1.

Introduction

A foreign currency exchange rate is a price that represents how much it costs to
buy the currency of one country using the currency of another country. Currency
traders buy and sell currencies through foreign Currency exchang transactions
based on how they expect currency exchange rates will fluctuate. When the value
of one currency rises relative to another, traders will earn profits if they
purchased the appreciating currency, or suffer losses if they sold the appreciating
currency.

2. Foreign currency exchange rates

An exchange rate is a rate at which one currency will be exchanged for another
currency or the relative value of one currencyto another. Most exchange rates
are defined as floating and will rise or fall based on the supply and demand in the
market. Exchange Difference is resulting from translating a given number of
units of one currency in to another currency. Exchange rates can be changed
because of a number of economic factors affecting the supply and demand for a
nation’s currency.

There are a number of Factors causing fluctuations on a nation’s currency of

supply and demand

 Level of inflation
 Balance of payments
 Changes in a country’s interest rate
 Investment levels
 Stability and process of governance

The relative value of one currency to another may be expressed in two different
ways:

2.1. Direct exchange rate and

2.2. Indirect exchange rate

2.1. Direct Exchange Rates

The direct exchange rate (DER) is the number of local currency units (LCUs)
needed to acquire one foreign currency unit (FCU) . From the viewpoint of
Ethiopian entity, the direct exchange rate can be viewed as Ethiopian cost of one
foreign currency unit. The direct exchange rate ratio is expressed as follows, with
the LCU, the Ethiopian Birr, in the numerator:

Ethiopian Birr - equivalent value

DER = 1FCU

The direct exchange rate is used most often in accounting for foreign operations
and transactions because the foreign currency–denominated accounts must be
translated to 2their U.S. dollar–equivalent values.

For example, on january 20, 2023 an Ethiopian company acquire one dollar for 54
birr. What is the exchange rate for one dollar?

solution

DER= 54 birr

1 dollar

= 54 birr per dollar

2.2. Indirect Exchange Rate

The indirect exchange rate (IER) is the reciprocal of the direct exchange rate. It
is the number of Foreign currency units (FCUs) needed to acquire one Local
currency unit (LCU).

From the view point of Ethiopian entity, the indirect exchange rate is

IER= 1 FCU

Ethiopian birr – equivalent value

For Example: On January 1, 2023, an Ethiopian based company can purchase one
Dollar for Br. 54.
IER= $1

Br.54

= 0.0185/Birr

2.3. Effects of foreign exchange rate

If Direct exchange rate increases or Indirect exchange rate decreases

 Weakening of Local currency

 Taking More Local currency to acquire one Foreign Currency.
 One LCU acquiring Fewer FCUs.
 Export Increase and Import Decrease.

If Direct exchange rate Decreases or Indirect exchange rate Increase

 Strengthening of Local currency

 Taking Less Local currency to acquire one Foreign Currency.
 One LCU acquiring Higher FCUs.
 Export Decrease and Import Increase

3. Accounting for Foreign Currency Transactions

Businesses that involve in international trades or Multi-National Company (MNC)

need foreign currencies to enter into different transactions. A “Multi-National
Company” is one that conducts its business in more than one country via
branches, joint ventures, subsidiaries etc. In most countries, the foreign currency
is treated as a commodity or a money-market instrument. Thus, different Multi-
National Companies (MNCs) involve buying and selling of foreign currency. The
following different Exchange Rates are applicable for buying and/or selling
foreign currency:

3.1. Types of exchange rate

3.1.1.Spot Rates: are rates used by banks for immediate delivery or receipts of a
foreign currency. The two spot rates are
(i) Spot Selling Rate: The rate charged by the bank for current sales in foreign
currency

(ii) Spot Buying Rate: The rate applied by the bank to acquire a foreign currency.
The spot buying rate is usually lower than the spot selling rate.

3.1.2.Forward Rates: are rates applied to foreign currency transactions to be

consummated at a future date. The two forward rates are:

(i) Forward Selling Rate: The rate charged by the bank for future 4sales in
foreign currency, and

(ii) Forward Buying Rate: The rate applied by the bank to acquire a foreign
currency in the future. The forward buying rate is usually lower than forward
selling rate.

3.1.3.Spread: is the difference between the selling and the buying spot rates and
represent gross profit to a foreign currency trader.

