Transcript Chapter 10

Chapter 10
Accounting for Foreign Currency
Basics in Foreign Exchange
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Foreign exchange is traded
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“Over-the-counter” (OTC)
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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
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Foreign exchange instruments include
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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
Spot Market
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Rates are normally quoted from a trader’s
perspective in two rates
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Example - $1.9072/82
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Bid - $1.9072
Ask - $1.9082
Sometimes given as a mid-rate ($1.9077)
International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black
Foreign Currency Transactions
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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
Foreign Currency Transactions
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If a transaction is denominated in a foreign
currency and settled at a subsequent balance
sheet date, four problems arise involving
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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
Foreign Currency Transactions
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Have two components
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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
Foreign Currency Transactions
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IAS 21 and SFAS 52
Example – Equipment and A/P are recorded at the
spot rate on the transaction date – Why?
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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
IAS 21
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Requirements
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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
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
Illustration – Journal Entries
March 1
March 31
April 30
Purchases
A/P
€200,000 x 1.3112
262,240
Foreign exchange loss 7,760
A/P
€200,000 (1.3112 – 1.35)
262,240
7,760
A/P
270,000
Foreign exchange gain
4,000
Cash
266,000
International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black
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
Illustration: Accounting for
Debt in a Foreign Currency
January 1
June 30
Cash
Notes Payable
1,612,800
Notes Payable
32,600
Foreign Exchange Loss
(CHF.7901 -.8064) x CHF 2 million
1,612,800
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
International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black
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
Translation terminology
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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
Key issues for translation
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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
Current/Noncurrent Method
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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
Translation Exchange Rates
International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black
Monetary/Nonmonetary
Method
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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
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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
Current Rate Method
(Closing Rate Method)
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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
International Accounting
Standards
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IAS 21
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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
U.S. Accounting Standards
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FASB Statement No. 52 objectives
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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
Translation Process – SFAS 52
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Functional currency must be established
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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
The Temporal Method
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Used to remeasure financial statements from a
foreign currency to the functional currency
Requirements are as follows
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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
The Temporal Method
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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
How Remeasurement Works
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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
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Used when the functional currency is defined as the
foreign currency
Steps in the current rate method
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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
The Current Rate Method
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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
Translation Choices
International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black
Foreign Currency and
Intercompany Transactions
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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
Long-term Investment
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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
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Stockholders’ Equity – Current rate method
Income Statement – Temporal method
International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black
Elimination of Intercompany
Profits
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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
Statement of Cash Flows
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Guidelines are given in SFAS 95 and IAS 7
Example – U.S. parent and British subsidiary
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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
Statement of Cash Flows
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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
The Impact of IAS 21
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Requires disclosure of the following
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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
IAS 21
Convenience Translations
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Requirements include the following
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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
Disclosure of the Impact of
Statement 52
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Requires disclosure of the following
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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