11/02/2021 CFA Exam Review - Level 2 - Lesson 1: Defining the Presentation Currency, Functional Currency, Local Currency, and

cy, and Foreign Cur…

Overview
Lesson 1: Defining the Presentation Currency, Functional Currency, Local Currency, and Foreign Currency

Transaction Exposure

This lesson includes printable lecture slides. Download

Upon completion of this lesson, candidates should be able to:

LOS 15a: Distinguish among presentation (reporting) currency, functional currency, and local currency.

LOS 15b: Describe foreign currency transaction exposure, including accounting for and disclosures
about foreign currency transaction gains and losses.

LOS 15c: Analyze how changes in exchange rates affect the translated sales of the subsidiary and parent
company.

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Study Guide
Lesson 1: Defining the Presentation Currency, Functional Currency, Local Currency, and Foreign Currency

Transaction Exposure

LOS 15a: Distinguish among presentation (reporting) currency, functional currency, and local currency.
Vol 2, pp 117

Most multinational companies engage in two types of foreign currency-related activities that require
special accounting treatment.

1. They undertake transactions that are denominated in foreign currencies.

2. They invest in foreign subsidiaries that keep their accounts in foreign currencies.

To report these activities in their consolidated financial statements, multinationals must translate foreign
currency amounts related to these activities into the currency in which they present their financial
statements. Before moving into the details regarding currency translation, we define the following
important terms:

The presentation currency (PC) is the currency in which the parent company reports its financial
statements. It is typically the currency of the country where the parent is located. For example, U.S.
companies are required to present their financial results in USD, German companies in EUR,
Japanese companies in JPY, and so on.
The functional currency (FC) is the currency of the primary business environment in which an entity
operates. It is usually the currency in which the entity primarily generates and expends cash.
The local currency (LC) is the currency of the country where the subsidiary operates.

Since the local currency is generally the entity's functional currency as well, a multinational parent with
subsidiaries in different countries around the world is likely to have a variety of different functional
currencies.

LOS 15b: Describe foreign currency transaction exposure, including accounting for and disclosures about
foreign currency transaction gains and losses. Vol 2, pp 118–129
LOS 15c: Analyze how changes in exchange rates affect the translated sales of the subsidiary and parent
company. Vol 2, pp 118–129

A foreign currency is defined as any currency other than the entity's functional currency. Therefore, foreign
currency transactions are those that are denominated in a currency other than the company's functional
currency. Foreign currency transactions may involve:

an import purchase or an export sale that is denominated in a foreign currency; or

borrowing or lending funds where the amount to be repaid or received is denominated in a foreign
currency.

Each of these transactions gives rise to a foreign currency-denominated asset or a liability for the company.

1.1  Foreign Currency Transaction Exposure to Foreign Exchange Risk

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Suppose that a U.S. company purchases (imports) goods worth €1m from a German company, and must
pay for the goods in EUR within 90 days. By deferring payment, the U.S. company runs the risk that the EUR
will appreciate versus the USD, in which case it would need to expend more USD to settle the €1m
obligation. The U.S. company is said to have foreign currency transaction exposure.

For an import purchase, foreign exchange transaction exposure for the importing company arises
when it defers a payment that must be made in foreign currency. The importer faces the risk that the
value of the foreign currency will increase between the purchase date and the settlement date.
Appreciation of the foreign currency would mean that the importer will have to spend more units of
domestic currency to purchase the required amount of foreign currency to settle the obligation.
For an export sale, foreign exchange transaction exposure for the exporting company arises when it
allows the purchaser to make the payment sometime after the purchase date and agrees to be paid
in foreign currency. The exporter faces the risk that the value of the foreign currency will decrease
between the date of sale and the settlement date. Depreciation of the foreign currency would mean
that the exporter will receive a lower number of units of domestic currency upon converting the
foreign currency amount when it is received.

An important thing for you to note is that all foreign currency transactions are recorded at the spot
exchange rate on the transaction date. Foreign currency transaction risk only arises when the payment and
settlement dates are different.
Both U.S. GAAP and IFRS require that changes in the value of a foreign currency asset/liability resulting
from a foreign currency transaction be recognized as gains/losses on the income statement (see Example
1.1). The exact amount of gains/losses recognized depends on:

Whether the company has an asset or a liability that is exposed to foreign exchange risk.
Whether the foreign currency increases or decreases in value versus the domestic currency.

