exchange

Foreign Currency Transactions | Advanced Accounting | CPA Exam FAR

hello and welcome to this session this

is Professor Farhad in this session

we're going to be doing accounting for

foreign currency transaction this topic

is covered in advanced accounting as

well as international accounting and

it's surely covered on the CPA exam the

fourth section if you want additional

lectures about these topics please go to

forehead lectures comm now before I

proceed I would like to make a quick

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let's start to take a look at foreign

currency transaction and what do they

entail so it's a very important concept

and you need to learn about it okay what

are the problems with recording and

reporting foreign currency transactions

here's what's gonna happen we have a US

company buying goods and services from

Germany and here's what's gonna happen

they're buying the goods and services

from Germany the German company they

want to be paid in Euros the US company

they'll have to record their

transactions in u.s. dollar

okay so transaction in a foreign

currency must be translated so now we're

gonna be doing what we're gonna be

translating it means Express them at a

dollar amount because we are you

eccentric I am u.s. centric we're always

assuming we are the concurrence in US

currency before they can be aggregated

with domestic transaction so any

transaction will have to be translated

and if you are buying or if you are

selling you might have a receivable or a

payable so if you are buying from a

foreign from a Germany you're gonna have

it payable if you are selling to a

German company are gonna have a

receivable so you're gonna have payable

and receivable that are denominated in

foreign currency okay

but when we report them they're going to

be reported in US dollar and if you

don't know this there's gonna be changes

and the value of the currency therefore

we might have again and we might have a

losses which we will talk about

in this session now also company might

use hatching strategy with derivatives

to minimize the impact of exchange rate

why because exchange rate could go up

could go down depending if you have a

receivable or a payable I'll explain

this you might be hurt or you might

benefit but you don't want to take that

chance you're not in the business of of

playing the foreign foreign foreign

currency market you are in the business

of selling your product making sure you

are paid and making sure you are paid

enough money to compensate you so that's

why you might use hedging strategies

which we would look at in the next

session so the hedging strategy just

hold on it for now

basic terminology you need to be aware

of when we are dealing with foreign

currency translation is something called

the direct exchange rate and the

indirect exchange rate they're basically

the same thing depending on how the

information is given to you you need to

know the difference so what is a direct

exchange rate okay it's the unit of

domestic currency and again we are the

u.s. domestic currency that can be

converted into one unit of foreign

currency for example we could say the

direct rate is valid 50 one-dollar 51

pennies for one british pound simply put

you need dollar one dollar and 51

pennies to buy one british pound or you

might say for example for a euro dollar

30 for a euro so you need one dollar and

30 cent for the euro won one dollar and

thirty US sent to buy one euro

this is the direct exchange how much

your currency buys in another currency

okay for example you might you might

need only point zero zero ten to buy one

yen okay or on the other hand we can

express the currency in the indirect

exchange rate what's the indirect

exchange rate it's how much before you

need foreign currency to buy US dollar

it all you have to do is take the direct

rate and divide it by one point five one

seven so simply put what you need to do

is if you take one divided by

one point five one seven it means you

need sixty five British pound to buy a

US dollar so simply put you will need to

buy but you need sixty five British

pound to buy a dollar now for the Euro

let's do the same thing for the year or

how much Euros do you need well let's

find out one divided one point three you

need seventy six euros to buy US dollar

well for for the yen one divided by

point zero zero one I just made up this

are point zero zero one you need 1,000

yen so you need for the yen so if you

are a Japanese individual you need to

have 1,000 yen to buy one US dollar this

is the indirect rate the US will say we

need point zero zero one to buy a yen

which is less than a penny okay so make

sure you know the difference between

direct and indirect and I will try to

hopefully make it easier for you and we

look at the problem other terminology

you need to be aware of is the spot rate

what is the spot rate the spot rate is

the rate today how much today or at this

moment for that matter because the

exchange rate change this changes

