Foreign Exchange Fluctuations     
 

Topic Outline:

The topic should describe how special issues focusing mainly on Foreign Exchange Fluctuations affect performance evaluation in multinational companies with the following objectives:

1. Demonstrate an understanding of the impact of foreign exchange rate changes on financial statements

2. Identify and explain issues in the accounting for foreign operations (e.g.,historical vs. current rate and the treatment of translation gains and losses)

3. Define functional currency

4. Calculate the financial ratio impact of a change in exchange rates impact on management and investor behavior of volatility in reported earnings. 

​

Definition of Terms 

• 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 unit, joint venture, or branch whose activities are based in a country other than that of the reporting enterprise.

• Functional Currency -  is the currency of the primary economic environment in which the entity operates.

• Presentation Currency -  the currency in which the financial statements are presented.

• Spot Rate - Spot rates are the current exchange rates at which specific currencies can be bought or sold on currency exchange rates. 

​

There has been rapid expansion of companies operating globally that exposes them to transactions denominated in foreign currencies.

Companies operating globally will be recording the following accounting transactions: 

1. Accounting for sales made abroad and denominated in a foreign currency.

2. Accounting for purchases made abroad and denominated in a foreign currency

3. Accounting for assets held abroad and valued in a foreign currency. 

4. Accounting for liabilities held abroad and valued in a foreign currency. 

5. Accounting for a foreign subsidiary that will be consolidated with the parent company's financial statements 

 

Throughout the year, these global corporations interact with various currencies on a regular basis. These transactions must be converted to U.S. dollars along with the financial information from their overseas subsidiary in order to be included in the parent company's consolidated financial statements. After conversion, the sums can be combined.

 

Exchange rates, which are reported as spot rates and indicate the rate in effect on a particular day—sometimes known as the rate on the balance sheet date—are used to conduct conversion. Direct or indirect quotes are offered for these exchange rates.

Direct Quotes: This indicates the quantity of local currency needed to exchange for one unit of foreign currency. One US dollar and seven cents can be traded for one British pound, for example, if the conversion rate is $1.07 (local currency) to £1 (foreign currency).

 

Indirect Quotes: This shows how much foreign currency must be exchanged for one unit of local currency. For instance, £0.93 to $1.00 indicates that one US dollar can be purchased with £0.93. An alternative way to put it is that one US dollar is worth £0.93. The outcome of this computation is £0.93, which is obtained by dividing £1 by $1.07.

 

Translation from direct to indirect and vice versa: 

Direct to Indirect 

Local / Foreign Currency

1 / $1.07 = £0.93 

£0.93 per $1

Indirect to Direct 

Foreign / Local Currency

1 / £0.93  = $1.07

$1.07 per £1

 

A currency's exchange rate may be fixed by the government or it may fluctuate as a result of market forces. A currency's value has decreased in relation to another if it depreciates versus that other currency. On the other hand, when a currency acquires value in relation to another, it is said to have appreciated. These variances, sometimes referred to as currency fluctuations, may produce profits or losses.

​

The accounts receivable are likewise denominated in the foreign currency when a sale takes place in that currency. An exchange gain is recorded on the balance sheet date if the value of the US dollar declines.

In a similar vein, accounts payable are likewise made in the currency of the purchase. The decline of the US dollar results in an exchange loss recorded in the balance sheet date.

​

Exports and imports are usually the main foreign exchange transactions. Two essential prerequisites for managing foreign exchange transactions are outlined in ASC 830:

​

1. Every account used to record a foreign exchange transaction should be measured using the functional currency—typically the reporting currency—at the current exchange rate on the day of the transaction.

2. All balances should be updated to reflect the exchange rate in effect on the date of each balance sheet. Gains or losses resulting from exchange rate fluctuations will be included in the income statement for the period in which the change occurred. Additionally, if there is a change in the exchange rate between the balance sheet date and the payment date,  further adjustments may be necessary.

​

There are three primary processes involved in integrating a foreign subsidiary into the financial statements of the parent company:

1. modifying the financial statements of the subsidiary to abide by U.S. GAAP guidelines.

2. To comply with reporting standards, the trial balance should be converted into the functional currency if it differs from the subsidiary's.

3. Converting the financial data from the functional (often US dollars) to the reporting (typically EUR) currency. The parent business must provide worksheet eliminations for this process prior to consolidating the overseas subsidiary's financial statements.

