I'm Larry Walther, this is principlesofaccounting.com, Chapter 15.
And in this module,
we will be considering accounting issues that arise in global commerce.
First, recognize that financial statements of a subsidiary might be prepared in their
local currency, the currency of the country in which they operate or
which their domiciled.
However, the financial statements of the parent company
reporting to the shareholders, so they would be reporting in reporting
currency of the country, their home base of country.
So, the subsidiary's financial statements are prepared in one currency.
And the parent's financial statements and the statements that are delivered to
shareholders might be prepared in a different currency.
And so for reporting purposes we obviously have a problem because we can't
add different currencies together and make any logical totals.
And so we have to deal with that.
In the consolidation of financial statements,
we have to convert the subsidiaries into the reporting currency of the parent.
And there's actually two methods that emerge.
One is translation and another is remeasurement.
Now translation is used when the subsidiary is somewhat autonomous.
It's free standing, self-supporting, generating and reinvesting cash flows.
In those cases what we'll do is convert the assets and liabilities to the parent's
currency based on the prevailing exchange rates at the balance sheet date.
And this may cause the trial balance of the subsidiary to no longer be in balance,
we might need a plug to balance the balance.
That plug is referred to as a translation adjustment.
The cumulative translation adjustment is reported
typically as a component of other comprehensive income or
part of stockholder's equity, but not operating income.
This contrasts to re-measurement,
it's used when translation method is not deemed to be appropriate.
These would be other cases, such as maybe the subsidiary's an extension of
the parent's operation, like an importing subsidiary or something.
Its primary or functional currency might be the currency of the parent,
even though for convenience,
the financial statements are prepared in a local currency, a different currency.
And in that case, we convert the assets and liabilities using
a variety of exchange rates depending on the nature of the asset and liability.
The specifics of this would typically be covered in advanced accounting courses,
but what's important in those cases,
you would have a plug to balance your trial balance.
And is considered to be a part of the operating income, so it's a remeasurement
gain or loss, and it becomes part of the income determination for the entity.
So there are some significant issues there.
Let's though next turn our attention to global trading transactions,
where we buy and sell goods and make or take payment in a foreign currency.
So when I say when a firm buys or sells goods from or
to foreign firms, and the currency for settlement is the foreign currency,
the amounts must be converted for record keeping purposes.
For example assume Bentley's Bike Shop of the United States purchased bicycles from
GiroCycle of Switzerland, agreeing to pay 20,000 Swiss francs within 60 days.
So Bentley has engaged in a foreign currency transaction.
Assume the exchange rate, it's also called the spot rate on any given date,
assume the spot rate is $0.90 per Swiss franc.
So what have we done here?
Well, in a journal entry, we bought inventory 20,000 Swiss francs, but
we're gonna denominate it in our reporting currency of US dollars.
20,000 Swiss francs at $0.90 a piece comes to $18,000.
So, we'll debit inventory 18,000 and credit accounts payable 18,000.
The question that arises is what happens if exchange rates change and
we have to pay more or less than $18,000 to buy the 20,000 Swiss
francs 60 days from now when we settle this transaction?
And so here's what happens, I'm assuming by August 29th the settlement date
that the spot rate has risen to $0.95.
So we go down to the bank and
say hey we want to buy $20,000 Swiss Francs and they say well it's $19,000.
So we have to deliver $19,000 credit cash to satisfy an account
payable that's on the books at only $18,000 debit accounts payable.
We need a $1,000 debit to balance, and we record that as a loss.
We don't go back and change the recorded value for the inventory,
we view this as a currency exchange loss that's reported in the income statement.
Of course if the exchange rate had gone the other way we could have a foreign
currency gain or credit to balance out the entry.
Foreign currency payables and receivable that exist at the close of an accounting
period must be adjusted to reflect the spot rate on the balance sheet date.
So not only do we recognize foreign currency exchange gains and
losses concurrent with settling transactions to the extent we have any
outstanding payables and receivables at the balance sheet date.
Or for that matter, we're holding foreign currency at the balance sheet date.
We record it at the spot rate on the balance sheet date,
in the reporting currency, and the changes in values that
are occurring because of that process are recognized in income.
Example, on December 1 of 20X1, Vigeland Corporation sold goods to a customer
in England, agreeing to accept payment of 100,000 British pounds in 90 days.
The spot rate for the pound on that date was $1.75.
By December 31, when financial statements were prepared,
the spot rate had increased to $1.90.
But then by the time settlement occurred in February 28th of the next year,
the exchange rate had dropped back to $1.70 so
it had a volatile exchange rate, let's see what happens.
First of all, we record the sale on December 1,
debit accounts receivable and credit sales, $175,000.
That's 100,000 British pounds at a $1.75 per pound.
At our balance sheet diet we adjust the account receivable,
we increase it to $190,000.
We're adding $15,000 to it and recognizing a currency exchange gain.
That reflects the incremental increase in the US dollar equivalent of
the receivable.
And it goes the other way in the next year and now booking a loss,
the receivable has declined.
When we collect the receivable,
the 100,000 British pounds only bring $1.70 each, or $170,000.
Although our receivable was last adjusted and created 190,000.
So we've got a $20,000 debit, or loss, to balance that particular entry.
Now, companies may not like these exchange gains and losses and there are a variety
of strategies that can be undertaken to hedge or avoid these risks.
We might make or take payment in our home currency,
not agreeing to foreign currency transactions.
Or we might structure financial agreements with banks or
other financial institutions or foreign currency exchange
brokers or even commodity exchanges to enter into offsetting positions so
that we don't have a net exposure to our foreign currency risk.
So there are a variety of ways to deal with that,
by companies that choose to avoid this particular accounting outcome.