Two identical subsidiaries, same local-currency books, same exchange rates. One reports a translation gain in equity, the other a remeasurement loss in net income. The only difference is which currency the parent named as functional.
- Local currency: the national currency of the country where the entity operates. A Thai subsidiary keeps books in baht.
- Functional currency: the currency of the primary economic environment in which the entity operates, meaning the currency in which it primarily generates and spends cash.
- Presentation currency: the currency in which the consolidated financial statements are presented, normally the parent's home currency.
Usually all three coincide for a self-contained foreign operation. For accounting purposes, a foreign currency is any currency other than the entity's functional currency. That definition drives everything: a transaction is a foreign currency transaction only if it is denominated in something other than the functional currency.
A foreign currency transaction arises when a company makes an import purchase or export sale denominated in a foreign currency, or borrows or lends in one.
Common mistakes
- Naming the method before the functional currency. The chain runs functional currency, then method, then where the adjustment lands. Candidates who pick "current rate because it is a foreign subsidiary" miss temporal cases where the parent's currency is functional.
- Translating equity at the current rate. Common stock and beginning retained earnings use historical rates under both methods. In Example 1, using 0.80 on the $10,000 stock erases the entire €2,000 adjustment.
- Assuming temporal exposure equals net assets. It is net monetary position. Example 1's $2,000 net monetary liability, not $10,000 net assets, drives the €400.
Bottom line
- Local currency is where the entity sits, functional currency is where it earns and spends cash, presentation currency is where the parent reports
- Transaction gains and losses always go to net income, even unrealized ones at a balance sheet date; location on the income statement is a free choice
- Receivable plus strengthening foreign currency equals gain; payable plus strengthening foreign currency equals loss
- Functional currency equals local currency means current rate method, adjustment to equity as CTA
Exam shortcut
Read the stem for the functional currency first; that word decides the method, the exposure, and the destination of the adjustment. If the vignette says the subsidiary is self-contained, autonomous, or transacts locally, functional equals local, so current rate. If it says the subsidiary is an extension of the parent, buys and sells mostly with the parent, or the parent's currency is functional, use temporal.
The full lesson (about 2,378 words, 16 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- multinational operations
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