WU, COBE.

ACF, ADVANCED ACCOUNTING-II CHAPTER FOUR HANDOUT

CHAPTER FOUR
FOREIGN CURRENCY ACCOUNTING
4.1. INTRODUCTION
Each country uses its own currency as the unit of value for the purchase and sale of goods and
services. The currency used in the United States is the U.S. dollar, the currency used in Mexico is
the Mexican peso, and so on. If a U.S. citizen travels to Mexico and wishes to purchase local
goods, Mexican merchants require payment to be made in Mexican pesos. To make a purchase, a
U.S. citizen has to acquire pesos using U.S. dollars. The foreign exchange rate is the price at
which the foreign currency can be acquired. A variety of factors determine the exchange rate
between two currencies; unfortunately for those engaged in international business, the exchange
rate can fluctuate over time.
4.2. Types of currency-related exposures
Foreign currency risk – the net potential gain or loss which can arise from exchange rate changes
to the foreign currency exposure of the enterprise. In this context foreign currency risks can be
viewed as having three components:
1. Translation exposure (accounting exposure):- this exposure results from the translation of
foreign currency denominated financial statements into dollars. Only those financial
statement items translated at current rate of accounting create an accounting exposure
2. Transaction exposure: - this exposure exists between the time of entering a transaction and
the time of settling it. It affects the current cash flows of the enterprise. The resulting cash
gains and losses are realized and affect the enterprise’s working capital and earnings
3. Economic exposure – it arises because of the possible reduction, in terms of the domestic
reporting currency of the discounted future cash flows generated from foreign investments
or operations due to real changes (inflation adjusted) in exchange rates. It represents a long-
term potential threat or benefit to a company carrying out business in foreign countries.
4.3. Accounting for Foreign Currency Transactions
A foreign currency transaction is a transaction that is denominated or requires settlement in a
foreign currency, including transactions arising when an entity:

 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; or

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 Otherwise acquires or disposes of assets, or incurs or settles liabilities, denominated in a

foreign currency.
In most countries foreign currency is treated as a commodity or a money-market instrument. The
buying and selling of foreign currency as commodity results in variation in its exchange rate. A
“Multi-National Company” is one that conducts its business in more than one country via
branches, joint ventures, subsidiaries etc. If all its transactions are accounted for in one currency,
no problem arises, however often local currencies are used which must be denominated in some
other currency – the country where the country is headquarter. The transactions engaged into by
the multinational company must be recorded in the reporting currency in the accounting records
of the enterprise. The company uses the appropriate spot rate is used for this purpose.

If the spot exchange rate for the foreign currency changes on the date of financial statement
preparation prior to settlement of the transaction, or on the settlement date itself, a foreign
currency transaction gain or loss is recognized for display in the income statement of the
enterprise for the accounting period in which the rate changes.For purchase of merchandise from a
foreign supplier, the selling spot rate is used to determine the local currency denomination.

There are many reasons why a country’s currency price changes of which the major one are the
following,

 Inflation rates
 Interest rates and
 Trade surplus and deficits
Exchange rate showing the value of Canadian dollar in terms of other foreign currency are quoted
daily in many Canadian newspapers. The amounts that usually appear are called direct quotations,
which means that the amount represents the cost in Canadian dollar to purchase one unit of foreign
currency. For example a quotation of 1 pound = CDN$2.2972 means that it cost 2.2972 Canadian
dollars. An indirect quotation will state the cost in a foreign currency to purchase 1 Canadian
dollar
Illustration
Accounting for a foreign currency transaction is illustrated using the following rates:
Date Rate (US$ / C$)
Jan 31 1.53
Feb 28 1.55