constantly how much it you will need to

how much you can exchange your currency

into a foreign currency rate at which

currencies can be exchanged today or

this moment then you have to know what

is a forward or future or future it

what's the forward rate it's the rate at

which currencies can be exchanged at

some future date for example today's

date is what today is November the 16th

today is November the 16th so this is

the sorry this is the spot rate November

the 60 now I can look up the forward

rate for the currency for example let's

assume the Euro today is dollar 30 I

want to know on December 16th or

December 16th a month from now how much

can i buy euro while they might say you

can buy the euro at dollar 25 you might

be able to buy the euro at dollar 35

this is the forward rate so if you know

you're gonna have to come up you have to

pay something in Europe

you want to pay your German supplier an

euro today the rate is number 30 but you

don't have to pay them until a month

from today well you cannot you don't

want to wait until month from today

because a month from today the euro

could be dollar fifty for the euro could

be ninety pennies who knows so you don't

take that chance you might buy something

in the forward market to lock in your

rate $1 $25 thirty five whatever the

rate is you can lock it so it's the rate

that you can lock basically you will pay

a fee and as a result someone will

guarantee that on that date if you want

buy the currency you can pay for example

dollar twenty eight and we'll guarantee

you will deliver German sorry not German

euros to you for that rate so this is

what the forward rate is and what kind

of work problems with that forward

exchange rate this is what I'm talking

about now contract to exchange

currencies of different countries on a

stipulated future date and a specified

rate this is called the future rate so

how much do we agree to exchange the

rate so someone will say pay me $100

today as a fee and I will sell you the

Euro for dollar 28 December the 60 so

basically they are guaranteeing it it's

the risk you just you're gonna pay them

a fee okay that's their job now what is

what is a floating rate floating rate

means the rate between currencies always

fluctuate and that's why we have to

learn about this chapter so relationship

between major currencies is determined

by supply and the main factor political

risk economic risk so on and so forth

okay increase risk the companies doing

business with a foreign company so what

happened is this when you buy when you

buy goods and services from a foreign

company and you have to pay them in

their currency you might be taking a

risk

why let's assume you have a payable of

100,000 yen for payable 100,000 yen all

right what does that mean it means

that's assume a month from today you

have to you have to pay this money today

today what happened is this today when

the transaction took place you owed the

Japanese company 100,000 yen well you

can buy the yen at point zero zero for

three so this is the spot rate on the

transaction date the spot rate so right

now you think well today if I pay them

today or what I have to come up with is

four hundred and thirty-four

dollars okay now let's fast forward when

the settlement date came the settlement

means when the day you need to pay them

want to settle the transaction guess

what now you need point zero zero six

towba to pay to pay them to 100,000 yen

so 100,000 yen times point zero zero six

you need six hundred and twenty five

dollars you might be saying or what's

the big deal between 434 and 625 well if

you add zeroes to these amounts then the

risk is substantial so that's why you

have the risk when you buy Japanese

product you have the risk because you're

gonna have to pay them in Japanese yen

and Japanese yen between now and the

settlement date could become cheaper

which is good or it becomes more

expensive which is not good so again

this let's assume just kind of just tell

you this also works in your favor so

let's assume on the settlement date the

rate is point zero zero three zero just

to make it easy

then only what you have to pay is three

hundred dollars so you thought you're

gonna pay for thirty four now you pay

only three hundred dollars but again

that sort of you are taking and you're

not in the business of foreign currency

risk you're in the business of buying

material building your product selling

your product okay so transaction are

normally measured and recorded in the

terms of the currency in which they are

reported in which the reporting entity

prepare its financial statement once

again we are talking US dollar for our

purposes so the reporting currency is

usually the currency where the company

is located again US dollar for our

purposes you're reporting currency could

be different if you're in Canada it's

the Canadian dollar transaction between

a US firm and a foreign company okay

company negotiate whether settlement is

to be used to be paid in US dollar or

Ana foreign currency so if it's in u.s.

