements of foreign subsidiaries into the parent company's reporting currency.
• It is typically applied when the foreign subsidiary's functional currency is its local currency, indicating a self-sustaining operation.
• All assets and liabilities on the balance sheet are translated using the current exchange rate on the balance sheet date.
• Revenue and expense items from the income statement are usually translated using the average exchange rate for the period.
• Translation adjustments arising from this method are recorded in a separate component of equity, often referred to as accumulated other comprehensive income (AOCI), rather than impacting net income directly.¹⁶, ¹⁷

Formula and Calculation

Under the current rate method, different components of the financial statements are translated using specific exchange rates:

• Assets and Liabilities: Translated at the current exchange rate (closing rate) prevailing at the balance sheet date.
  [ \text{Assets}{\text{Parent}} = \text{Assets}{\text{Subsidiary}} \times \text{Current Exchange Rate} ]
  [ \text{Liabilities}{\text{Parent}} = \text{Liabilities}{\text{Subsidiary}} \times \text{Current Exchange Rate} ]

• Income Statement accounts (Revenues and Expenses): Translated at the average exchange rate for the period. While theoretically the rate at each transaction date should be used, an average rate is often practical and permitted if transactions occur uniformly throughout the period.¹⁵
  [ \text{Revenues}{\text{Parent}} = \text{Revenues}{\text{Subsidiary}} \times \text{Average Exchange Rate} ]
  [ \text{Expenses}{\text{Parent}} = \text{Expenses}{\text{Subsidiary}} \times \text{Average Exchange Rate} ]

• Equity accounts (e.g., Common Stock): Translated at the historical exchange rate that existed when the equity was originally issued.¹³, ¹⁴
  [ \text{Common Stock}{\text{Parent}} = \text{Common Stock}{\text{Subsidiary}} \times \text{Historical Exchange Rate} ]

• Dividends: Translated at the exchange rate on the date the dividends were declared.

Any resulting differences from these translations are recognized as a translation adjustment and reported in a separate component of equity, specifically within other comprehensive income (OCI).¹¹, ¹²

Interpreting the Current Rate Method

The current rate method aims to preserve the financial relationships, such as financial ratios, that existed in the foreign entity's functional currency financial statements. For instance, the gross profit margin calculated from the subsidiary's income statement in its functional currency will remain the same after translation to the parent company's reporting currency because both revenues and expenses are translated at the same average rate.¹⁰

The translation adjustment (gain or loss) reported in equity reflects the change in the parent company's net investment in the foreign subsidiary due to fluctuations in exchange rates. A positive adjustment indicates that the foreign currency has appreciated against the reporting currency, increasing the value of the net assets. Conversely, a negative adjustment results from depreciation. This approach isolates the impact of currency fluctuations on the overall investment without distorting the parent company's net income from ongoing operations.⁹

Hypothetical Example

Imagine US-based "Alpha Corp" has a wholly-owned subsidiary, "Beta Ltd.," in Europe. Beta Ltd. uses the Euro (€) as its functional currency, and Alpha Corp.'s reporting currency is the US Dollar ($). At the end of the fiscal year, Alpha Corp. needs to translate Beta Ltd.'s financial statements.

Let's assume the following:

• Balance Sheet Date (Current) Exchange Rate: $1.10 per €
• Average Exchange Rate for the year: $1.15 per €
• Historical Exchange Rate (when equity was issued): $1.20 per €

Beta Ltd.'s Financial Statements (in €):

Balance Sheet (as of Dec 31)

• Cash: €1,000,000
• Property, Plant & Equipment: €5,000,000
• Accounts Payable: €700,000
• Long-term Debt: €3,000,000
• Common Stock: €1,500,000
• Retained Earnings: €800,000

Income Statement (for the year ended Dec 31)

• Revenue: €2,500,000
• Operating Expenses: €1,800,000
• Net Income: €700,000

Translation using the Current Rate Method:

1. Assets & Liabilities (translated at current rate of $1.10/€):

   • Cash: €1,000,000 × $1.10/€ = $1,100,000
   • Property, Plant & Equipment: €5,000,000 × $1.10/€ = $5,500,000
   • Accounts Payable: €700,000 × $1.10/€ = $770,000
   • Long-term Debt: €3,000,000 × $1.10/€ = $3,300,000

2. Income Statement (translated at average rate of $1.15/€):

   • Revenue: €2,500,000 × $1.15/€ = $2,875,000
   • Operating Expenses: €1,800,000 × $1.15/€ = $2,070,000
   • Net Income: $2,875,000 - $2,070,000 = $805,000

3. Equity (Common Stock translated at historical rate of $1.20/€):

   • Common Stock: €1,500,000 × $1.20/€ = $1,800,000
   • Retained Earnings: Transferred from prior period's translated balance, adjusted for current period's translated net income and dividends. For simplicity, assume prior period retained earnings were $960,000. New Retained Earnings = $960,000 + $805,000 = $1,765,000.

