What is currency conversion?
Currency translation is the process of converting one currency into another, often in connection with the financial results of a parent company’s foreign subsidiaries into its functional currency – the currency of the primary economic environment in which a company generates and spends cash flows.
For reasons of transparency, companies with foreign exposures may be required to report their accounting figures in one currency.
The central theses
- Currency translation allows a company with foreign operations or subsidiaries to reconcile all of its financial statements in relation to its local or functional currency.
- Currency translation uses the exchange rate at the period end for assets and liabilities, the exchange rate on the date income or expense was recognized in the income statement and a historical exchange rate on the date of recognition in equity.
- There are two main methods of currency translation: the current method, when the subsidiary and parent company use the same functional currency; and the temporal method in case this is not the case.
- Translation risk arises for a company when exchange rates fluctuate before the financial statements have been reconciled. This risk can be hedged with currency derivatives or currency positions.
This is how currency conversion works
Many companies, especially large ones, are multinational and operate in different regions of the world using different currencies. If a company sells in a foreign market and then sends payments home, the revenue must be reported in the currency of the place where most of the cash is primarily earned and spent. Alternatively, in the rare event that a company has a foreign subsidiary, such as in Brazil, that does not return money to the parent company, the functional currency for that subsidiary would be the Brazilian real.
Before the financial statements of a foreign entity can be translated into the reporting currency, the financial statements of the foreign entity must be prepared in accordance with generally accepted accounting principles (GAAP). If this condition is met, financial statements expressed in functional currency should use the following exchange rates for conversion:
- Assets and Liabilities: The exchange rate between the functional currency and the reporting currency at the end of the period.
- income statement: The exchange rate on the date income or expense was recognized; a weighted average price over the period is acceptable.
- Equity capital: The historical exchange rate at the time of entry into equity; The change in retained earnings is based on historical exchange rates in the income statement for each period.
Currency translation gains and losses are recorded in the financial statements. The change in foreign currency translation is part of accumulated other comprehensive income, is reported on a company’s consolidated statement of equity and is transferred to equity on the consolidated balance sheet.
If an entity has overseas branches that keep accounts in a foreign currency, it will disclose the above methodology in its footnotes under “Note 1 – Summary of Significant Accounting Policies” or something substantially similar.
The Financial Accounting Standards Board (FASB) Accounting Standards Codification Topic 830 entitled “Foreign Currency Matters” provides comprehensive guidance on the valuation and translation of foreign currency transactions.
Currency conversion accounting methods
There are two general ledger accounting standards for handling currency conversion.
- The electricity rate method: A foreign currency translation method in which most of the items in the financial statements are translated at the current exchange rate. The current rate method is used in cases where the subsidiary is not well integrated with the parent company and the local currency in which the subsidiary operates is the same how its functional currency.
- The temporal method: Also known as the historical method, this method converts the currency of a foreign subsidiary into the currency of the parent company. The temporal method is used when the local currency of the subsidiary is not the same as the currency of the parent company. Depending on the balance sheet item to be converted, different exchange rates are used.
Translation risk is the exchange rate risk associated with companies that trade in foreign currencies and list foreign assets on their balance sheets.
Companies that own assets abroad, such as B. Plant and equipment, must convert the value of these assets from the foreign currency to the home country currency for accounting purposes. In the US, this accounting conversion is usually done quarterly and annually. The translation risk arises from how much the value of the assets fluctuates due to exchange rate movements between the two countries involved.
Multinational companies with international offices are most exposed to translation risk. However, companies that do not have branches abroad but sell products internationally are also exposed to a translation risk. When a company earns income overseas, it must convert that income into its home or local currency when reporting its financials at the end of the quarter.
Currency conversion example
International sales accounted for 64% of Apple Inc.’s revenue for the quarter ended December 26, 2020. In recent years, the negative impact of a rising US dollar has been a recurring theme for the iPhone maker and other large multinationals. When the greenback appreciates against other currencies, it then weighs on international financial numbers when converted to US dollars.
Companies like Apple try to overcome adverse exchange rate fluctuations by hedging their currency exposure. Foreign exchange (forex) derivatives such as futures contracts and options are purchased to allow companies to lock in an exchange rate and ensure it stays the same over a period of time.
Constant currencies is another term that appears frequently in financial statements. Companies with offices abroad often choose to publish reported figures alongside figures that remove the effects of exchange rate fluctuations. Investors generally pay close attention to constant currency numbers, recognizing that currency movements can obscure a company’s true financial performance.
For the second fiscal quarter ended November 30, 2020, Nike Inc. reported a 9% increase in sales, adding that sales were up 7% on a constant currency basis.