Chapter Five Accounting for Foreign Currency Transactions and Translations

Chapter Five
Accounting for Foreign Currency Transactions and Translations
IFRS governing the translation of foreign currency financial statements and the accounting for
foreign currency transactions are found primarily in IAS 21, The Effects of Changes in Foreign
Exchange Rates.
IAS 21 applies to:
 Accounting for foreign currency transactions (e.g., exports, imports and loans) which are
denominated in other than the reporting entity’s functional currency.
 Translation of foreign currency financial statements of branches, divisions, subsidiaries
and other investees that are incorporated in the financial statements of an entity by
consolidation, proportionate consolidation or the equity method of accounting
Definitions of terms
Closing rate. This refers to the spot exchange rate (defined below) at the end of the reporting
period.
Conversion. The exchange of one currency for another.
Exchange difference. The difference resulting from reporting the same number of units of a
foreign currency in the presentation currency at different exchange rates.
Exchange rate. This refers to the ratio for exchange between two currencies.
Fair value. The amount for which an asset could be exchanged, or a liability could be settled,
between knowledgeable willing parties in an arm’s-length transaction.
Foreign currency. A currency other than the functional currency of the reporting entity (e.g., the
Japanese yen is a foreign currency for a euro-reporting entity).
Foreign currency financial statements. Financial statements that employ as the unit of measure
a foreign currency that is not the presentation currency of the entity.
Foreign currency transactions. Transactions whose terms are denominated in a foreign
currency or require settlement in a foreign currency. Foreign currency transactions arise when an
entity:
[A] Buys or sells goods or services whose prices are denominated in foreign currency;
[B] Borrows or lends funds and the amounts payable or receivable are denominated in
foreign currency;
[C] Is a party to an unperformed foreign exchange contract; o
[D] For other reasons acquires or disposes of assets or incurs or settles liabilities denominated
in foreign currency.
Foreign currency translation. The process of expressing in the presentation currency of the
entity amounts that are denominated or measured in a different currency.
Foreign entity. When the activities of a foreign operation are not an integral part of those
of the reporting entity, such a foreign operation is referred to as a foreign entity.
Foreign operation. A foreign subsidiary, associate, joint venture or branch of the reporting
entity whose activities are based or conducted in a country other than the country where the
reporting entity is domiciled.
Functional currency. The currency of the primary economic environment in which the
entity operates, which thus is the currency in which the reporting entity measures the items in its
financial statements, and which may differ from the presentation currency in some instances.
 Chapter Five Accounting for Foreign Currency Transactions and Translations

Presentation currency. The currency in which the reporting entity’s financial statements are
presented. There is no limitation on the selection of a presentation currency by a reporting entity.
Spot exchange rate. The exchange rate for immediate delivery of currencies exchanged

OBJECTIVES OF TRANSLATION AND THE FUNCTIONAL CURRENCY CONCEPT

The objectives of translation are

 To provide “information that is generally compatible with the expected economic effects
of a rate change on an enterprise’s cash flows and equity” and
 To 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. generally accepted accounting principles”[1].

To decipher these objectives, one must first understand the functional currency concept.

Functional Currency Concept

An entity’s functional currency is the currency of the primary economic environment in which
it operates. Normally, a foreign entity’s functional currency is the currency it receives from its
customers and spends to pay its liabilities.
 An entity does not have a free choice of functional currency
 An entity cannot change functional currency unless facts and circumstances relevant to its
determination change
IAS 21 states that an entity should consider the following factors in determining its functional
currency:
a) The currency that mainly influences sales prices for goods and services (often the
currency in which prices are denominated and settled)
b) The currency of the country whose competitive forces and regulations mainly determine
the sales prices of its goods and services
c) The currency that mainly influences labour, material and other costs of providing goods
or services (often the currency in which prices are denominated and settled)
Sometimes the functional currency of an entity is not immediately obvious. Management must
then exercise judgement and may also need to consider:
[A] The currency in which funds from financing activities (raising loans and issuing equity)
are generated
[B] The currency in which receipts from operating activities are usually retained

