Advanced financial accounting PowerPoint presentation. In this presentation, we’re going to discuss foreign currency exchange rates get ready to account with advanced financial accounting, foreign currency exchange rates, let’s first define foreign currency transactions. So what are from foreign currency transactions? When are we going to need to account for foreign currency transactions. So from our perspective, we’re going to be looking at this from the perspective of a US company US company that is having their books then accounted for or measured in dollars. And when you think about the foreign currency transaction, it’s just like anything else, but it can be a little bit more confusing. So you want to remember, of course, that the dollar is basically the measuring tool.
So anything we put on the books, like if we put inventory on the books, we might count the units of inventories, but of course, we have to measure them on our financial statements in dollars. Same kind of things can be true with foreign currency. It’s another kind of units, we can almost think of them as some kind of investment as stocks or something like that. Even though they are a currency, and we’re going to have to record them on our rubber books with our measuring tool that we’re currently using, and that’s going to be dollars. So foreign currency transactions for a US company include sales purchases and other transactions. So if we sell something, purchase something, or have some other transaction that gives rise to a transfer a foreign currency. In other words, we’re paying or receiving some foreign currency rather than our currency, which is the US dollar, the recording of receivables or payables that are in foreign currency denominations. In other words, we might buy something or sell something on account meaning we result in a receivable or payable on the books and at the future point in time when we either receive or pay, we’re going to be receiving or pain in the foreign currency, once again, results in the foreign currency transaction. So those are the kind of transactions that we’ll be looking into here. TRANSLATION The process of restating foreign currency transactions to US dollar equivalent values. So when we put this on our books, we have the same problem, as we do with basically anything else. That’s not dollars, right, we got to measure it in dollars. So if we bought inventory, we’re not going to call it 10 units of inventory got to measure it in dollars. If we bought equipment, we’re not going to say we have one forklift, we got to measure it in dollars, same thing is going to be happening with the foreign currency. Now the foreign currency is kind of similar to other types of investments like stocks and bonds in that there’s basically a market for the foreign currency is something that’s trading hands typically.
So typically, we can figure out what the exchange rate is at least on a specific point in time. And think about, think about what it would be then now of course, if we have accounts receivable or accounts payable, or if we’re going to get paid in the future, then the valuation has a little bit of a timing issue that we’ll have to deal with as well. So we’ll have to take those into considerations as we value the foreign currency transactions for our books, which of course we need to value them in US dollars. So foreign subsidiaries foreign subsidiary, Prepare financial statements into home currency. So, if we have a foreign subsidiary in another country, then they would they would basically be performing obviously their financial statements in their currency in a foreign currency with respect to the US company. So the foreign currency amounts need to be translated to US dollar equivalence, so they can be consolidated with the US parent financial statements.
So, if the US company has a subsidiary in another country that is conducting their books and their financial statements in a foreign currency, then we’re going to need to consolidate the books possibly and when we do that consolidation, we will need to take those foreign currency financial statements translate them into the US currency so that we can then conduct the consolidation process exchange rates foreign currency exchange rates are established daily by foreign exchange brokers who are agents for individuals and countries that want to deal in foreign currencies. Some countries maintain an official fixed rate of currency exchange They have established a fixed exchange rates for dividends remitted outside the country. And exchange rates will change based on many economic factors affecting the supply and demand of the currency of a nation. Some factors include, we’ll get into those factors in a second, but just note that when you’re thinking about the foreign currency exchange rates, basically you’re you’re basically thinking about a market. So there’s a lot of factors that will be involved in it. But similar to other other types of transactions, we’re basically saying, you know, foreign currencies are being exchanged in a similar way, from an economic standpoint as basically other things like stocks and other types of investments. And And because of this, the sameness to the one of the characteristics of currency being that it’s, it’s something that has a value that’s constant. So we know that $1 is the same as another dollar in terms of value. That means that we can value our currency because we have a market that’s currently exchanging Typically, and therefore, we can basically value our currency in a similar way as if a stock is traded on a stock exchange. We know the current value of the stock. Why? Because it’s currently being traded for that, and all the common stocks are the same. That’s the point of the common stock. So we have a similar situation with the currency so we can basically value the currency.
