A foreign currency transaction is a transaction which is denominated in or requires settlement in a foreign currency. An enterprise either buys or sells goods or services whose price is denominated in a foreign currency. It can also borrow or lend funds when the amounts payable or receivable are denominated in a foreign currency.
The measurement basis, most commonly adopted by enterprises in preparing financial statements is historical cost. Financial statements prepared under historical cost convention do not have regard for changes in price levels.
Thus; they do not reflect financial realities.
This is where current cost accounting comes in handy. Current cost represents the amount the firm would have to pay currently to obtain the asset or its services.
CURRENT ACCOUNTING RULES FOR FOREIGN CURRENCY TRANSACTIONS.
One of the pertinent issues in foreign currency is the transaction rate. Two methods of translating foreign currency transactions are used to address this problem of transaction rate. These are; the functional currency method also referred to as the temporal method and the presentation currency method (closing method).
Under the functional currency method, all monetary assets and liabilities are translated at the closing rate. Non-monetary transactions are shown in terms of historical cost and translated at the spot rate. Spot rate is the exchange rate existing as at the date of the transaction.
Non –monetary items that are carried at fair value are translated using exchange rates prevailing when the values were determined.
Income statement items are translated at the rate ruling at the time the transactions occurred. If transactions are numerous over the year and the exchange rate does not fluctuate widely over the year, the average rate can be used. Depreciation is translated at the rate applied to translate the property, plant and equipment in the balance sheet. And, any exchange difference is dealt with in the income statement as income or expense in the period in which it arises.
However, under the presentation currency method, the assets and liabilities both monetary and non-monetary of the foreign entity should be translated at the closing rate. The income and the expense items of the foreign entity should be translated at exchange rates at the date of the transactions. All resulting exchange differences should be classified as equity until the disposal of the net investment.
The other issue with foreign currency transactions is on how to treat exchange differences arising out of settled transactions as well as unsettled transactions. The rule is that exchange gains are included in the income statement if they are to be realized. However, for unsettled exchange gains, the inclusion is not appropriate since it violates the prudence principle and the revenue recognition principle.
Of essence also, is how to calculate the interest of the minority when consolidating for a foreign subsidiary. The prevailing rule is that the share in the minority interest in the profit for the year will be their share of the shilling equivalent of the profit shown by the subsidiary. The minority should also be credited or debited with their share of all exchange differences.
GAINS AND LOSSES ON FORWARD CONTRACTS, AS A MEASURE OF THE PERFORMANCE OF FOREIGN EXCHANGE RISK MANAGERS.
One of the challenges facing financial managers today is forex risk exposure. Two types of exchange rates exist. These are; the spot exchange rate and the forward exchange rate. The spot rate is the rate for today whereas the forward exchange rate is the rate today for exchanging one currency for another at a specific future date. The forward market provides the finance manager with a facility to buy or sell a fixed amount of foreign currency at a fixed rate on some future date.
Foreign exchange exposure (forex) / risk exist whenever some of the company’s assets and/ or liabilities are not denominated in the currency of its home country. The performance of a foreign exchange risk manager would be evaluated on the basis of how fast and effective he identifies the values that are exposed to the risk of loss if exchange rates were to change by a significant margin. He must also be able to make a decision on whether he believes that exchange rates can be forecasted or speculated. Lastly, and most importantly his performance will be evaluated based on the strategies of identifying and reducing forex risks by choosing from the many hedging devises available. Through internal hedging, a good financial Manager adjusts the contract price to forward rates instead of invoicing using the spot rate(s). If a contract is being quoted in the home currency, the price in the home currency can be based on the forward rate of exchange rather than on the spot rate.This incorporates into the contract price the expected rise or fall in the exchange rates between the date the contract was designed and the settlement date. The method can however be used only with non-standard contracts which are priced in the home currency.
EXCHANGE RATES FOR TRANSLATING ASSETS
There is need to translate financial statements from their historical cost conventions to their current cost equivalents. This is because current costs reflect a true measure of the current values of items/transaction in the financial statements. If the financial statements are already in their current cost forms, the need of translation does not arise. This is because the translation rate would always be 1 and the items would not change.
Appropriate methods of translating assets from their historical costs include; the current power purchasing method and the current cost accounting method. Selection of the measurement bases exhibit different degrees of relevance and reliability. Management must seek a balance between relevance and reliability.
Under the current cost accounting approach, each item of the financial statements are restated in terms of current value of the item. Assets are shown in terms of what such assets would currently cost. By using appropriate conversion rates, the current cost method makes adjustments on: property, plant and equipment, depreciation inventory and the accounts receivables. By incorporating these changes, the financial statements are restated in their current value terms.
The managent of risk by financial managers is important in an organization. With an aim of reducing the risk of exchange loss risks, the managers must apply relevant methodologies if their performance evaluation is a thing to go by.
Consequently, financial statements need restatements to incorporate the element of price level changes. And as various techniques for restatements exist, financial managers ought to be wary of their financial implications and use the most appropriate.
Jeter, DC and P.K Chaney, WIE Advanced Accounting 2nd edition Wiley 2003, ISBN; USA
Chuo Keizai Sha, Practice for Foreign exchange Accounting; 2003, University press USA
Chuo-Keiza-Sha, Accounting practice for transactions in foreign currency and currency derivatives, 2000, ISBN; USA
Cite this Rules for Foreign Currency Transactions
Rules for Foreign Currency Transactions. (2016, Dec 13). Retrieved from https://graduateway.com/rules-for-foreign-currency-transactions/