Foreign currency translation methods

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Foreign currency translation methods
Currency translation on foreign currency denominated financial statements. (table of contents image by Kirubeshwaran from Fotolia.com)

In accounting, foreign currency translation is used to remeasure a foreign subsidiary's financial statements denominated in a foreign currency so that they can be presented in the same reporting currency as that for the parent company. Without foreign currency translation, consolidating financial statements between foreign subsidiaries and their home company would be impossible. Foreign currency translation may treat different financial statement items differently in terms of what exchange rates are applied--current or historical. Balance sheet items are often translated differently than income statement items and current and non-current items may be handled separately as well.

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Current Rate Method

Under the current rate method, all assets and liabilities are translated using the current rate, i.e. the exchange rate on the balance sheet date, rather than when the translation is performed. Items in the equity section, including the closing entry of dividends to retained earnings, are translated using historical rates, i.e. rates at the time each of transactions occurred. Income statement items are also translated using actual exchange rates, i.e. rates at the dates when revenues and expenses are recognised. However, given the impracticability of applying different rates to numerous income statement items, the Financial Accounting Standards Board permits the use of an average rate for the statement period. The current rate method is the most widely used currency translation method, according to Investopedia.

Temporary Rate Method

Unlike the current rate method, which uses one single exchange rate for all asset and liability items, the temporary rate method uses both current rate and historical rate. The principle is that balance sheet items should be translated based on how they are carried on an entity's books. Some are valued and carried at fair market value such as receivables and others are valued and carried at historical purchase cost such as fixed assets. When an item regularly adjusts and updates its carrying value, the value is then temporary in nature and the temporary rate method recognises that. It does not attempt to assign a fixed, historical exchange rate to translate a value that is no longer valid. Assets and liabilities that are carried at current values are translated at the current exchange rate and items carried at historical costs are translated at their respective historical exchange rates.

Monetary Method

Like temporary rate method, monetary method also treats asset and liability items differently. Monetary method makes the distinction of monetary vs. non-monetary assets and liabilities. The principle is that monetary accounts are readily convertible to cash and their values fluctuate over time. Therefore, applying a historical rate to lock in the original value does not reflect the economic reality of how monetary items such as marketable securities can change in value over time. As such, monetary method translates monetary accounts at the current exchange rate and non-monetary accounts like land at historical rates.

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