Foreign Transactions and operations accounting

Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority and you can order it here)

When business transactions are undertaken abroad, accounting for these transactions by a U.S. company is done in U.S. dollars – the unit of measurement in the United States.  The accountant normally becomes involved in foreign transactions and operations in one of two ways:

1. Foreign currency transactions – transactions that require settlement in a foreign currency, including buying and selling, borrowing or lending, and investing.

2. Translation of financial statements of a foreign subsidiary or branch office whose statements are denominated in foreign currency.

Foreign currency transactions are accounted for as follows according FASB No. 52:

1. Receivables, payable, revenues, and expenses are translated and recorded in dollars at the spot rate existing on the transaction date.  An exchange rate that indicates the price of foreign currencies on a particular date for immediate delivery is called a spot rate.

2. At the balance-sheet date, receivables and payable are adjusted to the spot rate.

3. Exchange gains and losses resulting from changes in the spot rate from one point in time to another are usually recognized in the current period's income statement.

Accounting required for forward exchange contracts depends upon management's intent when entering into the contract.  A summary of accounting for forward exchange contracts is shown here.

Accounting principles for purposes of consolidation, combination, or reporting on the equity method for foreign operations (branches, subsidiaries) can be summarized in broad terms as follows:

1. Foreign currency financial statements must be in conformity with generally accepted accounting principles before they are translated.

2. The FUNCTIONAL CURRENCY of an entity is the currency of the primary economic environment in which the foreign entity operates.  The functional currency may be the currency of the country in which the foreign entity is located, the U.S. dollar, or the currency of another foreign country.  If the foreign entity's operations are self-contained and integrated in a particular country and are not dependent on the economic environment of the parent company, the functional currency is the foreign currency.  The functional currency of a foreign company would be the U.S. dollar if the foreign operation is an integral component or extension of the parent company's operations.  The daily operations and cash flows of the foreign operation of the foreign entity are dependent on the economic environment of the parent company.

3. If the functional currency is the local currency of the foreign entity, the current rate method is used to translate foreign currency financial statements into U.S. dollars.  All assets and liabilities are translated by using the current exchange rate at the balance sheet dates.  This method provides that all financial relationship remain the same in both local currency and U.S. dollars.  Owners' equity is translated by using historical rates; revenues and gains and expenses and losses are translated at the rates in existence during the period when the transactions occurred.  The translation adjustment which result from the application of these rules are reported as a separate component in owners' equity of the U.S. company's consolidated balance sheet (or parent-only balance sheet if consolidation was not deemed appropriate.)

4. If the functional currency is the reporting currency (the U.S. dollar), the foreign currency financial statements are re-measured into U.S. dollars using the temporal method.  All foreign currency balances are restated to U.S. dollars using both historical and current exchange rates.  Foreign currency balances which show prices from past transactions are translated by using historical rates; foreign currency balances which show prices from current transactions are translated by using the current exchange rate.  Translation gains or losses that result from the re-measurement process are reported on the U.S. company's consolidated income statement.

Proponents of the current rate method maintain that the use of this method will reflect most clearly the true economic facts since presenting all revenue and expense items at current rates reflects the actual earnings (those that can be remitted to the home country) of a foreign operation at that time.  Also, stating all items at the current rate retains the operating relationships after the translating intact with those that existed before the translation.  Critics of the current rate method claim that since fixed assets are translated at the current rate and not at the rate that existed when they were acquired, the translated amounts do not represent historical costs and are not consistent with generally accepted accounting principles.

Since the temporal method states monetary assets at the current rate, proponents of this method claim that this reflects the foreign currency's ability to obtain U.S. dollars.  Since historical rates are used for long-term assets and liabilities, the historical cost principle is maintained.  However, the use of the temporal method distorts financial statement relationships that exist before and after re-measurement.

The appended exhibits illustrate the temporal method and the current rate method.  The temporal method illustration assumes that the functional currency of a Canadian subsidiary is the U.S. dollar.  The current rate method assumes that the functional currency of the Canadian subsidiary is the Canadian dollar.  The Canadian subsidiary was established at the beginning of the year.  The current rate of exchange is $.80; the historical rate used for the building and common stock is $.90; the average rate for the year is $.85.  The computation of the exchange loss for the year is shown in an accompanying schedule.  The temporal method's $10,406 exchange loss occurred because the subsidiary held net monetary assets denominated in Canadian dollars when the Canadian dollar decreased in value relative to the U.S. dollar.  The current rate method's translation adjustment for the year which results from the impact of rate changes on the net monetary position during the year is also shown in a separate schedule.

The exposure to exchange translation losses is not usually the same as the economic exposure to exchange losses.  Economic exposure is due to many factors including rates of inflation, regulation, interest rate changes, and other factors.  Translation exposure is related to what accounts have to be translated at current exchange rates.  A company's exposed position represent the net balance of all accounts translated at current exchange rates.  Accounts translated at historical rates are not exposed to translation adjustments because the same conversion rate is used each year.  The net translation exposure position of a firm can be explained as follows:

Items contributing to exposure:

1. Current assets (not including prepaid expenses).

2. Investments denominated in fixed amounts of local currency (German marks; English pounds).

3. Long-term receivables (net of allowances).

Items lessening exposure:

1. Inventories

2. U.S. dollar assets included in a, b, and c above.

3. Local currency liabilities.

The algebraic sum of the items listed represents the company's net exposure to risk of loss (or exposure to gain) through exchange fluctuations.  An exposed position can usually be managed by controlling the company's position in listed securities and by the use of forward exchange contracts.

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