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Foreign Currency Transactions


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Used for MBA professional accounting class room presentation and it includes FASB rules and forex currency dealings details for purchase and sale of goods and services with foreign party.

Published in: Economy & Finance, Business
  • Any transaction for personal use is not be entered through the company's records unless if it is done by using the company's funds. If so, you need to debit advance till it is recovered.
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  • Just want to inquire, what is the entry if you purchase a foreign currency for personal use?
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  • hope you allow me to save this. I find it helpful for my report in our class. i'm a student and i'll be reporting on this topic.
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  • so easy to understand, it can be recommend for all beginners particularly students.
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  • Dear,Sir

    Please help me to Exchange UIA currency to my Bank Account
    hear is the website

    Regard : Salam Sunil
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Foreign Currency Transactions

  1. 1. Accounting for Forex Transactions Foreign Currency Transactions
  2. 2. Exchange Rate Mechanisms <ul><li>Prior to 1973, currency values were generally fixed. The US $ was based on the Gold Standard. </li></ul><ul><li>Since 1973, exchange rates have been allowed to fluctuate. </li></ul><ul><li>Several valuation models exist. </li></ul>Independent Float Pegged to Another Currency EURO Dollars
  3. 3. Different Currency Mechanisms <ul><li>Independent Float (the currency is allowed to fluctuate according to market forces) </li></ul><ul><li>Pegged to another currency (the currency’s value is fixed in terms of a particular foreign currency, and the central bank will intervene to maintain the fixed value) </li></ul><ul><li>European Monetary System – A common currency (the euro) is used in different countries. Its value floats against other world currencies. </li></ul>
  4. 4. Foreign Exchange Markets <ul><li>Countries use currencies for internal economic transactions. </li></ul><ul><li>To make transactions in another country, units of that country’s currency may need to be acquired. </li></ul><ul><li>The price at which a currency can be acquired is known as the “exchange rate.” </li></ul>
  5. 5. Foreign Exchange Rates <ul><li>Exchange rates are published daily in the Wall Street Journal. </li></ul><ul><ul><li>These are “end-of-day” rates, as of 4:00pm Eastern time on the day prior to publication </li></ul></ul><ul><li>Remember – Rates change constantly </li></ul><ul><li>The difference between the rates at which a bank is willing to buy and sell currency is known as the “spread.” </li></ul>These are wholesale prices. Retail prices are higher.
  6. 6. Foreign Exchange Rates As the relative strength of a country’s economy changes . . . . . . the exchange rate of the local currency relative to other currencies also fluctuates. ?¥ = $?
  7. 7. Foreign Exchange Rates <ul><li>Spot Rate </li></ul><ul><li>The exchange rate that is available today. </li></ul><ul><li>Forward Rate </li></ul><ul><li>The exchange rate that can be locked in today for an expected future exchange transaction. </li></ul><ul><li>The actual spot rate at the future date may differ from today’s forward rate. </li></ul>
  8. 8. Foreign Exchange Forward Contracts This forward contract allows us to purchase 1,000,000 ¥ at a price of $.0080 US in 30 days. But if the spot rate is $.0069 US in 30 days, we still have to pay $.0080 US and we lose $1,100 !! A forward contract requires the purchase (or sale) of currency units at a future date at the contracted exchange rate.
  9. 9. Foreign Exchange Options Contracts An alternative is an option contract to purchase 1,000,000 ¥ at $.0080 US in 30 days. But it costs $.00002 per ¥. That way, if the spot rate is $.0069 in 30 days, we only lose the $20 cost of the option contract! An options contract gives the holder the option of buying (or selling) the currency units at a future date at the contracted “ strike ” price.
  10. 10. Foreign Currency Option Contracts <ul><li>A “put” option allows for the sale of foreign currency by the option holder. </li></ul><ul><li>A “call” option allows for the purchase of foreign currency by the option holder. </li></ul><ul><li>(Remember: An option gives the holder “the right but not the obligation” to trade the foreign currency in the future.) </li></ul>
  11. 11. Foreign Currency Transactions <ul><li>A U.S. company buys or sells goods or services to a party in another country. This is often called “foreign trade.” </li></ul><ul><li>The transaction is often denominated in the currency of the foreign party. </li></ul>The major accounting issue: How do we account for the changes in the value of the foreign currency?
  12. 12. Foreign Currency Transactions <ul><li>FASB No. 52 </li></ul><ul><li>Requires a two-transaction perspective. </li></ul><ul><li>Account for the original sale in US $ </li></ul><ul><li>Account for gains/losses from exchange rate fluctuations. </li></ul>
