Foreign currency translation is a process used to convert financial statements from one currency to another. It is a critical component of financial reporting for multinational companies that operate in multiple countries and require a consolidated view of their financial results.
The accounting treatment for foreign currency translation involves the application of specific accounting standards and requires a comprehensive understanding of the underlying transactions and processes.
Accounting Treatment
The accounting treatment of foreign currency translation requires a consistent application of the exchange rate in order to accurately reflect the financial performance of a company.
The accounting standards used for foreign currency translation are specified by the International Accounting Standards Board (IASB) in IAS 21 The Effects of Changes in Foreign Exchange Rates.
The following steps outline the accounting treatment for foreign currency translation:
- Identifying functional currency: The functional currency is the currency of the primary economic environment in which the entity operates. It is the currency in which the entity primarily generates and expends cash.
- Determining the exchange rate: The exchange rate used for foreign currency translation should be the rate that is most appropriate for the transaction being translated. This may be the spot rate at the transaction date, the average rate for the period, or a historical rate.
- Translating foreign currency transactions: All foreign currency transactions should be translated into the functional currency using the exchange rate in effect at the transaction date.
- Translating foreign currency financial statements: All foreign currency financial statements should be translated into the functional currency using the exchange rate at the end of the reporting period.
- Recording exchange gains or losses: Any gains or losses resulting from foreign currency transactions or the translation of foreign currency financial statements should be recorded in the income statement as a separate line item.
Audit Risks
Foreign currency translation poses several audit risks that must be considered by auditors in order to ensure the accuracy of financial statements. The following are ten key audit risks associated with foreign currency translation:
- Inconsistent application of exchange rates: This risk arises when different exchange rates are used for similar transactions, resulting in an inconsistent reflection of financial performance.
- Misapplication of accounting standards: This risk occurs when accounting standards are not correctly applied, leading to incorrect translations and an inaccurate reflection of financial performance.
- Misclassification of functional currency: This risk arises when the functional currency is misclassified, resulting in incorrect translations and an inaccurate reflection of financial performance.
- Misalignment of exchange rates: This risk occurs when exchange rates are misaligned with the transaction date, leading to incorrect translations and an inaccurate reflection of financial performance.
- Inaccurate recording of exchange gains or losses: This risk arises when exchange gains or losses are not recorded correctly, leading to an inaccurate reflection of financial performance.
- Unauthorized or improper currency hedging: This risk occurs when currency hedging is not properly authorized or managed, leading to incorrect translations and an inaccurate reflection of financial performance.
- Inadequate controls over foreign currency transactions: This risk occurs when controls over foreign currency transactions are not adequate, leading to incorrect translations and an inaccurate reflection of financial performance.
- Inadequate documentation of foreign currency transactions: This risk arises when there is inadequate documentation of foreign currency transactions, making it difficult to determine the correct exchange rate and leading to incorrect translations.
- Inadequate segregation of duties: This risk arises when segregation of duties is not adequate, leading to incorrect translations and an inaccurate reflection of financial performance.
- Lack of IT systems support: This risk occurs when IT systems are not properly configured to support foreign currency translation, leading to incorrect translations and an inaccurate reflection
Audit Assertions
In the audit of foreign currency translation, the auditor is concerned with the following audit assertions:
- Existence: The foreign entity’s financial statements are prepared from valid transactions and events, and the assets, liabilities, and equity of the foreign entity exist.
- Valuation and Allocation: The assets, liabilities, and equity of the foreign entity are valued and allocated appropriately.
- Rights and Obligations: The foreign entity has rights and obligations to its assets, liabilities, and equity.
- Completeness: The foreign entity’s financial statements are complete and include all transactions and events that have taken place.
- Accuracy: The foreign entity’s financial statements accurately reflect the underlying transactions and events.
- Cutoff: The foreign entity’s financial statements are properly recorded in the correct accounting period.
- Classification: The foreign entity’s financial statements are properly classified in accordance with accounting standards.
- Presentation and Disclosure: The foreign entity’s financial statements are presented and disclosed in accordance with accounting standards.
Walkthrough Testing
Walkthrough testing is a key audit procedure for foreign currency translation. The objective of walkthrough testing is to understand the foreign entity’s accounting and control systems, including its systems for preparing financial statements, translating foreign currency amounts into the reporting currency, and reconciling subsidiary records to the consolidated financial statements.
To perform walkthrough testing, the auditor should review the foreign entity’s accounting policies, procedures, and processes, and ask questions of the entity’s accounting personnel to gain an understanding of how the entity prepares its financial statements.
The auditor should also review the foreign entity’s trial balance, general ledger, and other supporting documentation to gain a comprehensive understanding of the entity’s accounting processes.
Test of Control
Test of control is another important audit procedure for foreign currency translation. The objective of test of control is to evaluate the effectiveness of the foreign entity’s internal controls over its accounting processes, including its control environment, information technology, and accounting systems.
To perform test of control, the auditor should review the foreign entity’s internal controls, including its policies and procedures, to assess their design and operating effectiveness.
The auditor should also perform tests of the entity’s controls, including tests of its information technology systems and data processing procedures, to determine whether the entity’s controls are functioning effectively.
Substantive Audit Procedures
- Review of Accounting Policies: The auditor should review the foreign entity’s accounting policies to ensure that they are consistent with accounting standards and are appropriate for the entity’s operations.
- Reconciliation of Foreign Currency Transactions: The auditor should perform a reconciliation of foreign currency transactions to ensure that they have been accurately translated into the reporting currency.
- Analysis of Foreign Currency Accounts: The auditor should analyze the foreign entity’s foreign currency accounts to determine if any significant fluctuations have occurred, which may indicate the need for further investigation.
- Review of Exchange Rate Differences: The auditor should review the exchange rate differences to ensure that they are reasonable and appropriate for the entity’s operations.
- Review of Exchange Rate Assumptions: The auditor should review the exchange rate assumptions used in the foreign currency translation process to ensure that they are consistent with accounting standards.
- Testing of Translation Adjustments: The auditor should perform substantive tests of the foreign currency translation adjustments to determine if they are reasonable and appropriate.
- Review of Supporting Documentation: The auditor should review supporting documentation, such as invoices and contracts, to ensure that the foreign currency transactions have been accurately translated into the reporting currency.
- Review of Intercompany Balances: The auditor should review intercompany balances to ensure that they have been accurately translated into the reporting currency and are consistent with the corresponding accounts of the parent company.
- Testing of Foreign Entity Financial Statements: The auditor should perform substantive tests of the foreign entity’s financial statements, including its balance sheet, income statement, and cash flow statement, to determine if the financial statements are accurate and complete.
- Comparison with Prior Periods: The auditor should compare the current period’s financial statements with the prior period’s financial statements to identify any significant changes or trends. The auditor should investigate any significant changes or trends to ensure that they are reasonable and appropriate.
