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Somaiya Institute of Management Studies and Research
International Financial Management Project on Accounting Implication on Foreign Currency transaction
Index Introduction...........................4 Accounting Issues on foreign currency transaction..............5
Accounting for foreign currency transaction...................................................................5 Accounting for foreign operation.....................................................................................5
Problem of market determined foreign exchange value..........6
Translation Method..........................................................................................................6 Translation at Balance sheet Date....................................................................................7
Approaches to Accounting Transactions..........................8
Two transactions – recognize approach...........................................................................8 Two transaction – defer....................................................................................................9 One transaction – recognize.............................................................................................9
Accounting implication of Foreign Exchange Forward Contracts.............................10 Case Study: Infosys Technologies Limited (Annual Report 2008)........................12
In the globalization environment business empire are growing across the borders, entire world is single market for company. Indian business enterprises spreading their activities across the world. Being the part of the world market is not going to be easy there are cultural difference, legal issues and currency and settlement issues. In 1973 International Monetary Fund permitted member of countries to select and maintain an exchange arrangement of their choice. Indian exchange rates were controlled by RBI (Reserve Bank of India) and at the end of 1992, a dual exchange rate system was introduced and a year later, India moved to a unified market determined exchange rate. In terms of fiscal control we are in the process of moving full convertibility from the present regime of partial convertibility. These changes will force Indian enterprises to face the full impact of exchange risk. This paper deals with accounting implication on foreign exchange transaction.
Definition of Foreign currency transaction As per Accounting Standard -11
A foreign currency transactions is a transactions which is denominated in or requires settlement in foreign currency, including transactions arising when an enterprise either. a. b. c. d. buys or sells goods or services whose price is denominated in a foreign currency, borrows or lends funds when the amounts payable or receivable are denominated in a foreign currency, becomes a party to an unperformed forward exchanges contracts: or Otherwise acquires or disposes of assets or incurs or settles liabilities, denominated in a foreign currency.
In simple word a transaction that requires settlement in a foreign currency is a called foreign currency transaction.
Accounting Issues on foreign currency transaction
If foreign currency transaction is settled in on the date of transaction one can easily record the transaction as per current spot price of foreign exchange but when transaction is carried forward there we need to study the effects of foreign transaction due to changes in foreign currency valuation. In India for the accounting purpose foreign activities of an Indian enterprise are divided in to two categories.
Accounting for foreign currency transaction
It may enter into transactions which are denominated in foreign currency like import and export of goods or services borrowing or lending of money, acquisitions and sale of securities outside India and subscription by foreign firms to shares issued by Indian companies.
Accounting for foreign operation
It may have foreign operations conducted through branches, subsidiaries, associates, etc. The feature of a foreign operation is that it maintains its own accounting records and prepares financial statements in the local currency.
The two principal accounting issues common to both types of activities relate to the choice of the rate of exchange to be issued and the manner of dealing with the loss or gain arising from the differences in the exchange rates. Foreign exchange differences arises because companies record transactions on accruals basis, as per Indian tax law a firm can record entry on received or accrual basis. The companies can avoid the problem of foreign exchanges differences by: a. Settlement in only one currency b. Recording accounting entries of foreign currency transaction when they are converted in to local currency. c. Fixed exchange rate of exchange to be used. However, this solution is not feasible because these options are not available when company purchase or sales in foreign exchange transactions.
Problem of market determined foreign exchange value.
Assume an Indian company agrees to sells 100 items to a U.S. Company at $100 each. The item cost Rs. 3,000 each to make. The exchange rate when the sale is recorded is Rs.50 = $ 1. The Indian company records show: Sales Cost Profit Rs. 500,000 300,000 200,000
And the balance sheet shows debtors of Rs. 500,000 The customer pays after two month later when the rate is $ 1 = Rs. 45 and the company received Rs. 450,000. It has therefore lost of Rs. 50,000, not from trading, but from the decision to hold a dollar asset (the debt) while the value of the dollar decreased. When a foreign currency transaction takes place it has to be accounted by using a rate of exchange rate and if the transaction is not settled by that day then we have exchange rate difference situation. Suppose this monetary item is settled partly on some other date but in same financial period then we can book trading gain or loss for that financial period. Further if the transaction is carried forward to the next financial year then we will express these monetary items as outstanding items on date balance sheet date with foreign exchange rate for the given date for example foreign exchange rate declared by RBI on 31st march. These processes will continue till the transaction is settled down. The main issues in this process are a. Fixing the exchange rate for initially accounting for the transaction. b. Accounting with the exchange rate gain or loss arising on partial or full settlement during the same financial year c. Dealing with the exchange gain or loss on conversion of the foreign currency monetary item on the date of balance sheet.