After these translations, the balance sheet must balance. The difference between translated assets and translated liabilities plus equity (Common Stock and Retained Earnings) is the cumulative translation adjustment (CTA), reported within other comprehensive income.

• Total Translated Assets: $1,100,000 + $5,500,000 = $6,600,000

• Total Translated Liabilities: $770,000 + $3,300,000 = $4,070,000

• Translated Equity (excluding CTA): $1,800,000 (Common Stock) + $1,765,000 (Retained Earnings) = $3,565,000

• Calculated CTA (plug figure): Total Assets - Total Liabilities - Translated Equity = $6,600,000 - $4,070,000 - $3,565,000 = -$1,035,000. This negative CTA reflects a translation loss, indicating the Euro depreciated against the Dollar over the period, reducing the translated value of Beta Ltd.'s net assets.

Practical Applications

The current rate method is widely applied by multinational corporations with foreign subsidiaries that operate as self-contained entities. It is a cornerstone of preparing consolidated financial statements under both U.S. Generally Accepted Accounting Principles (GAAP) (specifically FASB ASC 830) and International Financial Reporting Standards (IFRS) (under IAS 21) when the foreign entity's functional currency is its local currency.

Companies use this method to reflect the economic reality of their ⁷, ⁸foreign operations. For example, a U.S. technology company with a manufacturing plant in Vietnam, where the Vietnamese Dong is the functional currency, would use the current rate method to translate the plant's financial results into U.S. dollars for consolidation. This approach is beneficial because it preserves the original financial relationships within the foreign entity's financial statements, which can be useful for assessing the foreign subsidiary's performance independently. It also helps manage translation exposure, a form of accounting risk arising from currency fluctuations, by moving the translation adjustments directly to equity rather than through the income statement.

Limitations and Criticisms

Despite its widespread use, the curr⁶ent rate method has certain limitations and criticisms. One common critique is that while it preserves financial relationships on the income statement (e.g., gross margin), it can distort certain balance sheet relationships, such as the debt-to-equity ratio, if the currency exchange rates fluctuate significantly. This is because debt (a liability) and equity are translated at different rates (current vs. historical/roll-forward retained earnings), which can impact the perceived financial leverage of the consolidated entity.

Another point of contention is how translation adjustments are hand⁵led. By routing them through other comprehensive income (OCI) and accumulating them in equity, these gains or losses do not directly impact the current period's net income. While this reduces volatility in reported earnings, some argue that it may obscure the economic impact of currency fluctuations on the overall value of the firm, potentially making it harder for investors to fully assess risk and performance. Academic research continues to explore the value relevance of these translation adjustments. Furthermore, the method assumes that a foreign entity is financially⁴ and operationally independent, which may not always be truly the case, especially for highly integrated global operations.

Current Rate Method vs. Temporal Method

The current rate method and the temporal method are the two primary approaches for foreign currency translation, each applied based on the foreign entity's functional currency.

The key differentiator lies in the treatment of non-monetary assets and liabilities and where translation gains and losses are recognized. The current rate method is generally simpler and better reflects the financial position of a self-sustaining foreign operation, while the temporal method is used when the foreign operation is considered an extension of the parent company, often due to high integration or operations in a hyperinflationary economy.

FAQs

When is the current rate method used?

The current rate², ³ method is used when a foreign subsidiary's functional currency, the currency of its primary economic environment, is the local currency where it operates. This implies the subsidiary is largely self-sustaining and not highly integrated with the parent company's day-to-day operations.

What is functional currency?

Functional currency is the currency of the primary economic environment in which an entity operates. It's the currency in which the entity primarily generates and expends cash. This determination is crucial because it dictates which foreign currency translation method a company must use.

Where do translation adjustments appear under the current rate method?

Translation adjustments resulting from the current rate method are reported as a separate component of equity, typically within accumulated other comprehensive income (AOCI). They do not directly impact the parent company's net income for the period, which helps reduce earnings volatility.

Does the current rate method affect financial ratios?

The current rate method generally preserves the financial ratios that exist in the foreign subsidiary's original functional currency financial statements. This is because most items are translated using consistent rates (e.g., all balance sheet items at the current rate, all income statement items at the average rate), maintaining their proportional relationships.¹