Foreign Currency Translation for the CPA FAR Exam
Understand foreign currency translation under ASC 830 for the CPA exam, including functional currency, remeasurement, translation adjustments, and transaction gains and losses.
Overview of ASC 830: Foreign Currency Matters
When a US parent company has foreign subsidiaries that keep their books in a foreign currency, the parent must convert those financial statements into US dollars for consolidation. ASC 830 governs this process. Foreign currency questions on the CPA FAR exam test your ability to determine the functional currency, apply the correct conversion method, and account for the resulting gains and losses.
Functional Currency
The functional currency is the currency of the primary economic environment in which the entity operates. It is typically the currency in which the entity primarily generates and expends cash. ASC 830 provides several economic indicators to help determine the functional currency, including cash flow indicators, sales price indicators, sales market indicators, expense indicators, financing indicators, and intercompany transaction indicators.
If the functional currency is the local (foreign) currency, the foreign subsidiary's financial statements are translated into the reporting currency. If the functional currency is the US dollar (the parent's currency), the statements are remeasured into US dollars. In highly inflationary economies (cumulative inflation of approximately 100% or more over three years), the functional currency is considered to be the reporting currency (US dollar), and remeasurement is required.
Translation (Current Rate Method)
When the functional currency is the local currency, translation is performed using the current rate method:
- Assets and liabilities: Translated at the current exchange rate at the balance sheet date.
- Equity accounts: Translated at historical exchange rates (the rates in effect when the equity transactions occurred).
- Revenues and expenses: Translated at the exchange rate at the date of the transaction, or a weighted-average rate for the period may be used as a practical expedient.
The resulting translation adjustment is reported in other comprehensive income (OCI) and accumulated in accumulated other comprehensive income (AOCI) as a component of equity. This adjustment is often called the cumulative translation adjustment (CTA). The CTA is not recycled into net income unless the parent sells or substantially liquidates its investment in the foreign subsidiary.
Remeasurement (Temporal Method)
When the functional currency is the US dollar, remeasurement is performed using the temporal method:
- Monetary assets and liabilities (cash, receivables, payables, debt): Remeasured at the current exchange rate.
- Nonmonetary assets and liabilities (inventory at cost, fixed assets, intangible assets, equity): Remeasured at historical exchange rates.
- Revenues and expenses: Generally at exchange rates in effect when the transactions occurred. However, cost of goods sold, depreciation, and amortization are remeasured at the historical rates related to the underlying assets.
The resulting remeasurement gain or loss is reported in net income on the income statement, not in OCI. This is a key distinction from translation adjustments.
Foreign Currency Transactions
When a US company enters into transactions denominated in a foreign currency (such as purchasing inventory from a foreign supplier and paying in euros), the company must record the transaction at the spot rate on the transaction date. At the balance sheet date, any foreign-currency-denominated monetary assets or liabilities are remeasured at the current spot rate, and the resulting gain or loss is recognized in net income.
Example: A US company purchases goods for 100,000 euros when the rate is $1.10 per euro, recording a $110,000 payable. At year-end, the rate is $1.15 per euro. The payable is remeasured to $115,000, and a $5,000 foreign currency transaction loss is recognized in net income.
Hedge Accounting and Foreign Currency
Entities may use derivative instruments to hedge foreign currency risks. Under ASC 815, hedges of net investments in foreign operations are accounted for with gains and losses reported in OCI (matching the treatment of the CTA). Hedges of foreign-currency-denominated forecasted transactions may qualify for cash flow hedge accounting, with gains and losses also deferred in OCI until the forecasted transaction affects earnings.
Exam Preparation Tips
- First determine the functional currency; this dictates whether you translate (current rate method) or remeasure (temporal method).
- Translation adjustments go to OCI; remeasurement gains and losses go to net income.
- Under the temporal method, monetary items use current rates and nonmonetary items use historical rates.
- Under the current rate method, all assets and liabilities use the current rate.
- Foreign currency transaction gains and losses on monetary items are always recognized in net income.
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