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Mar 30 1.56
A Canadian firm purchases merchandise with an invoice price of $1,000 US on January 31, with
payment due March 30, and a fiscal year end of February 28. What entries are necessary?
At the date of purchase, this entry would be made:
Purchases 1,530
Accounts Payable 1,530
By the end of the fiscal year, the firm has incurred a $20 loss, as the firm is now liable for
C$1,550, rather than the C$1,530 at which the transaction was initially recorded conceptually, the
firm has essentially three alternatives at year end:
 Ignore the fluctuation
 Adjust the amount of the purchase (called the one transaction approach)
 Recognize the change in currency value as an exchange loss (the two transaction approach)
Ignoring the loss is potentially dangerous, Adjustment of the price of the transaction does not
reflect the real economic events
The two transaction approach is the preferred (and generally accepted) alternative
The recognition of the exchange rate fluctuation as a separate economic event is consistent with
the view that the purchase is entirely separate from any arrangement which may have been made
for payment
At fiscal year end, the recognition of the loss is recorded in the following manner
Foreign Currency Loss 20
Accounts Payable 20
At this time, the foreign currency liability is now reported at its Canadian dollar equivalent, and
the loss is recognized in the period in which it has occurred. At final payment, this entry is made:
Accounts payable 1,550
Foreign Currency Loss 10
Cash 1,560
This further loss is also recognized in the period in which it occurs
In all cases, the foreign currency loss is a period cost, recognized in the period in which the
change in exchange rates took place Canadian companies have no particular advantage when
dealing internationally, and must frequently accept that international transactions are to be
denominated in a foreign currency rather than Canadian. These foreign currency transactions must
be recorded in the reporting currency of the company. The assets and liabilities denominated in the

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foreign currency must be repaid in that currency, so the Canadian company will bear the risks and
costs associated with the inevitable currency fluctuations.

How does accounting for foreign currency transactions work?

When the transaction is initially entered, the amounts are recorded in the reporting currency of the
companies entering into the transaction. At each statement date, the foreign currency amount is
restated to the reporting currency equivalent, and a gain or loss is recognized. At the time of
settlement of the asset or liability, the amount is again restated to the reporting currency
equivalent, and a further gain or loss is recognized

4 . 4 . F O R E I G N C U R R E N C Y T R A N S L AT I O N

Business firms conduct operations in countries other than their home country through branch
offices, subsidiaries, affiliates, joint ventures, and other entities. Domestic firms account for their
foreign investments following the same accounting principles that they use for domestic
investments:

1. The fair value method when the ownership percentage does not convey significant influence,
usually less than 20 percent
2. The equity method when the ownership percentage does convey significant influence,
usually between 20 percent and 50 percent
3. The consolidation method for majority-owned investments (unless government restrictions
severely constrain a parent company’s ability to exercise control of the foreign subsidiary)

The foreign entities keep their accounting records in their local currencies. To apply the
appropriate accounting method for these investments, the reporting entity (say, the U.S. parent)
must translate the foreign (say, U.K.) entity’s financial statements from the foreign currency
(pound sterling, £) into the reporting currency (dollar, $), a process known as foreign currency
translation.

Translating the financial statements of foreign entities requires responses to two questions:

1. Which exchange rate should a firm use to translate each account in a foreign entity’s
financial statements?

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2. How should the firm treat any adjustment, analogous to a gain or loss that arises from
translation?
4.4.1. Exchange Rate Used in Translation
Accounting distinguishes between the historical exchange rate and the current exchange rate. The
historical exchange rate refers to the exchange rate in effect when a firm first recorded a
particular transaction. The historical exchange rate for inventories, property, plant, and equipment
is the exchange rate at the time the firm acquired these items. The historical exchange rate for
bonds payable and common stock is the exchange rate at the time the firm issued these securities.
The current exchange rate refers to the exchange rate at the date of the balance sheet for balance
sheet items and to the actual exchange rate at the time of income transactions during the current
period (or the average exchange rate as an approximation to the actual exchange rate) for income
statement items. Firms could conceivably use the historical exchange rate for each financial
statement item, the current exchange rate for each item, or some combination of the two.

4.4.2. Treatment of Changes in Amounts that Result from Translation

Translating the amount of a financial statement account measured in a foreign currency into units
of the reporting currency may give rise to an adjustment, depending on the exchange rate used in
translation.

 When firms translate foreign currency amounts into reporting currency amounts using the
historical exchange rate, changes in exchange rates do not affect the reporting currency
amount of that item because, by definition, those items appear in the reporting currency at
their acquisition cost translated at the exchange rate on the date of acquisition for assets (or on
the date of issue for equities).

