Accounting & Taxes

1. Basic Knowledge and Importance of Foreign Currency Transactions

Under Japanese accounting standards, foreign currency transactions refer to cases where the transaction amount or receivables/payables are denominated in a foreign currency. For example, this includes sales priced in U.S. dollars or borrowings in euros. Since Japanese companies prepare financial statements in yen, such transactions must be converted to yen using an appropriate exchange rate.

As a general rule, transactions are recorded in yen at the exchange rate on the transaction date. At the fiscal year-end, any remaining foreign currency-denominated receivables and payables must be revalued using the closing rate. Resulting foreign exchange gains or losses directly affect the company's profit or loss.

The importance of properly handling foreign currency transactions increases as companies expand globally. Japanese subsidiaries of foreign companies frequently deal with foreign currency transactions, such as capital injections or intercompany loans, as well as import/export settlements. Inadequate processing not only leads to inaccurate financial reporting but can also result in erroneous tax filings.

Therefore, a proper understanding of foreign currency transaction fundamentals and accurate conversion and processing is a key skill for any CFO or accounting manager.

2. Relationship Between Subsidiary Operations in Japan and Foreign Currency Translation

Japanese subsidiaries must always consider the difference between transaction currencies and their reporting currency (yen).

Although many transactions are executed in dollars or euros, they must be recorded in yen. For instance, if a parent company extends a USD-denominated loan to its Japanese subsidiary, the subsidiary must convert the amount to yen at the exchange rate on the receipt date and revalue it using the year-end rate.

Similarly, accounts receivable from overseas customers and accounts payable to foreign suppliers must be revalued in yen using the fiscal year-end rate to reflect appropriate valuation.

All foreign currency transactions occurring during daily operations must be converted at year-end and incorporated into the financial statements. Therefore, performance management and foreign currency translation are inseparable for Japanese subsidiaries.

3. Impact of Exchange Rate Fluctuations and Risk Management

Exchange rate fluctuations significantly affect corporate earnings and financial standing. For example, if the yen depreciates, the yen-equivalent value of foreign currency liabilities increases, resulting in valuation losses. Conversely, yen appreciation reduces the yen value of foreign currency assets, also causing valuation losses. In recent years, such fluctuations have become increasingly volatile, with sharp shifts over short periods.

These fluctuations can cause unexpected gains or losses, making foreign exchange risk management a critical issue.

Common hedging methods include forward exchange contracts or options that fix future exchange rates. Balancing foreign currency revenues and expenses (e.g., offsetting dollar-denominated sales with dollar expenses) is also effective.

It’s important to conduct exchange rate scenario analyses in advance to understand how fluctuations will impact profits and financial indicators.

4. Application Standards and Procedures in Foreign Currency Translation

Japanese accounting standards specify uniform procedures for handling foreign currency transactions.

Transactions are recorded using the exchange rate on the transaction date. At fiscal year-end, monetary items (e.g., deposits, receivables, payables, borrowings) are revalued using the closing rate.

In contrast, inventories and fixed assets are generally kept at their original acquisition rate and not revalued at year-end.

For tax purposes, the Corporation Tax Act stipulates specific conversion rules. For instance, short-term deposits must be revalued using the year-end rate, while long-term deposits remain at the original transaction rate.

Conversion methods vary depending on asset type and holding period. Companies may use alternative methods by filing a prior notification or obtaining approval from the tax office.

If accounting and tax treatments differ, taxable income must be adjusted through a reconciliation schedule when filing tax returns.

Even if the parent company applies IFRS or US GAAP, the subsidiary’s financial statements and tax filings in Japan must comply with Japanese rules.

5. What is the "15% Rule": Overview and Application Examples

The "15% rule" under the Corporation Tax Act is a special provision applicable during significant exchange rate changes. It allows certain foreign currency-denominated assets or liabilities to be revalued at the year-end exchange rate if the difference between this value and the book value exceeds approximately 15%.

Normally, long-term receivables and payables are not revalued at year-end, but under this rule, they can be revalued and the resulting gains or losses can be recognized in the current period without prior notification.

For example, suppose a company obtained a $100,000 loan at 1 USD = 108 yen (totaling 10.8 million yen). If the year-end rate is 1 USD = 135 yen, the revalued amount becomes 13.5 million yen, a 2.7 million yen increase—about 25%. Since this exceeds the 15% threshold, the company may recognize the difference as a 2.7 million yen foreign exchange loss (tax-deductible) in the current period.

Likewise, if a strong yen causes a 15% or more drop in asset value, the resulting valuation loss can also be recorded.

Note that the rule must be applied collectively. If multiple assets or liabilities in the same currency meet the 15% threshold, all of them must be revalued—partial application is not allowed. For instance, if both USD loans A and B meet the threshold, the rule cannot be applied to A only.