Chapter 10

1. Chapter 10 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 International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

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

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

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

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

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

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

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

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 firm’s books are closed at the end of the calendar quarter. International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

11. 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 International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

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

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

14. 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 International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

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

16. Key issues for translation • Exchange rates at which various accounts are translated from one currency into another • Subsequent treatment of gains and losses International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

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

18. Translation Exchange Rates International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

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

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

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

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

23. 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 enterprise’s 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 International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

24. 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 International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

25. 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 International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

26. The Temporal Method • Easier to remeasure the balance sheet before the income statement • Translation adjustment is taken to the income statement International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

27. 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

28. 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 International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

29. 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 International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

30. Translation Choices International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

31. 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 International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

32. 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 International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

33. 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 International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

34. 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. International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

35. 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) International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

36. 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 International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

37. 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 International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

38. 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 International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black