In this lecture, I explain the functional currency concept and introduce translation of financial statement using the premeasurement method (temporal method) and translation method (current rate method). This an advanced accounting topic.
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The objectives are to provide information that is compatible with the exposed economic effects of an exchange rate change on a firm’s cash flows and equity, and to reflect in the consolidated statements the financial results and relationships of the individual entities as measured in their functional currencies in conformity with U.S. GAAP.
The functional currency is the currency of the primary economic environment in which the foreign entity conducts its operations and generates and expends its cash.
Under the current method, all assets and liabilities are translated using the current exchange rate on the balance sheet date. For income statement accounts (revenues and expenses),a weighted-average exchange rate is used to approximate the results that would be obtained from translation of each transaction. Under the temporal method, monetary assets and liabilities are translated at the cur- rent exchange rate. Assets and liabilities carried at historical cost are translated at historical exchange rates. Assets and liabilities carried at current values (such as inventory carried at market under the lower of cost or market rule) are translated at the cur- rent exchange rate. Revenues and expenses that relate to assets and liabilities translated at historical rates (such as depreciation expense, amortization expense, and the cost of sales) are translated at the historical rates used for the related assets and liabilities. Other revenues and expenses are converted using a weighted-average rate.
The tem- poral method (also referred to as remeasurement) is appropriate when the functional currency is the U.S. dollar or when the for- eign environment is highly inflationary. The current method (also referred to as translation) is appropriate when the func- tional currency is the local currency. If the functional currency is the currency of a third country, it is necessary to remeasure the accounts first into the functional currency using the temporal method and then to translate the accounts into U.S. dollars (the reporting currency) using the current method.