When the U.S. firm owns a controlling interest (more than 50%) in another firm in a foreign country, special consolidation problems arise. The subsidiary`s financial statements are usually prepared in the language and currency of the country in which it is located and in accordance with the local accounting principles. Before these foreign currency financial statements can be consolidated with the U.S. parent`s financial statements, they must first be adjusted to conform with U.S. GAAP and then translated into U.S. dollars.

Two different procedures may be used to translate foreign financial statements into U.S. dollars: (1) translation procedures and (2) remeasurement procedures. Which one of these two procedures is to be used depends on the determination of the functional currency for the subsidiary.

The Functional Currency

FASB 52, Foreign Currency Translation (ASC 830-10-15) defines the functional currency of the subsidiary as the currency of the primary economic environment in which the subsidiary operates. It is the currency in which the subsidiary realizes its cash flows and conducts its operations. To help management determine the functional currency of its subsidiary, SFAS 52 provides a list of six salient economic indicators regarding cash flows, sales price, sales market, expenses, financing, and intercompany transactions. Depending on the circumstances:

  • The functional currency can be the local currency. For example, a Japanese subsidiary manufactures and sells its own products in the local market. Its cash flows, revenues, and expenses are primarily in Japanese yen. Thus, its functional currency is the local currency (Japanese yen).

  • The functional currency can be the U.S. dollar. For foreign subsidiaries that are operated as an extension of the parent and integrated with it, the functional currency is that of the parent. For example, if the Japanese subsidiary is set up as a sales outlet for its U.S. parent, i.e. it takes orders, bills and collects the invoice price, and remits its cash flows primarily to the parent, then its functional currency would be the U.S. dollar.

The functional currency is also the U.S. dollar for foreign subsidiaries operating in highly inflationary economies (defined as having a cumulative inflation rate of more than 100% over a three-year period). The U.S. dollar is deemed the functional currency for translation purposes because it is more stable than the local currency.

Once the functional currency is determined, the specific conversion procedures are selected as follows:

  • Foreign currency is the functional currency - use translation procedures.

  • U.S. dollar is the functional currency - use remeasurement procedures.

Translation Procedures

If the local currency is the functional currency, the subsidiary`s financial statements are translated using the current rate method. Under this method:

  • All assets and liabilities accounts are translated at the current rate (the rate in effect at the financial statement date).

  • Capital stock accounts are translated using the historical rate (the rate in effect at the time the stock was issued).

  • The income statement is translated using the average rate for the year.

  • All translation gains and losses are reported on the balance sheet, in an account called "Cumulative Translation Adjustments" in the stockholders` equity section.

The purpose of these translation procedures is to retain, in the translated financial statements, the financial results and relationships among assets and liabilities that were created by the subsidiary`s operations in its foreign environment.


Assume that the following trial balance, expressed in the local currency (LC) is received from a foreign subsidiary, XYZ Company. The year-end exchange rate is 1 LC = $.1.50, and the average exchange rate for the year is 1 LC = $1.25. Under the current rate method, XYZ Company`s trial balance would be translated as follows:


Exhibit 1 shows the translation procedures applied to XYZ Company`s trial balance. Note that the translation adjustment is reflected as an adjustment of stockholders` equity in U.S. dollars.

Remeasurement Procedures

If the U.S. dollar is considered to be the functional currency, the subsidiary`s financial statements are then remeasured into the U.S. dollar by using the Temporal Method. Under this method:

  • Monetary accounts, such as cash, receivable, and liabilities, are remeasured at the current rate on the date of the balance sheet.

  • Nonmonetary accounts, such as inventory, fixed assets, and capital stock, are remeasured using the historical rates.

  • Revenues and expenses are remeasured using the average rate, except for cost of sales and depreciation expenses that are remeasured using the historical exchange rates for the related assets.

  • All remeasurement gains and losses are recognized immediately in the income statement.

The objective of these remeasurement procedures is to produce the same U.S. dollar financial statements as if the foreign entity`s accounting records had been initially maintained in the U.S. dollar. Exhibit 2 shows these remeasurement procedures applied to XYZ Company`s trial balance. Note that the translation gain/loss is included in the income statement.


Note: A fluctuation in the exchange rate between the functional currency and the other currency is a gain or loss that ordinarily should be included in determining net income when the exchange rate changes. But if the functional currency is the U.S. dollar and the transaction is denominated in U.S. dollars, no foreign currency transaction gain or loss occurs. Translation adjustments are gains and losses from translating financial statements from the functional to the reporting currency. They should be reported in other comprehensive income. They are not included in the determination of net income. A foreign currency transaction gain or loss ordinarily should be included as a component of income from continuing operations in the period in which the exchange rate changes. However, a gain or loss on a foreign currency transaction that hedges a net investment in a foreign entity is not included in the determination of net income but is reported in the same manner as a translation adjustment. Thus, the translation loss and the transaction gain should be reported in accumulated other comprehensive income.

Interpretation of Foreign Financial Statements

To evaluate a foreign corporation, we usually analyze the financial statements of the foreign corporation. However, the analysis of foreign financial statements needs special considerations:

  • We often have the tendency of looking at the foreign financial data from a home country perspective. For example, a U.S. businessman has the tendency of using U. S. Generally Accepted Accounting Principles (GAAP) to evaluate the foreign financial statements. However, U.S. GAAP are not universally recognized and many differences exist between U.S. GAAP and the accounting principles of other countries (industrialized or nonindustrialized).

  • Because of the diversity of accounting principles worldwide, we have to overcome the tendency of using our home country GAAP to evaluate foreign financial statements. Instead, we should try to become familiar with the foreign GAAP used in the preparation of these financial statements and apply them in our financial analysis.

  • Business practices are culturally based. Often they are different from country to country and have a significant impact on accounting measurement and disclosure practices. Therefore, local economic conditions and business practices should be taken into consideration to correctly analyze foreign financial statements.

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