Accounting for Foreign Currency

1
Chapter 16

• Accounting for Foreign Currency

2
Basics in Foreign Exchange

• Foreign exchange is traded
• Over-the-counter (OTC)
• Made up of commercial and investment banks
• On an exchange
• Over the Internet

3
Basics in Foreign Exchange

• Foreign exchange instruments include
• Spot transaction exchange takes place within 2
  days of a trade agreement uses the spot rate
• Outright forwards exchange takes place 3 or
  more days after the date of a trade agreement
  uses forward rate
• FX swap one currency is exchanged for another
  on one date and then swapped back at a future
  date
• Future an agreement to trade currency at a
  specific price on a specific date
• Option the right, but not the obligation, to
  trade foreign currency in the future

4
Spot Market

• Rates are normally quoted from a traders
  perspective in two rates
• Example - 1.9072/82
• Bid - 1.9072
• Ask - 1.9082
• Sometimes given as a mid-rate (1.9077)

5
Foreign Currency Transactions

• Denominated in currency other than the reporting
  currency of the firm
• No problems if transactions are denominated in
  the firms domestic currency
• If transaction is settled immediately, the
  transaction is recorded at the spot rate

6
Foreign Currency Transactions

• If a transaction is denominated in a foreign
  currency and settled at a subsequent balance
  sheet date, four problems arise involving
• Initial recording of the transaction
• Recording of foreign currency balances at
  subsequent balance sheet dates
• Treatment of any foreign exchange gains and
  losses
• Recording of the settlement of foreign currency
  receivables and payables when they come due

7
Foreign Currency Transactions

• Have two components
• Monetary component cash received/paid or
  accounts receivable/payable
• Nonmonetary component equipment or inventory
  purchased or sold
• IAS 21 and SFAS 52 recognize gains and losses in
  income at the balance sheet date

8
Foreign Currency Transactions

• IAS 21 and SFAS 52
• Example Equipment and A/P are recorded at the
  spot rate on the transaction date Why?
• Transaction is divided into 2 parts purchase of
  equipment and decision to finance through A/P
• At balance sheet date, equipment remains at
  historical cost, A/P changes to reflect new spot
  rate
• Any difference between the spot rates is a gain
  or loss, reflected in the period in which the
  rate changed

9
IAS 21

• Requirements
• Monetary items are recorded at the closing rate
• Nonmonetary items should recorded at the
  historical exchange rate
• Nonmonetary items carried at fair value should be
  recorded at the rate in effect when the fair
  values were determined

10
Illustration

• U.S. firm imports equipment from Germany on
• March 1 for 200,000 when the exchange rate
• is 1.3112 per euro. Payment in Euro does not
• have to be made until April 30. Assume that on
• March 31, the exchange rate is 1.35 and on
• April 30 is 1.33. The firms books are closed
• at the end of the calendar quarter.

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Illustration Journal Entries

• March 1 Purchases 262,240
• A/P 262,240
• 200,000 x 1.3112
• March 31 Foreign exchange loss 7,760
• A/P 7,760
• 200,000 (1.3112 1.35)
• April 30 A/P 270,000
• Foreign exchange gain 4,000
• Cash 266,000

12
Illustration Accounting for Debt in a Foreign
Currency

• On January 1, a U.S. firm borrows 2 million
• Swiss francs for 5 years at 3 interest paid
• semiannually in Swiss francs. The principal
• does not have to be repaid until the end of the
• loan. The loan is adjusted for exchange rate
• changes every 6 months. Exchange rates are
• January 1 .8064
• June 30 .7901
• December 31 .8839
• Average (1st 6 months) .79825
• Average (2nd 6 months) .8370

13
Illustration Accounting for Debt in a Foreign
Currency

• January 1 Cash 1,612,800
• Notes Payable
  1,612,800
• June 30 Notes Payable 32,600
• Foreign Exchange Loss
  32,600
• (CHF.7901 -.8064) x CHF 2 million
• Interest Expense 23,948
• Foreign exchange gain
  245
• Cash
  23,703
• CHF2,000,000 x (.03/2) 30,000 x .79825
  23,948
• CHF30,000 x .7901 23,703

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Illustration Accounting for Debt in a Foreign
Currency

• Dec. 31 Foreign exchange loss 187,600
• Notes Payable
  187,600
• (.7901-.8839) x CHF 2million
• Interest Expense 25,110
• Foreign exchange loss 1,407
• Cash 26,517
• CHF30,000 x .8370 25,110
• CHF30,000 x .8839 26,517

15
Translation terminology

• Functional currency currency of the primary
  economic environment in which the company
  operates
• Reporting currency currency in which the parent
  company prepares its financial statements
• Foreign currency any currency other than the
  functional currency of the company
• Local currency currency of a particular country
  being referred to
• Exchange difference difference resulting from
  translating a given number of units of one
  currency into another currency at different
  exchange rates
• Foreign operation a subsidiary, associate,
  joint venture, or branch whose activities are
  based in a country other than that of the
  reporting enterprise

16
Key issues for translation

• Exchange rates at which various accounts are
  translated from one currency into another
• Subsequent treatment of gains and losses

17
Current/Noncurrent Method

• Current assets and liabilities are translated at
  current exchange rates
• Noncurrent assets and liabilities and
  stockholders equity are translated at historical
  exchange rates
• Anything due to mature in one year or less or
  within the normal business cycle should be
  translated at the current rate
• Everything else should be carried at the rate in
  effect when the translation was originally
  recorded
• Accounts should be grouped according to maturity

