chapter 16 accounting for foreign currency. basics in foreign exchange foreign exchange is traded...
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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 ratechanges every 6 months. Exchange rates are:
January 1 $.8064June 30 $.7901December 31 $.8839Average (1st 6 months) $.79825Average (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 = $23,948CHF30,000 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
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
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
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