dollars there is not really a lot of

risk but if it's in a foreign currency

then you are taking risk if settled by

foreign currency US firm measured the

receivable or the table and dollar we

have to measure them in dollar but the

transaction is denominated in foreign

currency so when we say you're gonna

have to pay one hundred thousand yen

well we don't record on our books one

hundred thousand

we converted 100,000 yen at point zero

four and we say it's 400.000 of four

hundred dollars okay so it's denominated

and the foreign currency that it's

recorded in US dollar so foreign

currency transaction requires payment or

receipts and a foreign currency okay

so US firm exposed to risk to

unfavorable changes an exchange rate now

just one that you know it could be

unfavorable or it could be favorable but

the the what we are discussing here is

the risk and risk we're gonna assume

unfavorable now how does it work

if the direct exchange increases what

does that mean

okay or it means the foreign currency

weakened if the direct exchange

increases let's assume downward 32 by a

euro okay this was the spot rate now

let's assume you have a payable we have

an accounts payable and you purchase one

hundred thousand worth of euros right

now you need one hundred and thirty

thousand dollar let's assume the foreign

currency unit is strengthened what does

that mean it means now you need dollar

forty to buy a euro

okay $100,000 times 140 now your payable

is 140,000 well it means more dollars

needed to acquire the foreign currency

what happened is this the foreign

currency strengthened you need more

instead of 130 you need dollar 40 now

what happened is you have to come up

with more dollars what does that mean it

means you are at a loss you are at a

loss now let me give you the other

scenario the other scenario is if the

foreign if the opposite happened well

let's let's look at the others let's

look at the other scenario if

direct exchange decreases if the direct

exchange decreases so simply put now so

the euro now is dollar 25 and you have

to come up with 100,000 euro so you need

125,000 it means the foreign currency

weakened well guess what now you need

fewer dollars to acquire the foreign

currency

therefore you are at a gain you are at

again so remember but this relationship

is the opposite if you have a receivable

if you have an account receivable if you

have an account receivable you want the

US dollar to weaken if you have a

receivable in foreign currency you want

the US dollar to weaken why because when

you receive the German at the euros if

the US dollar is cheaper you can buy

more US dollar so the opposite would

account receivable if you have a

receivable you want your home currency

to go down if you have a payable you

have you you want you want your home

currency to go up to strengthen it means

the other currency to go down okay so if

your currency strengthened and you have

a payable you want that you want a page

you want strong currency if you have a

payable what dates are we are we need to

be aware of okay

translate an account in denominated in

foreign currency we have to be concerned

with three dates sometime it's two dates

sometimes it's three first is the

transaction date the date the

transaction takes place two is the

balance sheet date balance sheet date

means if the transaction took place and

it's not gonna be settle until the next

period then what's gonna happen you have

to prepare the balance sheet so you have

to worry about the balance sheet day but

we have to do on the balance sheet date

then we have the settlement date the

date that you have to pay pay the money

this is the settlement date three

different dates and this is as

complicated as it gets so what you have

to do and in those states increases or

decreases generally reported there's a

foreign currency transaction or gain

sometime prefer to exchange gain or

exchange loss know that it goes on the

income statement so any gains and losses

and a foreign currency goes on the

income statement this is important this

is important gains and losses from

foreign currency goes on the income

statement in other words they don't go

on the balance sheet and other

comprehensive income they go on the

income statement so let's take a look at

an example to see what we are doing here

okay on this de some dude in December of

the current here tella tax system a

company based in Seattle entered into

the following transactions old so we're

gonna have a receivable seven office

computer store can't be located in

Columbia for eight million five hundred

forty-one thousand pesos on the state

the spot rate is three sixty five pesos

per US dollar so simply put we should

goods to Columbia as a result the

Columbian will have to pay us but

they're gonna pay us in pesos you pick

their back cannot mexican Colombian

pesos and we know as of today as of

today the each three hundred and sixty

five pesos will buy a US dollar this is

the indirect exchange this is the

indirect if you are not comfortable with

the indirect exchange convert the

indirect exchange into a direct exchange

by taking one divided by three sixty

five which is point zero zero two seven

so each each point zero zero two seven

US dollar will buy your pesos or in

other words three hundred and sixty five

pesos will buy a US dollar okay it's the

same thing so how do we record the

transaction well guess what first we

have to record the transaction in us

that we have a receivable so we'll take

the amount of the pesos which is eight

million five hundred and forty forty-one

pesos and we're gonna divide it by 365

365 pesos and as a result we're gonna

have a receivable of twenty-three

