8.5 Effects of Foreign Exchange Fluctuations Flashcards
functional currency
currency of the primary economic environment in which the entity operates. Normally, that environment is the one in which it primarily generates and expends cash
foreign currency
any currency other than the entity’s functional currency
reporting currency
currency in which an entity prepares its financial statements
4 ways Foreign Currency transactions appear
- Buys or sells on credit;
- Borrows or lends;
- Is a party to a derivative instrument; or,
- Acquires or disposes of assets, or incurs or settles liabilities, fixed in a foreign currency.
Aspects of Cross-Border Transactions
What are the recorded at
How do they recognize gains loss
OCI or net income
Transactions are recorded at the spot rate in effect at the transaction date
Transaction gains and losses are recorded at each balance sheet date and at the date the receivable or payable is settled. The gains or losses ordinarily are included in the determination of net income
When the amount of the functional currency exchangeable for a unit of the currency in which the transaction is fixed increases, a transaction gain is recognized on a Receivable
Loss is recognized on a payable
Exchange Rate Exposure
When a U.S. firm purchases from, or sells to, an entity in a foreign country, the transaction is recorded in U.S. dollars (the firm’s domestic currency).
If the exchange rate of the two currencies (i.e., the units of one currency required to purchase a single unit of the other) is fixed, the existence of a foreign-denominated receivable or payable raises no measurement issue.
transaction gain or loss
When calculated?
The gain or loss incurred at the settlement date, which affects the firm’s cash flows
translation gain or loss
Translation gains and losses arise from the use of accrual-basis accounting and must be calculated whenever financial statements are prepared during the payment deferral period
Two-Transaction Perspective on Exchange Rate Fluctuations
Two-transaction treatment is in accordance with U.S. GAAP
purchase or sale of merchandise is one transaction, and the future acquisition of foreign currency (either to pay a liability or as proceeds from a sale) is a separate transaction
By not settling immediately, the importer or exporter has assumed some degree of exchange rate risk, which is a financing decision, not a merchandising decision. These exchange gains or losses could have been avoided if full settlement had been made on the date of the purchase or sale.
One-transaction treatment is Impermissible under U.S. GAAP. Views all aspects of an exchange as a single transaction.Accordingly,the original amount recorded is considered an estimate, subject to adjustment when the exact cash outlay required for the purchase or the exact cash received from the sale is known.
Accounting for Transaction Gains and Losses (theory)
A TRANSACTION gain (loss) results from a change in exchange rates between the functional currency and the currency in which the transaction is denominated
It is the change in functional currency CASH FLOWS
- Actually realized on settlement and
- Expected on unsettled transactions.
Transactions are recorded at the spot rate in effect at the transaction date.
Transaction gains and losses are recorded at each balance sheet date and at the date the receivable or payable is settled. The gains or losses ordinarily are included in earnings
Accounting for Transaction Gains and Losses
Example
Transaction Date
Inventory 152,250
Accounts payable 152,250
(At Spot Rate)
Reporting Date:
Accounts payable $750
Transaction gain $750
Exchange Rate falls meaning Less D for F
Settlement Date: (Exchange Rate Rises. More D for F
Accounts payable ($152,250 – $750) $151,500
Transaction loss 1,500
Cash $153,000
ie
Receivable Foreign Appreciates = Gain (foreign buys more D)
Payable Foreign Appreciates = Loss (foreign buys fewer D)
Remeasurement Theory
When a FOREIGN entity’s ACCOUNTING records are not kept int it’s FUNCTIONAL currency> (local)Remeasure using TEMPORAL METHOD. (ie Poland Company records in Z, actually USES EURO.»_space;Remeasure
Then TRANSLATE if RePORTING is different than FUNCTIONAL.
So remeasure from local reporting to Functional. Then translate to reporting
Any net gain or loss on remeasurement of monetary assets and liabilities is recognized in current income from continuing operations. This accounting treatment was adopted because gains or losses on remeasurement affect functional currency cash flows.
Maintaining the records of a subsidiary in a local currency not the functional currency increases earnings volatility. All ratios that use current earnings or its components are affected by exchange rate fluctuations during the remeasurement process.
Remeasurement List
Monetary items are remeasured at the Current Rate
The following are examples of monetary items:
- Receivables
- Payables
- Inventories carried at market
- Marketable securities carried at Fair Value
Nonmonetary balance sheet items and related revenue, expense, gain, and loss amounts are remeasured at the Historical Rate
(a) marketable securities carried at Cost
but not debt securities to be held to maturity
(b) inventories carried at Cost
(c) cost of goods sold
(d) prepaid expenses
(e) property, plant, and equipment
(f) depreciation
(g) intangible assets
(h) amortization of intangible assets
(i) deferred income
(j) common stock
(k) preferred stock carried at its issuance price
(l) any noncontrolling interest
Translation
What items and what method
Translation is necessary when the functional currency differs from the reporting currency.
-Assets and liabilities are restated using the current exchange rate on the reporting date.
Shareholders’ equity items are restated at their historical rates
-Revenues, expenses, gains, and losses are restated using the historical rates in effect when they were recognized. If this method is impracticable, a weighted-average rate for the period may be used.
A gain or loss on foreign currency translation is a component of other comprehensive income, not earnings.
Thus, even large exchange rate fluctuations between the functional and reporting currencies will have little effect on income statement ratios.
