seen that fluctuations in exchange rates may cause gains or losses for companies with accounts payable or receivable in foreign currencies. Exchange rates fluctuate on a duily basis. For convenience, however” the company usually waits until the account is paid or collected before recording the related gain or loss. An exception to this convenient practice occurs at the end of the accounting period.
An adjusting entry j’s made to recognize any gains or losses that have accumulated on any foreign payables or receivables through the balance sheet date. ‘ To illustrate, assume that on November 10 a U.S. company buys equipment from a Japanese company at a price of 10 million yen (¥1O,000,000), payable on January 10 of the following year. If the exchange rate is $0.0100 per yen on November 10, the entry to record the purchase .would be:Now assume that on December 31, the exchange rate has fallen to $0.0097 per yen.
At this exchange rate, the U.S.’ company’s account payable is equivalent to only $97,000 (¥lO,OOO,OOOX $0.(097). Gains and losses from changes in exchange rates arc recognized in the period in which the change occurs. Therefore, the American company should make an adjusting entry to restate its liability at the current dollar-equivalent and to rccognize any related gain or loss. This entry, dated December 31, would be:Similar adjustments should be made for any other accounts payable or receivable at yearend that are fixed in terms of a foreign currency. If the exchange rate changes again between the date of this adjusting entry and the date that the U.S. company pays the liability, an additional gain or loss must be recognized.
Assume, for example, that on January lO the exchange rate has risen to $0.0099 per yen. The U.S. company must now spend$99.000 to buy the ¥lO,OOQ,OOQ,neededto pay its liability to the Japanese company.
Thus, the rise in.the exchange rate has caused the U.S. company a $2,000 ‘loss since year-end. The entry to record payment of the a on January 10 would be:Notice the overall effect of entering into this credit transaction stated in yen was a $1,000 gairr’due to fluctuations in the exchange rate for the yen between November lO and the date of payment (January lO).
The V.S. company recognized a $3,000 gain on fluctuations in the exchange rate from November 10 through the balance sheet date (December 31). This was partially offset in the next yttal year by a $2,000 loss on fluctuations in the exchange rate between December 31 and January lO. The overall effect can be computed directly by multiplying the amount of the foreign currency times the change in exchange rates between the transaction date and the payment date (¥lO,OOO,OOQX [$0.0 I00 – $0.OQ99] = $1,000 gain).Notice that the cash effects from foreign exchange rate fluctuations for associated transactions do not occur until the transaction is completed and the payment is made. That is, foreign exchange rate gains or losses recorded for receivables or payables do not involve cash flows (excluding tax effects).
As we have demonstrated, the cash flow effect of the exchange rate fluGtuation associated with the credit transaction for the purchase of equipment occurs on the date of payment, January 10 (expected cash outflow = $100,000; actual cash outflow = $99,000). The $3,000 gain recorded at the balance sheet date and the $2,000 loss recorded at the date of payment have no associated cash flow effects.
Gains and losses from fluctuations in exchange rates on transactions carried out in a foreign currency should be included in the income statement. They typically follow income from operations and are presented in a manner much like interest expense and gains and losses on the sale o!plant assets.Currency Fluctuations-Who Wins and Who loses? Gains and “lossesfrom fluctuatio~s in exchange rates aresustained by companies (or individuals) that have either payables or receivables that are fixed in terms of a foreign currency. United States. companies that import foreign products .usually have large foreign liabilities, Companies-that export U.S. products to other countries are likely to have large receivables stated in foreign currencies.
As foreign exchange rates (stated in dollars) fall, U.S.-based importers will gain and exporters will Jose: When it foreign exchange rate falls, the foreign currency becomes less expensive. Therefore, importers will have to spend fewer dollars to pay their foreign , liabilities. Exporters, on the other hand, will have to watch their foreign receivables become worth fewer and fewer dollars. Whenforeign exchange rates rise, this situation reverses. Importers will lose, because more dollars are required to pay the foreign debts. Exporters will gain, because their for- ‘ eign receivables become equivalent to an increasing number of dollars. ‘ . Strategies to Avoid LOlSes from Rate Fluctuations There are two basic approaches to avoiding losses from fluctuations in foreign exchange rates. One approach is to insist that ‘receivables’ and payables be settled at specified amounts of domestic currency.