thousand four hundred dollars once again

we divided because we are giving how

much pesos can bias in US dollar okay so

we have a receiver of twenty three

thousand four hundred in sales of twenty

three thousand four hundred this is

called the transaction date on the

transaction date we use the spot rate

and the spot rate was each three hundred

and sixty five pesos

by you a US dollar or point zero zero

seven US dollar we'll get you a pesos

the Colombian pesos now let's take a

look at the transaction on December 31st

because this is the balance sheet

prepare the journal entry to adjust the

account as of December 31st now what I

want you to do just I want you to create

a receivable create a receivable the T

accounts receivable which is I'm just

gonna put it right here receivable

account receivable and we have in that

receivable twenty three thousand four

hundred twenty three four hundred so on

the side on a ship or a piece of paper

right 23400 now assume on December 31st

the direct exchange was point zero zero

two six eight so could you tell me what

happened now today Colombian pesos we

used to need point zero zero two seven

okay now all what we need is point zero

zero two six what happened to the US

dollar the US dollar strengthened

strengthen get this is stronger the US

dollar is stronger is this good for us

or bad for us this is bad why is it bad

well because we have a receivable it

means now if we get the money we buy

less US dollar because the the dollar

strengthened therefore therefore what's

gonna happen is this I shouldn't have

raised s but I will do it again

so remember we have a receivable of

twenty three four hundred now we

remeasured receivable well that's an

error so now we have eight million five

hundred and forty-one thousand if we

converted at the date at December 31st

straight now our Siebel is worth twenty

two thousand eight forty but it was

worth twenty three thousand four hundred

what does that mean it means we lost the

receivable lost value of five hundred

dollars time e to the t account here

account receivable we had twenty three

four hundred now what we're gonna have

to reduce it to reduce by five hundred

and ten now the receivable is twenty-two

8:19 now therefore we have to reduce the

receivable so we credit the receivable

510 and we debit transaction loss which

is an income account it goes on the

income statement

now the receivable is twenty two

thousand eight hundred and ninety we're

not done yet

we haven't settled the transaction we're

gonna wait until the settlement date but

or what we know now as of December 31st

we have a loss let's look at the

settlement date the settlement date was

January tenth assume that the direct

exchange rate at the settlement date is

0.32 what happened now well here's what

happened the rate started at point zero

zero two seven then it became the direct

exchange became point zero zero two six

two six eight so the US dollar

strengthened then by the settlement date

the US dollar weakened now we need point

zero zero three to the US dollar

weakened the US dollar weakened now if

you want the indirect exchange in case

you are wondering what's the indirect

exchange just take one divided by point

zero zero three two it means now 300 you

need three hundred and twelve pesos to

buy a dollar okay so the pesos increased

in value it means we weakened and we

like this why do we like this because we

like this because we have an account

receivable we want the US currency to go

down it means we need more US dollar to

buy a pesos

it means the pesos will buy you more US

dollar we receive in pesos we want the

US dollar to go then we want the US

dollar to go down

okay now let's compute how much do we

need well by the settlement date whence

everything is settled let's let's

compute what we need we have eight

million five hundred and forty-one

thousand pesos now we're gonna settle

them means we're gonna have to pay it

pay it at point zero zero three two

simply put I'm sorry we're gonna we're

gonna convert them at point zero zero

three two we are going to receive twenty

seven thousand three hundred and thirty

one dollars hold on a second the last

time the receivable was worth twenty two

thousand eight ninety by the time they

paid us

the pesos really went up and we did very

well so this is the US dollar so we're

gonna be receiving once you receive the

pesos we converted at point zero zero

three two because the US dollar weakened

it bought us more US dollar account

receivable is twenty two thousand eight

ninety that's the last time we computed

the receivable twenty two thousand eight

ninety we remove it and we have again a

4441 and this game goes through income

so we have again notice because you have

a receivable you wanted the US dollar to

weakened first it went it strengthened

first its strengthened at the settlement

date you had the loss by the ten days

later the US dollar weakened something

happened from December 31st of January

tenth which is good for us the US dollar

weakened the pesos went up

therefore you had a large gain and this

is really the large gain four thousand

four hundred now bear in mind you know

overall you had the gain of four

thousand four hundred but remember this

is not the net gain if you want to know

the net gain four thousand four hundred

minus minus the five hundred and ten

dollars remember you had a you had a

loss earlier you had a loss so the

difference between them is then AB gain

on the transaction been obtained now

let's take a look at another on the

other side of the entry now we did the

receiver let's do a payable because it's

good to look at both to see how this

work during December of the current year

ten attacks company a company in Seattle