  13. 13. Foreign Currency Transactions ? . . . but the cash flow is at a later date . . . . . . fluctuating exchange rates can result in exchange rate gains or losses. When a transaction occurs on one date (for example a credit sale) . . .
  14. 14. Foreign Currency Transactions ? When the rate is expressed as the US $ equivalent of 1 unit of foreign currency, the rate is called a “ DIRECT QUOTE”
  15. 15. Foreign Currency Transactions When the rate is expressed as the US $ equivalent of 1 unit of foreign currency, the rate is called a “ DIRECT QUOTE” When the rate is expressed as the number of foreign currency units that $1 will buy, the rate is called an “ INDIRECT QUOTE”
  16. 16. Foreign Exchange Transaction Example <ul><li>On 12/1/08, Nuuk sells inventory to Coventry Corp. on credit. Coventry will pay Nuuk 10,000 British pounds in 90 days. </li></ul><ul><li>The current exchange rate is $1 = .6425 £. </li></ul><ul><li>Prepare Nuuk’s journal entry. </li></ul>
  17. 17. Foreign Exchange Transaction Example <ul><li>On 12/31/08, the exchange rate is $1 = .6400 £. </li></ul><ul><li>At the balance sheet date we have to “re-measure”, or adjust, the original A/R to the current exchange rate. </li></ul>
  18. 18. Foreign Exchange Transaction Example <ul><li>On 3/1/09, Coventry Corp. pays Nuuk the 10,000 £ for the 12/1/08 sale. </li></ul><ul><li>The exchange rate on 3/1/09, was $1 = .6500 £. </li></ul><ul><li>On 3/1/09, we have to do TWO things. </li></ul><ul><li>First, we must “re-measure” the A/R. </li></ul>
  19. 19. Foreign Exchange Transaction Example <ul><li>On 3/1/09, Coventry Corp. pays Nuuk the 10,000 £ for the 12/1/08 sale. </li></ul><ul><li>The exchange rate on 3/1/09, was $1 = .6500 £. </li></ul><ul><li>On 3/1/09, we have to do TWO things. </li></ul><ul><li>Second, we must record receipt of the £. </li></ul>
  20. 20. Hedging Foreign Exchange Risk <ul><li>Companies will seek to reduce the risks associated with foreign currency fluctuations by “hedging” their exposure </li></ul><ul><li>This means surrendering a portion of potential gains to offset possible losses by entering into a potential transaction whose exposure is the opposite of that for the existing transaction. </li></ul>
  21. 21. Hedging Foreign Exchange Risk To control for the risk of exchange rate fluctuation, a forward contract for currency can be purchased. Hedging effectively reduces the uncertainty associated with fluctuating exchange rates.
  22. 22. Hedging Foreign Exchange Risk <ul><li>To hedge a foreign currency transaction, companies may use foreign currency derivatives </li></ul><ul><li>Two common tools: </li></ul><ul><ul><li>Foreign currency forward contracts </li></ul></ul><ul><ul><li>Foreign currency options </li></ul></ul>
  23. 23. Accounting for Derivatives SFAS 133 provides guidance for hedges of four types of foreign exchange risk. Recognized foreign currency denominated assets & liabilities. Forecasted foreign currency denominated transactions. Unrecognized foreign currency firm commitments. Net investments in foreign operations
  24. 24. Accounting for Derivatives <ul><li>Often a transaction involving a credit sale/purchase is denominated in a foreign currency. </li></ul><ul><li>On the transaction date, the foreign currency receivable/payable is recorded. </li></ul><ul><li>If a forward contract is entered into to hedge the transaction, SFAS No. 133 requires the forward contract be carried at FAIR VALUE . </li></ul>?
  25. 25. An Interesting Footnote <ul><li>When foreign currency loans are made on a long-term basis to a foreign branch, subsidiary or equity method affiliate, SFAS 52 requires that foreign exchange gains and losses be deferred in other comprehensive income until the loan is repaid. Only the forex gains and losses related to the interest receivable are currently recorded in net income. </li></ul>
  26. 26. Translation of Financial Statements If we control our subsidiaries, why don’t they all use the U.S. $ as their currency? Our subsidiaries in other countries are required by local regulations to use the local currency where they are located. Their statements must be translated to US $.
  27. 27. Translation of Financial Statements In addition, many countries have different accounting rules that we must consider before translating the sub’s financial statements.
  28. 28. Exchange Rates Used in Translation <ul><li>To translate a foreign subsidiary’s financial statements into U.S. $, we must use both: </li></ul><ul><li>Historical Exchange Rates and </li></ul><ul><li>Current Exchange Rates. </li></ul>
  29. 29. Exchange Rates <ul><li>Historical Exchange Rates – those which existed at the time a transaction occurred </li></ul><ul><li>Current Exchange Rate – the exchange rate which exists at the balance sheet date </li></ul>
  30. 30. Translation Adjustments <ul><li>The use of different exchange rates during translation means the resulting financial statements will not balance! </li></ul><ul><li>To force the statements to balance, an account called “Translation Adjustment” is debited or credited. </li></ul>