 When firms translate foreign currency amounts into reporting currency amounts using the
current exchange rate, changes in exchange rates do affect the reporting currency amount of
that item because those items have reporting currency amounts different from those at the date
of acquisition for assets (or at the date of issue for equities).

When the reported amount of these items varies as a result of a change in the exchange rate,
accountants refer to the amount as a foreign exchange adjustment. Firms might conceivably treat
the foreign exchange adjustment in one of two ways:

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1. Include the amount as a foreign exchange gain or loss in the computation of net income for
the period, which firms then close to retained earnings.

2. Include the amount as a foreign exchange adjustment in other comprehensive income, a

separate component of the shareholders’ equity account, bypassing the income statement.
This treatment resembles that for unrealized holding gains and losses on marketable equity
securities classified as available for sale.

These two treatments result in identical total shareholders’ equity. They differ with respect to the
effects that the foreign exchange adjustment has on net income and on particular shareholders’
equity accounts. U.S. GAAP and IFRS require firms to use the historical exchange rate in some
situations and the current exchange rate in others. The appropriate exchange rate depends both
on whether a particular foreign operation uses a foreign currency as the primary currency for
conducting its operations or whether it uses the reporting currency as its primary currency for
operations. The next section explains U.S. GAAP and IFRS more fully.

4.5. U.S.GAAP and IFRS FOR FOREIGN CURRENCY

T R A N S L AT I O N

We discuss and illustrate next the U.S. GAAP and IFRS provisions for foreign currency
translation. We begin with a discussion of the functional currency and then illustrate foreign
currency translation procedures. FUNCTIONAL CURRENCY U.S. GAAP and IFRS require firms
to identify the functional currency of each foreign entity. The functional currency refers to the
currency of the primary economic environment in which each foreign entity operates. The
functional currency depends on the operating characteristics of the foreign entity. Statement of
Financial Accounting Standards (SFAS) No. 52 requires firms to classify each foreign entity into
one of two categories:

1. Autonomous: foreign operations are primarily contained within a particular foreign country.
That is, the foreign entity obtains capital, acquires inventories and labor services, sells to
customers, and retains earnings within the foreign country. The currency of the foreign
entity is the functional currency for self-contained foreign operations.
2. Extension of parent entity’s operations: foreign operations are primarily an extension of the
parent’s operations. That is, the foreign entity obtains capital from the parent company or
borrows in the currency of the parent, acquires inventories from the parent, and remits

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earnings back to the parent. The reporting currency is the functional currency for foreign
units that operate as extensions of the parent.
Exhibit 1 lists the five attributes of SFAS No 52 for identifying the functional currency and
characteristics that suggest use of the currency of the foreign entity as the functional currency and
those that suggest use of the reporting currency as the functional currency.

Exhibit 1
Factors for Identifying the Functional Currency of a Foreign Unit under U.S. GAAP
Currency of Foreign Entity Reporting Currency is the
Attributes is the Functional Currency Functional Currency
Cash Flows of Foreign Receivables and payables Receivables and payables
Entity denominated in foreign denominated in reporting
currency and not usually currency and readily
remitted to parent currently available for remittance to
parent
Sales Prices Influenced primarily by local Influenced by worldwide
competitive conditions and competitive conditions and
not responsive on a short- responsive on a short-term
term basis to exchange rate basis to exchange rate
changes changes
Cost Factors Foreign entity obtains labor, Foreign entity obtains labor,
materials, and other inputs materials, and other inputs
primarily within its own primarily from the country of
country the reporting entity
Financing Financing denominated in Financing denominated in
currency of foreign entity or currency of the reporting
generated internally by the entity or ongoing fund
foreign entity transfers from the parent

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Relations between Parent Low volume of High volume of

and Foreign Entity intercompany transactions intercompany transactions
and little operational and extensive operational
interrelations between parent interrelations between parent
and foreign entity and foreign entity