Example 1.1
Accounting for Foreign Currency Transactions
U.S.Co purchases goods from GermanCo for €200,000 on September 1, 2008, and agrees to make the
payment in EUR in 60 days. U.S.Co's functional and presentation currency is the USD. Spot exchange
rates between the EUR and USD are as follows:

September 1, 2008: $/€ = 1.3805

October 31, 2008: $/€ = 1.4025

Given that U.S.Co's accounting year ends on December 31, how will this foreign currency transaction
affect the company's financial statements?
Solution:

U.S.Co prepares its accounts in USD. On the transaction date (September 1, 2008) it recognizes a liability
of $276,100. This is because on the transaction date, U.S.Co could have settled the transaction by
purchasing and delivering €200,000 to GermanCo at the then-current spot exchange rate (1.3805$/€).
U.S.Co would have been able to purchase €200,000 for $276,100 (calculated as €200,000 × 1.3805$/€) on
the transaction date.

Instead, U.S.Co settles the obligation 60 days after the transaction date. In the period between the
transaction and settlement dates, the EUR has appreciated relative to the USD. U.S.Co actually ends up
paying $280,500 (calculated as €200,000 × 1.4025$/€) to purchase €200,000 on October 31. By deferring
the payment, U.S.Co incurs a loss of $4,400 (calculated as $280,500 − $276,100) on the transaction. This

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is a realized loss (as the company actually paid $4,400 more than the original obligation it recognized on
its USD-denominated financial statements), which is reported on U.S.Co's 2008 income statement.

In Example 1.1, the transaction date and the settlement date occurred in the same reporting period (2008).
If the balance sheet date occurs between the transaction date and settlement date:

Foreign exchange gains/losses (based on changes in the exchange rate between the transaction date
and the balance sheet date) are still recognized on the income statement (even though they have not
been realized) for the period in which the transaction occurred.
Once the transaction is settled, additional gains/losses are recognized (based on changes in the
exchange rate from the balance sheet date till the settlement date) in the period during which the
transaction was settled.
Aggregating the foreign exchange gains/losses over the two accounting periods results in an amount
that equals the actual realized gain/loss on the foreign exchange transaction (see Example 1.2).

Example 1.2
Accounting for Foreign Currency Transactions
U.S.Co exports goods worth £15,000 to U.K.Co on November 30, 2008, and agrees to be paid in GBP on
January 31, 2009. U.S.Co's functional and presentation currency is the USD. Spot exchange rates
between the GBP and USD are as follows:

November 30, 2008: $/£ = 1.5054

December 31, 2008: $/£ = 1.5386
January 31, 2009: $/£ = 1.4975

Given that U.S.Co's accounting year ends on December 31 how will this foreign currency transaction
affect its financial statements?
Solution:
On November 30, 2008, U.S.Co will recognize an asset (receivable) worth $22,581 (calculated as £15,000 ×
1.5054$/£ = $22,581). This amount represents the USD value of the receivable based on the spot
exchange rate on the transaction date.
The company's year-end is December 31, which falls between the transaction date and the settlement
date. Therefore:

On its 2008 financial statements, the company is required to recognize (unrealized) foreign
exchange gains/losses based on the change in the USD-denominated value of the receivable due
to changes in the exchange rate from the transaction date till the balance sheet date.
The value of the receivable rises to $23,079 (calculated as £15,000 × 1.5386$/£) on December
31, 2008.
Therefore, U.S.Co recognizes a profit of $23,079 − $22,581 = $498 on its income statement for
2008.
Since the transaction is settled in 2009, the company is required to recognize on its financial
statements for 2009, foreign exchange gains/losses based on the change in the USD-denominated
value of the receivable due to changes in the exchange rate between the balance sheet date and
the settlement date.
The value of the receivable falls to $22,462.50 (calculated as £15,000 × 1.4975$/£) on January
31, 2009.

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Therefore, U.S.Co recognizes a loss of $23,079 − $22,462.50 = $616.50 on its income

statement for 2009.
The aggregate foreign currency gain (loss) recognized over the two accounting periods
(2008−2009) by U.S.Co equals $498 − $616.50 = −$118.50.
The overall gain (loss) can also be calculated as the USD-denominated value of the
receivable on the settlement date ($22,462.50) minus the USD-denominated value of the
receivable on the transaction date ($22,581), which equals −$118.50.

