Understanding foreign currency translation
Foreign currency translation, or FX translation, is the process in which an international business translates the results of its foreign subsidiaries into domestic currency for accounting purposes.
This concept is crucial largely due to the constant fluctuation of foreign exchange (FX) rates, which impacts the value of assets and liabilities in foreign currencies. In accounting, even tiny differences like these can lead to significant fluctuations in the reported earnings and equity. Ergo, businesses must accurately account for these fluctuations and provide appropriate disclosures.
It is also particularly important today, as globalization has allowed businesses to easily expand across borders and tap into foreign markets. It is also crucial as it holds businesses to the General Accepted Accounting Principles (GAAP), which is a set of accounting rules, standards, and procedures that govern public companies.
Here are the three methods to calculate foreign currency translation:
Current rate method
This method, also referred to as the balance sheet foreign currency translation, involves translating all assets and liabilities of the foreign subsidiary into the parent company’s functional currency at the current exchange rate. However, the company’s equities are translated using the historical foreign currency translation rates.
Temporal rate method
The temporal rate method, also known as the historical method, considers both current and historical foreign currency translation rates based on the entity’s books. There is no universal exchange rate that applies to all items.
Monetary-nonmonetary translation method
The monetary-nonmonetary method compartmentalizes the monetary and non-monetary assets and liabilities. Monetary accounts are translated at the current exchange rate because these items are readily convertible into cash and values. Non-monetary items are translated at historical rates.
What is the foreign currency translation adjustment?
There is one more item to pay attention to when analyzing the balance sheet with foreign currency translations — the foreign currency translation adjustment, or more commonly known as the cumulative translation adjustment (CTA).
This adjustment accounts for any differences between the reported values of assets and liabilities due to varying FX rates. The gains and losses from this are compiled as an entry in the income statement of a translated balance sheet. More specifically, a positive CTA indicates a net gain from foreign currency translation, while a negative CTA indicates a net loss.
It is also important to note that the impact of foreign currency translation on the balance sheet can vary depending on the method and exchange rates used. For this reason, it’s often best to consult a professional accountant regarding the regulations around foreign currency translation.
How does the foreign currency translation process work?
Let’s take a hypothetical scenario to illustrate this.
A Singapore-based company, let’s call it XYZ Pte Ltd, designs bespoke software solutions for businesses in the USA, UK, and Australia. Because of their presence in several countries and the involvement of numerous global transactions (with multiple currencies), the business is required to perform FX translations on a regular basis.
Here’s what happens during the process:
- XYZ Pte Ltd translates the value of its receivables into its own currency, which is known as the functional currency. Note: The company uses the spot exchange rate, which is the rate applicable on the date of the transaction. And, because the exchange rate between the company’s base local currency and the corresponding foreign currency constantly fluctuates, it means that the value of its receivables (which are in SGD), also continuously fluctuates.
- Upon the conversion from the respective foreign currencies to SGD, the final SGD amount will reflect either a gain or a loss.
- XYZ Pte Ltd updates the value of all assets and liabilities during the reporting period.
At the end of the reporting period, XYZ Pte Ltd will have a final figure that states whether their foreign ventures led to a net profit or loss.
Here’s a more detailed breakdown:
Due to the involvement of multiple currencies, each of XYZ Pte Ltd’s clients has separate accounts receivable.
Each transaction was entered on 30 Jun 2023 and the spot exchange rate between SGD were as follows:
With that, here’s what the accounting entries would look like for these clients:
However, between the payment initiation time and the settlement time, the FX rates between SGD and the other currencies have deviated. Therefore, XYZ Pte Ltd must update its accounts to reflect the changes.
Because of this change, the new accounting journal will look like this:
This example depicts the potential slippage of revenue that a company can incur due to FX rate fluctuations that occur between the payment and settlement time. On the other hand, if the exchange rates become more favorable during this period, XYZ Pte Ltd will have made a profit.
A crucial item to note is the importance of maintaining consistency throughout the currency translation process to ensure the accuracy and reliability of the financial statements.
What are translation risks?
By definition, translation risks are the exchange risks associated with companies that trade in more than one currency and have foreign assets on their balance sheets. More precisely, it’s the risk that the value of a business's equities, assets, liabilities, or income will change due to exchange rate fluctuations. Translation risks are also referred to as “accounting exposure”.
This happens because FX rates can vary dramatically in a short period of time, especially during major economic announcements such as interest rate decisions. In addition, this risk is present whether the exchange rate increases or decreases the value of an asset.
There is also a clear line to be drawn between transaction risk and translation risk. Transaction risks refer to the risks that when the value of a business transaction may change before the completion, due to changes in the FX rates. Translation risks, on the other hand, solely focus on the change in the value of a foreign-held asset due to changes in the FX rates.
Fortunately, there are a variety of mechanisms that allow businesses to hedge against translation exposure.
Managing translation risks
To manage (and mitigate) translation risks, the most common options are currency swaps or futures contracts. These methods enable companies to lock in an exchange rate for a future date or allow businesses the right to buy or sell foreign currencies at a pre-determined price.
In addition, companies can also request to trade (buy and sell goods or services) in a foreign currency. This way, the risks associated with local currency fluctuations will be transferred from the company to the client because they will be the party responsible for making the currency exchange.
🔑Read more: 5 Ways to Reduce Your Business FX Risks
Using constant currencies in foreign currency translation
Constant currencies are exchange rates used to minimize the effect of FX volatility during the calculation of financial performance numbers in financial statements. This is typically used by companies with significant operations in foreign countries because floating exchange rates can often mask the true performance.
The notion behind this theory is that it helps provide a more accurate gauge of performance for a company, devoid of external factors such as the unpredictability of foreign exchange rate mechanisms.
However, constant currencies are not a substitute for accurate foreign currency translations. Instead, they’re a complementary tool used in conjunction with standard foreign currency translation methods to provide a more in-depth analysis of a company’s financial performance.
Best practices for foreign currency translations
The foreign currency translation process is, no doubt, a complex one. But adhering to the best practices can ensure accurate and reliable financial statements over the long term. Here are some practical tips for achieving this:
- Consistency: Maintain consistency in the methods and procedures used across the translation process. In addition, any changes in approach should be clearly documented.
- Seek expert advice: The process of foreign currency translation requires careful consideration and attention, especially for corporates that have a presence in more than a handful of countries. Always consult an expert to ensure regulatory compliance and the accuracy of data.
- Stay up to date: Accounting standards and industry regulations are constantly evolving. Keeping up to date with the latest changes helps ensure your financial statements are meeting current requirements.
- Use technology: Use automation tools or accounting software to streamline the translation process and minimize errors.
Reducing global payment costs with Wallex
With a Wallex Multi-Currency Account, businesses can easily manage dozens of international currencies. In other words, it permits better control over disbursements, so companies can avoid unfavorable exchange rates.
Tips for success to navigate the ever changing economic landscape