Foreign Currency Transactions
Summer I 2009
1. In most countries, a country’s currency is treated much like a
commodity or money market instrument.
2. In the United States, foreign currencies are bought and sold by the
international banking departments of commercial banks.
3. The buying and selling of foreign currencies result in variations in the
exchange rate between the currencies of two countries. For example,
suppose the exchange rates for the British pound are:
Foreign Currency in Dollars in Foreign
U.S. Dollars Currency
Thus, 1 British pound could be exchanged for about $1.50; while $1
could be exchanged for about .64 British pounds. Note that the two
exchange rates are reciprocals (1/0.636 = 1.572 or 1/1.572 = 0.636). 4. Since our perspective will be from the U.S. company records, we will
use direct exchange rates to convert to U.S. dollars. For example,
suppose a contract indicates 152,000 British pounds. Using the
exchange rate given above, the conversion is made by multiplying
152,000 by $1.572 to arrive at $238,934.
5. Factors that affect fluctuations in exchange rates include a country’s
balance of payments surplus or deficit, global rates of inflation, money
market variations (such as interest rates) in the individual countries,
capital investment levels, and the monetary actions of central banks of
B. Foreign Currency Transactions
1. Transactions are usually measured and recorded in terms of the
currency in which the reporting entity prepares its financial statements.
This currency is usually the domestic currency or reporting currency.
2. Assets and liabilities are denominated in a currency if their amounts
are fixed in terms of that currency. Therefore, it is possible to have
transactions measured in U.S. dollars but denominated in a foreign
currency such as French francs.
3. If a transaction between two U.S. companies requires payment of a
fixed number of U.S. dollars, the accounts are both measured and
denominated in U.S. dollars.
4. With a transaction between a U.S. company and a foreign company,
the parties usually negotiate whether settlement is in U.S. dollars or in
the domestic currency of the foreign company. If settled in the foreign
currency, the U.S. company will measure the receivable or payable in
U.S. dollars, but the transaction will be denominated in the specified
foreign currency. This situation is referred to as a foreign currency
transaction. Exchange gains or losses will result. If unsettled at the
end of the year, an unrealized exchange gain or loss should be
recognized to show the change in exchange rates from the transaction
date to the end of the period. To the foreign company, the transaction
is both measured and denominated in its domestic currency. Thus, the
transaction is a foreign transaction but not a foreign currency
5. If a transaction is measured and denominated in U.S. dollars, no
exchange gain or loss will result.
6. Exchange gains or losses are handled by an approach known as the
two-transaction approach. Under this approach, the initial foreign
currency transaction is one transaction, while any exchange gains or
losses that result from exchange rate changes are a second transaction.
C. Forward Exchange Contracts
1. A forward exchange contract is an agreement with a foreign currency
dealer to exchange different currencies at some future date at a
specified exchange rate. Forward exchange rates may be larger or
smaller than spot exchange rates for a foreign currency depending
upon the foreign currency dealer’s expectations about exchange rate
2. Forward exchange contracts are used to hedge or neutralize the effects
of changing exchange rates.
3. Most forward exchange contracts are for 30 to 180 days. However,
they are usually available for any time period up to 12 months. 4. If the forward exchange rate is greater than the spot exchange rate, the
difference is referred to as a premium (the foreign currency is selling
at a premium in the forward market). If the spot exchange rate
exceeds the forward exchange rate, the difference is referred to as a
5. Premiums or discounts are usually amortized by the straight-line
method over the term of the forward contract and the amortized
amount is reported as a financial expense or revenue.
D. Illustration – Export Transaction
1. Suppose Amanda Company (of the U.S.) sells inventory to Tea and
Crumpets, Inc. of Great Britain for 50,000 British pounds. The
transaction occurs on March 1, 20X4 and will be settled on June 1,
20X4. Amanda uses a periodic inventory system. On March 1, 20X4,
the British pound is worth $1.55 and on June 1, 20X4, it is worth $1.48.
2. Amanda Company entries would be:
March 1, 20X4
Accounts receivable 77,500
June 1, 20X4
Exchange loss 3,500
Accounts receivable 77,500
The decrease in the value of the British pound from $1.55 to $1.48 results in an exchange loss to the U.S. company since the pounds it receives are worth less than they were at the transaction date ($1.55 - $1.48) X 50,000 pounds = 3,500 loss.
3. Suppose U.S. company purchases goods from a British company on October 1, 20X4, for 3,500 British pounds. Payment for the goods is due on March 1, 20X5. On October 1, 20X4, the exchange rate is 1 pound = $1.50. On December 31, 20X4, the exchange rate is $1.48 and on March 1, 20X5, the exchange rate is $1.53.
U.S. company entries:
October 1, 20X4
Accounts payable 5,250
December 31, 20X4
Accounts payable 70
Exchange gain 70
March 1, 20X5
Accounts payable 5,180
Exchange loss 175
Note that the year 20X4 will show a $70 exchange gain, while the year 20X5 shows an exchange loss of $175. The net exchange loss of $105 is allocated between the years as required by accrual accounting.