Note that in Example 1.1:

U.S.Co had a liability exposure (in the form of an account payable) to foreign exchange risk. As the
foreign currency (EUR) appreciated, U.S.Co recognized a loss as the USD-denominated value of its
liability increased.

Further, in Example 1.2:

U.S.Co had an asset exposure (in the form of an account receivable) to foreign exchange risk. As the
foreign currency (GBP) appreciated (from the transaction date until the balance sheet date) U.S.Co
recognized a gain as the USD-denominated value of its asset increased.
As the foreign currency (GBP) depreciated (from the balance sheet date till the settlement date)
U.S.Co recognized a loss as the USD-denominated value of its asset decreased.

Table 1.1 summarizes how the nature of a company's exposure to exchange rate risk and the direction of
change in the value of the foreign currency impact the foreign exchange gain or loss recognized by a
company.

Table 1.1   
    Foreign Currency
Transaction Type of Exposure Strengthens Weakens
Export sale Asset (account receivable) Gain Loss
Import purchase Liability (account payable) Loss Gain

1.2  Analytical Issues
Both IFRS and U.S. GAAP require foreign exchange transaction gains/losses to be recognized on the income
statement, regardless of whether or not they have been realized. However, neither set of standards
specifies where on the income statement these gains/losses must be presented. Companies usually report
foreign exchange transaction gains/losses:

as a component of other operating income/expense; or

as a component of nonoperating income/expense.

This choice can have a substantial impact on the reported operating profit margin.

If a foreign currency transaction gain is recognized as a part of operating income, the operating profit
margin would be higher than it would be were the transaction gain recognized as a part of
nonoperating income.

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If a foreign currency transaction loss is recognized as a part of operating expenses, the operating
profit margin would be lower than it would be were the transaction loss recognized as a part of
nonoperating expenses.
Note that the placement of the foreign currency transaction gain/loss (under operating
income/expense versus nonoperating income/expense) has no impact on the gross profit and net
profit margins.

Another analytical issue relating to foreign currency transaction gains/losses is that when the balance sheet
date lies between the transaction and settlement dates, the eventual translation gain/loss recognized can
be significantly different from the amount recognized initially. Notice (in Example 1.2) how the foreign
currency transaction gain recognized in 2008 ($498) does not accurately reflect the loss that was ultimately
realized in 2009 ($118.50).

1.3  Disclosures Relating to Foreign Currency Transaction Gains and

Losses
IFRS and U.S. GAAP require disclosure of the aggregate amount of foreign currency transaction gains and
losses included in net income for the period, but do not require disclosure of whether they are classified as
operating or nonoperating income/expenses. Further, details regarding the exact line item in which these
gains/losses are included is also not required.

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Flashcards
Lesson 1: Defining the Presentation Currency, Functional Currency, Local Currency, and Foreign

Currency Transaction Exposure

1
fc.L2R16L01.0001_1812

List foreign currency-related activities that

require special accounting treatment. Transactions denominated in foreign
currencies.

Investment in foreign subsidiaries that keep

their accounts in foreign currencies.

2
fc.L2R16L01.0002_1812

RC: Currency of the country where the parent

Distinguish among presenting (reporting)
currency, functional currency, and local
currency.
is located and in which it reports financial
results.
FC: Currency in which the entity generates
and expends cash; operational currency.

LC: Currency of the country where the

subsidiary operates.

3
fc.L2R16L01.0003_1812

Transactions exposure results from an import

Describe foreign currency transaction purchase or an export sale, usually reported
exposure, including accounting for and as a component of other operating income or
disclosure of foreign currency transaction expense, or in nonoperating income or
gains and losses. expense.

When the balance sheet reporting period falls

between transaction and settlement date,
currency transaction gains and losses are
reported in net income.

4
fc.L2R16L01.0004_1812

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Explain IFRS and U.S. GAAP disclosure
requirements relating to foreign currency
transaction gains and losses.
IFRS and U.S. GAAP require disclosure of the
aggregate amount of foreign currency
transaction gains and losses included in net
income for the period, but do not require
disclosure of whether they are classified as
operating or nonoperating income/expenses.

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