Now, of course, that doesn’t mean relative currencies will change relative to each other, just like stocks and bonds will go up and down. So there’s going to be a change a lot of fluctuation with the value of currencies as they are related to each other. But at any given time, we should be able to determine what that what that value is given the current conditions of the market. So some factors that influence the exchange rates could be the level of inflation, balance of payments, changes in interest rates, changes in investment levels of instability of the government. And again, from an economic standpoint, notice this basically comes down to supply and demand of the currency of a nation right. And those are going to be the things that are going to be affecting the supply and demand of the of the of the nation currency. Just like again the supply and demand of stocks or anything else and that’s how we’re going to value it based on the market. And then we’re going to basically depend on the market when we are considering the valuation and then and then conducting the exchange rates. So the direct and the direct and indirect exchange rates, direct exchange rates, which we’re going to say as a D are direct exchange rate is the number of local units LC us needed to acquire one foreign currency unit. So we’re typically talking the number of dollars that are going to needed to be required for one foreign currency unit, and some other foreign currency if we’re from the perspective of a US company. So we’re talking about local units, the dollar needed to acquire one foreign currency unit, whatever other currency that we’re doing business with in our negotiation the direction exchange rate ratio from the viewpoint of a US entity will be below example $1 and 20 cents can purchase one pound. So if we have the direct exchange rate, we’re going to say that the US dollar equivalent value of one foreign currency unit over one foreign currency unit, for example, that would mean the direct exchange rate is $1 and 20 cents over one pound, which means we have $1 and 20 cents per pound, basically.
So that means that we’re going to have $1 and 20 cents can purchase one pound, the indirect exchange rate, the reciprocal of the direct exchange rate from us entity standpoint perspective, the indirect exchange rate is going to be one foreign currency unit divided by US dollar equivalent value of one foreign currency units or so the indirect exchange rate is equal to one pound over $1 and 20 cents which is equal to point 8333 pounds to the dollar. So eight point, I mean point 833 pounds is necessary for $1. If we take a quick example, if we start with $10 and multiply it times that point 8333, then we’re going to get pounds of 8.33. If we were to take that and multiply it times to 1.2, which is the direct exchange rate, then that would take us back to the original $10. The direct exchange rate is identified as American terms. In other words to indicate that it is US dollar based and represents an exchange rate quote from the perspective of a person in the US. In other words, if you were taking a look at the direct exchange rate, I’m going to scroll back up a bit. We have in our example $1 and 20 cents in dollars to the pound here. So it’s basically expressed in dollars. If you take a look at the example then, if we were starting basically here and we had something that was worth 8.33 pounds, Then we’re going to use the direct exchange rate because that’s basically telling the user that’s, that’s looking at the thing for perspective of dollars, how many dollars that’s going to be kind of like the conversion in dollars. So if we’re looking at something that’s 8.33 pounds, we use the direct exchange rate times 1.2. dollars to the pound. And that’s going to give us then the $10 equivalent when we’re thinking about the indirect exchange rate, identified as foreign currency terms, to indicate that direct exchange rate from the perspective of a person using a foreign currency, this means the exchange rate shows the number of units of the local currency units per one US dollar. So obviously, on the other side of things, if we’re on if we’re looking at the perspective, from exit from, in this example, the pound, then we’re looking at the indirect exchange rate, which is going to be point 833 pounds to the dollar. So now if we look at our example here, we’re going to say well, if it’s $10, if you’re looking at something from $10 and you’re looking at it from the perspective of how many pounds is that going to cost, then we have the indirect exchange rate, point 8333. And that’s going to give us the number of pounds, which is the point, which is the 8.33.
So you can see that who’s been directed at when we’re thinking about are we using the direct exchange or the indirect exchange rate, you’re trying to make it as easy as possible from the perspective of the user being, you know, the primary user being in the in the dollars or in the, in the foreign currency, the terms currency is the number is the number, the numerator, the base currency is the denominator in the exchange ratio, then we want to think about the concept of weakening of the US dollar versus strengthening of the US dollar. So when we think about this examples of our is the currency getting weaker and stronger, this really gets more solidified. When we do actual practice examples when we actually use these rates, within example problems, you’ll get a much better feel if you actually worked through The example problems of these concepts of what when when $1 is getting stronger or weaker? And then you’ll be able to answer these questions on a on like a theoretical term type of basis, a multiple choice type of question much more easily. So we can have the US dollar when the direct exchange rate increases. So when we’re thinking about the direct exchange rate, for example, our example was $1 and 20 cents for a pound. If it was, if it went up, if the direct exchange rate was $1 and 50 cents or $2 for a pound, then you have a weakening of the dollar because it’s costing more dollars to get one unit of the next unit whatever other unit in this case the pound strengthening of the US dollar, the exchange, the exchange rate decreases, so obviously, the inverse would be the case for a strengthening of the dollar. In other words, in our example, it took $1 and 20 cents to get one pound. If it was going to go down in the one pound only cost us $1 instead of $1 20. Now one pound is is costing less to us. So for example, if it only costs us 50 cents to get one pound, it went from 120 down to 50 cents. Well, now we have a strengthening of the dollar in relation to the pound.