The facts need not clearly signal a unique classification: a particular foreign operation can
combine aspects of the self-contained entity while still being integrated with the parent. For
example, a foreign unit may acquire raw materials from the reporting entity and remit 50 percent
of its earnings back to the reporting entity but may obtain funds within the foreign country and
sell primarily to local customers. Management must weigh all of the evidence to decide which
characterization better describes the foreign operation.
International Accounting Standard (IAS) 21 uses similar factors to SFAS No. 52 in identifying the
functional currency but places different weights on the various factors. The primary economic
environment in which a foreign entity operates, the determinant of the functional currency, is the
one in which it generates and expends cash. The cash flows of primary importance are those
related to the purchase and sale of goods and services. Firms consider:
1. The currency that primarily influences sales prices for goods and services (usually the
currency in which the foreign entity denominates and settles sales of its goods and
services).
2. The currency of the country whose competitive forces and regulations primarily
influence the sales prices.
3. The currency that primarily influences labor, material, and other costs of providing
goods and services (usually the currency in which suppliers denominate and require
settlement of such goods and services).
These three factors are the primary factors in identifying the functional currency under IFRS.
Additional factors to consider if these three factors do not clearly identify the functional currency
include the following:
1. The currency in which the foreign entity generates funds from financing.
2. The currency in which the foreign entity retains cash flows from operating activities.
3. The proportion of the activities of the foreign entity with the reporting entity.

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4. The extent to which the cash flows from the activities of the foreign entity remain with
the foreign entity or are readily available for remittance to the reporting entity.
5. The extent to which the cash flows of the foreign entity are sufficient to service debt
obligations without funds from the reporting entity.
6. Whether the activities of the foreign entity are an extension of the reporting entity
instead of carried out with a significant degree of autonomy.
Note two important differences between U.S. GAAP and IFRS with respect to identifying the
functional currency:
1. U.S. GAAP uses a broad set of operating and financing criteria, whereas IFRS places
heavier weight on the currency in which a foreign entity makes purchases and sales of
goods and services.
2. U.S. GAAP uses the distinction between an autonomous foreign unit and a unit operating
as an extension of the as a primary scheme for identifying the functional currency,
whereas IFRS treats this distinction as only one additional factor to consider.
Thus, the functional currency of a foreign entity might differ depending on whether a reporting
entity uses U.S. GAAP or IFRS.
4.5.1. Foreign Currency Translation Provisions
The following summarizes the provisions for foreign currency translation
1. Both SFAS No.  52 and IAS 21 require the all-current translation method for self-
contained, or autonomous, foreign entities (functional currency is that of the foreign
entity or some foreign currency other than that of the reporting entity).
2. SFAS No. 52 requires the monetary-nonmonetary translation method for foreign entities
that operate as extensions of the reporting entity (functional currency is that of the
reporting entity). IAS 21 also requires use of the monetary-nonmonetary method in
these cases, but recall that for the functional currency of a foreign entity to be that of
the reporting entity under IFRS requires use of the additional factors in identifying the
functional currency.
4.6. Rationale for Foreign Currency Translation Provisions
Implicitly underlying the foreign currency translation procedures required by U.S. GAAP and
IFRS are two types of U.S. management control patterns for foreign operations:

 When a domestic parent invests in self-contained foreign operations and does not expect to
recapture its investment for several years, it puts its investment at risk to exchange rate

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changes. It delegates to managers in the foreign country the day-to-day management

decisions. Whether those foreign managers choose highly leveraged or conservative
financing, the U.S. parent considers only its own investment at risk and has put that
investment at risk for several years. The next section illustrates the method required for
self-contained foreign operations—the all-current translation accounting method. This
method calculates an exchange adjustment based on the parent’s investment in the
shareholders’ equity (= assets – liabilities) of the foreign unit. Because the parent intends to
allow the foreign unit to retain the net assets represented by its investment for many years,
U.S. GAAP and IFRS require firms to include the exchange adjustment in Accumulated
Other Comprehensive Income, a separate shareholders’ account, not in periodic net income.
For the investor in a self-contained foreign operation, U.S. GAAP and IFRS attempt to
present results as though the investor sees only its investment at risk, not the individual
assets and liabilities or the results of day-to-day operations.

