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Accounting For Foreign Currency Transactions
Accounting For Foreign Currency Transactions
Accounting For Foreign Currency Transactions
Introduction
Companies may make purchases from and sales to companies in other countries. Such transactions are settled in
either of the domestic currencies of the parties involved. Business transactions that are settled in a currency other
than of the domestic (home country) currency are referred to as foreign currency transactions. One of the
transacting parties usually will settle the transaction in its own domestic currency and also measure the
transaction in its own domestic currency. The other transacting party will settle the transaction in a foreign
currency but will need to measure the transaction in its domestic currency. To measure and record the transaction
in domestic currency, an exchange rate between the currencies should be developed. Given that rates of exchange
vary, the number of units of one currency required to acquire another currency could change between the time the
exchange (transaction) occurs and the payment is made. Therefore, such transactions may expose an entity to
risks and opportunities depending on how exchange rates change over time. To this end, the chapter focuses on
how a domestic entity should account for transactions which are denominated or settled in a foreign currency.
The currency used to settle the transaction is termed as the denominated currency where as, the currency used to
measure or record the transaction is referred to as the measurement currency. Whenever a transaction is
denominated in a currency different than the measurement currency, exchange rate risk exists, and exchange rates
must be used for measurement purposes. The process of expressing a transaction in the measurement currency
when it is dominated in a different currency is referred to as a foreign currency translation. Denominating a
transaction in a currency other than the entity‟s domestic or reporting currency requires the establishment of a rate
of exchange between the currencies.
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Specifying the exchange rate as „Birr 25 per British pound‟ is an example for a direct exchange rate, then one
British pound would cost Birr 25. The indirect quote would be the reciprocal of the direct quote, or 0.04 British
pounds per Birr (Birr 1/Birr 25).
Exchange Rate Quotes
Direct quote Indirect Quote
1 British pound = birr 25 birr 1 = 0.04 British pound
Exchange rates are often quoted in terms of a buying rate (the tender price) and a selling rate the (offered price).
The buying and selling rates represent what the currency broker (usually a commercial bank) is willing to
pay to
acquire or sell a currency. The difference between these two rates represents the broker‟s commission and often is
referred to as spread.
Exchange rates fall in to two primary groups, spot rate and forward rates.
Spot rate refers to the exchange rate for immediate delivery of currencies exchanged
Forward rate refers to the exchange rate of different currencies at a future point in time, such as in 30, 60, 90 or
180 days.
Changes in Exchange Rates
Exchange rates are continuously changing showing the strengthening or weakening of one currency relative to the
other.
Strengthening Currencies
A foreign currency that is strengthening in value in relation to the domestic currency becomes more expensive to
purchase because more amounts of the domestic currency is needed to obtain a unit of the foreign currency.
Accordingly, the Direct Exchange Rate increases.
If the British pound strengthens or gains against the Birr, the direct exchange rate will increase and the indirect
exchange rate will decrease because more amounts of birr is needed to obtain a unit of the pound. A weakening of
the birr has the same effect on the direct rate as does the strengthening of the foreign currency, the British pound
in this case.
Weakening Currencies
A foreign currency that is weakening in value in relation to the domestic currency becomes less expensive to
purchase because fewer amounts of the domestic currency are needed to obtain a unit of the foreign currency.
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Accordingly, the Direct Exchange Rate decreases.
If the British pound weakened against the Birr, the direct exchange rate will decrease and the indirect exchange
rate will increase. A strengthening of the birr has the same effect on the direct rate as does the weakening of the
foreign currency, the British pound in this case.
As a result of such fluctuations in the exchange rate, an exchange difference (Gain or Loss) results when there is a
change in the exchange rate between the transaction date and the date of settlement. When the transaction is
settled within the same accounting period as that in which it occurred, all the exchange difference is recognized in
that period. However, when the transaction is settled in a subsequent accounting period, the exchange difference
is recognized at the end of each intervening accounting period up to the period of settlement based on the change
in exchange rates on the statement date.
Assume a U.S. company sells Equipment to a British company and the Equipment must be paid for in 30 days
with U.S. dollars. This transaction is denominated in dollars and will be measured by the U.S. Company in
dollars. Changes in exchange rate between the U.S. dollar and the British pound from the transaction date to the
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settlement date will not expose the U.S. company to any risk of gain or loss from exchange rate changes.
However, if we assume the transaction to be settled in British pounds, changes in the exchange rate subsequent to
the transaction date expose the U.S. Company to risk of exchange rate loss or gain. This is because the transaction
is denominated in British pounds but will be measured by the U.S. Company in dollars. If the U.S. dollar
strengthens against the British pound (British pound weakens), the U.S. Company will experience a loss because
it is holding an asset (a receivable of British pounds) whose price and value declined. If the dollar weakens, the
opposite effect would be experienced.
Illustration:
On June 1, 2009, a U.S. Company sells Mining Equipment which has a cost of $250,000 to a British Company for
180,000 British pounds, with payment due July 1, 2009. On June 1, 2009, the British pound is worth $1.70, and
on July 1, 2009, the pound is worth $1.60.
U.S. Company‟s Records British Company‟s Records
June 1, 2009
Accounts receivable 306,000
Sales Revenue 306,000 Equipment 180,000
Cost of Goods sold 250,000 Accounts Payable 180,000
Inventory 250,000
July 1, 2009
Cash 288,000*
Foreign Currency trans. Loss 18,000** Accounts Payable 180,000
Accounts Receivable 306,000 Cash 180,000
The decrease in the value of the British pound form $1.70 to $1.60 resulted in an exchange loss to the U.S.
Company since the pounds it received are less valuable than they were at the transaction day. The British
company doesn‟t experience an exchange Gain or Loss. This is because the British company both measured and
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denominated the transaction in pounds.
Illustration:
A U.S. Company purchased goods from a foreign company on November 1, 2009. The purchase in the amount of
1,000 Euros is to be paid on February 1, 2010, in Euros. The spot rate on the date of purchase was 1 Euro = $ 1.50
The exchange rates on December 31, 2009, end of the accounting period, and on the settlement date were 1 Euro
= $ 1.52 and 1 Euro = $ 1.55
U.S. Company Records:
Nov. 1, 2009
Inventory 1,500
Accounts Payable 1,500
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other words, if the transaction had been settled at year-end, the U.S. Company would have so expend $1.520 to
acquire 1,000 Euros. Therefore, a loss of $20 is traceable to the unperformed portion of the transaction.
On the settlement date, the dollar has further lost its value against the Euros by $0.03 ($1.55 - $1.52) from its year
end value. This resulted in additional loss of $30 ($0.03*1,000) to be recognized on the settlement date. Note that
the company experienced a loss of $50 due to changes in the exchange rate. This total loss is allocated between
2009 and 2010 in accordance with accrual accounting.
The risks associated with changes in exchange rates may be mitigated by entering, into forward exchange
contracts. Any premium or discount arising at the inception of a forward exchange control is accounted for
separately from the exchange differences in forward exchange contract. The premium or discount on the contract
is measured by the difference between the exchange rate at the date of the inception of the forward exchange
contract and the forward rate specified in the contract. Exchange difference on a forward exchange contract is the
difference between (a) the foreign currency amount of the contract translated at the exchange rate at the reporting
date, or the settlement date where the transaction is settled during the reporting period, and (b) the same foreign
currency amount translated at the latter of the date of inception of the forward exchange contract and the last
reporting date.
In recording a forward exchange contract intended for trading or speculation purposes, the premium or discount
on the contract is ignored and at each balance sheet date, the value of the contract is marked to its current market
value and the gain or loss on the contract is recognized.
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