Accounting for Foreign Currency Chapter 16 Accounting for Foreign Currency

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

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

Spot Market Rates are normally quoted from a trader’s perspective in two rates Example - $1.9072/82 Bid - $1.9072 Ask - $1.9082 Sometimes given as a mid-rate ($1.9077)

Foreign Currency Transactions Denominated in currency other than the reporting currency of the firm No problems if transactions are denominated in the firm’s domestic currency If transaction is settled immediately, the transaction is recorded at the spot rate

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

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

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

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

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 firm’s books are closed at the end of the calendar quarter.

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

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

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

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

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

Key issues for translation Exchange rates at which various accounts are translated from one currency into another Subsequent treatment of gains and losses

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

Translation Exchange Rates

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

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

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

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

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

The Temporal Method Easier to remeasure the balance sheet before the income statement Translation adjustment is taken to the income statement

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

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

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

Translation Choices

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

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

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

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 company’s cash flow statement.

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)

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

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 entity’s functional currency and the method of translation used to determine the supplementary information