Washington enter into the following

transaction now we purchased computer

chips from a Taiwan company so we're

gonna have payable in a foreign currency

dominated table that's worth half a

million Taiwanese yen the direct

exchange on this date the direct

exchange was point zero three nine one

okay simply put we sold them I'm sorry

we bought from them half a million worth

of Taiwanese dollar now they want to

receive Taiwanese dollars they don't

they're not interested in u.s. dollar

therefore today if we take half a

million times point zero three nine one

so how much are we responsible for so

half a million times point zero three

nine one we are responsible for 19,500

we have a table of nineteen thousand

five hundred so this is the direct

exchange so you need three pennies three

point nine one tends to buy so simply

put here what we're saying you need

point zero point zero three nine one if

you want to know the indirect exchange

take one divided by point zero three

nine one so so you need 10.10 point nine

eight to buy a dollar ten point nine

eight ten one is to buy analogous if

you're interested in that so on the set

on the transaction date on the

transaction date we record the payable

either debit purchases or debit

inventory depending on the inventory

system we are using on this date anyhow

we debit week we have an Accounts

Payable dominated in a foreign currency

of nineteen thousand five hundred and

fifty again what I suggest you do wish

to create a tea account called accounts

payable and park in there 19550 in this

took place on December 12 on December

31st the Taiwan is great okay now if we

want to if we want to buy Taiwanese

dollar we need three point point zero

three five one well what was the prior

year the Priory eight plus point zero

three nine one now the rate or what we

need is point zero three five one we

need less we need less US dollar what

does that mean we are at again now in

this situation the US dollar is stronger

and that's good why because we have a

payable we have a payable we want to

have a strong US dollar why because with

a strong US dollar we need less US

dollar to buy Taiwanese dollar okay so

let's see how it works so now half a

million times point zero three point

zero three five

we only need point zero three five one

two by the Taiwanese dollar so we need

to come up with seventeen thousand five

fifty the balance in the payable was

nineteen thousand five hundred and fifty

when we initially took the transaction

on December the 12th guess what we have

two thousand we are responsible $2,000

less so now what's gonna happen

you'll debit the payable two thousand

now you are responsible for seventeen

thousand five fifty and unfortunately

that's not the settlement date that's

the balance sheet day so now we adjusted

how it works to make sure we show the

risk of the foreign currency transaction

or in this in this situation the reward

we have again remember this game goes to

income so now our net income went up by

$2,000 as a result of this transaction

that's very good but not yet not yet we

still gonna have to wait until the

settlement date now now maybe we should

do it now and settle it today and send

them the money okay but we're gonna have

to wait okay

On January 10th that's when the

settlement they took place the exchange

rate was points three point zero three

nine eight what was the prior yet the

last time we did it was point zero three

five one oh boy

now the US Dollars friend the US dollar

weakened we need now point zero three

nine eight to buy a a a a Taiwanese

dollar so we have half a million of

those we are responsible for point zero

three nine eight let's do the math see

how much do we need half a million times

point zero three nine eight

we need 19900 we need 19900 to settle

huh yet to settle because we have a

payable and the last time we thought our

payable was seventeen thousand five

hundred okay last time we did the

measure of the transaction well simply

put so we need to come up with cash

19900 our payable is seventeen thousand

five fifty now we have a transaction

loss of two thousand three hundred and

fifty now that's not too bad

well what's the net transaction what's

the net foreign currency transaction we

had a gain of 2000 a loss of 2350 yes

overall we had the loss of 350 overall

okay compared to the initial first

transaction okay so we have a loss but

it's only 350 you just make sure you

remember that any foreign currency

transaction gain or losses are included

in net income or included net income and

we have two transaction approach for

this the sale or purchases if you'd as a

transaction separate from the financing

arrangement okay

therefore the dollar amount recorded in

sales or purchases is determined by the

exchange rate on the transaction date

you know we can do we can have the

adjustment of the foreign currency

denominated and receivable or payable

recorded directly that the transaction

gain or loss recorded the net income

okay so it's just basically simply put

all and all gains and losses goes into

net income from foreign currency

translation we have a receivable might

go up or civil might go down a table

might go up a table might go down the

offsetting

entry either again or a loss and the

foreign currency and the gain or a loss

once again goes into a net income now

why I keep emphasizing this point

because when you get when you look at

when we look at the translating

financial statement well we have to know

if it goes into net income or OCI other

comprehensive income so that's why I'm

emphasizing this point if you have any

questions any comments by all means

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