Statement of Financial Accounting Standards No. 52
The current translation standard— Statement of Financial Accounting Standards No. 52 (FASB 52)—was adopted in 1981.10 According to FASB-52, firms must use the current rate method to translate foreign-currency-denominated assets and liabilities into dollars. All foreign currency revenue and expense items on the income statement must be translated at either the exchange rate in effect on the date these items are recognized or at an appropriately weighted average exchange rate for the period. The most important aspect of this standard is that most FASB-52 translation gains and losses bypass the income statement and are accumulated in a separate equity account on the parent’s balance sheet. This account is usually called something like “cumulative translation adjustment.”
FASB 52 differentiates between the functional currency and the reporting currency. An affiliate’s functional currency is the currency of the primary economic environment in which the affiliate generates and expends cash. If the enterprise’s operations are relatively self-contained and integrated within a particular country, the functional currency will generally be the currency of that country. An example of this would be an English affiliate that both manufactures and sells most of its output in England. Alternatively, if the foreign affiliate’s operations are a direct and integral component or extension of the parent company’s operations, the functional currency will be the U.S. dollar. An example of this would be a Hong Kong assembly plant for radios that sources the components in the United States and sells the assembled radios in the United States. It is also possible that the functional currency is neither the local currency nor the dollar but, rather, a third currency. However, in the remainder of this appendix, we will assume that if the functional currency is not the local currency, then it is the U.S. dollar.
Guidelines for selecting the appropriate functional currency are presented in Exhibit 10A.1. There is sufficient ambiguity to give companies some leeway in selecting the functional currency. However, in the case of a hyperinflationary country —defined as one that has cumulative inflation of approximately 100% or more over a three-year period—the functional currency must be the dollar.