The other approach is called hedging ‘and can be accomplished in a number of ways. To illustrate the first approach, assume that a U.S. company makes large credit sales to companies in Mexico; but anticipates that the exchange rate for the Mexican peso will gradually decline. The U.S. company can avoid losses by setting its sales prices in dollars. Then, if the exchange tate does decline, the Mexican companies will have to spend more pesos to PJlY for their purchases; but the V.S: company will not receive fewer dollars. On the other hand, the V.S. company will benefit from making credit purchases from Mexican companies at prices stated in pesos, because a decline in the exchange rate will reduce the number of dollars needed to pay for these purchases. ‘ The interests of the Mexican companies, however, are exactly the opposite of those of the U.S. company. If the Mexican companies anticipate an increase in the exchange rate for the U.S. dollar, they will want to buy at prices stated in pesos ‘and sell at prices stated in dollars: Ultimately, the manner in which the transactions will be priced simply. depends ,on which company is in the better bargaining position. Hedging, Hedging refers to the strategy. of “sitting on both sides of the fence’; -that is, of taking offsetting positionsso that your gains and losses tend to offset one another. To illustrate the concept, assume that after a few beers you make a large bet on a football game. Later you have second thoughts about the bet, and you want to eliminate your risk of incurring a loss.
You could “hedge” your original bet by making a similar bet on, ‘ the other team. I~ this way, you will lose one bet, but you will win the other=-your loss ‘ will be offset by acorresponding gain A company that has similar amounts, of accounts receivable and accounts payable in the same foreign’ currency, automatically has a hedged position. A decrease in the foreignexchange rate will cause losses on the foreign receivables and gains on the foreign payables. If the exchange rate, rises, the gains on the foreign receivables will be offset by losses on the foreign payables. Most companies, of course, do not have similar amounts of receivables and payables –
in the same foreign currency:
However, they may create thissituation by buying or seiling’ foreign currency future contracts. These contracts, commonly called futures. are the right to receive a specified quantity of foreign currency at a future date. In short. they are accounts receivable in foreign currency. Thus a company that has only foreign accounts payable may hedge its position by purchasing a similar dollar amount of foreign currency future contracts, Then; if the exchange rate rises, any losses on the foreign payables will be offset by a gain in the value of the future contracts.
A company with only foreign receivables may hedge its position by selling future contracts, thus receiving dollars today and creating a liability payable in foreign currency.Exchange Rates and Competltlv,e Prices Up to this point, we have discussed only the gains and losses incurred by companies that have receivables or payables stated in terms of a foreign currency.
However, fluctuations in exchange rates change the relative prices of goods produced in different countries. Exchange rate fluctuations may make the prices of a country’s p-oducts more or less competitive both at home andto custozners throughout the world. Even a small store with no foreign accounts receivable or payable may find its business operations greatly affected by fluctuations in foreign exchange rates.
Consider, for example, a small store in Kansas that sells a U.S.-made brand of television sets. \f foreign exchange rates faU, which happens when the doUat is strong, the price of foreign-made television sets will decline. Thus, the store selling U.S.-made television sets may have to compete with stores selling imported television sets at lower prices. Also, a strong dollar makes U.S; goods more expensive to customers in foreign countries. Thus a U.S. television manufacturer will find it more difficult to sell its products abroad.
The situation reverses when the dollar is weak-s-that is, when foreign exchange rates are relatively high. A weak dollar makes. foreign imports More expensive to U.S. consumers.
Also, a weak dollar makes U.S. products less expensive to customers in foreign. ooumri~.’In summary, we may say thata strong U.S. dollar helps companies that sell foreignmade goods in the U.S. market. A weak dollar, on the other hand, gives a competitive advantage to companies that sell U.S. products both at home and abroad. – Consolidated Financial Statements That Include Foreign Subsidiaries In, we discussed the concept of consolidated financial statements.
These . statements .view the operations of the parent company’ and its subsidiaries as if the affiliated’ companies were a single business entity. Several special accounting problems arise in preparing consolidated financial statements when subsidiaries operate in foreign ‘countries. First; the accounting records of the foreign subsidiaries must be translated into U.S. dollars. Second, the accounting principles in use in the foreign countries may differ significantly from U.S. generally accepted accounting principles. These problems pose interesting challenges to professional accountants and will be addressed in later accounting courses. Readers of the financial statements of U.S.-based corporations, however,’ should know that the consolidated financial statements of these companies are expressed in, U.S. dollars and conform to U.S. generally accepted accounting