A foreign currency is a currency other than the entity’s functional currency. If the functional
currency of a German subsidiary is the euro, the U.S. dollar is a foreign currency of the German
subsidiary. If the functional currency of the German subsidiary is the U.S. dollar, the euro is a
foreign currency to the German subsidiary.
 Chapter Five Accounting for Foreign Currency Transactions and Translations

The local currency is the currency of the country to which reference is made. Thus, the
Canadian dollar is the local currency of a Canadian subsidiary of a U.S. firm. The subsidiary’s
books and financial statements will be prepared in the local currency in nearly all cases involving
foreign currency financial statements, regardless of the determination of the functional currency

The reporting currency is the currency in which the consolidated financial statements are
prepared. The reporting currency for the consolidated statements of a U.S. firm with foreign
subsidiaries is the U.S. dollar. Foreign currency statements are statements prepared in a
currency that is not the reporting currency (the U.S. dollar) of the U.S. parent-investor

FOREIGN EXCHANGE MARKETS

Each country uses its own currency as the unit of value for the purchase and sale of goods and
services. The currency used in the United States is the U.S. dollar, the currency used in Mexico
is the Mexican peso, the currency used in the countries of ours is Birrs and so on. If a U.S.
citizen travels to Mexico and wishes to purchase local goods, Mexican merchants require
payment to be made in Mexican pesos. To make a purchase, a U.S. citizen has to acquire pesos
using U.S. dollars. The foreign exchange rate is the price at which the foreign currency can be
acquired. A variety of factors determine the exchange rate between two currencies; unfortunately
for those engaged in international business, the exchange rate can fluctuate over time.

Today, several different currency arrangements exist. Some of the more important ones and
the countries affected follow:

1. Independent float: The value of the currency is allowed to fluctuate freely according to
market forces with little or no intervention from the central bank (Canada, Japan, Sweden,
Switzerland, and United States).
2. Pegged to another currency: The value of the currency is fixed (pegged) in terms of a
particular foreign currency and the central bank intervenes as necessary to maintain the fixed
value. For example, the Bahamas, Panama, and Saudi Arabia peg their currency to the U.S.
dollar.
3. European Monetary System (euro): In 1998, the countries comprising the European
Monetary System adopted a common currency called the euro and established a European
Central Bank.2 Until 2002, local currencies such as the German mark and French franc
continued to exist but were fixed in value in terms of the euro. On January 1, 2002, local
currencies disappeared, and the euro became the currency in 12 European countries. Today,
16 countries are part of the euro area. The value of the euro floats against other currencies
such as the U.S. dollar

The Mechanics of Exchange Rates

 Chapter Five Accounting for Foreign Currency Transactions and Translations

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 made by a foreign
currency trader who is usually employed by a large commercial bank.

 A direct quote measures how much of the domestic currency must be exchanged to
receive one unit of the foreign currency (1 FC). Direct quotes allow the party using the
quote to understand the price of the foreign currency in terms of its own “base” or
domestic currency. This method is frequently used in the United States, and direct quotes
are published daily in financial papers such as The Wall Street Journal.
 Indirect quotes, also known as European terms, measure how many units of foreign
currency will be received for one unit of the domestic currency. Thus, if the direct quote
for a foreign currency (FC) is $0.25, then one FC would cost $0.25. The indirect quote
would be the reciprocal of the direct quote, or 4 FC per dollar ($1.00 divided by $0.25).

The business news often reports that a currency has strengthened (gained) or weakened
(lost) relative to another currency. Assuming a direct quote system, such changes
measure the difference between the new rate and the old rate, as a percentage of the old
rate.

