What it means
The method takes its name from the current, meaning closing, exchange rate applied to the whole balance sheet. Every asset and every liability, whether cash, machinery, inventory or a long-term loan, is converted at the same rate on the reporting date.
The income statement is treated differently, using the average rate over the year on the reasonable assumption that revenue and costs arose evenly across the period. Many groups use a weighted average when trading is seasonal or when the currency moved sharply mid-year.
Equity items are the exception, staying at the historical rates in force when they arose. That mixture of closing, average and historical rates is exactly why the translated balance sheet does not balance by itself and needs a plug figure.
That plug is the cumulative translation adjustment, a reserve inside equity that absorbs the difference and builds up over successive years. Crucially it never touches reported profit until the foreign operation is sold, at which point the accumulated amount is recycled into the income statement.
The current rate method is applied when the subsidiary's functional currency, the currency of the economy it mainly operates in, is its own local currency. Where the subsidiary is really an extension of the parent, transacting mostly in the parent's currency, the temporal method is used instead and its differences do run through profit.
In practice
Real-world examples.
Example
A US food group consolidates its Brazilian subsidiary, which buys, produces and sells almost entirely in Brazilian reais. Because the real is clearly the subsidiary's functional currency, the group applies the current rate method and books a large negative translation reserve in a year when the real weakens.
Example
An engineering group reports group profit up 6% while its Indian arm grew 14% in rupees. Translating income at a weaker average rate absorbed most of the growth, and management adds a constant currency table to its results presentation to make the point.
Example
A private equity owner sells a European portfolio company after seven years. The accumulated translation reserve built up under the current rate method is recycled to the income statement on completion, adding $4,200,000 to the reported gain.
Formula
Calculation
Assets and liabilities: translated at the closing rate on the balance sheet date
Income and expenses: translated at the average rate for the period
Equity: translated at historical rates
Cumulative translation adjustment = closing net assets at closing rate - (opening net assets at opening rate + profit at average rate)
Worked example: a US parent owns a Canadian subsidiary. At the year end the subsidiary has total assets of 8,000,000 Canadian dollars and total liabilities of 5,000,000 Canadian dollars, so net assets are 3,000,000 Canadian dollars. The closing rate is $0.75 per Canadian dollar.
Translating the balance sheet: assets become 8,000,000 x 0.75 = $6,000,000 and liabilities become 5,000,000 x 0.75 = $3,750,000, leaving translated net assets of $6,000,000 - $3,750,000 = $2,250,000.
The income statement uses the average rate of $0.78. Revenue of 12,000,000 Canadian dollars translates to 12,000,000 x 0.78 = $9,360,000, and net income of 900,000 Canadian dollars translates to 900,000 x 0.78 = $702,000.
Opening net assets were 2,100,000 Canadian dollars at an opening rate of $0.80, giving 2,100,000 x 0.80 = $1,680,000. The translation adjustment for the year is therefore $2,250,000 - ($1,680,000 + $702,000) = $2,250,000 - $2,382,000 = -$132,000, which is posted to the translation reserve in equity and does not reduce reported profit.Case study
Seen in the real world.
Thornfield Industrial Group is a fictional, illustrative maker of pumps and valves listed in the United States, with a substantial manufacturing subsidiary in Canada that sells to Canadian customers, buys Canadian components and employs Canadian staff. Its auditors confirmed that the Canadian dollar was the subsidiary's functional currency, so the current rate method applied.
In one year the Canadian dollar fell from $0.80 to $0.75 against the US dollar. The subsidiary had its best year on record in local currency, yet the translated contribution to group net assets fell, and a negative translation adjustment of $132,000 landed in the group's equity reserve. Investors on the results call asked whether the Canadian business was struggling.
The chief financial officer answered by splitting the disclosure. Thornfield began reporting each subsidiary's local currency performance alongside the translated figures and explaining the reserve movement separately as a non-cash item. The fictional group also considered a net investment hedge to stabilise the reserve, but concluded the hedging cost was not justified for an exposure that never affected cash or profit.
Watch out
Common mistakes.
- Applying the closing rate to the income statement as well as the balance sheet, when revenue and expenses should be translated at the average rate for the period.
- Assuming translation differences reduce distributable profit, when under this method they sit in equity and only reach profit if the subsidiary is disposed of.
- Choosing the current rate method by default without first determining the subsidiary's functional currency, which is what decides whether this method or the temporal method applies.
Questions
People also ask.
When is the temporal method used instead?
When the subsidiary's functional currency is the parent's currency, typically because it is an extension of the parent rather than a self-contained operation, and its differences do go through profit.
Which rate applies to share capital and pre-acquisition reserves?
Historical rates, meaning the rate in force when the balance arose, which is one reason the translated balance sheet needs a balancing reserve.
Does the method change how much cash the group has?
No, it is purely a reporting convention, and no cash moves as a result of applying it.
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