1. Accounting for Foreign Currency
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 trader’s 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 firm’s 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 $ 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 $ The firm’s books are closed
at the end of the calendar quarter.

11. Illustration – Journal Entries
March 1 Purchases ,240
A/P ,240
€200,000 x
March 31 Foreign exchange loss 7,760
A/P ,760
€200,000 ( – 1.35)
April 30 A/P ,000
Foreign exchange gain ,000
Cash ,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 $.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 ,612,800
Notes Payable ,612,800
June 30 Notes Payable ,600
Foreign Exchange Loss ,600
(CHF ) x CHF 2 million
Interest Expense ,948
Foreign exchange gain
Cash ,703
CHF2,000,000 x (.03/2) = 30,000 x = $23,948
CHF30,000 x = $23,703

14. Illustration: Accounting for Debt in a Foreign Currency
Dec. 31 Foreign exchange loss 187,600
Notes Payable ,600
( ) x CHF 2million
Interest Expense ,110
Foreign exchange loss 1,407
Cash ,517
CHF30,000 x = $25,110
CHF30,000 x = $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 company’s 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 entity’s functional currency and the method of translation used to determine the supplementary information