In addition to the environmental characteristics just discussed. companies with international business dealings encounter problems-from multiple currencies. Consider, for example. a Japanese company that sells merchandise to a U.S. corporation. The Japanese company will want to be paid in Japanese currency-yen-but the U.S. company’s bank account contains U.S. dollars. Thus one currency must be converted into another. Most banks participate in an international currency exchange, which enables them to – buy foreign currencies at the prevailing exchange rate. Thus a U~S. corporation can pay a liability to a Japanese company through the international banking system.
The U.S. company will pay its bank in dollars. The bank will then use these dollars to purchase the required amount of yen on the international currency exchange and will arrange for delivery of the yen to the Japanese company’s bank.’ Exchange Rates A currency exchange rate is the amount i’t costs to purchase one unit of currency with another currency. Thus the exchange rate may be viewed the “price” -of buying one unit of a foreign currency. stated in terms of the domestic currency (which for our purpose is U.S. dollars). Exchange rates fluctuate daily, based en the worldwide supply and demand for particular currencies. The current exchange rate between the dollar and ‘most major currencies is published daily in the financial press. For example. a few of the exchange rates recently listed in The Wall Street Journal are shown below.Exchange rates may be used to determine how much of one currency is equivalent to a given amount of another currency.Assume that a U.S. company owes a Japanese company I million yen (expressed ¥l ,000.000). How many dollars are needed to settle this obligation. assuming that the current exchange rate is $0.0106 per yen? To restate an amount of foreign currency in terms of the equivalent amount of U.S. dollars. we multiply the foreign currency amount by the exchange rate. as follows
This process of restating an amount of foreign currency in terms of the equivalent number of dollars is called translating the foreign-currency.
Alternatively. the U,S. company may send the Japanese company a check (or a bank draft) stated in dollars. The Japanese company can then arrange to have the dollars converted into yen through its bank in Japan. -70 convert an amount of dollars into the equivalent amount of a foreign currency, we would divide the dollar amount by the exchange rate. For example, $10,600 -i- $0.0 I06 per yen = ¥ I,000,000.Exchange Rate “Jargon” In the financial press. currencies are often described as “strong” or “weak,” or as rising or falling against one another,
For example. an evening newscaster might say. “A strong dollar rose sharply against the weakening British pound, but fell slightly against the Japanese yen and the Swiss franc.” What does this tell us about exchange rates? To understand such terminology, we must remember that an exchange rate is simply the price of one currency stated in terms of another currency. Throughout this chapter, we refer to the prices of various foreign currencies stated in tenns of U’!S. dollars. In other countries, however, the U.S. dollar is’ a foreign currency. and itsprice is stated in
• terms of the local (domestic) currency. .To, illustrate, consider our table from The Wall Street Journal. which shows the exchange rate for the Japanese .yen to be $0.0 I06. At this exchange rate. $1 is equivalent to ¥94 (¥94 x $0.0 I06 per yen = $1). Thus. while we would say that the exchange rate for the Japanese yen is $0.0106, the Japanese would say that the exchange rate for the U.S. dollar is ¥94. Now let us assume that the exchange rate for the yen (stated in dollars) rises to $O.lH09.
At this exchange rate, $1 is equivalent to only ¥92 (¥92 X $o.n I09 = $1). In the United States, we would say that the exchunge rute for the yen has risen from $().OI06 to SO.OI0′). In Japan, however, they would say that the exchange rate for the dollar hasfalle;, from ¥94 to ¥92. In the financial press, it might be said that “the yen ha~ risen against the dollar” or that “the dollar hasfallen against the yen.” The two statements mean the same thing-that the yen has become more valuable relative to the dollar. ‘ Now let us return to our original phrase,
“A strong dollar rose sharply against the weakening British pound, but fell slightly against theJapanese yen and the Swiss franc.” When exchange rates are stated in terms of U.S. dollars, this statement means that the price (exchange rate) of the British pound fell sharply. but the prices of the Japanese yen and the Swiss franc rose slightly. A currency is described as “strong” when its exchange rate is rising relative to most other currencies and as “weak” when its exchange rate is falling. Exchange rates fluctuate because of changes in the environmental forces discussed earlier in this chapter. Ac.counting for Trans.actions with ..Foreign Companies When a U.S. company buys or sells merchandise in a transaction with a foreign COIllpany, the transaction price may be stipulated either in U.S. dollars or in units of the foreign currency. If the price is stated in dollars, the U.S. company encounters no special accounting problems. The transaction may be recorded in the same manner as are similar transactions with domestic suppliers or customers. If the transaction price is stated in terms of the foreign currency, the company encounters two accounting problems. First. as the U.S. company’s accounting records are maintained in dollars, the transaction price must be translated into, dollars before the transaction can be recorded. The second problem arises when (.I) the purchase or sale is made on account and (2) the exchange rate changes between the date of the transaction and the date that the account is paid. This fluctuation in the exchange rate will causethe’ U.S. company to experience either a gain or a loss in the settlementof the transaction.