18
Translation Exchange Rates
19
Monetary/Nonmonetary Method

• Accounts are considered as monetary or
  nonmonetary
• Monetary assets and liabilities translated at the
  current rate
• Nonmonetary assets and liabilities and
  stockholders equity translated at historical
  rates
• Assets and liabilities are translated on the
  basis of attributes instead of time

20
Temporal Method

• Cash, receivables, and payables are translated at
  the current rate
• Other assets and liabilities may be translated at
  current or historical rates, depending on their
  characteristics
• Assets and liabilities carried at past exchange
  prices are translated at historical rates
• Assets and liabilities carried at current
  purchase or sales exchange prices or future
  exchange prices would be translated at current
  rates
• This flexible method ensures that parent currency
  is the single unit of measure

21
Current Rate Method (Closing Rate Method)

• All assets and liabilities are translated at the
  current exchange rate
• Net worth is translated at the historical rate
• Results in translated statements that retain the
  same ratios and relationships that exist in the
  local currency

22
International Accounting Standards

• IAS 21
• If foreign operations are integral to the
  operations of the reporting company, the temporal
  method is used
• Exchange gains and losses are taken to income
• If foreign operations are considered to be
  foreign entities, the closing rate method is used
  
• Exchange differences are taken to equity until
  investment disposal
• Financial statements in hyperinflationary
  economies must be adjusted for price level
  changes according to IAS 29, then translated into
  the reporting currency

23
The Temporal Method

• Used to remeasure financial statements from a
  foreign currency to the functional currency
• Requirements are as follows
• Remeasure cash, receivables, and liabilities at
  the current balance sheet rate
• Remeasure inventory, fixed assets, and capital
  stock at the appropriate historical exchange
  rates
• Remeasure most revenues and expenses at the
  average rate for the year cost of sales and
  depreciation expense are translated at the
  appropriate historical exchange rates
• Take all remeasurement gains or losses directly
  to the income statement

24
The Temporal Method

• Easier to remeasure the balance sheet before the
  income statement
• Translation adjustment is taken to the income
  statement

25
How Remeasurement Works

• Lower-of-cost or market values of inventory
  should be calculated first
• Cost Historical cost in foreign currency x
  Exchange rate in effect when inventory was
  acquired
• Market Market value in foreign currency x
  Exchange rate in effect when market was
  determined
• Test is performed in the reporting currency

26
The Current Rate Method

• Used when the functional currency is defined as
  the foreign currency
• Steps in the current rate method
• Total assets and liabilities are translated at
  the current exchange rate
• Stockholders equity accounts are translated at
  the appropriate historical rate for the period
• All revenue and expense items are translated at
  the average exchange rate for the period
• Dividends are translated at the exchange rate in
  effect when they were issued
• Translation gains and losses are taken to a
  accumulated translation adjustment account in
  stockholders equity

27
The Current Rate Method

• Better to translate the income statement first
  because the translation gain or loss becomes a
  balance sheet plug figure
• Translation adjustment is taken to stockholders
  equity

28
Translation Choices
29
Foreign Currency and Intercompany Transactions

• Gains and losses on foreign currency debt are
  often adjusted to interest expense
• Intercompany transactions are both long and
  short-term
• Intercompany profits can arise when the parent
  sells goods or services to the sub
• A portion of these profits can be related to
  exchange rate changes

30
Long-term Investment

• Settlement is not planned in the near future
• If, for example, a loan is given from a parent to
  a sub and is expected to be paid back, the
  exchange gain or loss is recognized in the income
  statement of the subsidiary
• If the loan is long-term, the exchange gain or
  loss is taken to
• Stockholders Equity Current rate method
• Income Statement Temporal method

31
Elimination of Intercompany Profits

• Profits must be eliminated upon consolidation,
  combination, or the equity method
• Profits are based on the exchange rates at the
  dates of the sales or transfers
• Temporal method inventory is carried at
  historical cost, so inventory balance remains the
  same

32
Statement of Cash Flows

• Guidelines are given in SFAS 95 and IAS 7
• Example U.S. parent and British subsidiary
• The British sub 1st prepares its own statement of
  cash flows in British pounds.
• The cash flows are translated into dollars using
  the actual exchange rate in effect when the cash
  flows took place or the average exchange rate for
  the year.
• The translated cash flows are consolidated with
  the parent companys cash flow statement.

33
Statement of Cash Flows

• Starts with Net Income
• Foreign exchange gains or losses must be excluded
  from cash flows from operating activities
  (non-cash item)

34
The Impact of IAS 21

• Requires disclosure of the following
• Amount of exchange differences included in the
  net profit or loss for the period
• Net exchange differences classified as equity as
  a separate component of equity a reconciliation
  of the amount of such differences at the
  beginning and end of the period
• If the reporting currency is different from the
  currency of the country in which the enterprise
  is domiciled, must disclose the reason for using
  a different currency
• The reason for any change in reporting currency
• A change in the functional currency of either the
  reporting entity or a significant foreign
  operation and the reason therefore

35
IAS 21 Convenience Translations

• Requirements include the following
• Identify supplementary information to distinguish
  it from the information that complies with IFRS
• Disclose the currency in which the supplementary
  information is displayed
• Disclose the entitys functional currency and the
  method of translation used to determine the
  supplementary information