Chapter 10

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

International Accounting & Multinational Enterprises Chapter 10 Radebaugh, Gray, Black

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

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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)

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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

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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
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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

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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

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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

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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 A/P 200,000 x 1.3112 262,240 262,240

March 31

Foreign exchange loss 7,760 A/P 200,000 (1.3112 1.35)

7,760

April 30

A/P 270,000 Foreign exchange gain 4,000 Cash 266,000

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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
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Illustration: Accounting for Debt in a Foreign Currency

January 1 Cash Notes Payable 1,612,800 1,612,800

June 30

Notes Payable 32,600 Foreign Exchange Loss (CHF.7901 -.8064) x CHF 2 million

32,600

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
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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

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Key issues for translation

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

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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
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Translation Exchange Rates

International Accounting & Multinational Enterprises Chapter 10 Radebaugh, Gray, Black

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
International Accounting & Multinational Enterprises Chapter 10 Radebaugh, Gray, Black

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
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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

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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

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U.S. Accounting Standards

FASB Statement No. 52 objectives

Provide information that is generally compatible with the expected economic effects of a rate change on an enterprises cash flows and equity Reflect in consolidated statements the financial results and relationships of the individual consolidated entities as measured in their functional currencies in conformity with U.S. GAAP

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Translation Process SFAS 52

Functional currency must be established

Functional currency can only change if operating criteria used in its selection have changed

Current rate or temporal method is used

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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

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The Temporal Method

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

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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
International Accounting & Multinational Enterprises Chapter 10 Radebaugh, Gray, Black

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

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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

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Translation Choices

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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
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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

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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

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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.

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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)

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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

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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

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Disclosure of the Impact of Statement 52

Requires disclosure of the following

Aggregate transaction gain or loss included in income Analysis of changes in stockholders equity, including Beginning and ending cumulative translation adjustments Aggregate adjustment for the period resulting from translation adjustment and gains and losses from certain hedges and intercompany balances Amount of income taxes for the period allocated to the translation adjustments Amounts transferred from cumulative translation adjustments and included in determining net income for the period as a result of the sale or complete or substantially complete liquidation of an investment in a foreign entity
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