Currency Translation Adjustment
Many companies hold assets and liabilities in foreign countries. (For our purposes, foreign means outside of the U.S.) Assets and liabilities in foreign countries are generally recorded in that country's currency, i.e., the functional currency as they are purchased. Asset and liabilities then get translated from the functional currency into U.S. dollars.
Many assets and liabilities get translated at the exchange rate from the time of acquisition. Thus, the dollar value of the asset of liability remains unchanged over time. Certain assets and liabilities, however, are translated into current U.S. dollars, when the exchange rate may differ from an earlier period when a similar translation was made. This difference in exchange rates would produce a currency translation gain or loss.
The gain or loss on a translation of a foreign currency financial statement is reported as a separate item in stockholder's equity. Translation gains and losses are not recognized in net income.
For example, if we generate accounts receivable worth five million French Francs when five Francs could be exchanged for one dollar, then the asset would be translated as an asset costing $1 million. If at the end of the following reporting period you can get six Francs to the dollar, then the FF5,000,000 asset would translates into an $833,333 asset. The asset remains recorded at $1,000,000, however, and the $166,666 translation loss is accumulated in a separate record in stockholder's equity. The loss remains in that account until it is realized through the collection of the revalued receivables.
Economics of Translation Gains and Losses
Exchange rate gains and losses on foreign assets do not reflect actual cash flow ultimately available to shareholders. They may portend the enhancement or decline of an asset's future cash generating capability in U.S. dollars, but they do not affect the capital actually invested in U.S. dollars.
Categories of assets and liabilities subject to current exchange rates in translation of results tend to be those items whose gains or losses will be realized in a few accounting periods.
Behavioral Impact
Allowing the currency translation gains and losses to affect EP can reward or penalize managers for currency fluctuations that may not be permanent.
Allowing such fluctuations to affect EP results could make managers more risk averse with regards toward investment in certain foreign assets.
Alternative Treatments
Treat as equity (default):
Currency translation gains or losses are simply restatements of stockholdersÂ’ equity. They can simply be treated as equity since no further investment or returns have actually been realized.
The benefit of this approach is that managers will simply focus on the amount of capital actually invested in U.S. dollars in a foreign operation and record future profits in U.S. dollars, translated from the functional currency, as the return on that dollar investment.
Treat as an unrealized gain or loss:
Currency translation gains and losses can be seen as representing unrealized gains or losses on foreign assets or liabilities. If the assets generate fixed income or the liabilities represent fixed payments, then those unrealized gains or losses represent actual economic events that can be objectively recognized in the current period. Unrealized gains and losses would affect net income and net assets.
The benefit of this treatment is that the economic impact on certain assets and liabilities are recognized in EP in a more "real time" basis.
Many currencies fluctuate in unpredictable ways relative to the U.S. dollar. This means that the cumulative translation gain or loss is likely to go up and down over time in a somewhat random fashion. Managers subject to the recording of the unrealized gains or losses represented by the CTA may therefore be subject to buffeting exchange rates that matter little over time.
