For consolidation purposes, a foreign entity is required to apply GAAP and prepare financial information in its functional currency. For example, impairment adjustments should be determined and recorded in a foreign entity’s functional currency.

To translate a foreign entity’s functional currency financial statements into the reporting currency, a reporting entity should utilize the exchange rates as detailed in the Figure FX 5-2. The effect of changes in exchange rates between the foreign entity’s functional currency and the reporting currency is recognized in the reporting entity’s cumulative translation adjustment (CTA) account. See FX 5.6 for further information on the CTA account.

Figure FX 5-2
Exchange rates used to translate the financial statements of a foreign entity

ASC 830 does not address the translation of amounts in a foreign entity’s accumulated other comprehensive income (OCI), such as unrealized gains and losses on derivative instruments designated as cash flow hedges and available-for-sale securities, and unrecognized pension balances. There are two approaches for translating amounts reclassified out of accumulated OCI used in practice. Under the “historical rate approach”, amounts reclassified out of accumulated OCI are translated using the same rate used when the transactions were recorded in OCI. Under the “current rate approach” the amount of accumulated OCI reclassified to net income each period is translated using the exchange rate in the period in which the reclassification adjustment is reflected in net income. The current rate approach is consistent with the FASB’s stated view that the issuance of FASB Statement 158 (codified in ASC 715), Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, was not intended to change the way that net periodic benefit expense for pension plans is determined. Prior to the issuance of FAS 158, the components of the net pension asset or liability remained off balance sheet until they were amortized into net periodic benefit expense. When the net pension asset or liability was amortized, employers translated those amounts, along with the other components of net periodic benefit expense, using current exchange rates (similar to other income statement amounts). Thus, the application of the current rate approach is consistent with practice prior to the issuance of FAS 158.

Although we believe that both the historical rate approach and the current rate approach are acceptable under US GAAP, we believe the arguments in support of the historical rate approach are more conceptually sound (i.e., that accumulated other comprehensive income is analogous to retained earnings and that reclassification adjustments are not recognition events). However, we acknowledge that the use of the historical rate approach gives rise to practical challenges in tracking the historical exchange rates associated with accumulated OCI. We believe that a number of approaches (averaging, first-in, first-out, etc.) to simplify that process would be acceptable. A reporting entity should elect a method of reclassifying amounts out of OCI and apply it consistently.

Example FX 5-1 illustrates the process of financial statement translation when a foreign entity’s books and records are maintained in its functional currency.

EXAMPLE FX 5-1
Translation of foreign entity financial statements maintained in a foreign entity’s functional currency

USA Corp is a US registrant that uses the US dollar (USD) as its reporting currency.

Britannia PLC is a wholly-owned subsidiary of USA Corp located in the United Kingdom. It is a distinct and separable operation of USA Corp and has a functional currency of the British pound sterling (GBP); therefore, it meets the definition of a foreign entity of USA Corp.

Britannia PLC maintains its books and records in GBP. Its GBP financial statements are shown below.

There is no opening balance in USA Corp’s CTA account related to its investment in Britannia PLC because we have assumed that the 1/1/X2 exchange rate between the GBP and USD has not changed since USA Corp acquired Britannia PLC.

The relevant exchange rates are shown in the following table.

How should USA Corp translate Britannia PLC’s financial statements for inclusion in its USD consolidated financial statements?

The following table shows (1) Britannia PLC’s GBP balances on 12/31/X2, (2) the rate used to translate each account, and (3) Britannia PLC’s translated USD balances, which are included in USA Corp’s consolidated US dollar financial statements. Retained earnings is translated using the historical exchange rate because we have assumed that exchange rate at 1/1/X2 had not changed since Britannia PLC was acquired.

The entry recorded to the CTA account is calculated as follows: