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Chapter 10 Accounting for Foreign Currency Basics in Foreign Exchange Foreign exchange is traded “Over-the-counter” (OTC) Made up of commercial and investment banks On an exchange Over the Internet Basics in Foreign Exchange Foreign exchange instruments include

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chapter 10

Chapter 10

Accounting for Foreign Currency

basics in foreign exchange
Basics in Foreign Exchange
  • Foreign exchange is traded
    • “Over-the-counter” (OTC)
      • 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 exchange3
Basics in Foreign Exchange
  • Foreign exchange instruments include
    • 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
Spot Market
  • Rates are normally quoted from a trader’s perspective in two rates
    • Example - $1.9072/82
      • 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
Foreign Currency Transactions
  • 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 transactions6
Foreign Currency Transactions
  • If a transaction is denominated in a foreign currency and settled at a subsequent balance sheet date, four problems arise involving
    • 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 transactions7
Foreign Currency Transactions
  • Have two components
    • 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 transactions8
Foreign Currency Transactions
  • IAS 21 and SFAS 52
  • Example – Equipment and A/P are recorded at the spot rate on the transaction date – Why?
    • 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
IAS 21
  • Requirements
    • 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
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
Illustration – Journal Entries

March 1 Purchases 262,240

A/P 262,240

€200,000 x 1.3112

March 31 Foreign exchange loss 7,760

A/P 7,760

€200,000 (1.3112 – 1.35)

April 30 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
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 currency13
Illustration: Accounting for Debt in a Foreign Currency

January 1 Cash 1,612,800

Notes Payable 1,612,800

June 30 Notes Payable 32,600

Foreign Exchange Loss 32,600

(CHF.7901 -.8064) x CHF 2 million

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 currency14
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
Translation terminology
  • 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
Key issues for translation
  • 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
Current/Noncurrent Method
  • 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
Translation Exchange Rates

International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

monetary nonmonetary method
Monetary/Nonmonetary Method
  • 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
Temporal Method
  • 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
Current Rate Method (Closing Rate Method)
  • 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
International Accounting Standards
  • IAS 21
    • 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
U.S. Accounting Standards
  • FASB Statement No. 52 objectives
    • 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
Translation Process – SFAS 52
  • Functional currency must be established
    • 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
The Temporal Method
  • Used to remeasure financial statements from a foreign currency to the functional currency
  • Requirements are as follows
    • 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 method26
The Temporal Method
  • 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
How Remeasurement Works
  • 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
The Current Rate Method
  • Used when the functional currency is defined as the foreign currency
  • Steps in the current rate method
    • 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 method29
The Current Rate Method
  • 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
Translation Choices

International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

foreign currency and intercompany transactions
Foreign Currency and Intercompany Transactions
  • 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
Long-term Investment
  • 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
    • Stockholders’ Equity – Current rate method
    • Income Statement – Temporal method

International Accounting & Multinational Enterprises – Chapter 10 – Radebaugh, Gray, Black

elimination of intercompany profits
Elimination of Intercompany Profits
  • 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
Statement of Cash Flows
  • Guidelines are given in SFAS 95 and IAS 7
  • Example – U.S. parent and British subsidiary
    • 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 flows35
Statement of Cash Flows
  • 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
The Impact of IAS 21
  • Requires disclosure of the following
    • 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
IAS 21 Convenience Translations
  • Requirements include the following
    • 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
Disclosure of the Impact of Statement 52
  • Requires disclosure of the following
    • 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