Foreign Currency Transaction Exposure: Accounting for and Disclosures

Foreign currency transaction exposure is the risk of the exchange rate fluctuating before the payment obligation is fulfilled. If the foreign currency rises in value, it costs more in a company’s home currency. If a company imports or sells goods and products overseas, the profit it makes on the transaction partly depends on the exchange rate.

Assume Tiger Ltd, a Mexico-based company, exports goods to a distributor in India. The payment will be made in Indian Rupees having a value of MXN 100,000. Tiger operates on 30-day credit terms. However, a month later, the distributor is ready to pay up. The exchange rate has changed. Now, the currency conversion translates to a sale of MXN 90,000. Tiger Ltd. suffers a loss of MXN 10,000 due to foreign currency transaction exposure.

Both IFRS and US GAAP require the change in the value of the foreign currency asset or liability due to a foreign currency transaction to be treated as a gain or loss reported on the income statement.

Example 1: Accounting for Foreign Currency Transactions With Settlement before the Balance Sheet Date

This example exhibits a hypothetical Tata Motors’ accounting. Tata Motors sells manufactured products to AIMCO, a US-based company. The payments must be settled in Indian Rupees (INR) before the balance sheet date. The fundamental principle is that all transactions are recorded at the spot rate on the transaction date. 

Suppose Tata Motors sells products worth 50,000 USD to AIMCO on March 1, 2015; the credit period is 2 months. AIMCO makes a payment of 50,000 USD on May 1, 2015. Tata Motors’ functional and presentation currency is INR. Spot exchange rates between the USD and INR are as follows:

$$\small{\begin{array}{l|r|r} \textbf{Date} & \textbf{USD} & \textbf{INR}\\ \hline \text{March 1, 2015} & \text{1 USD} & 60.0\\ \hline \text{May 1, 2015} & \text{1 USD} & 61.0\\  \end{array}}$$

Tata Motors’ financial year ends on June 30. How will Tata Motors account for the foreign currency transaction? Further, what is the effect of this transaction on the 2015 financial statements?

Solution

On March 1, 2015, Tata Motors will have account receivables of INR 3,000,000 (USD 50,000 × INR 60). Instead, AIMCO purchases goods worth USD 50,000 on May 1, when the value of USD has increased to 61. The resulting net gain to Tata Motors is INR 50,000 (INR 3,050,000 – INR 3,000,000). INR 50,000 is called a foreign currency gain, and it is recognized on the income statement. Tata Motors’ balance sheet will record a cash increase of INR 3,050,000 and an inventory decrease of INR 3,000,000.

The net effect on the financial statements is seen as follows:

$$\small{\begin{array}{l|r} \textbf{Balance Sheet} & \textbf{Amount in Indian Rupees (INR)}\\ \hline\textbf{Assets}&\\ \hline\text{Cash} & 3,050,000\\ \hline\text{Inventory} & -3,000,000\\ \hline\text{Liabilities + Stockholders Equity} &\\ \hline \text{Retained earnings} & 50,000\\ \end{array}}$$

$$\small{\begin{array}{l|r} \textbf{Income Statement} & \textbf{Amount in Indian Rupees (INR)}\\ \hline\text{Revenues and Gains} & {}\\ \hline\text{Expenses and Losses} & {}\\ \hline \text{Foreign exchange gain} & 50,000\\  \end{array}}$$

Example 2: Accounting for Foreign Currency Transactions With Intervening Balance Sheet Dates

Assume that Tata Motors’ financial statements have to be prepared on March 31, 2015. Spot exchange rates between the USD and INR are as follows:

$$\begin{array}{l|r|r} \textbf{Date} & \textbf{USD} & \textbf{INR}\\ \hline \text{March 1, 2015} &  \text{1 USD} & 60.0\\ \hline\text{March 31, 2015} &  \text{1 USD}& 60.6\\ \hline \text{May 1, 2015} & \text{1 USD} & 61.0\\  \end{array}$$

