When a U.S. multinational corporation has a parent-subsidiary relationship with a foreign company the parent company is usually required to prepare consolidated financial statements. The financial statements of the foreign subsidiary must be redone using the U.S. generally accepted accounting principles (GAAP). The foreign accounts must be translated from the foreign currency into U.S. dollars. To make the translation, the first step is to identify three currencies:

1. Currency of books and records (CBR) is the currency in which the foreign financial statements are denominated.
2. Functional currency (FC) is the one in which the subsidiary generally buys, sells, borrows, repays, etc., and
3. The reporting currency (RC) is the one in which the consolidated financial statements are denominated.

There are basically three approaches to currency translation: Temporal rate method, current rate method, and use of both methods Using the current rate method, all assets and liabilities are translated using the current rate (exchange rate on the balance sheet date). Owners' equity and dividends are translated at historical rates (exchange rate at the time the asset was acquired, liability incurred, or element of paid-in capital was issued or reacquired). Income statement items can be translated using the average exchange rate (the average of the exchange rate at the beginning of the accounting period and the current rate). Under the temporal rate method, the objective is to measure each subsidiary transaction as though the transaction had been made by the parent. Monetary items (e.g. cash, receivables, inventories carried at market, payables, and long-term debt) are recalculated using the current exchange rate. Other items (e.g. prepaid expenses, inventories carried at cost, fixed assets, and stock) are recalculated using historical exchange rates.

Citation:

http://findarticles.com/p/articles/mi_qa3674/is_199404/ai_n8732752

http://www.springerlink.com/content/j061g5025223hk51