💰Intermediate Financial Accounting II Unit 8 – Foreign Currency Transactions & Translations

Key Concepts and Definitions

• Foreign currency transactions involve monetary amounts denominated in a currency other than the entity's functional currency
• Functional currency represents the primary economic environment in which an entity operates and generates cash flows
• Reporting currency refers to the currency used in presenting financial statements (usually the functional currency)
• Exchange rate specifies the amount of one currency that can be exchanged for a unit of another currency
  • Spot rate is the exchange rate for immediate delivery
  • Forward rate is the exchange rate for future delivery
• Foreign currency translation involves restating financial statements from the functional currency to the reporting currency
• Remeasurement converts financial statement items from a foreign currency into the functional currency

Foreign Currency Transaction Basics

• Foreign currency transactions arise when a company buys or sells goods or services in a foreign currency
• These transactions also occur when a company borrows or lends funds denominated in a foreign currency
• Settling foreign currency transactions involves exchanging the foreign currency for the company's functional currency
• Foreign currency transactions are initially recorded using the spot exchange rate on the transaction date
  • The spot rate is used because it represents the rate at which the transaction could be settled immediately
• Gains or losses can result from changes in exchange rates between the transaction date and the settlement date
• Companies must properly account for and disclose foreign currency transactions in their financial statements

Exchange Rates and Their Impact

• Exchange rates fluctuate based on various economic, political, and market factors
• Changes in exchange rates can significantly impact a company's financial performance and position
• Appreciation of a foreign currency relative to the functional currency results in foreign currency gains
  • For example, if a U.S. company has a receivable denominated in euros and the euro appreciates, the company will recognize a foreign currency gain
• Depreciation of a foreign currency relative to the functional currency leads to foreign currency losses
• Companies must monitor exchange rate movements and assess their potential impact on foreign currency transactions
• Volatility in exchange rates can introduce additional risk and uncertainty into a company's operations

Recording Foreign Currency Transactions

• Foreign currency transactions are initially recorded in the functional currency using the spot exchange rate on the transaction date
• The spot rate is used because it represents the rate at which the transaction could be settled at that point in time
• For example, if a U.S. company purchases inventory from a supplier in Japan for 1,000,000 yen when the spot rate is 110 yen per dollar, the transaction would be recorded as a $9,090.91 purchase (1,000,000 yen ÷ 110)
• The recorded amount serves as the historical cost basis for the related asset, liability, revenue, or expense
• Subsequent changes in exchange rates do not affect the initially recorded amount of the transaction
  • However, these changes can impact the settlement of the transaction and result in foreign currency gains or losses

Adjusting and Settling Foreign Currency Balances

• At the end of each reporting period, companies must adjust their foreign currency balances to reflect the current exchange rates
• Monetary assets and liabilities denominated in a foreign currency are adjusted using the spot rate at the balance sheet date
  • Monetary items include cash, receivables, and payables
• Non-monetary assets and liabilities (such as inventory and fixed assets) are not adjusted for changes in exchange rates
• Adjusting foreign currency balances results in unrealized foreign currency gains or losses
  • Unrealized gains or losses are recognized in the income statement for the current period
• When a foreign currency transaction is settled, any difference between the recorded amount and the settlement amount is recognized as a realized foreign currency gain or loss

Translation of Foreign Currency Financial Statements

• Companies with foreign subsidiaries or operations must translate their financial statements into the reporting currency
• The translation process involves converting the foreign currency amounts into the reporting currency using appropriate exchange rates
• The current rate method is commonly used for translating foreign currency financial statements
  • Assets and liabilities are translated using the spot rate at the balance sheet date
  • Income statement items are translated using the average exchange rate for the period
  • Equity accounts are translated using historical exchange rates
• Translation adjustments arising from the translation process are recorded in other comprehensive income (OCI)
  • These adjustments do not impact net income but are included in shareholders' equity

Hedging Foreign Currency Risk

• Companies can use various hedging strategies to manage their exposure to foreign currency risk
• Forward contracts allow companies to lock in a future exchange rate for a specific date and amount
  • Forward contracts can be used to hedge recognized foreign currency transactions or firm commitments
• Options provide the right, but not the obligation, to buy or sell a foreign currency at a predetermined exchange rate
  • Options offer flexibility and can be used to hedge anticipated foreign currency transactions
• Companies can also use natural hedges by matching foreign currency assets and liabilities to offset exposure
• Hedge accounting rules specify the conditions under which hedge transactions can be accounted for as hedges
  • Proper documentation and effectiveness testing are required to qualify for hedge accounting treatment

Practical Applications and Real-World Examples

• Multinational companies regularly engage in foreign currency transactions and face exchange rate risk
  • Examples include Apple, ExxonMobil, and Coca-Cola, which have significant international operations
• Retailers that import goods from foreign suppliers must manage their foreign currency exposure
  • For instance, a U.S. retailer importing clothing from China must consider the impact of changes in the USD/CNY exchange rate
• Companies with foreign subsidiaries must translate their financial statements into the reporting currency
  • General Electric, with subsidiaries in multiple countries, must translate its foreign currency financial statements into U.S. dollars
• Hedging strategies are commonly used to mitigate foreign currency risk
  • Airlines, such as Delta and United, often hedge their exposure to jet fuel prices denominated in foreign currencies
• Investors and analysts must consider the impact of foreign currency fluctuations when evaluating a company's financial performance
  • Changes in exchange rates can affect a company's reported revenues, expenses, and profitability