A foreign currency transaction is required to be accounted and Indian company as at the date on which the transaction occurs by translating the foreign currency into Indian rupees by using the spot rate at that date. A spot rate is a quotation for delivery of foreign currency within two business days. When selling and buying rates quoted separately the corresponding rate should be used. It is also permissible to use a rate which is close to the actual rate. For example when there are several transactions in a given foreign currency an average rate for week or month should be considered. When there are wide range of fluctuations in exchange rates, then care has to be taken to ensure that single rate used is an appropriate substitute for the host of actual rates which is supposed to represent. In India Reserve Bank of India declares official rate for foreign exchange on daily basis..
A transaction in foreign currency may be settled either partly or fully, on a date later than the date of transaction, by converting rupees in to foreign currency or vice versa, at a rate different from the transaction rate. This will result in exchanges difference and such difference either gain or loss is recognized in the revenue statement of the financial statement in which the settlement takes place.
Translation at Balance sheet Date
When Indian companies submit their balance sheet they translate their foreign currency items into rupees on balance sheet date by using closing rate and the resultant exchange difference is recognized in the profit and loss account. The aspects of accounting for initial transaction, conversion and translation at the balance sheet date are illustrated in the following example. A computer provider company in India on credit from US company 60 numbers of computer printers at US$350 each on January 31, 2008. The terms are that the amount should be settled by payment of US$10,500 each on February 27, 2008 and April 30, 2008. The financial year of the Indian company ends March 31. The stock of these computers held as on March 31, 2008. The spot exchange rates on various dates are as follows. For US$ 1. January 31, 2008 February 27, 2008 March 31, 2008 April 30, 2008 Rs.46.04 Rs.46.09 Rs.46.06 Rs.45.96
Approaches to Accounting Transactions
Two transactions – recognize approach
Under this approach the transaction is divided into two aspects one is purchase aspects and other one is settlement aspects. The second one is treated as a method of financing and hence, the gain or loss on account of exchange difference on this monetary component of the transaction is recognized in the income statement in the manner similar to treatment of interest. The non-monetary component of the transaction, the inventory is not distributed for the change in exchange rates. The notional exchange gain or loss arising on restating the monetary item at the rate prevailing on balance sheet date is also recognized in the income statement. The accounting entries will be appears in the accounting book is as follows. Date Jan 2008 Feb 2008 Particulars 31, Purchases (Printers) To Account payable (US firm) (60 * 350* 46.04)) 27, Accounts Payable (US Firms) Exchange Loss (10,500* (46.09 – 46.04) To Bank 31, Exchange Loss To Accounts payable c/f next year (10,500 * (46.06-46.04)) 30, Accounts payable Exchange loss b/f from last year To Bank To Exchange gain (10500 * (46.06-45.96)) Debit 966,840.00 Credit 966,840.00 483,420.00 525.00 483,945.00 210.00 210.00 483,420.00 210.00 482,580.00 1,050.00
Mar 2008 Apr 2008
Two transaction – defer
Under this method the gain or loss on translation on balance sheet date is deferred and recognized on the date of settlement. Only realized exchange gain or loss recognized under this method. The accounting entries will be appears in the accounting book is as follows. Date Jan 2008 Feb 2008 Particulars 31, Purchases (Printers) To Account payable (US firm) (60 * 350* 46.04)) 27, Accounts Payable (US Firms) Exchange Loss (10,500* (46.09 – 46.04) To Bank 30, Accounts payable To Bank To Exchange gain (10500 * (46.04-45.96)) Debit 966,840.00 Credit 966,840.00 483,420.00 525.00 483,945.00 483,420.00 482,580.00 840.00
One transaction – recognize
Under the third method all events subsequent to the initial transaction are treated as part of such initial transaction. Hence the loss on February 28 and March 31 would be adjusted to inventory or cost of goods sold. The again on April 30 would also be adjusted as above. If the goods are not in stock, the adjustment will be to retained earnings.
