Foreign Currency Transactions and Translation

Foreign Currency Transactions: Recognition and Measurement

Foreign currency transactions are transactions denominated in a currency other than the entity’s functional currency—the primary currency of its operating environment. These include sales, purchases, loans, and investments in foreign currency.

• At the transaction date, companies record the transaction at the spot exchange rate.

• At each subsequent reporting date, monetary items (e.g., cash, receivables, payables) are remeasured using the closing rate.

• Non-monetary items (e.g., inventory, fixed assets at historical cost) are not remeasured, remaining at the rate on the transaction date.

Any difference arising from exchange rate changes between the transaction date and the settlement or reporting date is recognized as a foreign exchange gain or loss in net income.

Example: Recording and Settling a Foreign Purchase

A US company purchases inventory from a European supplier for €100,000 when the EUR/USD rate is 1.10. The initial entry is made at $110,000. If the payable is unpaid at year-end and the exchange rate has changed to 1.15, the liability is revalued to $115,000, and a $5,000 foreign exchange loss is recognized.

Translation of Foreign Operations

When an entity has foreign subsidiaries, branches, or associates, their financial statements—often prepared in a different functional currency—must be translated into the parent’s reporting currency for consolidation.

• Assets and liabilities are translated at the closing rate at the balance sheet date.

• Income and expenses are translated at rates on the transaction dates or average rates for the period.

• Equity items are translated at historical rates.

The resulting translation differences are not recognized in net income but are reported in Other Comprehensive Income (OCI) and accumulated in a separate equity account (cumulative translation adjustment, CTA) until disposal of the foreign operation.

Functional Currency Determination

The functional currency is the currency of the primary economic environment in which the entity operates. Determining the correct functional currency is crucial and depends on various factors, including:

• The currency influencing sales prices and costs

• The country’s competitive forces and regulations

• The currency in which financing is obtained

Once determined, the functional currency is used for all initial measurements and translation procedures.

Hyperinflationary Economies

If a subsidiary operates in a hyperinflationary economy, special accounting procedures apply under both US GAAP and IFRS, including restatement of financial statements for inflation prior to translation.

Disposal of a Foreign Operation

When a foreign operation is disposed of (e.g., sale or liquidation), the cumulative amount of translation adjustments related to that operation is reclassified from OCI to net income, reflecting the realized gain or loss from exchange rate movements over the life of the investment.

Disclosure Requirements

Both US GAAP (ASC 830) and IFRS (IAS 21) require comprehensive disclosure of:

• The functional currency of the reporting entity and its significant foreign operations

• The amount of foreign exchange gains and losses recognized in net income

• The nature and amount of translation adjustments in equity/OCI

• The impact of changes in functional currency, if any

Relevant Accounting Standards

• US GAAP: ASC 830 – Foreign Currency Matters

• IFRS: IAS 21 – The Effects of Changes in Foreign Exchange Rates

Both standards provide guidance on foreign currency transactions, translation of financial statements, and reporting of translation differences.

Summary Table: Foreign Currency Accounting

Accounting Aspect	Treatment
Transaction Recognition	Initial measurement at spot rate on transaction date
Remeasurement (Monetary Items)	At period-end closing rate; gains/losses in net income
Translation (Foreign Operations)	Assets/liabilities at closing rate; income/expenses at average rate; differences in OCI
Disposal of Foreign Operation	Reclassify cumulative translation adjustment to net income
Disclosure	Functional currency, FX gains/losses, CTA, policies

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