What is Foreign Currency Translation?

Foreign Currency Translation

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Foreign Currency Translation

Foreign Currency Translation is a process used by multinational companies to convert the financial statements of their foreign subsidiaries into the currency of the parent company. This is done in order to prepare consolidated financial statements, which provide a comprehensive view of the overall company’s financial position.

Typically, each foreign subsidiary conducts business and maintains its accounting records in its own local currency. But for the purpose of preparing consolidated financial statements, all the financial information needs to be presented in a single currency.

The process of foreign currency translation involves several steps:

  • Identifying the Functional Currency: The functional currency is the primary currency in which the subsidiary operates and carries out its business transactions. It could be the local currency of the country where the subsidiary is located, or it could be a different currency, depending on various factors such as the currency of the primary economic environment in which the subsidiary operates.
  • Translating Financial Statement Items: The individual items in the subsidiary’s financial statements are translated into the parent company’s currency. According to U.S. GAAP, assets and liabilities are translated at the exchange rate in effect at the balance sheet date, while income statement items are translated at the average exchange rate for the period.
  • Recording Translation Adjustments: Any gains or losses that result from the translation process are not included in net income but are reported as a separate component of equity in the consolidated balance sheet. These are known as “translation adjustments” and reflect the impact of exchange rate movements on the parent company’s net investment in the subsidiary.

It’s important to note that foreign currency translation can significantly impact a company’s reported earnings and equity, and therefore it is crucial to understand how it is done when analyzing a multinational company’s financial statements.

Example of Foreign Currency Translation

Imagine a U.S.-based corporation called “TechGlobal Corp.” that owns a subsidiary in Japan, called “TechGlobal Japan. TechGlobal Japan’s financial year has ended and it needs to report its results back to the parent company in the United States.

For simplicity, let’s consider just one item from the financial statements: TechGlobal Japan’s revenue. Suppose that TechGlobal Japan earned ¥1,200,000,000 in revenue over the financial year.

However, TechGlobal Corp. reports its financials in U.S. dollars, not in Japanese yen. So, the revenue figure needs to be translated from yen into dollars.

Let’s assume the average exchange rate over the year was $1 = ¥110. To convert the revenue into U.S. dollars, we divide the revenue in yen by the exchange rate:

¥1,200,000,000 / 110 = $10,909,091

So, TechGlobal Corp. will report the translated revenue from TechGlobal Japan as approximately $10.91 million in its consolidated financial statement.

Similarly, the assets, liabilities, and other items on the income statement would be translated at the appropriate exchange rates. Note that the actual translation process might be more complex, especially when dealing with items that require historical exchange rates or dealing with changes in currency values over time. But this gives a simplified view of the basic process of foreign currency translation.

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