The transactions engaged in to by the multinational company must be recorded

in the reporting currency in the accounting records of the enterprise. The
appropriate spot rate is used for this purpose. If the spot exchange rate for the
foreign currency changes on the date of financial statement preparation prior to
settlement of the transaction, or on the settlement date itself, a foreign currency
transaction gain or loss is recognized for display in the income statement of the
enterprise for the accounting period in which the rate changes. For MNC, if all its
transactions are accounted for in one currency, no problem arises, however often
local currencies are used and thus, MNCs are exposed to different risks as
discussed in the next topic as a result of foreign exchange rate fluctuations.

4. Accounting for Foreign Currency Translation

4.1. Types of Currencies

4.1.1.Functional Currency - of a foreign entity as the currency of the primary

economic environment in which the entity operates; normally, that is the
currency of the environment in which an entity primarily generates and expends
cash. Functional currency is the monetary unit of account of the Principal
Economic Environment in which an economic entity operates. The functional
currency is used to differentiate between two types of foreign operations:

(i). Those that are self-contained and integrated into a local environment

(ii).Those that are an extension of the parent and integrated with the parent

4.1.2.Reporting Currency – is the currency in which the parent company

prepares its financial statements; that is the currency used in published reports
and financial documents of the parent company. It is a currency in which the
parent firm prepares its own financial statements; that is, US dollars for a US
companies or Birr for Ethiopian companies.

4.1.3.Foreign Currency – any currency other than the reporting currency of the
parent company

4.1.4.Local Currency is the currency unit used in a country referenced. Local

currency is the currency in the country where the foreign subsidiary is operating.
For example, Birr is the local currency in Ethiopia.

Exchange Difference (Spread)– difference resulting from translating a given

number of units of one currency into another currency at different exchange
rates.

Foreign Operation – a subsidiary, associate, joint venture, or branch whose

activities are based in a country other than that of the reporting enterprise.

4.2. Determination of Foreign Currency5

The functional currency for a given foreign operation is a matter of fact.

Management judgment is required in the functional currency determination
process. The most important economic factors are set forth below and possibly
others, should be considered both individually and collectively when determining
the functional currency.5

 Cash Flow Indicator – denomination of cash flows.

 Sales Price Indicator – responsiveness of selling prices to exchange rates on
a short-term basis.
 Sales Market Indicator - existence of an active local sales market for the
product
 Expense Indicator – existence of a local source for operating costs
 Financing Indicator – denomination of the firm's primary financing
 Intercompany Indicator – the volume of intercompany transactions.

To determine the functional currency, the most heavily weighted factors are
indicators related to Cash Flows and Expense and Revenue Items. Based on the
above six indicators, Multinational company may use the reporting currency or
local currency, or foreign currency other than local currency for the operation
of foreign subsidiary. The functional currency may be the currency of the
country in which the foreign entity is located (local currency), the reporting
currency, or the currency of other foreign country (foreign currency).6

 If the foreign entity's operations are self-contained and integrated in a

particular country and are not dependent on the economic environment of
the parent company, the functional currency is the foreign currency (either
local currency or foreign currency other than local currency).
 The functional currency of a foreign company would be the reporting
currency if the foreign operation is an integral component or extension of
the parent company's operations. That is, the daily operations and cash
flows of the foreign operation of the foreign entity are dependent on the
economic environment of the parent company.
 An exception is required for subsidiaries located in environments in which
the cumulative rate of inflation during the preceding three years exceeds
100 percent. In such hyper inflationary environments, the reporting
currency becomes the functional currency. A Local Currency can be a
Functional Currency only in a Stable Economy if:
• Cash flows are local currency
• Sales prices are determined by local conditions / in local currency
• Expenses are paid in local currency / driven by local conditions
• Financing done in local currencies
• Inventory value liked to local conditions.

When a multinational enterprise prepares consolidated or combined financial

statements that include the operating results, financial position and cash flows of
foreign subsidiaries or branches, the enterprise must translate the amounts in
the financial statements of the foreign entities from the entities’ functional
currency to the reporting currency. Similar treatment must be given to
investments in other (foreign) investee’s for which the parent company uses the
equity method of accounting. In addition, if foreign entity’s accounting records
are maintained in a local currency of the foreign country that is not the entity’s
functional currency; the foreign entity’s account balances must be re-measured to
the functional currency from local currency.