For example, if the dollar strengthened or gained 20% against a foreign currency (FC)
from its previous rate of $0.25, the dollar would now command more FC (i.e., the FC
would be cheaper to buy). To be exact, the new exchange rate would be $0.20 [$0.25
(20% 0.25)]. Therefore, the strengthening currency would be evidenced by a reduction in
the directly quoted amount and an increase in the indirectly quoted amount. The opposite
would be true for a weakening of the domestic currency. The reaction to a strengthening
or weakening of a currency depends on what type of transaction is contemplated. For
example, an American exporter would want a weaker dollar because the foreign importer
would need fewer of its currency units to acquire a dollar’s worth of U.S. goods. Thus,
U.S. goods would cost less in terms of the foreign currency. If the dollar strengthened so
that one could acquire more foreign currency units for a dollar, importers would benefit.
Therefore, U.S. companies and citizens would have to spend fewer U.S. dollars to buy
the imported goods.
 Chapter Five Accounting for Foreign Currency Transactions and Translations

Exchange rates often are 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 (normally a
large commercial bank) is willing to pay to acquire or sell a currency. The difference or spread
between these two rates represents the broker’s commission and is often referred to as the points.
The spread is influenced by several factors, including the supply of and demand for the currency,
the number of transactions taking place, currency risk, and the overall volatility of the market
For example, assume a currency broker agrees to pay $0.20 to a holder of a foreign currency and
agrees to sell that currency to a buyer of foreign currency for $0.22. In this case, the broker will
receive a commission of $0.02 ($0.22 - $0.20).

Exchange rates fall into two primary groups. A spot rate is the rate of exchange for a currency
with delivery, selling, or buying of the currency normally occurring within two business days. In
addition to exchange rates governing the immediate delivery of currency, forward rates apply to
the exchange of different currencies at a future point in time, such as in 30 or 180 days. Although
not all currencies are quoted in forward rates, virtually all major trading nations have forward
rates

Accounting for Foreign Currency Transactions

Export sales and import purchases are international transactions: they are components of what is
called trade. When two parties from different countries enter into a transaction, they must decide
which of the two countries currencies to use to settle the transaction. For example, if a U.S.
 Chapter Five Accounting for Foreign Currency Transactions and Translations

computer manufacturer sells to a customer in Japan, the parties must decide whether the
transaction will be denominated (payment will be made) in U.S. dollars or Japanese yen.

 Export sale: A transaction exposure exists when the exporter allows the buyer to pay in a
foreign currency and allows the buyer to pay sometime after the sale has been made. The
exporter is exposed to the risk that the foreign currency might depreciate (decrease in
value) between the date of sale and the date of payment, thereby decreasing the U.S.
dollars ultimately collected.

 Import purchase: A transaction exposure exists when the importer is required to pay in
a foreign currency and is allowed to pay sometime after the purchase has been made. The
importer is exposed to the risk that the foreign currency might appreciate (increase in
value) between the date of purchase and the date of payment, thereby increasing the U.S.
dollars that have to be paid for the imported goods.

Assume a U.S. company sells mining 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 the 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. Now assume that the same
transaction occurs except that the transaction is to be settled in British pounds. Because this
transaction is denominated in pounds and will be measured by the U.S. Company in dollars,
changes in the exchange rate subsequent to the transaction date expose the U.S. Company to the
risk of an exchange rate loss or gain. If the U.S. dollar strengthens, relative to the pound, the U.S.
Company will experience a loss because it is holding an asset (a receivable of British pounds)
whose price and value have declined. If the dollar weakens, the opposite effect would be
experienced. Whether a transaction is settled in dollars versus a foreign currency is a matter that
is negotiated between the transacting parties and is influenced by a number of factors. A bank
wire transfer is generally used to transfer currency between parties in different countries. For one
of the parties, the currency will be a foreign currency; for the other party, the currency will be its
domestic currency.

To summarize, changes in exchange rates do not affect transactions 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 the exchange rate between the
transaction date and settlement date result in a gain or loss to the reporting entity. These gains
or losses are referred to as exchange gains or losses, and their recognition requires special
accounting treatment.
 Chapter Five Accounting for Foreign Currency Transactions and Translations

Purchase of Merchandise from a Foreign Supplier

Assume that on April 18, 1999, Worldwide Corporation purchased merchandise from a German
supplier at a cost of 100,000 euros. The April 18, 1999, selling spot rate was €1 = $1.05. Because
Worldwide was a customer of good credit standing, the German supplier made the sale on 30-
day open account.
Required:
Prepare journal entries for Worldwide Corporation on April 18, 1999, assuming that Worldwide
uses the perpetual inventory system.
Journal Entry for Purchase of Merchandise from German Supplier Payment Made in Euros:
Inventories 105000
April 18, Trade Accounts Payable 105,000
1999
(To record purchase of 30-day open account from German supplier for €100,000, translated at
selling spot rate of €1 = $1.05 (€100,000 x $1.05 = $105,000).