​

Furthermore, two translation techniques for translating the financial statements of a foreign company into US dollars for consolidation are described in ASC Topic 830. The functional currency of the subsidiary, which stands for the main economic environment in which the company operates, determines which translation technique should be used.

​

Note: Entities must report, either immediately on the financial statements or in the accompanying notes, the total profits or losses from foreign currency transactions that affected the calculation of net income for the period in accordance with ASC 830. In the financial statement footnotes, companies should also offer an analysis of changes in cumulative translation adjustments. Presenting the beginning balance of cumulative translation adjustments, adding or removing the aggregate adjustments, and displaying the final balance of cumulative translation adjustments are the usual steps involved in this process. The statement of comprehensive income contains information about any adjustments made during the current year.

​

Method 1: Translation from the Functional Currency into the Presentation Currency (FCPC/Closing/Current Rate Method / Net Investment Method / Translated Method).

The following circumstances govern the use of this method:

- The local currency unit (LCU), which is the currency of the nation in which the subsidiary operates, or a currency from a third country should be used as the functional currency, which is different from the presentation currency.

- The closing/current rate method's salient features are as follows:

- On the date of the balance sheet, both monetary and non-monetary assets and liabilities are translated using the current exchange rate.

- Equity accounts are translated using historical rates that were in force on the day of investment, or when equities were first recorded, in the foreign entity's accounting records, with the following exceptions:

- Initial retained earnings, which are determined by summing up the balance at the conclusion of the prior year.

- Dividends are converted using the historical exchange rate in effect on the declaration date, or alternatively on the date of payment.

- The overseas operation's revenue and expenses are converted using the historical or real spot currency rates in effect on the dates of the transactions. When transactions are frequent and dispersed equally throughout the course of the year, it is generally more practical to use the average exchange rate.

Up until the foreign operation is closed, any ensuing variations (translation gains or losses) are included in other comprehensive income. These differences are subsequently reflected in the profit or loss statement after disposal.

​

Method 2: Translation into the Functional Currency / Remeasurement of Foreign Currency Financial Statements to the Functional Currency (Temporal Method / Remeasurement Method). 

The following situations call for the application of this method:

• The subsidiary conducts transactions in local or multiple currencies, or the functional currency—which is different from the presentation currency—is not the functional currency of the subsidiary.

The following are the temporal method's main features:

• The closing exchange rate is used to translate or remeasure monetary assets and liabilities, including cash, fixed deposits, receivables, payables, and the majority of liabilities.

• The exchange rate in effect on the transaction date (historical rate) is used to translate or remeasure non-monetary items recorded at historical cost or carried at previous exchange prices, such as inventories, fixed assets, investments at cost, prepaid items excluding prepaid interest, and intangible assets.

• Non-monetary items (such as trading securities, inventories kept at replacement cost, and revalued fixed assets) must be adjusted using the exchange rate in effect on the date of the revaluation or determination of fair value, regardless of whether they are valued at fair market value or based on current or projected future exchange rates

• With the exception of the first retained earnings, which are set equal to the year-end balance of the prior year, equity accounts for shareholders are adjusted using historical rates in accordance with the rates in place when equities were first recorded in the foreign entity's accounting records. The historical exchange rate in effect on the declaration date, or alternatively, the payment date, is used to modify dividends.

• The overseas operation's revenue and expenses are adjusted based on the currency rates that were in effect on the dates of the transactions. These rates are usually actual or spot rates (historical rates). However, for pragmatic reasons, the average exchange rate is frequently applied to items with a high volume of uniformly dispersed transactions throughout the course of the year.

• The period's income statement or profit and loss statement must include a disclosure of any remeasurement gain or loss.

 

 

 

 

 

 

 

 

 

 

 

 

​
 

Practice Exercises 

THEORIES

 1. Which of the following best describes the impact of foreign currency fluctuations on a company's financial statements?

