CHAPTER -4-
The Effects of Changes in Foreign
Currency Exchange Rates
• Foreign currency refers to all currencies other than domestic currency for a given
country.
• Foreign currencies are purchased and sold by the international banking
departments of commercial banks.
Exchange Rate:
• An exchange rate is simply the price of one currency in terms of another
currency. Exchange rates fluctuate on a continuous basis.
Factors Affecting Exchange Rate
1. Inflation Rate
2. Interest Rate
3. Political Stability
4. Trade Balance
2
Exchange Rate Quotation:
1. Direct Quote: Measures how much units of domestic currencies are exchanged
for one unit of foreign currency.
2. Indirect Quote: Measures how much units of foreign currencies are exchanged
for one unit of domestics currency.
Exchange Rate Quotes
Direct Quote Indirect Quote
1 FC = Br. 0.25 Br. 1 = 4 FC
3
Strengthening and Weakening Currency:
• Strengthening currency would be evidenced by a
reduction in the directly quoted amount and an
increase in the indirectly quoted amount.
• The opposite would be true for a weakening of the
domestic currency.
• Weakening domestic currency can encourage
export trade.
• Strengthening domestic currency encourage
import. 4
5
Buying Rate (The Bid Price) And A Selling
Rate(the Offered Price):
• The buying and selling rates represent what
the currency broker (normally a commercial
bank) is willing to pay to acquire or sell a
currency.
• The difference or spread between these two
rates represents the broker’s commission.
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Spot Rate And Forward Rate:
A spot rate: is the rate of exchange for a
currency with immediate delivery, selling, or
buying of the currency normally occurring
within two business days.
Forward rates: apply to the exchange of
different currencies at a future point in time,
such as in 30, 60, 90, or 180 days.
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8
Forward contract: An agreement to exchange currencies at a specified
price with delivery at a specified future point in time.
Example: assume the forward rate to buy a FC to be delivered in 90 days
is Br. 1.650. This means that, after the specified time from the inception
of the contract date (90 days), one FC will be exchanged for Br. 1.650,
regardless of what the spot rate is at that time.
9
If the forward rate is greater than the spot rate at inception
of the contract, the contract is said to be at a premium (as in
the above example). The opposite situation results in a
discount.
10
• The interest rate differential between holding an
investment in foreign currency and holding an
investment in domestic currency over a period
of time a primary factor which can influence
forward rate.
• Assume that the spot rate is 1 FC = Br. 0.60 and
that you want to determine a 6-month forward
rate. Further, assume that the Birr could be
invested at 4.5% and the FC could be invested at
7.25%. 11
The forward rate would be calculated as follows:
12
Accounting For Foreign Currency Transactions:
Exchange gain/loss: rises from the difference between
exchange rates of currencies.
Example: assume that an Ethiopian business enterprise
required €10,000 (10,000 Euros) to pay for merchandise
acquired from a Germany supplier. The spot rate on date of
purchase is 1€= 50ETB
Record all necessary entries under the following cases
a. Spot rate on date of payment is1€= 50ETB
b. Spot rate on date of payment is1€= 60ETB
c. Spot rate on date of payment is1€= 40ETB
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• Changes in exchange rates do not affect
transactions that are both denominated and
measured in the reporting entity’s currency.
• However, if a transaction is denominated in a
foreign currency and measured in the
reporting entity’s currency, changes in the
exchange rate between the transaction date
and settlement date result in a gain or loss to
the reporting entity. 14
Illustration: assume that an Ethiopian Company sold mining
equipment on June 1, 200X4, with the corresponding
receivable to be paid or settled on July 1, 20X4. The
equipment has a selling price of Br. 306,000 and a cost of Br.
250,000. On June 1, 20X4, the Indian Rupee (denoted here
as ₨) is worth Br. 1.70, and on July 1, 20X4, rupee is worth
Br. 1.60.
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16
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• Unsettled Foreign Currency Transactions
If a foreign currency transaction is unsettled at
year-end, an unrealized gain or loss should be
recognized to reflect the change in the exchange
rate occurring between the transaction date and
the end of the reporting period.
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Example: assume Ethiopian Company purchased
goods from a foreign company on November 1,
20X1. The purchase in the amount of 1,000
foreign currencies (FC) is to be paid for on
February 1, 20X2, in foreign currency.
To record or measure the transaction, the domestic
company would make the following entry,
assuming an exchange rate of 1 FC = Br. 0.50:
19
Assuming the exchange rate on the December 31, 20X1 year-end
is 1 FC = Br. 0.52, the following entry would be necessary:
20
• Finally, assuming an exchange rate of 1 FC = Br. 0.55
on the settlement date (February 1, 20X2), the
domestic entity would make the following entry to
record the settlement:
21
Foreign Currency Translation
• Foreign currency translation is the process of expressing amounts
denominated or measured in foreign currencies into amounts
measured in the reporting currency of the domestic entity.
• Methods of Foreign currency translation:
1. Current Non-current methods
2. Monetary Non Monetary method
3. Current Rate Method
4. Temporal Method
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A. Current-non-current method–translates current accounts at
current exchange rates and non-current accounts at historical
rates;
B. Monetary-non-monetary method–translates monetary items at
current exchange rates and non-monetary items at historical
exchange rates;
C. Current rate method–translates all assets and liabilities at the
current exchange rate.