4.3. Foreign Currency Import and Export Transactions 7

An overview of the required accounting for an import or export transaction

denominated in a foreign currency, assuming the company does not use forward
contracts, is as follows:7

4.3.1.Transaction date: Record the purchase or sale transaction at the Local

Currency Units using the spot direct exchange rate on this date.

4.3.2.Balance sheet date: Adjust the payable or receivable to its Local Currency
Units, end-of-period value using the current direct exchange rate.

Recognize any exchange gain or loss for the change in rates between the
transaction and balance sheet dates.

4.3.3.Settlement date: Adjust the foreign currency payable or receivable for any
changes in the exchange rate between the balance sheet date (or transaction
date) and the settlement date, recording any exchange gain or loss as required
and also record the settlement of the foreign currency payable or receivable.

Illustration of Foreign Purchase Transaction 7

On October 1, 2014, ABC Company, an Ethiopian Company, acquired goods on

account from Martin, an American company, for $200,000.00. ABC prepared
Financial Statement at year end on December 31, 2014. Settlement of the
payables was made on April 1, 2015.

Spot rates

October ….........…..1$ = Br. 55 or 55/$

December 31......…1$ = Br. 59 or 59/$

April 1…………………..1$ = Br. 57 or 57/$

Required

Prepare a neccessary journal entry (ABC Company) for Foreign purchase

trasaction?

Solution

ABC Company

Date Explanation Debit Credit

October 1 Purchase/Inventory Br. 11,000,000

Account payable Br. 11,000,000

($200,000*Br. 55/$=
Br.11,000,000)

December 31 Loss on FET 800,000

Account payable 800,000

(200,000*59/$= Br. 11,800,000)

April 1 Account payable 400,000

Gain on FET 400,000

Account payable 11,400,00

Cash 11,400,000

($200,000*57/$= 11,400,000)

illustration
Suppose ethio telecom buys a large consignment of goods from a supplier in
Egypt. The order is placed on 1 April and the agreed price is 155,250 Egypt Dollar.
At the time of delivery the rate of foreign exchange was Birr 2.00 to 4.50 Egypt
Dollar.

Required

1. Show the initial recognition

2.What will the entries be if the exchange rate is 4.55 when payment is made on
may 1?.

Solution

Initial recognition- ethio telecom will recognize the purchase using its functional
currency (Birr) by applying the spot exchange rate when the purchase was made
(Birr 2.00 to 4.50 Egypt Dollar)

Inventory account (155,250 ÷ 4.50)....................Br 34,500

Payables account.........................................Br 34,500

 When ethio telecom comes to pay the supplier, it needs to obtain some foreign
currency. By this time, however, if the rate of exchange has altered to 3.55 to may
1, the cost of raising $155,250 would be (155,250÷ 4.55)= 34,121. The company
would need to spend only 34,121 to settle a debt for inventories 'costing' 34,500.
Since it would be administratively difficult to alter the value of the inventories in
the company's books of account, it is more appropriate to record a profit on
conversion of 379.

Account Payable..................................Br. 379

Gain on Foreign Exchange Transaction...................Br. 379

Account Payable.............................Br 35,000

Cash...........................Br 35,000
5. Translation Exchange rates

Translation methods may employ a single rate or multiple rates. There are three
alternative exchange rates for translation of foreign subsidiary financial
statements: current rate, historical rate, and average rate.

5.1.Current Rate – exchange rate prevailing as of the financial statement date

5.2.Historical Rate – exchange rate prevailing when a foreign currency asset was
first acquired or a foreign currency liability was first incurred10

5.3.Average Rate – is simple or weighted average exchange rate of either current

or historical exchange rates

6. Alternative Methods of Translation of Foreign Subsidiary's

Financial Statement

If the exchange rate for the functional currency of a foreign subsidiary or branch
remained constant instead of fluctuating, translation of financial statements
would be simple. All financial statement amounts would be translated at the
constant exchange rate. However, exchange rates fluctuate frequently. Hence, a
problem is faced which exchange rate to use. The several methods (translation
models) for foreign currency translation may be grouped into four basic classes
as shown below:

6.1. Current / Non-current Method

6.2. Monetary/ Non monetary Method

6.3. Temporal Method

6.4. Current Rate Method

In general, all the four translation models agree on the translation of sales
revenues & other revenues and most operating expenses on the income
statement except depreciation expense. Typically, these are translated using the
historical rate in effect when the revenue was earned or the expense recognized.
That may be an average rate for the period.
6.1. Current/Non-Current method

This method focuses on traditional accounting classification for assets and

liabilities: Balance Sheet Translation:

 Current items on the balance sheet (current assets and current liabilities)
are translated at the current rate. 11
 11Long-term items on the balance sheet (all other assets & liabilities) and
the elements of owners ‘equity are translated at historical rates

Income statement Translation:

 Depreciation expense & amortization expenses are translated at historical

rates applicable to the related assets.
 All other revenues and expenses are recognized at an average exchange
rate for the accounting period11

The principal objection of this method is with respect to inventories; it represents

a departure from historical cost. Inventories are translated at current rate, rather
than at historical rates in effect when the inventories were acquired, if the
current/ noncurrent method of translating foreign currency accounts is applied.
Cost of Goods Sold is translated at the current rate because inventory is
translated at current rate as it is current asset. Translation gains and losses under
this method are generally included in Net Income, but treatment is flexible.

116.2. Monetary/ Non-monetary Method

This method focuses on the financial character of assets & liabilities of the foreign
subsidiary financial statement rather than on their balance sheet classifications
to determine appropriate rate.

Foreign currency assets and liabilities expressed as a fixed number of currency

units are defined as monetary (receivables and payables). Other items are non-
monetary.

Balance sheet translation:

 Monetary items are translated at the current rate – i.e. monetary assets &
liabilities representing claims & obligations expressed in a fixed monetary
amount are translated at the current rate.
 Nonmonetary items are translated at the historical rate – i.e. all other
assets and liabilities, and owners' equity amounts are translated at
historical rates. Non-monetary items include fixed assets, long-term
investments, and inventories.

Income statement translation:12

 In the income statement, average exchange rates are applied to all

revenues and expense except depreciation expenses, amortization expense,
and cost of goods sold, which are translated at appropriate historical
rates.
 Supporters of this method emphasized its retention of the historical cost
principle in the foreign entity’s financial statements. 12

6.3. Temporal Method

The temporal model considers currency translation as a measurement

conversion process. This method cannot be used to change the attribute of an
item being measured; it can only change the unit of measure. 12Temporal
method considers time dimensions and foreign balance sheet items are measured
accordingly based on three different values: (i).Past exchange prices – Historical
Cost,

(ii).Current exchange prices - Current Value,

(iii).Future Values.

 12Cash, receivables, and payables are translated at the current rate

 Other assets and liabilities may be translated at current or historical
rates, depending on their characteristics
 Assets and liabilities carried at past exchange prices are translated at
historical rates
 Assets and liabilities carried at current purchase or sales exchange prices
or future exchange prices would be translated at current rates
 Cost of Goods Sold and Depreciation Expense are translated at their
historical rate.
 Exchange gains and losses from translation are included in current net
income.

136.4. Current Rate Method

 All balance sheet amounts other than owners’ equity items are translated
at the current rate.
 Owners' equity items are translated at the historical rates.
 Revenues and gains and expenses and losses are translated at the rates in
existence during the period when the transactions occurred (if practical);
otherwise an average exchange rate is used for all revenuers and expenses.

This method provides that all financial relationship remain the same in both local
currency and reporting currency. The translation adjustment which result from
the application of these rules are reported as a separate component in owners'
equity of the parent company's consolidated balance sheet (or parent – only
balance sheet if consolidation was not deemed appropriate).

13

Balance sheet accounts Temporal method Current rate method

exchange rate exchange rate

Asset

Cash and recievables Current rate Current rate

Marketable securities Current rate Current rate

Inventory at market Current rate Current rate

Inventory at cost Historical rate Current rate

Prepaid expenses Historical rate Current rate

PPE Historical rate Current rate

Intangable asset Historical rate Current rate

Libilities

Current liabilities Current rate Current rate

Deferred income Historical rate Current rate

Long term debt Current rate Current rate

Owner's Equity Current rate Historical rate