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Exhibit 6-3 lays out the distinction between transaction and translation gains and losses

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Exhibit 6-3 lays out the distinction between transaction and translation gains and losses. Differences in exchange rates in effect at the various dates shown cause the various types of exchange adjustments.

When considering exchange gains and losses, it is critical to distinguish between transaction gains and losses and translation gains and losses. A realized ( or settled) transaction creates a real gain or loss. Accountants generally agree that such a gain or loss should be reflected immediately in income. In contrast, translation adjustments (including gains or losses on unsettled transactions) are unrealized or paper items. The appropriate accounting treatment of these gains or losses is less obvious.

			Types of Exchange Adjustments
EXHIBIT 6-3
	date	statement date		date	financial statement date	financial statement date

 

Unsettled transaction

Exchange gain/loss

Transaction gain/loss

Translation gain/loss

Transaction

Financial

Settlement

Initial

Subsequent

 

 

 

Settled transaction

An informed reader of consolidated financial statements must understand three major issues associated with fluctuating exchange rates:

1. What exchange rate was used to translate foreign currency balances to domestic currency?
2. Which foreign currency assets and liabilities are exposed to exchange rate changes?
3. How are translation gains and losses accounted for?

These issues are examined in the rest of this chapter.

Foreign Currency Transactions

The distinguishing feature of a foreign currency transaction is that settlement is effected in a foreign currency. Thus, foreign currency transactions occur whenever an enterprise purchases or sells goods for which payment is made in a foreign currency or when it borrows or lends foreign currency. As an example, a company purchasing inventories denominated in Saudi Arabian riyals on account suffers an exchange loss should the riyal gain in value before settlement.

A foreign currency transaction may be denominated in one currency but measured in another. To understand why, consider first the notion of the functional currency. The functional currency of an entity is the primary currency in which it transacts business and generates and spends cash. If a foreign subsidiary’s operation is relatively self-contained and integrated within the foreign country (i.e., one that manufactures a product for local distribution), it will normally generate and spend its local (country-of-domicile’s) currency. Hence, the local currency (e.g., euros for the Belgian subsidiary of a U.S. parent) is its functional currency. If a foreign entity keeps its accounts in a currency other than the functional currency (e.g., the Indian accounts of a U.S. subsidiary whose functional currency is really British pounds, rather than Indian rupees), its functional currency is the third-country currency (pounds). If a foreign entity is merely an extension of its parent company (e.g., a Mexican assembly operation that receives components from its U.S. parent and ships the assembled product back to the United States), its functional currency is the U.S. dollar. Exhibit 6-4 identifies circumstances justifying use of either the local or parent currency as the functional currency.

To illustrate the difference between a transaction being denominated in one currency but measured in another, assume that a U.S. subsidiary in Hong Kong purchases merchandise inventory from the People’s Republic of China payable in renminbi. The subsidiary’s functional currency is the U.S. dollar. In this instance, the subsidiary would measure the foreign currency transaction—denominated in renminbi—in U.S. dollars, the currency in which its books are kept. From the parent’s point of view, the subsidiary’s liability is denominated in renminbi but measured in U.S. dollars, its functional currency, for purposes of consolidation.

FAS No. 52, the U.S. authoritative pronouncement on accounting for foreign currency, mandates the following treatment for foreign currency transactions:

1. At the date the transaction is recognized, each asset, liability, revenue, expense, gain, or loss arising from the transaction shall be measured and recorded in the

	Functional Currency Criteria
EXHIBIT 6-4
Economic Factors		Circumstances Favoring Local Currency as Functional Currency	Circumstances Favoring Parent Currency as Functional Currency
Cash flows		Primarily in the local currency and do not impact parent’s cash flows	Directly impact parent’s cash flows and are currently remittable to the parent
Sales price		Largely irresponsive to exchange rate changes and governed primarily by local competition	Responsive to changes in exchange rates and determined by worldwide competition
Sales market		Largely in the host country and denominated in local currency	Largely in the parent country and denominated in parent currency
Expenses		Incurred primarily in the local environment	Primarily related to productive factors imported from the parent company
Financing		Primarily denominated in local currency and serviced by local operations	Primarily from the parent or reliance on parent company to meet debt obligations
Intercompany transactions		Infrequent, not extensive	Frequent and extensive

Adapted from: Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 52, Stamford, CT: FASB, 1981, Appendix A.

functional currency of the recording entity by use of the exchange rate in effect at that date.

2. At each balance sheet date, recorded balances that are denominated in a currency other than the functional currency of the recording entity shall be adjusted to reflect the current exchange rate.

On this basis, a foreign exchange adjustment (i.e., gain or loss on a settled transaction) is necessary whenever the exchange rate changes between the transaction date and the settlement date. Should financial statements be prepared before settlement, the accounting adjustment (i.e., gain or loss on an unsettled transaction) will equal the difference between the amount originally recorded and the amount presented in the financial statements.

The FASB rejected the view that a distinction should be drawn between gains and losses on settled and unsettled transactions, because such distinctions cannot be applied in practice. Two accounting treatments for transactions gains and losses are possible.

Single-Transaction Perspective

Under a single-transaction perspective, exchange adjustments (both settled and unsettled) are treated as an adjustment to the original transaction accounts on the premise that a transaction and its settlement are a single event. The following example illustrates this treatment. On September 1, 2011, a U.S. manufacturer sells, on account, goods to a Swedish importer for 1 million Swedish krona (SEK). The dollar/krona exchange rate is $0.12 = SEK 1, the krona receivable are due in 90 days, and the U.S. company operates on a calendar-year basis. The krona begins to depreciate before the receivable is collected. By the end of the month, the dollar/krona exchange rate is $0.11 = SEK 1; on December

1, 2011, it is $0.09 = SEK 1. (These transactions are posted in Exhibit 6-5.)