CHAPTER FIVE

ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS

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.

The Mechanics of Exchange Rates

An exchange rate is a measure of how much of one currency may be exchanged for another currency.
These rates may be in the form of either direct or indirect quotes.
 Direct Exchange Rates (quotes) measure how much of a domestic currency must be exchanged to
receive one unit of a foreign currency. It allows the party using the quote to understand the price
of the foreign currency in terms of its own base or domestic currency.
 Indirect Exchange Rates (quotes) measure how many units of the foreign currency will be
received for one unit of the domestic or “base” currency.
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).

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 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 bid 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. Accordingly, the Direct Exchange Rate decreases.

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  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.

Basic Process for Translating Foreign Currency Denominated Transactions

1. Use the spot rate on the day that the transaction is first recorded to measure the transaction initially
2. Re measure the accounts that require foreign currency settlement from the first step on each balance
sheet date, using the spot rate for the balance sheet date – report any resultant translation gains or
losses in current earnings
3. On the settlement date re measure for a final time using the spot rate at that time with that gain or
loss since the last balance sheet date included in current earnings

Foreign Currency Transaction Gains and Losses

Changes in exchange rates do not affect transactions that are that are both denominated and measured in
the reporting entity’s currency. Therefore, these transactions require no special accounting treatment.
However, if a transaction is denominated in a foreign currency and measured in the reporting entity’s
currency, changes in exchange rate between the transaction date and the settlement date and/or the
statement date result in a gain or loss to the reporting entity. These gains and losses are referred to as
exchange gains and losses, and their reporting requires special accounting treatments.

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 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

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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

* $288,000 = 180,000 * $1.60

** $18,000 = [180,000 (1.70 – 1.60)]

The U.S. Company received the 180,000 pounds when the exchange rate is $1.60, making the dollar
equivalent value of the pounds $288,000 (180,000*$1.60)

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 denominated the transaction in pounds.

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Unsettled Foreign Currency Transactions

If a foreign currency transaction is unsettled at year-end, an unrealized gain or Loss should be recognized
to reflect the change in the exchange rate occurring between the transaction date and the end of the
reporting period (e.g., year-end).

This treatment focuses on accrual accounting and the fact that exchange gains and losses occur over time
rather than only at the date of settlement or payment. Therefore, at any given time the assets or liabilities
arising from a foreign currency transaction that is denominated in a foreign currency should be measured
at its fair value as suggested by the spot rate.

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

Dec. 31, 2009

Foreign Currency trans. Loss 20

Accounts Payable 20

Feb. 1, 2010

Accounts Payable 1,520

Foreign Currency trans. Loss 30

Cash 1,550

The increase in the value of each Euro from $1.50 to $1.52 on December 31, 2009, resulted in a loss to
the U.S. Company since, as of year end, the company would have to pay out more dollars than originally
recorded. In 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.

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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.

Conclusions:

 Increase in the selling spot rate for a foreign currency required by a U.S. multinational enterprise
to settle a liability denominated in that currency generate foreign currency transaction loss to the
enterprise because more U.S. dollars are required to obtain the foreign currency. Conversely,
decrease in the selling spot rate produces foreign currency transaction gain to the enterprise
because fewer U.S. dollars are required to obtain the foreign currency.

 In contrast, increase in the buying spot rate for a foreign currency to be received by a U.S.
multinational enterprise in settlement of a receivable denominated in that currency generate
foreign currency transaction gains to the enterprise. Where as, decreases in the buying spot rate
produce foreign currency transaction losses.

Forward Exchange Contracts

An enterprise may enter into a forward exchange contract or another financial instrument that is in
substance a forward exchange contract, which is not intended for trading or speculation purposes, to
establish the amount of the reporting currency required or available at the settlement date of a transaction.
The premium or discount arising at the inception of such a forward exchange contract should be
amortized as expense or income over the life of the contract. Exchange differences on such a contract
should be recognized in the statement of profit and loss in the reporting period in which the exchange
rates change. Any profit or loss arising on cancellation of renewal of such a forward exchange contract
should be recognized as income or as expense for the period.

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.