Overview

Foreign Exchange Fluctuations

There are many things to know and remember about foreign exchange fluctuations. This lesson will focus on the five accounting transactions and adjustments for
reporting that these fluctuations impact. The basis for this is to understand both the direct and indirect currency quotes and how to apply them to the transactions
and adjustments. Familiarity with ASC Topic 830 will help with this.

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

Demonstrate an understanding of the impact of foreign exchange fluctuations (2A.4.a):

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

Define functional currency.

Calculate the financial ratio impact of a change in exchange rates.

Discuss the possible impact on management and investor behavior of volatility in reported earnings.
Study Guide
Foreign Exchange Fluctuations

I. There has been rapid expansion of U.S. companies operating globally that exposes them to transactions denominated in foreign currencies. For the purpose of
this lesson we will assume that a U.S. company is the parent company and the subsidiary is operating in a foreign country.
A. U.S. 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 U.S. parent company's financial statements
B. These businesses will have multiple transactions in many currencies during the year. When the U.S. company's consolidated financial statements are
prepared these transactions, as well as the financial statements of their foreign subsidiary, must be converted to U.S. dollars. Once the conversion is
done the amounts can be added together.
C. The conversion is done using an exchange rate. The rates are quoted as a spot rate, meaning the rate that day. Sometimes it is referred to as the rate on
the date of the balance sheet, for example. The exchange rates are given in either a direct or indirect quote.
1. Direct quote: states the number of units of the domestic currency that can be converted into one unit of a foreign currency: $1.20 to £1 means one
U.S. dollar and 20 cents can be exchanged for one British pound.
2. Indirect quote: states the number of units of the foreign currency that can be converted into one unit of the domestic currency: £.83 to $1.00 means
.83 British pounds can be exchanged for one U.S. dollar. Said another way, one U.S. dollar will get you .83 British pounds. This is calculated as £1
divided by $1.20 = £.83.
D. The exchange rate of a specific currency can be allowed to fluctuate based on supply and demand or fixed by a government. When a currency falls
relative to another currency it has weakened against that other currency. When a currency rises relative to another currency it has strengthened against
that other currency. These are called currency fluctuations. These fluctuations result in gains or losses being recorded.
1. A sale denominated in a foreign currency means the accounts receivable is denominated in the foreign currency as well. If the dollar weakens, an
exchange gain is recorded on the balance sheet date. Accounts receivable increases and the gain increases net income.
2. For a purchase denominated in a foreign currency, the accounts payable is denominated in the foreign currency also. If the dollar weakens, an
exchange loss is recorded on the balance sheet date. Accounts payable increases and the loss decreases income.
E. Imports and exports are the most common type of foreign currency transactions. ASC Topic 830, has two requirements for foreign currency transactions:
1. At the date of a foreign currency transaction each account used in the recording of the transaction will be measured using the functional currency
(most often the reporting currency) using the exchange rate on that date.
2. At each balance sheet date, all balances will be adjusted to reflect the exchange rate on that balance sheet date.
Transactions recorded to accounts receivable and accounts payable will require an additional adjustment if the exchange rate has changed from
the balance sheet date in item D. above to the payment date.
F. There are two different translation methods identified in ASC Topic 830 to convert a foreign subsidiary's financial statements into U.S. dollars for
consolidation. The method used is determined by the functional currency used by the subsidiary. The company has no choice. A functional currency is
the currency of the primary economic environment the subsidiary operates in. Therefore, the subsidiary's local currency is its functional currency based
on its sales market, how selling price is determined, where expenses are incurred, source of financing, and extent of intercompany transactions.
1. When the subsidiary has transactions that were conducted in multiple currencies, these transactions must first be translated to the subsidiary’s
functional currency.
2. Subsidiary's currency is now adjusted to the functional currency: re-measure the financial statements into parent's currency using the historical
rate/temporal method.
a. Nonmonetary accounts are translated at historical rate. These accounts are marketable securities carried at cost; inventories carried at cost
and cost of sales; prepaid expenses; property, plant and equipment as well as depreciation expense.
b. Monetary accounts are cash, receivables, and payables. These are translated using the current exchange rate on the balance sheet date.
3. Subsidiary's currency is the functional currency: translate the financial statements into the parent's currency using the current rate method. All
assets and liabilities are translated using the exchange rate on the balance sheet date.
G. There are three steps to consolidate a foreign subsidiary into the parent's financial statements:
1. Modify the subsidiary's financials to conform to U.S. GAAP.
2. Re-measure the trial balance into the functional currency only when the subsidiary has conducted transactions in multiple currencies.
3. Translate the financials from the functional currency into the reporting currency. This requires the parent to prepare worksheet eliminations before
they consolidate the foreign subsidiary into the parent company.
H. The income statement and accompanying notes should provide information about the aggregate gains or losses from foreign subsidiaries during the
accounting period. The translation adjustments are usually presented showing the beginning amount of cumulative translation adjustments, plus or
minus the aggregate adjustment, and the resulting ending amount of cumulative translation adjustments. The amount of the current year adjustment is
reported on the statement of comprehensive income.

Summary
Global expansion of so many companies exposes them to foreign exchange fluctuations. Both sales and purchases made abroad are denominated in a foreign
currency. Fluctuations can have a positive or negative impact on the actual dollars exchanged for these transactions. Focus on how currencies are quoted to be
able to calculate the amounts and any fluctuations between transaction dates. ASC Topic 830 specifies two important dates. The first is the foreign currency
transaction date and the second is at the subsequent balance sheet date.
Flashcards
Foreign Exchange Fluctuations

1
FC.forex.fluctuations.FC001_1709

When a U.S. company operates globally and its financial statements Foreign transactions and the foreign subsidiary's financial statements
are to be consolidated with a foreign subsidiary, what must first must be converted (translated) to U.S. dollars using an exchange rate.
happen?

2
FC.forex.fluctuations.FC002_1709

In regards to exchange rates, what's the difference between a direct A direct quote states the number of units of the domestic currency that
quote and an indirect quote? can be converted into one unit of a foreign currency, whereas an
indirect quote states the number of units of the foreign currency that
can be converted into one unit of the domestic currency.

3
FC.forex.fluctuations.FC003_1709

What are currency fluctuations? Currency fluctuations are when the exchange rate of a specific
currency fluctuates based on supply and demand. When a currency
falls relative to another currency it has weakened against that other
currency. When a currency rises relative to another currency it has
strengthened against that other currency.

4
FC.forex.fluctuations.FC004_1709

What is a functional currency? A functional currency is the currency of the primary economic
environment the subsidiary operates in.

5
FC.forex.fluctuations.FC005_1709

If the subsidiary's currency is not the functional currency, first, re-

How does the consolidation process of a subsidiary change when the measure the financial statements into parent's currency using the
subsidiary's currency is not the functional currency vs. when it is? historical rate/temporal method. Then, translate nonmonetary
accounts at historical rate and monetary accounts at the current
exchange rate on the balance sheet date.

If the subsidiary's currency is the functional currency, translate the

financial statements into the parent's currency using the current rate
method.

6
FC.forex.fluctuations.FC006_1709
What are the three steps to consolidate a foreign subsidiary into the
parent's financial statements?
1. Modify the subsidiary's financials to conform to U.S. GAAP.
2. Re-measure the trial balance into the functional currency only if
the subsidiary's is not the functional currency.
3. Translate the financials from the functional currency into the
reporting currency.
Notes
Foreign Exchange Fluctuations

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