  31. 31. Translation Adjustments <ul><li>Exposure to translation adjustments is called “balance sheet,” “translation,” or “accounting” exposure. </li></ul><ul><li>Assets translated at the current exchange rate when the foreign currency is appreciating (increasing in value relative to the US$) generate positive translation adjustments (a credit entry) </li></ul><ul><li>Liabilities translated at the current exchange rate when the foreign currency is appreciating generate negative translation adjustments (a debit entry) </li></ul>
  32. 32. Balance Sheet Exposure Balance sheet items translated at current exchange rates change in $ value from one balance sheet to the next and are exposed to translation adjustments. Balance sheet items translated at historical exchange rates do not change in $ value from one balance sheet to the next and are NOT subject to balance sheet exposure.
  33. 33. Balance Sheet Exposure Net Asset Balance Sheet Exposure When assets translated at current rates > liabilities translated at current rates. Net Liability Balance Sheet Exposure When liabilities translated at current rates > assets translated at current rates.
  34. 34. Translation Methods Current Rate Method <ul><li>Use current exchange rates to translate all assets and liabilities. </li></ul><ul><li>Use historical (or average) exchange rates to translate equity accounts. </li></ul><ul><li>Use historical (or average) exchange rates to translate income statement accounts. </li></ul><ul><li>Assumes “net investment” in a foreign operation is exposed to foreign exchange risk </li></ul>Parent Subsidiary
  35. 35. Translation Methods Temporal Method <ul><li>Use historical exchange rates to translate assets and liabilities carried at historical cost. </li></ul><ul><li>Use current exchange rates to translate assets and liabilities carried at current cost or future value. </li></ul><ul><li>Use historical (or average) exchange rates to translate equity, revenue, and expense accounts. </li></ul><ul><li>Objective is to produce a set of U.S. dollar translated financial statements as if the foreign subsidiary had actually used U.S. dollars </li></ul>Parent Subsidiary
  36. 36. Disposition of Translation Adjustment <ul><li>Current Method </li></ul><ul><ul><li>Translation Adjustment is reported on the Balance Sheet. </li></ul></ul><ul><li>Temporal Method </li></ul><ul><ul><li>Adjustment is reported on the Income Statement as a Translation Gain or (Loss) </li></ul></ul>
  37. 37. Translation U.S. Accounting Rules <ul><li>SFAS No. 8 (1975) - Accounting for Translation of Foreign Currency Transactions and Foreign Currency Financial Statements. </li></ul><ul><li>SFAS No. 52 (1981) - Foreign Currency Translation. </li></ul><ul><li>SFAS No. 130 (1998) </li></ul>
  38. 38. SFAS No. 52 <ul><li>Recognized two types of subs: </li></ul><ul><li>Subs that do most of their transactions in U.S. $ </li></ul><ul><li>Subs that operate relatively independently of their U.S. parents. </li></ul>Applies the “local currency perspective”. Uses current rate method. Translation adjustment appears in the equity section. Temporal method still applies.
  39. 39. Functional Currency To determine whether a subsidiary is integrated with the parent or operates independently, SFAS 52 introduced the concept of functional currency . A company’s functional currency is the primary currency of the foreign entity’s operating environment.
  40. 40. Summary <ul><li>The existence of different currencies creates an accounting challenge when transactions are denominated in currencies different from those used to keep accounting records </li></ul><ul><li>FASB has adopted a “two-transaction” approach, separating the actual sale or purchase transaction from the currency exchange “speculation” </li></ul><ul><li>A variety of hedging practices may be used to reduce foreign currency exchange risk. The two most popular hedging instruments are foreign currency options and foreign currency forward contracts </li></ul>
  41. 41. Summary <ul><li>Because many US firms have significant financial investments in foreign countries, the translation of foreign currency financial statements is an important accounting challenge </li></ul><ul><li>The two primary methods used are the temporal and current rate methods </li></ul><ul><li>SFAS 52 established translation through the use of the current rate method when the foreign operation’s functional currency is a foreign currency </li></ul><ul><li>re-measurement through the temporal method is appropriate when the operation’s functional currency is the US$, or in the case of a highly inflationary economy </li></ul>
  42. 42. Possible Criticisms <ul><li>Some critics deride the “two transaction” approach adopted by the FASB, arguing that a single transaction has actually occurred. </li></ul><ul><li>Some financial experts feel that the FASB’s definition of what constitutes a hedge is far too narrow. </li></ul><ul><li>There is considerable controversy concerning the appropriate means of valuing options. </li></ul><ul><li>WHAT DO YOU THINK??? </li></ul>
  43. 43. Possible Criticisms <ul><li>Some critics contend that the functional currency decision can be quite subjective. </li></ul><ul><li>Others argue that having two fundamentally different approaches to translation creates confusion. </li></ul><ul><li>Reporting unrealized gains and losses as an element of the balance sheet is controversial. </li></ul><ul><li>WHAT DO YOU THINK???? </li></ul>