Credit Purchases with Prices Stated In a Foreign C”rrency Assume that on August I a U.S. company buys merchandise from u British company tit u price of IO.OO()British pounds (£10.000), with payment due in 60 days. The exchange rate on August I is $1.63 per British pound. The entry on August I to record this purchase (assuming use of a per- _ petual inventory system) would be:,Inventory 16.300′ Accounts Payable 16.300 To record the purchase of merchandise from a British company for £10.000 when the exchange rate is $1.63 per pound (£10.000 x $1.63 = $16.300).Let us now assume that by September 30, when the £ 10,000 account payable must be paid, the exchange rate has fallen to $1.61 per British pound. If the U.S. company had paid for the merchandise on August I, the cost would have been $16,300. On September 3Q, however, only $16,100 is needed to pay the £10,000 liability (£10,000 X $1.61 = $16, I(0). Thus the decline in the exchange rate has saved the company $200. This savings is recorded in the accounting records as a Gain on Fluctuations in Foreign Exchange Rates. The entry on September 30 to record payment of the liability and recognition of this gain would be Accounts Payable 16,300
Cash Gain ‘on Fluctuations in Foreign Exchange Rates . To record payment of £10,000 liability to British company and to recognize gain from decline in exchange rate: Incorrigibility (£10,000 x $1.63) ‘ ‘, $16,300 Amount paid (£10,000 x $1.61) 16,100 Gain from decline in exchange rate s-.2OO The foreign exchange rate 16,100 ‘ gain for the redit purchase Is 200 determined by using the exchange rate on the payment date Now let us assume that instead of declining, the exchange rate had increased from $1.63 on August I to $1.66 on September 30. Under this assumption, the U.S. company . would have to pay $16,600 in order to payoff the £10,000 liability on September 30. Thus the company would be paying $300 more than if the liability had been paid on August
This additional $300 cost was caused by the increase in the exchange rate and should be recorded as a loss. The, entry on September 30 would be: Accounts Payabl .,16,300 loss on Fluctuations 300 CashTo record payment of £10,000 liability to British company and to recognize loss from increase in exchange rate: Original liability (£10,000 x $1.63) .. $16,300 Amount paid (£10,000 x $1,66)16,600 loss from increase in exchange rate $300 A foreign exchange rate loss Occurs if the exchange rate 16,600 increases between the credit purchase date and the payment dale In ,summary, having a liability that is fixed in terms of a foreign currency results in a ‘ gain for the debtor if the exchange rate declines between the date of the transaction and , the date of payment. The gain results because fewer dollars will be needed to repay the debt than had originaly been owed.
An increase in the exchange rate, on the other hand, causes the debtor to incur a loss. In this case, the debtor will have to spend more dollars than had originally been owed in order to purchase the foreign currency needed to pay the debt. Credit Sales with Prices Stated in a Foreign Currency A company that makes credit sales at prices stated in a foreign currency also will experience gains or losses from fluctuations in the exchange rate.
To illustrate, let us change our preceding example to assume that the U.S. company sells merchandise on August 1 to the British company at a ‘price of £ I0,000 ..We shall again assume that the exchange rate on August 1 is $1.63 per British pound and that payment is due in 60 days. The entry on August 1 to record this sale would be: Accounts Receivable 16,300 Sales 16,300 To record sale to British company with sales price set at £10,000 (£10,000 x $1.63) = $16.300, To be collected in 60 days. In 60 days (September 30), the U.S. company will collect from the British company the U.S. dollar equivalent of £10,000. If the exchange rate on September 30