The selling spot rate was used in the journal entry, because it was the rate at which the liability to
the German supplier could have been settled on April 18, 1999.

Foreign Currency Transaction Gains and Losses

During the period that the trade account payable to the German supplier remains unpaid, the
selling spot rate for the euro may change. If the selling spot rate decreases (the euro weakens
against the dollar), Worldwide will incur a foreign currency transaction loss. Foreign currency
transaction gains and losses are included in the measurement of net income for the accounting
period in which the spot rate changes.
Assume that on April 30, 1999, the selling spot rate for the euro was €1 = $1.04 and Worldwide
prepares financial statements monthly. The accountant for worldwide records the following
journal entry with respect to the trade accounts payable to the German supplier:
Trade Accounts Payable 1,000
April 30, 1999 Foreign Currency Transaction Gains 1,000
(To recognize foreign currency transaction gain applicable to April 18, 1999, purchase from German
supplier, as follows:

Liability recorded on April 18 $105000

Less: Liability translated at April 30, selling spot rate: €1 = $1.04 (€100,000 x $1.04 = 104,000
 Chapter Five Accounting for Foreign Currency Transactions and Translations

$104,000)
Foreign currency transaction gain $1,000

Assume further that the selling spot rate on May 18, 1999, was €1 = $1.02. The May 18, 1999 ,
journal entry for Worldwide`s payment of the liability to the German supplier is shown below:

Trade Accounts Payable 104000

Foreign currency Transaction Gains 2,000
Cash 102,000

(To record payment for €100,000 draft to settle liability to German supplier, and recognition of
transaction gain (€100,000 x $1.02 = $102,000)).
Sale of Merchandise to a Foreign Customer
Assume that on May 17, 1999, Worldwide Corporation, which uses the perpetual inventory
system, sold merchandise acquired from a U.S. supplier for $12,000 to a French customer for
€15,000, with payment due June 16, 1999. On May 17, 1999, the buying spot rate for the euro
was €1 = $1.01.
Required:

Prepare journal entries for worldwide Corporation on May 17, 1999.

May 18 1999 Trade Accounts Receivable 15150

Sale 15,150

(To record sale on 30-day open account to French customer for €15,000, translated at buying spot
rate of €1 = $1.01 (€15,000 x $1.01 = $15,150).
May 18, Cost of Goods Sold 12000
1999
Inventories 12,000
(To record cost of merchandise sold to French customer).

Assuming that the buying spot rate for the euros was €1 = $0.99 (the euro weakened against the dollar)
on May 31, 1999, when Worldwide prepared its customary monthly financial statements, the following
journal entry is appropriate:
Foreign Currency Transaction Losses 300
Trade Accounts Receivable 300
(To recognize transaction loss applicable to May 17, 1999, sale to French customer as follows:
Asset recorded on May 17 1999 $15150
Less: Asset translated at May 31, 1999, buying spot rate: €1 = $0.99 (€15,000 x $0.99 = $14,850) 14,850
Foreign Currency Transaction Loss $300

If on June 16, 1999, the date when Worldwide received a draft for €15,000 from the French
customer, the euro had strengthened against the dollar to a buying spot rate of €1 = $0.995,
Worldwide`s journal entry would be as follows:
 Chapter Five Accounting for Foreign Currency Transactions and Translations

Cash 14925
Trade Accounts Receivable 14,850
Foreign Currency Transaction Gains 75

(To record receipt and conversion to dollars of €15,000 draft in payment of receivable from
French customer, and recognition of foreign currency transaction gain (€15,000 x $0.995 =
$14,925)