Accounting in a Global Market
Foreign currency exchange rates are used to express transactions in local currency in terms of U.S. dollars and vice versa. For example, if the exchange rate is $1 = 1.65 DM (Deutsche mark), and if one wishes to change 100 U.S. dollars into Deutsche marks, one will receive $100 ( 1.65 = 165 DM, and if one wishes to change 100 DM to U.S. dollars, one will receive 100 DM/1.65 = $60.61.
A foreign currency transaction occurs when a transaction is denominated in a currency other than that of the firm. For example, a foreign currency transaction occurs when a U.S. firm purchases electronics components from a Japanese firm and must make payment in yen.
This easiest way for a U.S. company to avoid foreign exchange risk is to denominate all transactions in U.S. dollars. Alternatively, there are a variety of methods for hedging foreign currency risk. One method is to enter into a foreign exchange forward or futures contract. See Chapter 12 for more details about hedging.
If the purchase is denominated in British pounds, the purchase of the oil is recorded at $144,900, or 5,000 barrels at £18 per barrel equals £90,000 at $1.61 equals $144,900.
In this situation the British pound increased in value from $1.50 to $1.53. This means the currency received in payment of the account will amount to more money in U.S. dollars. The exchange gain is $1,500 (£50,000 ( [$1.53–$1.50]).
According to U.S. accounting standards, foreign currency transaction gains and losses are included in income in the period in which the exchange rate changes. Any gains or losses that result from these changing exchange rates are measured and recognized separately from the underlying sale or purchase and are recorded as separate income statement items.
U.S. firms must consolidate all their majority-owned subsidiaries when preparing financial statements. Foreign currency statements can be consolidated only after they have been translated into U.S. dollars.
The two methods available for converting foreign currency financial statements into U.S. dollar financial statements are (a) translation and (b) remeasurement.
For foreign subsidiaries whose operations are well contained in the host country and that conduct most of their operations in the foreign currency, translation is used to convert the statements into U.S. dollars. Translation requires that all assets and liabilities be converted at the current exchange rate at the date of the financial statements. Income statement items are converted at the average exchange rate for the period.
Some foreign subsidiaries are simply an extension of the parent company’s operations. Most of their operations are conducted in U.S. dollars. For these companies, remeasurement is used to convert the statements into U.S. dollars. Remeasurement requires that monetary assets and liabilities be converted at current rates and nonmonetary assets and liabilities be translated at the rates prevailing when the particular item was acquired. Income statement items are converted at the average exchange rate for the period.
In most instances, the functional currency is the currency in which most of the subsidiary’s transactions are denominated.
With translation, all balance sheet items other than stockholders’ equity are converted at the current exchange rate at the date of the financial statements. Income statement items are converted at the average rate during the period. Dividends are converted using the exchange rate prevailing on the date the dividends were declared. Paid-in capital is converted at the historical rate, that is, the rate prevailing on the date the subsidiary was acquired or the stock was issued. Retained earnings is translated in the first year using historical rates, but in subsequent years, it is computed by taking the balance in retained earnings from the prior period’s translated...
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