Accounts receivable on each of the dates are determined as follows:

$$\small{\begin{array}{l|r|r|r} \textbf{Date} & \textbf{INR/USD Exchange Rate} & \textbf{INR Value} & \textbf{Change in INR Value}\\ \hline\text{1 March 2015} & 60.0 & 3,000,000 & \text{N/A}\\ \hline\text{March 31, 2015} & 60.6 & 3,030,000 & 30,000\\ \hline\text{May 1, 2015} & 61.0 & 3,050,000 & 20,000\\  \end{array}}$$

From the above table, an increase in the value of the Indian Rupee results in a foreign currency transaction gain of INR 30,000 from March 1, 2015, to March 31, 2015 (the balance sheet date). This gain is recognized as an unrealized gain in the 2015 income statement. A foreign currency gain of INR 20,000 occurs from the balance sheet date (March 31, 2015) to the transaction settlement date (May 1, 2015). The INR strengthened slightly against USD during this period resulting in an exchange rate of INR61/USD1 on May 1, 2015. Tata Motors will recognize a foreign currency transaction gain on May 1, 2015, of INR 20,000. It will be included in the company’s calculation of net income for the first quarter of the upcoming financial year.

In conclusion, from the transaction date to the settlement date, the Indian Rupee has increased in value by INR 1, which has generated a realized foreign currency transaction gain of INR 50,000. The first gain of INR 30,000 is recognized in 2015, and the second gain of INR 20,000 is recognized in the first quarter of the subsequent year. Ultimately, the net gain recognized in the financial statements equals the actual realized gain on the foreign currency transaction over the two months.

Key Points

If the balance sheet date is between the transaction date and the settlement date:

• The transaction is recomputed based on the exchange rate on the balance sheet date.
• The amount receivable is updated accordingly for Tata Motors, and the amount receivable as of March 31, 2015, is INR 3,030,000.
• The unrealized gain/loss is recognized in the income statement.
• When the realization of a gain/loss happens later, the balance sheet for the next period is updated with the balance transaction.

Under both IFRS and US GAAP, there is no mention of whether the gains or losses need to be treated as a part of the operating or the non-operating income. Therefore, an analyst should ensure consistency when comparing two firms either by treating gains/losses from the two companies as operating or non-operating income.

Disclosures for Foreign Currency Transaction Gains and Losses

Foreign currency transaction disclosures are commonly found both in the Management Discussion & Analysis (MD&A) and the Notes to Financial Statements sections of an annual report.

IFRS requires the amount of foreign exchange transaction gains/losses to be recognized in profit and loss. US GAAP requires disclosure of the aggregate transaction gain or loss included in determining net income for the period. However, neither standard requires disclosure of the line item in which these gains and losses are located.

Some companies may prefer not to disclose the amount or the location of their foreign currency transaction gains or losses if the amounts involved are immaterial. The reasons for unnecessary gains/losses may include:

• Relatively stable exchange rates between a company’s functional and foreign currencies.
• A company engages in a few and limited number of foreign currency transactions.
• Offsetting of foreign currency transaction gains by losses on other transactions, resulting in an immaterial net gain/loss.
• The company has foreign exchange hedge instruments such as foreign currency forward contracts and foreign currency options to offset foreign exchange gains and losses.

Question

XYZ is a hypothetical clothing company based in Europe. Euro is XYZ’s functional and presentation currency. XYZ supplies clothes worth £40,000 to a mall in the UK on December 1, 2018, under one-month credit terms. XYZ’s fiscal year-end is December 31.

What is the most accurate way of reporting XYZ’s foreign currency transaction on December 31, 2018, if the British pound strengthened and then weakened against the euro? Assume that all the other factors are held constant.

   A. A gain and then a loss.

   B. A loss and then a gain.

   C. A gain in both cases.

Solution

The correct answer is A.

A foreign currency receivable arising from XYZ’s export sale creates an asset exposure to foreign exchange risk. If the British pound, i.e., the foreign currency, strengthens, the receivable increases in value in terms of the euro, i.e., the company’s functional currency. This results in a foreign currency transaction gain.

XYZ will be able to convert the British pound when received into more units of the euro because the British pound has strengthened. Conversely, if the British pound weakens, the foreign currency receivable loses value in terms of the euro, leading to a loss.

B and C are incorrect according to the above explanation.

Reading 13: Multinational Operations

LOS 13 (b) Describe foreign currency transaction exposure, including accounting for and disclosures about foreign currency transaction gains and losses.