Definition of the current rate method
What is the current rate method?
The current rate method is a foreign currency conversion method in which most items of the financial statements are translated at the current exchange rate.
When a company has operations in other countries, it may need to exchange the foreign currency earned by these operations abroad into the currency used when preparing the financial statements of the company, the currency of presentation. The current rate method is used in cases where the subsidiary is not well integrated with the parent company, and the local currency in which the subsidiary operates is the same as its functional currency.
Key points to remember
- The current rate method is a standard method of currency conversion that uses the current market exchange rate.
- Currency translation is the process of converting the financial results of a parent company’s foreign subsidiaries into its functional currency.
- Businesses should report using the currency of the environment in which they primarily generate and spend cash.
- The going rate method is most often used when the subsidiary is quite independent from the activities of the parent company. It can be opposed to the temporal method.
Understanding the current rate method
Currency translation is the process of converting the financial statements in the functional currency of a foreign entity into the financial statements of the reporting entity.
The current rate method differs from the temporal (historical) method in that assets and liabilities are translated at current exchange rates as opposed to historical rates. This can create a high conversion risk as the current exchange rate may change. To help smooth this volatility, the gains and losses associated with this conversion are recognized in a reserve account, instead of the consolidated profit and loss account, which is used in the temporal method.
This helps reduce the volatility of consolidated results. It is also more useful for management, shareholders and creditors in valuing a business, as losses and gains resulting from currency translation are excluded from the recognition of consolidated earnings. In the current rate method, the cumulative translation adjustment (CTA), which is the loss / gain associated with the conversion of currencies, is carried on the balance sheet as an unrealized gain or loss.
Calculation with the current rate method
When converting currencies using the current rate method:
- The first step is to convert the income statement using the weighted average exchange rate observed over the reporting period.
- following, the assets and liabilities appearing on the balance sheet are converted at the current exchange rate. Please note that the issued share capital must be converted at the exchange rate observed on the issue date. Retained earnings are adjusted for net earnings less dividends.
- Finally, the balance sheet must be rebalanced following this accounting procedure. The CTA is used as an extension figure that cleans up the assets of the balance sheet with the liabilities and equity. The CTA is treated as an unrealized gain or loss, which can be realized later when the foreign affiliate is sold or depreciated.
Example of the current rate method
An example would be a Canadian subsidiary of a US company that does business using the Canadian dollar or “looney”.
When converting foreign currencies into the presentation currency of the company, the assets and liabilities shown on the balance sheet are converted into the presentation currency using the spot exchange rate on the balance sheet date. Shares and retained earnings are converted at their historical rates, while income statement items are converted at the weighted average rate for the accounting period.