  A. Foreign currency fluctuations have no effect on a company's financial statements.

  B. Foreign currency fluctuations only impact the balance sheet of a company.

  C. Foreign currency fluctuations can impact both the balance sheet and income statement of a company.

  D. Foreign currency fluctuations primarily affect the cash flow statement of a company.

​

​

 2. Which financial statement is primarily affected by foreign currency fluctuations?

  A. Income statement

  B. Balance sheet

  C. Cash flow statement

  D. Statement of changes in equity

​

 3. How are foreign currency fluctuations typically accounted for in a company's financial statements?

  A. They are recorded as gains or losses in the balance sheet.

  B. They are only disclosed in the footnotes to the financial statements.

  C. They are recognized as revenue or expenses in the income statement.

  D. They have no impact on the financial statements.

​

 4. When a company's functional currency differs from its reporting currency, which method is commonly used to translate its foreign subsidiary's financial statements?

  A. Closing rate method

  B. Temporal method

  C. Current rate method

  D.Historical rate method

​

 5. How are translation gains or losses typically reported in a company's financial statements?

  A. As adjustments to equity.

  B. As adjustments to revenue.

  C. As adjustments to retained earnings.

  D. As adjustments to expenses.

 

PROBLEMS

​

 1. On January 21,Selly, a U.S. company, purchased parts from Switzerland for €30,000 and recorded them in accounts payable as $39,930. On January 31, this same transaction is valued in accounts payable as $43,230. What is the direct rate for euros on January 21 and the indirect rate on January 31, respectively? 

  A. €1 = $1.21; €1 = $1.31

  B. €1.33 = $1.00 ; $1.00 = 0.69

  C. €1 = $1.31; $1 = €0.76

  D. €1 = $1.21; $1 = €0.76

 

 2. On September 3, Joji., a U.S. company, purchased a manufacturing press from Sharapriv. in London for £120,000. The spot rate on September 3 was $1 = £0.73. On September 30, the spot rate was $1.47 = £1. What value would Joji, Inc. use to record the payable on the date of the purchase and on its balance sheet on September 30, respectively?

  A. $246,600; $264,600

  B. $264,600; $246,600

  C. $131,386; $122,450

  D. $164,400;$176,400

 

 3.  On September 1, Year 5, JacknJill, Inc., a U.S. corporation, sold merchandise to a foreign entity for 375,000 Botswana pula. Terms of the sale require payment in pula on February 1, Year 6. On September 1, Year 5, the spot exchange rate was $0.20 per pula. At December 31, Year 5 (Joji's year-end), the spot rate was $0.19, but the rate increased to $0.22 by February 1, Year 6, when payment was received. How much should JacknJill report as foreign exchange transaction gain or loss as part of Year 6 income?

  A. $0

  B. $3,750 loss

  C. $11,250 gain

  D. $7,500 gain

​

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

​
 

Answer Key

​

Theory

1. Answer: C) Foreign currency fluctuations can impact both the balance sheet and income statement of a company.

2. Answer: B) Balance sheet

3. Answer: C) They are recognized as revenue or expenses in the income statement.

4. Answer: A) Closing rate method

5. Answer: A) As adjustments to equity.

​

​

Problem

1. Answer: B.) €1.33 = $1.00 ; $1.00 = 0.69

 

Direct Rate Jan 21: 39, 930 / 30,000 = 1.33

Indirect Rate Jan 31: 30,000 / 43, 230 = 0.69

 

1. Answer: D.) $164,400;$176,400

 

Direct Sept 3. = $1 =  £0.73 

Indirect = $1.37 =  £1.00

= 1.37 x 120,000 = 164,400

 

Indirect Sept. 30 = $1.47 = £1.00

Direct = $1 = £0.68 

=1.47 x 120,000 = 176,400

 

1. Answer: C.) $11, 250 gain

 

Dec. 31

0.19 x 375,000 = 71,250

 

Feb 1 

0.22 x 375,000 = 82, 500 

 

82,500 - 71, 250 = 11, 250 gain 

​

​

​

​

​

​

​

​

​

​

​

​

​

​

​

​

References:

Baguio,JD. (April 2024). RCMA 4: Special Issues. Pg. 1-3. 

Segal, Troy. (June 2021). “Currency Fluctuations: How They Affect the Economy.” Investopedia, Investopedia. Retrieved from : www.investopedia.com/articles/forex/080613/effects-currency-fluctuations-economy.asp.

Admin.(July 2012). “IAS Plus.” IAS 21 - The Effects of Changes in Foreign Exchange Rates. Retrieved from: www.iasplus.com/en/standards/ias/ias21.