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3 Keys to FX Translation Accounting

Translation and transaction accounting are often confused for one another — but the difference between them is important. How can you tell them apart?

Knowing which rates and which rules to apply are all it takes to understand the difference between translation and transaction accounting.

Simply put, translation accounting is the process used to turn foreign functional currency financial statements into U.S. dollar-denominated financial statements for consolidation and reporting purposes. Transaction accounting is used to report on non-functional currency activity and balances on functional currency books. Each has its own unique rule set.

In this blog, we’re going to focus on the basics of translation accounting assuming a foreign functional set of financial statements being consolidated into a USD reporting parent.

Key #1: Translation Rate for Income Statement

ASC 830 suggests that revenues, expenses, gains and losses be captured at the rate on the date the activity is recognized— but recognizes that as “generally impractical” and provides for a practical expedient. Most corporations translate the entire income statement of a foreign subsidiary, including revenues, expenses, taxes and other income, all at an income statement rate (ISR). That ISR is generally the simple average of market rates for the month or the prior month’s balance sheet rate, either of which provides a month’s entries at a rate relevant to the month and a weighted average rate for the year.

The income statement rate is used to 1) convert all foreign functional income statement lines into USD (for U.S. reporting entities) for consolidations and 2) record new non-functional currency transactions, even if the transactions are impacting only balance sheet accounts (e.g. debit inventory and credit accounts payable at the income statement rate).

In practice the rates used to record foreign transactions may not be the same rates that translate foreign income statement lines due to using a practical expedient.

NOTE: It is not appropriate to use the cumulative simple average of market rates for the year against the year-to-date income statement line items.

Key #2: Translation Rate for Assets & Liabilities

The balance sheet is broken into two sections for translation: assets & liabilities, and equity.

First, all assets and liabilities are converted at the balance sheet rate (month-end rate). The balance sheet rate is used to convert all foreign functional assets and liabilities into USD for consolidation with the rate changes driving a Cumulative Translation Adjustment (CTA) in OCI.

Translation occurs after foreign denominated monetary transactions have re-measured to functional currency. Whether it’s inventory or cash, all balances, now in functional currency, are translated at the same rate — the balance sheet rate. With translation accounting, you don’t need to differentiate between monetary and non-monetary balance sheet items.

Whether it’s inventory or cash, they all are translated at the same rate — the balance sheet rate.

Balance sheet rates are generally (and most appropriately) captured on the last market day of the financial period. If no rates are available due to an economic crisis (e.g. Argentine peso stopped trading at year-end in 2001) the appropriate rate is the rate from the first day trading resumes.

Key #3: Translation Rate for Equity

Next, all equity on the balance sheet is translated at the historic rate – with a couple of unusual exceptions. For example, the OCI related to hedge accounting is generally translated at the balance sheet rate.

Historic rates are the exchange rate applicable to a transaction when it was first recorded in the financials. Historic rates are used to convert foreign equity into USD for consolidation: the initial capital at that rate when the capital was invested, last year’s RE at the ISR for each related month, last month’s net income at last month’s ISR, etc.

When foreign assets and liabilities are translated at the balance sheet rate and equity is translated at historical rates, the USD version of this balance sheet won’t balance (assets will not equal liabilities plus equity). The difference required to balance is recorded to an account (in equity) called Cumulative Translation Adjustment (CTA). That’s where all the changes in an asset/liability are collected on foreign functional books until they hit earnings (e.g. changes in rates between the purchase of inventory and the recording of Cost of Sales are captured in CTA). The CTA is captured in order to balance the translated balance sheet.

So that’s it. Easy right? Just remember the three key rules for translating foreign functional financials into USD:

  1. The current period income statement translates at the income statement translation rate
  2. Period-end assets and liabilities translate at the balance sheet translation rate
  3. Equity elements and layers remain at historic rates, and CTA is adjusted to balance

Bonus Key: Reconciling CTA

If your auditor requires a reconciliation of CTA, you can use this method to prove out a one-month change:

Sum of:

Prior net asset/liability position @ Prior balance sheet rate
Prior net asset/liability position @ Current balance sheet rate
Current change in net asset/liability position @ Income statement transaction rate
Current change in net asset/liability position @ Current balance sheet rate
Dividend @ declaration rate less dividend at Income statement transaction rate

The result of adding these 3 changes will match one month’s change in CTA amount (the change for the period, not the cumulative CTA).

For more guidance on the basics of FX accounting, be sure to follow our Foreign Exchange Boot Camp Series! Sign up for the series (and other free webinars), here.

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