ACCOUNTING FOR CURRENCY EXCHANGE RATE CHANGES

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ACCOUNTING FOR CURRENCY EXCHANGE RATE CHANGES
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• OVERVIEW
• In previous chapters we discussed diversity of
• International Accounting and the associated
• difficulties.
• The history of international commerce was build
  on
• exchange of goods for goods, or payments for
  goods
• and services in form of gold or silver.
• The removal of Gold cover made currencies
• exchange more sensitive to the fluctuation in
  other
• currencies which, added more difficulties.
• To simplify , Multinational Organizations face
  the
• same problems under two conditions

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TRANSACTIONS RISK (Exposure)
TRANSALATION RISK (Exposure)

When compiling / preparing Financial Statements
at the end of the period (annually or quarterly.)
When recording transactions upon exchange of
values, Buying or Selling, goods or services.
B
A
RATE A
OR RATE B
OR BOTH
PREPARING YEAR-END FINANCIAL STATEMENTS

• Thus, which one should be used (A) or (B) above,
  or both?
• Which one would be more adventitious? And
• How this would affect comparability?

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• EXAMPLE
• On March 1, 2006, a subsidiary of US company
  purchased a land in France for 1,000 (Current
  rate of exchange was 1 Euro to 1 US dollar).
• On December 31, 2006, the time to consolidate the
  financial statements the exchange rate was 1 Euro
  to 1.5 US dollar.
• Then, the land would worth 1,500.
• The increase in value is only due to the
  difference between the exchange March 2006 and
  December 2006 rates. The opposite is also true.
• This will lead us to the question, as to what are
  the reasons and/or the forces behind the
  fluctuation of Exchange Rate

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• Changes and fluctuations in the Exchange Rates
  are due to one or combination of the following

• TRADE BALANCE OF PAYMENTS (SURPLUSES OR
  DEFICITS)
• When a country exports more than it imports,
  it is said to run a trade balance of payments
  surplus. Surpluses cause the nation's currency
  to appreciate in value (i.e., to strengthen). The
  opposite condition is a trade deficits causes a
  currency to command less of other nations'
  currencies.
• RELATIVE RATES OF INFLATION
• Currencies of countries with higher rates of
  inflation depreciate relative to the currencies
  of countries with lower levels of inflation.
  Generally speaking, inflation means that one is
  able to buy less and less of everything for a
  fixed amount of one's own currency.
• RELATIVE INTEREST RATES
• Whenever one nation has higher interest rates
  relative to other nations, its currency
  appreciates in value. (Foreigners purchase more
  of its currency in order to invest in and earn
  the higher interest.)
• POLITICAL FACTORS GOVERNMENT INTERVENTION
• For international transactions, the currencies
  of countries considered politically stable tend
  to be favored over the currencies of unstable
  countries. Governments also buy and sell
  currencies when they want to change exchange
  rates.

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THE FOLLOWING DIAGRAM SOULD HELP US VISULIZE THE
MAGNITITUDE OF RISK SAND TAND ASSOCIATED PROBLEMS.
IBM USA
IBM SUBSIDIARIES
FRANCE
AUSTRALIA
ISRAEL
CHINA
KOREA
JAPAN
HONG KONG
TRANS. BETWEEN SUBSIDIARIES AND CORP. OFFICE.
F. S. CONSOLIDATION PROCESS TO CORP. OFFICE
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The previous slides explored one issue relevant
to currencies exchange rates whether from
Countries or International Business point of
view.

• To over come such a problem. There two major
  methods are in use (with some guidelines from
  FASB).
• 1- CURRENT RATE METHOD
• The Current Rate Method will use the
  prevailing exchange rate at the time of preparing
  Financial Statements.
• DISADVANTAGES THIS METHOD IS INCOMPATABLE WITH
  GAAP HISTRORICAL COST PRINIPLES.

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• 2- TEMPORAL METHOD
• Under this method the nature of Assets, and
  Liabilities will determine the exchange rate to
  be used. For example, based on the liquidity of
  assets and liabilities the Current Exchange Rate
  Also known as Monetary/Non-Monetary Method
  should be used. As far as the least liquid
  assets and liabilities would require the use of
  Historical Exchange Rate Current / Non-Current
  Method.
• Most Revenues and Expenses are translated using
  the Average of rates during the accounting period
• DISADVANTAGES THIS METHOD RESULTES IN
  IMBALANCED FINANCIAL STATEMENTS.
• THE DIFFERENCE (THAT RESULTED FROM IMBALANCED
  STATEMENT DOES NOT FIT ANY OF THE CATAGORIES.)
• This difference will become Gain or Loss due to
  Translation.

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HIGHLIGHTS OF SFAS 52

• FUNCTIONAL CURRENCY
• When the subsidiary is relatively independent.
  Then
• The local currency is used for financial
  reporting .
• The Current Rate should be used in translation to
  US dollar.
• When the subsidiary is an extension of US parent
  company. Then
• The US currency is used for financial reporting.
• The Temporal method should be used in translation
  to US dollar.
• When the functional currency is neither the local
  or US but third country then SFAS 52 laid out two
  steps translation process (see Exhibit 3-3).
• HIGH INFLATION ? HYPERINFLATION PERIOD
• When inflation is 100 or over then the Temporal
  method should be used.

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FINAL NOTE

• Financial statements are intended to present
  an overall look at a company's operations and
  financial position.
• For multinational corporations, existing
  accounting tools are not always up to measuring
  earnings when fluctuating foreign exchange rates
  are introduced into that process.
• Foreign currency translation is one of the most
  difficult tasks facing accountants today, and
  potential solutions do not fit neatly into the
  traditional accounting model.
• Thus, when examining the financial statements of
  companies from different countries, special care
  should be taken to understand the companies'
  consolidation policies and how they translate the
  financial statements of their foreign operations.
  The variety of possible methods makes comparing
  the statements very , very difficult.