D. Temporal method (This method discussed later)
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Translation of Trail Balance Items
Trial Balance Items Spot Rate for Temporal Method
Assets and Liabilities
Measured at current values Current rates
Measured at historical cost Historical rates
Equity Accounts
Other than retained earnings Historical rates
Retained Earnings Translated beginning balance plus translated net income less dividends
translated at historical rates.
Revenue and Expenses
Representing amortization of Historical Rate
historical amounts
Not representing amortization of Weighted average rate
historical amounts
Translation gain or loss A balancing amount included as a component of current net income.
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Re-measurement of a Foreign Entity’s Account Balances
Example: ABC Company located in Ethiopia
has branch in France named Mason Branch.
Transactions of Mason Branch are recorded
using euro. Since the home office is in Ethiopia,
Mason Branch’s transactions should be
remeasured at Ethiopian Br. Transactions for the
Year 1999 are given below.
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A. CASH of Br. 1,000 was sent by the home office to Mason Branch (€1 = Br. 1.065).
B. Merchandise with a cost of Br. 60,000 was shipped by the home office to Mason Branch at a
billed price of Br. 90,000(€1 = Br. 1.065)
C. Equipment was acquired by Mason Branch for €527, to be carried in the home office accounting
records (€1 = Br. 1.054).
D. Sales by Mason Branch on credit amounted to € 92,500 (€1 = Br. 1.058). Cost of goods sold was
€64,818.
E. Collection of trade accounts receivable by Mason Branch amounted to € 68,400 (€1 = Br.
1.055).
F. Payment for operating expenses by Mason Branch totaled € 6,414 (€1 = Br. 1.060).
G. Cash of €39,750 was remitted by Mason Branch to home office (€1 = Br. 1.060).
H. Operating expenses incurred by the home office charged to Mason Branch totaled Br 3,000(€1 =
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Br. 1.063).
Journal Entries for 1999
Home office Mason Branch
Accounting Records (Ethiopian Birr) Accounting Records (Euro)
Investment in Mason Branch 1,000 Cash 939
Cash 1,000 Home office 939
Investment in Mason Branch 90,000 Inventories 84,507
Inventories 60,000 Home office 84,507
Allowance for Overvaluation of
Inventories: Mason Branch 30,000
Equipment : Mason Branch 555 Home office 527
Investment in Mason Branch 555 Cash 527
Trade accounts receivable 92,500
None Cost of goods sold 64,818
Sales 92,500
Inventories 64,818
None Cash 68,400
Trade accounts receivable 68,400
None Operating expenses 6,414
Cash 6,414
Cash 42,135 Home Office 39,750
Investment in Mason Branch 42,135 Cash 39,750
Investment in Mason Branch 3,000 Operating expenses 2,822
Operating expenses 3,000 Home office 2,822
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Investment in Mason Branch
Date Explanation Debit Credit Balance
1999 Cash Sent to Br. 1,000 Br. 1,000 d
Branch……………………………………
Merchandise Shipped to 90,000 91,000 d
Branch……………………..
Equipment Acquired by Branch, Carried in Home
Office Accounting Records …………………………. Br. 555 90,455 d
Cash Received from Branch…………………………. 42,135 48,310 d
Operating Expenses Billed to Branch……………… 3,000 51,310 d
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Home Office
Dat Explanation Debit Credit Balance
e
199 Cash Received from Home € 939 € 939 cr
9 Office………………………
Merchandise Received from Home 84,507 85,446 cr
Office……………
Equipment Acquired by Branch……….. €527 84,919 cr
……………….
Cash Sent to Home 39,750 45,169 cr
Office………………………………
Operating Expenses Billed by Home Office 2,822 47,991 cr
…………
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ABC Company
Mason Branch Trial Balance
December 31, 1999
Debit Credit
Cash €22,648
Trade Accounts Receivable 24,100
Inventories 19,689
Home Office €47,991
Sales 92,500
Cost of Goods Sold 64,818
Operating Expenses 9,236
Totals €140,491 €140,491
Sandino Company
Remeasurement of Mason Branch Trial Balance to Ethiopian Birr
December 31, 1999
Balance(Euros) Exchange Rates Balance(Birr) Dr
Dr (Cr) (Cr)
Cash €22,648 Br. 1.058(1) Br.23,962
Trade Accounts Receivable 24,100 1.058(1) 25,498
Inventories 19,689 1.065(2) 20,969
Home Office (47,991) (3) (51,310)
Sales (92,500) 1.0615(4) (98,189)
Cost of Goods Sold 64,818 1.065(2) 69,031
Operating Expenses 9,236 1.0615(4) 9,807
Subtotals €-0- Br. (232)
Foreign Currency Translation Loss 232
Total €-0- Br. -0-
(1) Current rate (on December 31,1999)
(2) Historical rate (when goods were shipped to branch by home office)
(3) Balance of Investment in Branch ledger account in home office accounting records
(4) Average of beginning (€1 = Br. 1.065) and ending (€1 = Br. 1.058) exchange rate, for Euro
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