 In contrast, management of a domestic parent extending its operations into a foreign country
has day-today control of assets, liabilities, and operations. It intends to require the foreign
entity to remit assets generated by earnings to the parent on an ongoing basis. Remitting
assets generated by periodic earnings will likely require the foreign entity frequently to
convert foreign currency into currency of the reporting entity. Thus, the assets generated by
foreign earnings are subject to exchange rate changes on a current basis. U.S. GAAP and
IFRS require such firms to include the exchange adjustment in net income each period by
using the monetary-nonmonetary translation method. The managers of the parent concern
themselves with the affiliate’s day-to-day operations. The monetary-nonmonetary translation
method attempts to reflect, in the reporting entity’s financial statements, this day-to-day
control that managers have over their integrated and extended foreign operations.

4.7. Foreign Currency Translations Methods \

a. ALL-CURRENT TRANSLATION METHOD

Self-contained foreign operations (where the functional currency is a foreign currency) must use
the all-current translation method. The all-current method translates assets and liabilities using the
exchange rate on the date of the balance sheet. It translates revenues, expenses, and net income
using the actual exchange rate at the date of transactions during the period (or the average
exchange rate during the period as an approximation). The foreign exchange adjustment that
results from applying the all-current method appears in other comprehensive income and then

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Accumulated Other Comprehensive Income, a separate shareholders’ equity account, and does not
affect net income each period. The rationale for the all-current method for self-contained foreign
operations results from the fact that only an investor’s investment in the net assets of the foreign
unit is at risk to exchange rate changes. That is, the U.S. investor has put at risk an amount equal to
the shareholders’ equity of the foreign unit. A decision to invest in a foreign unit and to permit the
foreign unit to retain, for internal growth, assets generated by earnings means that the parent will
not realize the benefit or incur the loss from exchange rate changes inherent in its net asset position
until either the foreign unit remits a dividend or the parent sells the foreign unit. Because such
events will not likely occur for many years, net income excludes the foreign exchange adjustment
each period under the all-current translation method.
b. MONETARY-NONMONETARY(TEMPORALMERHOD)TRANSLATION
METHOD
The accounting for foreign operations either highly integrated with a U.S. parent company (U.S.
GAAP) or where the functional currency of a foreign entity is the reporting currency must use the
monetary-nonmonetary translation method. The monetary-nonmonetary translation method
provides translated amounts for a foreign unit similar to the amounts that the parent would report if
it engaged in export transactions to carry out its foreign operations (that is, if it manufactured
goods in the country of the parent and then sold them to customers abroad) instead of operating
through a foreign entity. Because the operations of integrally related foreign units resemble export
activities, domestic firms achieve comparable reported amounts for both types of activities by
using the monetary-nonmonetary translation method.
The monetary-nonmonetary method translates monetary assets and liabilities using the current
exchange rate and translates nonmonetary assets and liabilities using the historical exchange rate.
Monetary items represent claims receivable or payable in a fixed number of foreign currency units
regardless of changes in exchange rates. Monetary items include cash, accounts receivable,
accounts payable, bonds payable, and most liabilities other than Advances from Customers.
Because firms translate monetary items using the current exchange rate, a foreign exchange
adjustment arises for these items when exchange rates change. The firm includes the foreign
exchange adjustment as an exchange gain or loss in measuring net income each period under the
monetary-nonmonetary method. The rationale results from noting that the foreign unit must
regularly convert currency (in this case from dollars to pounds or vice versa) to settle its
receivables or payables and will therefore realize the gain or loss in the near term. This near-term

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realization contrasts with the longer-term realizability of the foreign exchange adjustment from
self-contained foreign operations translated using the all-current method.
Nonmonetary items include inventories, prepayments, property, plant and equipment,
intangible assets, advances from customers, and common stock. Unlike monetary items,
nonmonetary items do not result in a fixed future cash inflow or outflow. Translating nonmonetary
items using the historical exchange rate results in reporting them at constant reporting-currency
amounts regardless of changes in the exchange rate.

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