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Accounting implication of Foreign Exchange Forward Contracts
In open market the spot exchange for a given currency is dependent on the supply and demand for that currency which in turn is influenced by international movements involving goods, services and investments and in some measures currency speculation. To reduce the exchange rate loss risk many enterprises enter into foreign currency transaction which serves as hedges. Hedging transactions have a cost either explicit or implicit, the enterprises has to evaluate the gain and loss from foreign currency due to non-hedging and cost due to hedging. A foreign currency hedge may be in the form of a foreign currency transaction involving acquisition of foreign currency asset like making foreign currency deposit or incurring foreign currency liability by taking foreign currency loan. The hedging cost incurred is normally recorded in the income statement. When a foreign currency liability is accounted for as a hedge of a net investment in an independent foreign operation, the exchange difference on the hedge item is adjusted to the retained earnings of the parent and is recognized in the income statement only on the sale of the investment which is hedge. A forward exchange contract is a contract to deliver or receive at a specified forward rate and on a stipulated future date. The forward exchange rate usually differs from the spot rate because of different economics factors. By and large this difference is attributable to the difference between the interest rates obtaining in the countries of the currencies under consideration. If the forward rate is more than the spot rate, the difference is called a “Premium” and when forward rate is less than the spot rate the difference is called a “Discount”. Forward contracts can be used for hedging or speculative purposes. As a hedging device, forward contracts cover an exposed net asset or liability position, or a net investment in a foreign operation, or an ideal foreign currency commitment. In forward contracts, the accounting issues relate to treatment premium and discounts. Since the forward contract are executory contracts, that is, they are yet to performed on the date the contract is entered into, they need not be accounted like any other transaction. The aspects of accounting for forward exchange are illustrated in the following example. An Indian company sold goods to a company in the USA on February 1, 2008 for an invoice price of US$ 10,000 when the spot rate was Rs. 45.70 per US dollar. Payment is to be received in three months on May 1, 2008. To avoid the risk of loss from decline in exchange rate on the date of receipt the Indian exporter acquired a forward contract to Sell US dollar 10,000 at Rs. 45.20 per dollar on May 1, 2008. The company accounting year end on March 31, 2008 and the spot rate on this date was Rs. 44.70 per US dollar. The spot rate on May 1, 2008 the date of receipt of money by the Indian exporter was Rs. 44.20 per dollar.
Accounting entries in the books of Indian company Date
Feb 1, 2008
Sunday Debtors (US Firm) To Sales (10,000 * 45.7) (initial accounting entry at the time of sale) Forward contract receivable Deferred Discount To Forward contract payable (Indian company sign the forward contract forward rate is lower than spot rate (45.70 45.20) so difference amount is treated as deferred discount and will be write-off in three month Exchange Loss To sundry debtors (10,000 * (45.7 – 44.7)) exchange loss due to decline in dollar value Forward Contract payable To Exchange Gain (10,000 * (45.7-44.7)) firms sign the forward contract and due to decline in dollar vale on march, Indian firms need to pay less rupees. Discount Expenses To Deferred Discount (Amortization of discount expenses for 2 months (5000*2/3)
Feb 1, 2008
Next financial year when Indian firm received final payment from US firm
May 1, 2008 Cash Exchange Loss To sundry debtors (payment received from US firm at the spot rate of Rs. 44.2) Forward Contract payable To Exchange Gain To Cash (exchange gain due to difference between spot rate on May (44.7 -44.2)) Cash To Forward contract (Indian firm received money from forward contract on forward rate) Discount Expenses To Deferred Discount (Amortization of discount expenses for 1 442,000.00 5,000.00 447,000.00
May 1, 2008
447,000.00 5000.00 442,000.00
May 1, 2008
May 1, 2008
Case Study: Infosys Technologies Limited (Annual Report 2008)
Infosys one of the giant software company in India who has diversified across the world. Infosys has its business in Asia, Australia, North America and Europe. Foreign exchange plays major role in Infosys revenue. Infosys entered in to forward contracts and hedged contracts to reduce the exchange risk. We have analyzed Infosys annual report for 2008 and figured out how this company shows foreign exchange accounting in the report. 1. Any income of losses by the forward contract had shown under the head “Other income” in Profit and Loss account. It also showed average rate as well as period rate for different currency.
2. Foreign Currency account balance had shown under the head “Cash and Bank Balance”.
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