International Developments in Accounting ACFI 3217 Dr. Samuel Owusu-Agyei HU 3.40

Foreign Exchange

Foreign Exchange Is the ratio of a unit of currency of a country to a unit of the currency of another country at the time of a buy or sell transaction. It considers supply and demand of two currencies, their economic performance, outlook for inflation, interest rate differentials and so on.

Foreign Exchange As these factors are generally in a state of perpetual flux, currency values fluctuate from one moment to the next. A currency’s level is largely supposed to be determined by the underlying economy, however, huge movements in a currency can dictate the economy’s fortunes. In this situation, a currency becomes a part of the whole economy which swings it.

Foreign Exchange Exchange rates affect flows of international trade by influencing the prices in different currencies. E.g. import export balance Foreign exchange also facilitates international investment and international financial transitions, including direct investments, stock and bond trades.

Foreign Exchange Market In most centres, the foreign exchange market has no central, physical market place. As businesses can be conducted via screen trading or telephone or other telecommunications mechanism. Trillions of dollars are traded each day in the foreign exchange market.

Players of Foreign Exchange Market Central Banks They ensure that the exchange rate moves in line with established targets set by the government. The Bank of England can use its reserves of foreign exchange to buy pounds in the foreign exchange market, thereby putting upward pressure on the pound (appreciation of pound).

Players of Foreign Exchange Market Central Bank Can use pounds held as reserves for other exchange currencies, thereby flooding the market with pound (depreciation of pound). Commercial Banks The sources from which companies and individuals obtain their foreign currency.

Players of Foreign Exchange Market Brokers They bring buyers, sellers and banks together and receive commission on deals arranged. Individual and Companies MNCs rely on the foreign exchange market to exchange country A’s currency for country B’s currency in order to purchase imports or to engage in direct foreign investment. To convert foreign revenues to their home currency.

Accounting for foreign currency- IAS 21 Objective of IAS 21 Prescribe how to include foreign currency transactions and foreign operations in the financial statements of an entity and how to translate financial statements into a presentation currency. [IAS 21.1]. The principal issues are which exchange rate(s) to use and how to report the effects of changes in exchange rates in the financial statements. [IAS 21.2].

IAS 21 Key Functional Currency: The currency of the primary economic environment in which the entity operates. (The term 'functional currency definitions [IAS 21.8] [IAS 21.1]. A foreign currency shall be recorded, on initial recognition in the functional currency, by applying the spot exchange rate between the functional currency and the foreign currency at the date of the transaction.

IAS 21 Presentation currency: The currency in which financial statements are presented. If the presentation currency differs from the entity’s functional currency, the entity would translate its results and financial position into the presentation currency.

IAS 21 Exchange difference: The difference resulting from translating a given number of units of one currency into another currency at different exchange rates. Exchange differences shall be recognised in profit or loss in the period in which they arise. Foreign operation: A subsidiary, associate, joint venture, or branch whose activities are based in a country or currency other than that of the reporting entity.

IAS 21 Basic steps for translating foreign currency amounts into the functional currency The reporting entity determines its functional currency. The entity translates all foreign currency items into its functional currency. The entity reports the effects of such translation in accordance with paragraphs 20-37 [reporting foreign currency transactions in the functional currency] and 50 [reporting the tax effects of exchange differences].

Currency concepts Two currency concepts FUNCTIONAL CURRENCY PRESENTATION CURRENCY Currency of the primary economic environment in which the entity operates. Any currency Some translation rules Measurement currency Other foreign currencies

Transaction and translation risk Transaction Risk: Transaction risk is the exchange rate risk associated with the time delay between entering into a contract and settling it. The greater the time differential between the entrance and settlement of the contract, the greater the transaction risk. Creates difficulties for individuals and corporations dealing in different currencies, as exchange rates can fluctuate significantly over a short period of time.

Transaction and translation risk The exchange rate risk associated with companies that deal in foreign currencies or list foreign assets on their balance sheets. The greater the proportion of asset, liability and equity classes denominated in a foreign currency, the greater the translation risk. Poses a serious threat for companies conducting business in foreign markets.

Transaction and translation risk Exchange rates usually change between quarterly financial statements, causing significant variances between the reported figures.

Transaction and translation risk 31 December 31 March 1 October Price = £100 At year end Upon receipt FX rate = $1.40/£ Invoice = $140 Debtor $140 Receipt $140 FX rate $1.50/£ FX rate $1.45/£ Debtor £93 Receipt £97 Asset worth £7 less Received £3 less TRANSLATION RISK TRANSACTION RISK

Example A limited company trading in the UK and reporting in £sterling, buys a non current asset on credit from Aurusbis AG, a company based in Germany, for 741,240 Euros (when FX rate was €1.42/£ on 1 June 2016. At the end of A limited financial year, which is 31 December, FX rate is €1.50/£.

Example 1). To recognise the transaction, the company record the cost of the non current asset and the liability in £sterling at the date of the original transaction (1 June 2016) as follows: Dr Non-current assets 522,000 Cr Current liabilities 522,000

Example 2). The value of the non-current asset will not change at the year end. However, because of the difference in the exchange from the date of the agreement, A Limited will now only need to pay Aurusbis £494,160 (741,240/1.50). It can therefore reduce its liability by £27,840 (i.e., 522,000 – 494,160) Dr Current liabilities 27,840 Cr Exchange gains (Expense account) 27,840

Example 3). If transaction is completed on 31 March 2017 and exchange is €1.45/£. The transaction is completed and therefore any liability included in the financial statements needs to be removed. The cash paid in the transaction is £511,200 (741,240/1.45) – which is more than is included in current liabilities at the year end. Dr Current liabilities 494,160 Dr Exchange loss (expense acct) 17,040 Cr Cash 511,200

Example Overall the transaction has result in A Limited making an exchange gain of £10,800 due to favourable exchange rates during the credit period. This is recognised in the financial statements over two accounting periods (gain in one/loss in the other). i.e., 27,840 -17,040 = £10,800

Functional currency If a foreign operation carries out its business as though it were an extension of the parent’s operations, then it almost certainly has the same functional currency as the parent. If the foreign operation is semi-autonomous it almost certainly has a different functional currency from the parent. Translation method used must reflect the economic reality of the relationship between the reporting entity (the parent) and the foreign operation.

Method of consolidation Currency differences arising from the retranslation at the end of each year are taken to equity (not through profit or loss) for the year and remain in equity until disposal of the net investment. Share capital is translated at the historical rate (rate when the parent acquired its interest). Pre acquisition reserves are translated at the historical rate, and post acquisition reserves are found as a balancing figure.

Method of consolidation Assets and liabilities of such foreign operations are translated at the closing rate (rate at the date of preparation of financial statements). Income and expenses are translated at the average rate (strictly, such transactions should be translated at the rate ruling at the date of each transaction but this is often impractical).

Exchange rates Statements Of Financial Position Assets & liabilities - @ closing rate Share Capital & pre-acq’n reserves - @ historic rate Post-acquisition reserves - @ balancing figure Income statement Income & expenses - @ actual/ average rate