ASC 830: Accounting for Foreign Currency Matters

The Financial Accounting Standards Board (FASB) provides guidance for U.S. companies on accounting for business activities conducted in currencies other than the U.S. dollar, codified in Accounting Standards Codification (ASC) Topic 830, Foreign Currency Matters. The standard establishes a framework to ensure foreign activities are reported consistently within a company’s U.S. dollar-based financial statements. The objective is to provide principles for converting the financial results of foreign operations into U.S. dollars, allowing stakeholders to see a comprehensive picture of a company’s financial health. ASC 830 addresses the complexities that arise from fluctuating exchange rates and their impact on a company’s financial position.

Determining the Functional Currency

The first judgment a company must make under ASC 830 is to determine the “functional currency” for each of its foreign operations. The functional currency is the currency of the primary economic environment where an entity operates, generating and expending cash. This is distinct from the “reporting currency,” which is the currency the parent company uses for its financial statements, usually the U.S. dollar for American corporations.

The functional currency is often the local currency of the country where the operation is located, but this is not always the case. For example, a subsidiary in Mexico might use the U.S. dollar as its functional currency if it conducts most of its business, such as selling products and securing financing, in U.S. dollars.

The standard provides several economic factors that management must evaluate to identify the primary currency influencing an entity’s operations. The indicators include:

• Cash flow indicators, which examine if cash flows are primarily in a foreign currency and if they directly impact the parent’s cash flows.
• Sales price and market indicators, which look at whether sales prices are determined by local competition or by worldwide prices and the parent’s currency.
• Expense indicators, which focus on whether labor, materials, and other costs are primarily denominated in the local currency.
• Financing indicators, which question if the entity is financed by its own operations or if it relies on the parent for funds.
• Intercompany transaction indicators, which assess the volume and nature of transactions between the foreign entity and its parent.

Accounting for Foreign Currency Transactions

Once the functional currency is established, the company must account for individual transactions denominated in a different currency through a process known as remeasurement. This applies whenever a company buys, sells, borrows, or lends in a currency other than its functional currency. The goal is to produce the same result as if the transaction had been recorded in the functional currency from the start.

A foreign currency transaction must be recorded in the entity’s functional currency using the exchange rate on that day, known as the spot rate. For instance, if a U.S. company with a U.S. dollar functional currency buys inventory from Japan for 1,000,000 yen when the rate is 130 yen to the dollar, it records the inventory and an account payable of approximately $7,692.

At each subsequent balance sheet date, a distinction is made between monetary and non-monetary items. Monetary items, such as cash and accounts receivable, are fixed in a specific number of currency units. These balances must be adjusted to reflect the current spot exchange rate, with any resulting gains or losses recognized in the income statement.

Non-monetary items, such as inventory and property, are not adjusted to the current exchange rate. They remain on the books at the historical exchange rate from the transaction date. The cost of goods sold or depreciation expense related to these assets is also based on this historical rate.

Translating Foreign Entity Financial Statements

When a U.S. parent company prepares consolidated financial statements, it must include the results of its foreign subsidiaries. If a subsidiary’s functional currency is different from the parent’s reporting currency, a process called translation is required. Translation converts the subsidiary’s financial statements from its functional currency into the parent’s reporting currency.

The translation process uses the current rate method. All assets and liabilities on the subsidiary’s balance sheet are translated using the current exchange rate, which is the spot rate on the balance sheet date.

The income statement is handled differently. All revenues, expenses, gains, and losses are translated using a weighted-average exchange rate for the period. Using an average rate is a practical measure that approximates the results of translating each transaction individually.

Equity accounts receive special treatment. Capital stock is translated using historical exchange rates from the dates the capital was contributed. Retained earnings is a composite account, where the beginning balance is the prior period’s ending translated balance, and current net income is added at the weighted-average rate. Dividends are translated at the exchange rate on the date of declaration.

Reporting Currency Gains and Losses

The accounting treatments for remeasurement and translation result in gains and losses that are reported in distinct ways. The classification of these amounts depends on which process generated them.

Gains and losses from the remeasurement of foreign currency transactions are reported directly in the income statement. These result from adjusting monetary assets and liabilities to the current exchange rate at the end of a period. Because they are included in net income, they affect a company’s earnings per share.

In contrast, the effects of the translation process are not included in net income. When a subsidiary’s financial statements are translated, a balancing figure known as the translation adjustment is created. This adjustment is reported as a component of Other Comprehensive Income (OCI).

The translation adjustment is accumulated in a separate component of stockholders’ equity called the Cumulative Translation Adjustment (CTA). The CTA represents the total unrealized gain or loss from translating the subsidiary’s financial statements. This amount is only reclassified from equity and recognized in the income statement when the company sells or liquidates its investment in the foreign entity.