Chapter 6–Foreign Currency Translation Introduction

Chapter 6–Foreign Currency Translation Introduction and Background Foreign Exchange Concepts and Definitions The objective of a currency is to provide a standard of value, a medium of exchange, and a unit of measure. Currencies of different nations perform the first two functions with varying degrees of efficiency but essentially all currencies provide a unit of measure. To measure a transaction in their own currencies, businesses around the globe rely on exchange rates negotiated on a continuous basis in foreign currency markets. An exchange rate is the ratio between a unit of one currency and the amount of another currency for which that unit can be exchanged at a particular time. The exchange rate can be compared directly or indirectly. Assume

that $1.60 can be exchanged for one British pound: direct quotation (US dollar equivalent): $1.60 1 = $1.60 indirect quotation (foreign currency per U.S. dollar): 1 $1.60 = £.625 The exchange rates that are used in accounting for foreign operations and transactions (other than forward contracts) are spot rates, current exchange rates, historical exchange rates, and average rates. They are defined as follows: 1 spot rate–the exchange rate for immediate delivery of currencies exchanged current rate–the rate at which one unit of currency can be exchanged for another currency at the balance sheet date or the transaction date historical rate–the rate in effect at the date a specific transaction or event occurred average rate–a simple or weighted average of either current or historical exchange rates Use of historical exchange rates shields financial statements from foreign currency translation gains or losses. The use of current rates causes translation gains or losses. We need to distinguish between translation gains and losses and transaction gains and losses both of which are considered exchange gains and losses. A realized (or settled) transaction creates a real gain or loss. This is a gain or loss that should be reflected immediately in income. A gain or loss on a settled transaction arises whenever the exchange rate used to book the original transaction differs from the rate used at settlement. If a US parent borrows £1000 when the exchange rate is $1.50=£1 and then converts the proceeds to dollars, it will receive $1500 and record a $1500 liability on the books. If the foreign exchange rate rises to $2.00=£1 when the loan is repaid, the US company will have to pay out $2000 to discharge its debt. The company has suffered a $500 exchange rate loss. This loss is a transaction loss. A translation gain or loss are unrealized or paper gains or losses or gains or losses on unsettled transactions. 2 Corporate Accounting Concepts and Relationships The accounting treatment of domestic and foreign entity relationships that involve some degree of control are summarized as follows: Domestic entity Foreign entity Accounting treatment Home office Branch Branch accounting Parent Subsidiary Consolidated financial statements Investor Investee Investment in foreign entity at cost or equity The above relationships suggest the need to combine or consolidate the foreign entity’s financial statements with those of the domestic entity. The financial statements of a foreign entity typically are measured in the currency of...

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