When a U.S. company buys or sells merchandise in a transaction with a foreign company, the transaction price may be stipulated either in U.S. dollars or in units of the foreign currency. If the price is stated in dollars, the U.S. company encounters no special accounting problems.
The transaction may be recorded in the same manner as are similar transactions with domestic suppliers or customers.
If the transaction price is stated in terms of the foreign currency, the company encounters two accounting problems. First, as the U.S. company’s accounting records are maintained in dollars, the transaction price must be translated into dollars before the transaction can be recorded. The second problem arises when (1) the purchase or sale is made on account and (2) the exchange rate changes between the date of the transaction and the date that the account is paid. This fluctuation in the exchange rate will cause the U.S. company to experience either a gain or a loss in the settlement of the transaction.
Compute gains or losses on receivables or payables that are stated in a foreign currency when exchange rates fluctuate.
L e a r n i n g O b j e c t i v e C
o th c e a
LO5
Confirming Pages
Foreign Currencies and Exchange Rates 693
Credit Purchases with Prices Stated in a Foreign Currency Assume that on August 1 a U.S. company buys merchandise from a British company at a price of 10,000 British pounds (£10,000), with payment due in 60 days. The exchange rate on August 1 is
$1.63 per British pound. The entry on August 1 to record this purchase (assuming use of a perpetual inventory system) would be:
The amount of a foreign currency credit purchase is determined by using the exchange rate on the date it is journalized
Inventory . . . 16,300
Accounts Payable . . . 16,300 To record the purchase of merchandise from a British company
for £10,000 when the exchange rate is $1.63 per pound (£10,000 ⫻ $1.63 ⫽ $16,300).
The foreign exchange rate gain for the credit purchase is determined by using the exchange rate on the payment date Accounts Payable . . . . . . 16,300
Cash . . . . . . 16,100 Gain on Fluctuations in Foreign Exchange Rates . . . . . . 200 To record payment of £10,000 liability to British company and to
recognize gain from decline in exchange rate:
Original liability (£10,000 ⫻ $1.63) . . . $16,300 Amount paid (£10,000 ⫻ $1.61) . . . . 16,100 Gain from decline in exchange rate . . . . $ 200
A foreign exchange rate loss occurs if the exchange rate increases between the purchase date and the collection date
Accounts Payable . . . . . . 16,300 Loss on Fluctuations in Foreign Exchange Rates . . . 300
Cash . . . 16,600 To record payment of £10,000 liability to British company
and to recognize loss from increase in exchange rate:
Original liability (£10,000 ⫻ $1.63) . . . $16,300 Amount paid (£10,000 ⫻ $1.66) . . . . 16,600 Loss from increase in exchange rate . . . . $ 300
Let us now assume that by September 30, when the £10,000 account payable must be paid, the exchange rate has fallen to $1.61 per British pound. If the U.S. company had paid for the merchandise on August 1, the cost would have been $16,300. On September 30, how- ever, only $16,100 is needed to pay the £10,000 liability (£10,000 ⫻ $1.61 ⫽ $16,100). Thus, the decline in the exchange rate has saved the company $200. This savings is recorded in the accounting records as a Gain on Fluctuations in Foreign Exchange Rates. The entry on September 30 to record payment of the liability and recognition of this gain would be:
Now let us assume that instead of declining, the exchange rate had increased from $1.63 on August 1 to $1.66 on September 30. Under this assumption, the U.S. company would have to pay $16,600 to pay off the £10,000 liability on September 30. Thus, the company would be paying $300 more than if the liability had been paid on August 1. This additional $300 cost was caused by the increase in the exchange rate and should be recorded as a loss. The entry on September 30 would be:
In summary, having a liability that is fixed in terms of a foreign currency results in a gain for the debtor if the exchange rate declines between the date of the transaction and the date of payment. The gain results because fewer dollars will be needed to repay the debt than had originally been owed. An increase in the exchange rate, on the other hand, causes the debtor to incur a loss. In this case, the debtor will have to spend more dollars than had originally been owed in order to purchase the foreign currency needed to pay the debt.
Credit Sales with Prices Stated in a Foreign Currency A company that makes credit sales at prices stated in a foreign currency also will experience gains or losses
wil11048_ch15_682-719.indd 693
wil11048_ch15_682-719.indd 693 11/13/10 10:45 AM11/13/10 10:45 AM
Find more at www.downloadslide.com
from fluctuations in the exchange rate. To illustrate, let us change our preceding example to assume that the U.S. company sells merchandise on August 1 to the British company at a price of £10,000. We shall again assume that the exchange rate on August 1 is $1.63 per British pound and that payment is due in 60 days. The entry on August 1 to record this sale would be:
In 60 days (September 30), the U.S. company will collect from the British company the U.S. dollar equivalent of £10,000. If the exchange rate on September 30 has fallen to $1.61 per pound, the U.S. company will collect only $16,100 (£ 10,000 ⫻ $1.61 ⫽ $16,100) in full settlement of its account receivable. Since the receivable had originally been equivalent to
$16,300, the decline in the exchange rate has caused a loss of $200 to the U.S. company. The entry to be made on September 30 would be:
Now consider the alternative case, in which the exchange rate rises from $1.63 at August 1 to $1.66 at September 30. In this case, the British company’s payment of £10,000 will convert into $16,600, creating a gain for the U.S. company. The entry on September 30 would then be:
Adjustment of Foreign Receivables and Payables at the Balance Sheet Date We have seen that fluctuations in exchange rates may cause gains or losses for com- panies with accounts payable or receivable in foreign currencies. Exchange rates fluctuate on a daily basis. For convenience, however, the company usually waits until the account is paid or col- lected before recording the related gain or loss. An exception to this convenient practice occurs at the end of the accounting period. An adjusting entry is made to recognize any gains or losses that have accumulated on any foreign payables or receivables through the balance sheet date.
