Question

IMC Corporation operates throughout North America and recently expanded operations, opening a small subsidiary in London, England.

In your post, address the following question:

Why is foreign currency translation important to IMC Corporation and other financial statement users? Provide examples.

Answer 1

In general, Foreign currency translation is used to convert the results of a parent company's foreign subsidiaries to it's reporting currency. This is a key part of the financial statement consolidation process. The steps in this translation process are as follows:

1. Determine the functional currency of the foreign entity.

2. Remeasure the financial statements of the foreign entity into the reporting currency of the parent company

3. Record gains and losses on the translation of currencies.

1. Determination of functional currency

  The financial results and financial pos of a company should be measured using its functional currency, which is the currency that the company uses in tthe majority of its business transactions.

If a foreign business entity operates primarily within one country and is not dependent upon the parent company, it's functional currency is the currency of the country, in which it's operations are located. However, there are other foreign operations of the parent company, and those financing is mostly supplied by the parent or other sources that use the dollar. In this matter, the functional currency of the foreign Operation is probably the dollar. These two examples anchor the ends of a continuum on which you will find the foreign operations. Unless an operation is clearly associated with one of the two examples provided, it is likely that you must make a determination of functional currency based on the unique circumstances pertaining to each entity. For example, the functional currency may be difficult to determine if a business conducts an equal amount of business in two different countries.

The functional currency in which a business reports it's financial results should rarely change. A shift to a different functional currency should be used only when there is a significant change in the economic facts and circumstances.

Example of functional currency determination

Krishna industries has a subsidiary in india, to which it ships it's body armor products for sale to local police forces. The indian subsidiary sells these products and then remits payment back to corporate headquarters. Krishna should consider US dollars to be the functional currency of this subsidiary.

Krishna industries also owns a subsidiary in Russia, which manufactures it's own body armor for local consumption, accumulates cash reserves, and borrows funds locally. This subsidiary rarely remits funds back to the parent company. In this case functional currency should be the Russian ruble.

Translation of the financial statements

When translating the financial statements of an entity for consolidation purposes into ththe reporting currency of a business, translate the financial statements using the following rules:

  1. Assets and Liabilities. Translate using the current exchange rate at the balance sheet date for assets and liabilities.

2. Income statement items. Translate revenues, expenses, gains, and losses using the exchange rate as of the date when those items were originally recognized.

3. Allocations. Translate all costs and revenue allocation using the exchange rates in effect when those allocatallocations are recorded. Example: depreciation, amortization of deferred revenues.

4. Different balance sheet date. If the foreign entity being consolidated has a different balance sheet date than that of the reporting entity, use the exchange rate in effect as of the foreign entities balance sheet date.

5. Profit eliminations. If there are intra - entity profits to be eliminated as part oof the consolidation, apply the exchange rate in effect on the dates when the underlying transactions took place.

6. Statement of cashflows. In the statement of cashflows, state all foreign currency cashflows at their reporting currency equivalent using the exchange rates in effect when the cashflows occurred. A weightweighted average exchange rate may be used for this calculation.

If there are translation adjustments resulting from the implementation of these rules, record the adjustment in the share holders equity section of the parent companies consolidated balance sheet.

If the process of converting the financial statements of a foreign entity into the reporting currency of the parent company results in a translation adjustments, report the related profit or loss in other comprehensive Income.