The critical first question: what is the functional currency?
The functional currency is the currency of the primary economic environment in which the entity operates — where it primarily generates and expends cash.
| TRANSLATION | REMEASUREMENT | |
|---|---|---|
| When used | Functional currency = local currency (books already in functional currency) | Functional currency = reporting currency (books kept in a different currency), or highly inflationary economy |
| Method | Current rate method | Temporal method |
| Assets/liabilities | All at the current (year-end) rate | Monetary at current; nonmonetary at historical |
| Income statement | Weighted average rate | Weighted average, except items tied to nonmonetary assets (COGS, depreciation) at historical |
| Equity | Historical rate | Historical rate |
| Adjustment goes to | OCI (cumulative translation adjustment) | Earnings (remeasurement gain/loss) |
IMPORTANT — the single most tested point: Translation adjustments go to OCI; remeasurement gains and losses go to net income. If you remember only one thing about this topic, remember that.
Monetary vs. nonmonetary
- Monetary (current rate under temporal method): cash, receivables, payables, debt — fixed in units of currency
- Nonmonetary (historical rate): inventory at cost, PP&E, intangibles, prepaid expenses, equity, deferred revenue
Foreign currency transactions
A transaction denominated in a foreign currency (e.g., a receivable payable in euros) is recorded at the spot rate on the transaction date, then remeasured at each balance sheet date, with the exchange gain or loss recognized in earnings.
EXAMPLE: A U.S. company sells goods for €100,000 when €1 = $1.10 (records $110,000 receivable). At year-end €1 = $1.15, so the receivable is remeasured to $115,000 and a $5,000 foreign exchange gain is recognized in earnings.
EXAM TIP: In a highly inflationary economy (cumulative inflation of roughly 100% over three years), the subsidiary must use the reporting currency as its functional currency — which means remeasurement into earnings rather than translation into OCI.