Academic journal article Journal of Accountancy

Three Common Currency-Adjustment Pitfalls: How to Correctly Account for Foreign-Currency Translations

Academic journal article Journal of Accountancy

Three Common Currency-Adjustment Pitfalls: How to Correctly Account for Foreign-Currency Translations

Article excerpt

[ILLUSTRATION OMITTED]

Although the rules on accounting for foreign-currency translations have not changed in many years, mistakes in this area persist. Such mistakes can result in misstatements in financial reporting, hurting the bottom line, creating false understandings of business results, and exposing companies to possible regulatory scrutiny

A key factor raising the stakes in foreign-currency reporting is the fact that U.S. companies are increasingly looking offshore for growth. U.S. exports are growing at a healthy pace, as a slumping dollar makes goods from the U.S. less expensive overseas. With the increase in foreign transactions comes a parallel increase in foreign-currency reporting, and since many companies do business in multiple countries, the complexity of such reporting is on the rise.

The risk of accounting errors in foreign-currency transactions has been compounded by significant volatility in the value of the U.S. dollar compared with some other currencies, especially in the past 18 months. And this volatility will likely continue, given recent headlines, such as the spike in the yen's value following Japan's devastating earthquake last March, the rise of China's yuan to a new high versus the U.S. dollar last summer, and runaway inflation in developing countries such as Venezuela.

THREE COMMON MISTAKES

As U.S. companies expand their presence in global markets, it is more important than ever to understand and address the most common pitfalls associated with working with foreign currencies. This article examines three frequent mistakes that accountants make regarding the reporting of foreign currencies. Avoiding these pitfalls can make a big difference to companies' financial statements.

Mistake 1: Hiding foreign-currency gains and losses in other comprehensive income (OCI) instead of recognizing them in net income. The first common mistake is difficult to detect without knowing how the accounting system consolidates subsidiaries. This mistake occurs when a company misclassifies a foreign-currency gain or loss in OCI instead of net income. Such a misclassification sounds benign, but it misstates net income and hides the gain or loss in an account that is normally presented as part of the statement of changes in equity

This mistake can arise when a company has an intercompany account (for example, a parent's intercompany receivable from a subsidiary) recorded on the books of companies with different functional currencies. The issue boils down to how to account for an intercompany balance when each of the parties has the balance recorded in different currencies (for example, the parent company records the balance in U.S. dollars, while the subsidiary records the balance in euros).

To illustrate, assume that on Jan. 1, 2011, Parent Company A lends $10 million to its subsidiary in Germany, and the loan is payable in U.S. dollars. On that date, Parent Company A records a $10 million receivable on its balance sheet, and the subsidiary records 6,961,000 [euro] on its balance sheet. Assuming the German subsidiary used the exchange rate of $1 = 0.6961 [euro] in its journal entry, the intercompany balance should be eliminated when the euro balance is translated to U.S. dollars, as shown in Exhibit 1.

Now assume that no other entries are recorded to this account, but that on March 31,2011, Parent Company A must report its financial statements. The prevailing exchange rate on that date is $1 = 0.7433 [euro]. Solely because of the change in the exchange rate, the company's intercompany accounts (prior to any currency translation adjustments) no longer balance, as shown in Exhibit 2.

Therefore, the German subsidiary must adjust its liability to Parent Company A from 6,961,000 [euro] to 7,433,000 [euro]. The subsidiary will credit its liability for 472,000 [euro]. The question is how the German subsidiary should record the offsetting debit to this transaction. …

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