Financial Statements: How Does Currency Translation Work
If your business entity operates in several countries, chances are you also use different currencies as part of your business operations. But when it comes to reporting your company’s finances through financial statement, you aren’t allowed to use more than one currency.
In order to have your financial statements recorded in a single currency, you’ll need to perform currency translation. What does currency translation entail and what are the different methods used in the process? This guide will answer both of those questions and give you tips to avoid common mistakes associated with currency translation in your accounting procedure.
In particular in this article, you will learn 1) what is currency translation, 2) why currency translation is needed and used, 3) the three steps of currency translation, 4) how the rates are determined, 5) avoiding the common mistakes, and 6) how to mitigate the risks of currency translation.
WHAT IS CURRENCY TRANSLATION?
Before we look at the definition of currency translation, it is a good idea to define some of the key terms used in the process. Below is a break down of the three key terms: currency, financial statements and exchange rates.
What are currencies?
Currency is a generally accepted form of money, which includes both coins as well as paper notes. It is issued by a specific government and circulated within the government’s jurisdiction.
Currency is used as the medium of exchange when people deal with goods and services. It is essentially the basis for trade.
Most countries of the world have their own currency. Some of the most known official currencies and their countries include:
- The US Dollar – United States
- The Chinese Yuan – China
- The British Pound – the United Kingdom
While most countries in the world use their unique currency, there are some instances where different legislations might use the same currency. A number of European countries, such as France and Germany, use the Euro, for example.
There are also other currency types, such as branded currencies and local currencies. But currency translation mainly deals with the tradable currencies.
What are financial statements?
A business, individual or other such entity must keep a formal record of their financial activities. This is often for taxation purposes and these records are called financial statements.
The most common financial statements for business include:
Currency translation might show in all of these statements, although it is most essential for balance sheet reporting.
What are exchange rates?
Exchange rates are used in order to state the price of a specific currency in another currency. It has two separate components: the domestic currency and the foreign currency.
Most exchange rates use the US dollar as the base currency, but the Euro is also often used for this purpose.
Exchange rates fluctuate almost daily. It is important to understand this, as currency translation might require you to use a specific exchange rate from the past. You can find out different exchange rates through services such as XE.
The definition of currency translation
In short, the definition of currency translation refers to the process of quoting the amount of money in one currency in the denomination of another currency. Companies typically need this process as part of their financial record keeping. Currency translation is often used in balance sheets.
Companies, which operate in different countries, tend to have to use different currencies as part of their bookkeeping. For example, a company which is headquartered in the US would mainly use the US dollar in its accounting. But it might also receive part of its revenue from sales in the United Kingdom. These sales would naturally use the British pound.
But for accounting, the company has to use only one currency and therefore it needs to translate the British pound into US dollar.
Currency translation must be recorded on the company’s balance sheet as an equity account. In some instances, such as in the case of large banks, the translation will be recorded as equity capital.
The difference between functional and operation currency
Multinational companies can use different currencies for its operations. These are often referred to as the operational currencies.
But for accounting purposes, the company also has to have a functional currency, which is the primary type of money the company uses. Most companies tend to use the currency of the nation they are headquartered as the functional currency. But this is not required and some companies choose to use a different currency – usually one that is the most relevant for its operations.
WHY IS CURRENCY TRANSLATION NEEDED AND USED?
As mentioned above, currency translations help a company create financial statements that feature a single currency. In fact, the governing tax authority often requires companies to only use one denominated currency as part of their recording procedure.
While currency translation is typically mandatory process, there are certain benefits to currency translation as well. In the modern world, the multinational company is becoming the norm and even small- and medium-sized businesses tend to have cross-border operations. For these companies, currency translation will be essential.
Using a single currency as part of financial statements will make these statements easier to read and analyze. It is near impossible to draw rational conclusions from a statement, which features more than one currency.
THE THREE STEPS OF CURRENCY TRANSLATION
So how does currency translation work in reality? In its essence, the process can be defined by three separate steps the company needs to take. These are:
- Determining the functional currency for the business
- Re-measuring the financial statements of the business in the functional currency
- Recording the gains and losses on the translation of currencies
To make sense of each step, lets now look at the process in more detail.
Step 1: Determining the functional currency
As discussed above, companies must pick a functional currency and do all of the financial reporting in this single currency.
While the functional currency is most often simply the company where the businesses main headquarters are, there are other ways to decide the functional currency. The other alternative often selects the functional currency based on the currency majority of its operations are conducted.
For example, while a company might have its headquarters in Brazil, its main business operations might take place in the US. Instead of using the Brazilian real, the business might choose to make the US dollar its functional currency.
The above two ways of picking the functional currency are relatively straightforward. Problems might arise if the company operates in equal measure in separate locations outside of its country of residence. The company will just need to decide the most convenient currency under these circumstances.
Furthermore, once a company decides its functional currency it shouldn’t make changes to it, at least not regularly. A change in functional currency should only take place in situations of significant change in economic facts and circumstances.
Step 2: Re-measuring the financial statements in the functional currency
Once the business has denominated its functional currency, it needs to ensure its financial statements only use the selected currency. Instead of recording losses in separate headings for sales in separate currencies, the balance sheet shall feature sales only in the functional currency.
Each aspect of the financial statement must be translated into the single currency. This involves calculating the total of the following items:
- The company’s assets and liabilities
- Specific items in the income statement:
- Revenue, expenses, gains and losses
- Business allocations such as depreciation and amortization
- Cash flows
Furthermore, it is crucial to keep a close eye on the dates in which any of the above transactions occurred. Currency translation often only occurs at the end of the financial year, but the rates you choose to use are determined by the transaction date in some instances.
The following section will deal more on how the actual rates are determined in terms of calculating the currency translation. For now, it is important to note you might need to use the exchange rates from the past as well as present. Therefore, proper bank statements and income records are essential to ensure you use the right rates.
Step 3: Recording the gains and losses on the currency translation
Finally, currency translation often results in translation adjustments. These adjustments must be recorded on the company’s balance sheet as well. They are mentioned in the equity section of the balance sheet.
Furthermore, the translation adjustment also requires the company to record the adjustment in the profit or loss statement of comprehensive income.
HOW ARE THE RATES DETERMINED?
As you are aware, exchange rates are constantly fluctuating. This fluctuation causes certain difficulties for companies, as they need to account for this in their currency translations.
Instead of simply checking the current exchange rate when translating currencies, you might sometimes need to use different rates either for a specific period or even for a specific date.
Below is a look at the different rates companies need to use and the parts of the statement that fall under this specific calculation method:
- The average rate for the period –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.
- The ending rate for the period – 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 – 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 7, even if the financial year ends on December 31, the exchange rate used should be from July 7.
Fixed assets are always translated with the historical rate. It must be noted they also won’t be re-translated later on.
Finally, you should keep in mind that equity accounts are generally never re-valued.
The above rate calculations and methods are largely universal. But 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.
AVOIDING THE COMMON MISTAKES IN CURRENCY TRANSLATION
Although the guidelines for currency translation have not evolved much in recent years, there are certain mistakes companies continue to make. These mistakes can naturally lead to misstatements in financial reporting and cause damage to the company’s bottom line. Overall, this leads to false statements and thus business results can be different from the real picture.
In order to avoid regulatory scrutiny and to ensure your statements are correct, it is a good idea to look at these common mistakes. This way you can learn from them and ensure to avoid falling foul of them with your currency translation.
Hiding gains and losses in comprehensive income instead of recognising in net income
The first mistake often involves companies misclassifying a foreign currency loss or gain in other comprehensive income instead of net income. This might not sound like a big issue, but it results in incorrect net income and hides the gain or loss in the account, resulting in missed changes in the equity part of the statement.
This mistake is most persistent with companies that have an intercompany account and this account it recorded on the books of other units with different functional currencies.
It is important to keep an eye on your company’s intercompany balance, especially if you have parties which record their specific balance in different currencies.
Furthermore, recording the gains or losses in other comprehensive income is not always wrong. In situations where these gains and losses are essentially permanent, the gains and losses will be recorded on other comprehensive income instead of net income.
Preparing the consolidated statement of cash flows based on amounts in the consolidated balance sheet
While the cash flow transactions can be translated by using the average rate for the period, many experts think the statement should use the historical rates for each transaction. The problem arises because accountants often support the indirect method. While this indirect approach can work with smaller companies, it can be dangerous with larger companies with multiple entities.
The indirect method used the historical average to calculate the cash flow. As mentioned above, you’ll use the average exchange rate for the period for translating the cash flow.
But in many instances, this can lead to large-scale errors, as exchange rates can fluctuate quite a bit. Therefore, it is better to avoid using historical averages and instead use the historical rate for the specific transaction across all cash flow calculations.
Not recognizing the need to modify accounting for translations in inflationary environments
Companies can sometimes end up operating in highly inflationary economies and this adds additional pressure to currency translation. But in many countries, such as the US, the general accounting rules require companies operating in a highly inflationary environment to re-measure as if the functional currency was the reporting currency of the business. This results in translation adjustments and changes slightly how the earnings are reported.
A recent example of this was the Venezuelan economy, which received a highly inflationary status in 2009. Companies operating in the country would have had to change their reporting method in terms of currency translation, although some initially forgot to do so.
HOW TO MITIGATE THE RISKS OF CURRENCY TRANSLATION
It is possible to mitigate the risk of currency translation through three simple practices. By using the following three methods, you can reduce accounting risks and improve the accuracy of your financial statements.
Implement proper accounting policies
First, it is essential to create clear accounting policies. This might sound obvious, but for companies operating in several different jurisdictions, this advice is essential. You need to have clear guidelines across the different entities to ensure the accounting practices used are universal across your company.
It is especially important to create a proper set of currency translation guidelines. These can guarantee companies to prepare and adjust to this at the initial phase to make currency translation later much more straightforward.
Scrutinize your accounting
You should also check your current accounting procedures and make sure each unit complies with the main accounting procedure of your reporting country. You need to be able to check each individual accounting procedure and backtrack on the information provided with ease.
Have appropriate internal controls to detect mistakes
Accounting mistakes can happen, but the crucial thing is to limit them as much as possible. You want to create an internal system that acknowledges mistakes, instead of having a tax authority accuse you of reporting errors.
The key is to ensure the internal controls focus tightly on the accounts in terms of net income and the currency translation account. This can guarantee your currency translation is a successful one.