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Prior to 1920 foreign currency translation was not a material issue. Although commodities were exchanged over international boundaries, few U.S. corporations had foreign subsidiaries or branches, thus most transactions were translated at spot rates. The accounting profession first addressed the issue in 1931 in a report called "Foreign Exchange Losses" which recommended basing foreign exchange gain or loss on classification of assets and liabilities as current or non-current. In 1939 the AICPA published Accounting Research Bulletin (ARB) No. 4 "Foreign Operations and Foreign Exchange Gains," which used the current/non-current method of foreign exchange. The current/non-current method provides that current assets and liabilities are translated at year-end exchange rates. Non-current assets and liabilities are translated at historical cost and exchange rates on date of acquisition. During 1944 - 1971 exchange rates were stable as the international monetary system was controlled by the Articles of Agreement of the International Monetary Fund adopted by most major countries in 1944, and commonly referred to as the "Bretton Woods Agreement." The monetary system was based on having most currencies valued by reference to the U.S. dollar. The value of the U.S. dollar was based on the supply of gold. The currency of all member countries was based on a pegged rate with the U.S. dollar. The pegged system was dependent on a number of items including uniformity in Central Bank policies of member countries, balance of payments, health of individual member economies and politics among member nations. Exchange rates were stable until the late 1960's. Member countries refused to devalue their currency due to inflation fears, unbalance of payments of member countries, the demand for the U.S. dollar exceeded the supply and finally by 1968 the United States had developed significant payment deficits which resulted in fluctuation of exchange rates. In 1971 the U.S. dollar was devalued and a new set of pegged rates were established in the "Smithsonian Agreement." The United States then went off the gold standard and in 1973 the U.S. devalued the dollar again. As a result of these events a modified floating system was developed which is still in use today. The currency of the 12 major countries is theoretically set by supply and demand. Central Banks of the various countries are free to purchase and sell foreign currencies to affect exchange rates. Other currencies are valued under a modified version of the floating rate or under a pegged system. In 1953, ARB 4 was replaced with ARB 43, "Foreign Operations and Foreign Exchange" which substantially continued with prior methods of current vs. non-current exchange translation. Due to exchange rate fluctuations of the early 1970's the Financial Accounting Standards Board (FASB) was forced to study the issue. The study eventually became FASB 8. This was a significant departure from prior methods. Basically FASB Statement No. 8 provided that cash, receivables and payables were translated at current exchange rates while fixed assets and liabilities were translated at historical rates. FASB 8 resulted in much criticism. Due to this criticism the FASB sponsored another study that resulted in FASB 52. The basic outcome of FASB 52 was that if a foreign entity's books are not kept in the functional currency, then the books must be re-measured into the functional currency prior to translation. For example, an U.S. parent may have a self-contained foreign subsidiary located in Germany. The German subsidiary may have a branch located in France. The functional currency is most likely German marks. The branch operations books kept in French francs must be re-measured in German marks (the functional currency) before translation into the reporting currency of the parent. Unrealized foreign currency gains or losses, except from re-measurement, are separately stated as a component of owner's equity. The accumulated translation adjustments are taken into account in measuring the gain or loss on sale of the investment of the foreign operations. Coupled with changes in FASB 52, the US Government created a new form of income called Subpart J in the Tax Reform Act of 1986. The purpose of Subpart J was to provide comprehensive rules for the taxation of foreign currency gains and losses, as well as their source and characterization. Subpart J adopted the functional currency concept of FASB #52. Under Subpart J, foreign subsidiary or branch financial statements whose functional currency was not the U.S. dollar had to be translated into the taxpayer's functional currency using the profit and loss method. This method has the effect of deferring unrealized foreign gains or losses. |
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