Foreign Currency Transactions
1. Foreign Currency Transaction Principles
Foreign currency transactions occur when a business engages in trading, purchasing, or selling goods or services in a currency other than its functional currency. The primary principles governing foreign currency transactions are the recognition of transactions at the exchange rate prevailing at the transaction date and the revaluation of outstanding foreign currency balances at the reporting date.
Example:
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Initial Transaction: A U.S. company purchases inventory from a supplier in Germany for €10,000. On the transaction date, the exchange rate is 1 EUR = 1.10 USD. Therefore, the company records the purchase as:
- Inventory (Asset) = €10,000 * 1.10 USD/EUR = $11,000
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Year-End Revaluation: At year-end, if the exchange rate changes to 1 EUR = 1.20 USD, the company must revalue the payable (if it continues to owe money) or the inventory (if applicable) in its financial statements:
- Inventory = €10,000 * 1.20 USD/EUR = $12,000
- The increase in value would typically be reflected in the income statement as a foreign currency exchange gain.
References:
- International Financial Reporting Standards (IFRS) 21, The Effects of Changes in Foreign Exchange Rates.
2. Functional Currency vs. Presentational Currency
Functional Currency:
The functional currency is the currency of the primary economic environment in which the entity operates. This usually reflects the currency in which the entity generates and expends cash.
- Example: A Canadian company operating primarily in Canada that transacts most of its business in CAD (Canadian Dollar) will recognize CAD as its functional currency.
Presentational Currency:
The presentation currency is the currency used in the financial statements to communicate financial information. It does not have to be the same as the functional currency.
- Example: The same Canadian company may choose to prepare its financial statements in USD for investors or stakeholders in the U.S. Thus, while its functional currency is CAD, the presentational currency is USD.
Relationships and Norms:
It's important to note that while entities can choose any presentation currency, significant amounts of conversion and currency exchange differences may arise if the functional currency is different from the presentation currency.
References:
- International Accounting Standard (IAS) 21, The Effects of Changes in Foreign Exchange Rates.
3. Foreign Currency Transactions in Financial Statements
Foreign currency transactions directly carried out by the reporting entity impact how they reflect their financial activity and position in their financial statements. Such transactions are initially recognized at the exchange rate on the transaction date and subsequently measured at the closing rate for those remaining at the reporting date.
Example:
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Transaction Recognition: A Mexican business sells services worth $5,000 to a U.S. client and invoices it in USD. The invoice date exchange rate is 18 MXN/USD.
- Recognition when the sale occurs:
- Revenue = $5,000 * 18 = 90,000 MXN
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Year-End Reporting: If the exchange rate at year-end is 19 MXN/USD, the business must record the revenue at the year-end rate, leading to an adjustment reflecting the exchange rate change:
- Revenue in financial statements at year-end = $5,000 * 19 = 95,000 MXN
- The increase will appear as a foreign currency exchange gain in the income statement.
References:
- IFRS 21, The Effects of Changes in Foreign Exchange Rates.
4. Foreign Currency Transactions in Overseas Transactions and Investments
When companies engage in overseas transactions or investments in foreign subsidiaries, understanding foreign currency transactions is crucial. Not only do the exchanges need to be recorded, but they also influence how profits and investments are reported in consolidated financial statements.
Example:
Overseas Investment: A U.S. company invests in a subsidiary in Japan for ¥100,000,000. When the investment is made, the exchange rate is 110 JPY/USD:
- Initial investment recorded = ¥100,000,000 / 110 = $909,090.91
Subsequent Reporting: If the subsidiary generates profits of ¥10,000,000 during the year, and the exchange rate becomes 120 JPY/USD by year-end:
- The profit when converted to USD becomes:
- ¥10,000,000 / 120 = $83,333.33
When consolidating, the parent company must recognize the profits and potentially any foreign currency translation adjustments in equity to reflect differences because profits are remitted to USD.
References:
- IAS 21, The Effects of Changes in Foreign Exchange Rates.
By following these standards and principles, businesses can accurately report their financial transactions impacted by foreign currencies and provide transparency for users of financial statements.