To illustrate, assume that the transaction illustrated in Exhibit 15–8 occurs on November 10 when a U.S. company buys equipment from a Japanese company at a price of 10 million yen (¥10,000,000), payable on January 10 of the following year. If the exchange rate is $0.0100 per yen on November 10, the entry for the U.S. company to record the purchase would be:
Accounts Receivable . . . 16,300
Sales . . . 16,300 To record sale to British company with sales price set at £10,000
(£10,000 ⫻ $1.63) ⫽ $16,300. To be collected in 60 days.
Cash . . . 16,600
Accounts Receivable . . . 16,300 Gain on Fluctuations in Foreign Exchange Rates . . . 300 To record collection of £10,000 receivable from British
company and to recognize gain from increase in exchange rate:
Original sales price (£10,000 ⫻ $1.63) . . . $16,300 Amount received (£10,000 ⫻ $1.66) . . . 16,600 Gain from increase in exchange rate . . . . $ 300 A foreign exchange rate
loss occurs when the exchange rate decreases between the sales date and the collection date
Cash . . . 16,100 Loss on Fluctuations in Foreign Exchange Rates . . . 200
Accounts Receivable . . . 16,300 To record collection of £10,000 receivable from British
company and to recognize loss from fall in exchange rate since date of sale:
Original sales price (£10,000 ⫻ $1.63) . . . $16,300 Amount received (£10,000 ⫻ $1.61) . . . 16,100 Loss from decline in exchange rate . . . $ 200
Confirming Pages
Foreign Currencies and Exchange Rates 695
Now assume that on December 31, the exchange rate has fallen to $0.0097 per yen. At this exchange rate, the U.S. company’s account payable is equivalent to only $97,000 (¥10,000,000 ⫻
$0.0097). Gains and losses from changes in exchange rates are recognized in the period in which the change occurs. Therefore, the American company should make an adjusting entry to restate its liability at the current dollar-equivalent and to recognize any related gain or loss.
This entry, dated December 31, would be:
Equipment . . . 100,000
Accounts Payable . . . 100,000 To record purchase of equipment from Japanese company at
a price of ¥10,000,000, payable January 10 (¥10,000,000 ⫻ $0.0100 ⫽ $100,000).
Assets purchased on account must be recorded in dollars using the exchange rate on the date of purchase
Exhibit 15–8
FOREIGN EXCHANGE TRANSACTION: U.S.
COMPANY BUYS EQUIPMENT FROM A JAPANESE COMPANY Recording the initial transaction
November 10: Japanese company records a sale and receivable of ¥10,000,000.
Effect of the transaction
January 10: records cash receipt of ¥10,000,000 and eliminates receivable.
December 31: Records a
$3,000 gain due to foreign exchange rate change.
Payable of $97,000 is used for balance sheet.
January 10: Records cash disbursement of $99,000, a $2,000 loss on payable, and eliminates payable.
Net gain on foreign exchange = $1,000.
November 10: U.S.
company records an asset and a payable of $100,000.
Similar adjustments should be made for any other accounts payable or receivable at year-end that are fixed in terms of a foreign currency.
If the exchange rate changes again between the date of this adjusting entry and the date that the U.S. company pays the liability, an additional gain or loss must be recognized. Assume,
The foreign exchange rate gain on accounts payable is included in year-end statements
Accounts Payable . . . 3,000 Gain on Fluctuations in Foreign Exchange Rates . . . 3,000 To adjust balance of ¥10,000,000 account payable to amount
indicated by year-end exchange rate:
Original account balance . . . $100,000 Adjusted balance (¥10,000,000 ⫻ $0.0097) . . . 97,000 Required adjustment . . . $ 3,000
wil11048_ch15_682-719.indd 695
wil11048_ch15_682-719.indd 695 11/13/10 10:45 AM11/13/10 10:45 AM
Find more at www.downloadslide.com
for example, that on January 10 the exchange rate has risen to $0.0099 per yen. As shown in Exhibit 15–8 , the U.S. company must now spend $99,000 to buy the ¥10,000,000 needed to pay its liability to the Japanese company. Thus, the rise in the exchange rate has caused the U.S. company a $2,000 loss since year-end. The entry to record payment of the account on January 10 would be:
Notice the overall effect of entering into this credit transaction stated in yen was a $1,000 gain due to fluctuations in the exchange rate for the yen between November 10 and the date of payment (January 10). The U.S. company recognized a $3,000 gain on fluctuations in the exchange rate from November 10 through the balance sheet date (December 31). This was partially offset in the next fiscal year by a $2,000 loss on fluctuations in the exchange rate between December 31 and January 10. The overall effect can be computed directly by mul- tiplying the amount of the foreign currency times the change in exchange rates between the transaction date and the payment date (¥10,000,000 ⫻ [$0.0100 ⫺ $0.0099] ⫽ $1,000 gain).
The $3,000 gain recorded at the balance sheet date and the $2,000 loss recorded at the date of payment have no associated cash flow effects.
Gains and losses from fluctuations in exchange rates on transactions carried out in a for- eign currency should be included in the income statement. They typically are presented in a manner much like interest expense and gains and losses on the sale of plant assets.