So let’s take the concept of weakening of the US dollar for the direct exchange rate increases. So if we take the the situation where the dollar is weakening, that means the direct exchange rate is increasing. It was taking us say, one $1 and 20 cents to purchase a pound. Now it’s taking $1 and 50 cents to purchase a pound for example. So it’s taking more US currency to purchase one foreign foreign currency unit cost us more US currency to get one foreign currency unit. One US dollar is acquiring fewer currency units. So the other way you can think about this is how many foreign currency units can I get with $1 and I’m getting you know less foreign currency units for $1. For example, the direct exchange rate increases from 1.33 to 1.45. So that would mean that it now has to went from 1.33 to get to get a foreign currency unit, and now it’s going up to 1.45. It’s taking more dollars to get to one foreign currency unit on the direct exchange rate strengthening of the US dollar direct exchange rate decreases. So what happens on the other side of things, obviously, now if we think about the strengthening, we’re going to say now that the direct exchange rate is going down at this point in time because it takes less dollars to purchase another unit of currency. So if it was if it was that 120 before to purchase one other unit of currency, foreign currency, now it’s going to be down to you know, 110 or something like that. It’ll be strengthening. So it’s taking less US currency to purchase one foreign currency unit. One US dollar is acquiring more for foreign currency units. So that’s But the two ways you can think of it, it takes less US currency to purchase one foreign currency unit, or one US dollar is acquiring more foreign currency units. So for example, if the direct exchange rate decreases from 1.245 to 1.26, then it was taking 1.4 $5 to get one foreign currency unit, and now it’s taking 1.2 $6 to get to one foreign currency unit, so it takes less dollars to purchase a foreign currency unit. Therefore, we have a strengthening of the dollar in relation to the foreign currency.
Now we have some terminology about the different types of rates. And these are kind of timing issues here. So we have this spot rate. So the term spot rate is the exchange rate for immediate delivery of currency. So for talking about something that’s going to be immediately exchanged or immediate delivery of the currency, immediate exchange rate, then we’re considering the spot rate. We can contrast this to something we’re predicting or having some transaction that’s going to happen in the future. If we have some kind of contract or something for a rate that’s going to something that’s going to take place in the future, then you might try to contrast this with some type of predictive rate that you think the rate will the exchange rate will be at some other time other than now, right. So when you think about the spot rate, you’re typically thinking now, this is the rate or exchange rate, as of this point in time as of now, or the exchange rate for the immediate delivery of currency, the current rate is going to be the spot rate on the entity’s balance sheet date. So when we think about the balance, when we think about the financial statements, then we’re going to think that the current rate is going to basically be that spot rate for the balance sheet date, which is going to be helping us to create the balance sheet at that point in time with regards to any kind of foreign currency transactions. So then we have the forward exchange rates, the forward rate on a date will not be the same as the spot rates. So when we think about a forward rate, that means we’re kind of considering a rate that’s going to be in the future for some reason, often this will be for forward contracts. And we’ll talk about forward contracts where we’re basically predicting out into the future, what the rate will be in the future. So when you’re thinking about exchange rates, and you’re thinking about the market for exchange rates, you can think about, you know, what people believe what currently is being exchanged with regards to rates at this point in time. And then you can also start to project out in the future and predict what you think the spot rates will be in the future. So when we think about the forward rate, we’re typically thinking about some rate into the future. And this could be useful again, if we’re talking about some type of exchange that’s going to happen in the future with regards to foreign currency and or if we have some type of contract, that’s going to be kind of predicting the rates out into the, into the future expectations about the relative value of currencies are built into the forward rate. So when you think about the forward rate, again, I would think of it kind of like a market type. transaction, people are predicting what the rate will be out into the future.
So we are currently transacting today. So we have a pretty solid market transaction going on there because the actual transactions are being made. But predictive transactions are being made as well about the the predictive foreign rates into the future. So these are going to be expectations about the relative rates for currencies are built into the forward contracts. So the spread then, is the difference between the forward rate and the spot rate at a given date and provides information about the the perceived strengths and weakness, weaknesses of the currencies. So you can basically kind of read into that when you’re looking at the forward rates versus the current spot rate, what people think about about the currencies, what are going to be the strengths and weaknesses, given the differences in those amounts, because obviously, if everything was static, then you would say the forward contract rates would be the same as the spot rates, the rates that were predicted in the future would be the same as today. Like, obviously, that’s not typically going to be the case almost never is that the case. Let’s take a look at a quick example. So let’s assume a US based company purchases inventory for 1000 pounds on 331. And the contract requires payment on 930. So in other words, we have a purchase taking place, if you remove the currency, I think the foreign currency would just be we’ve made a purchase on account, right, we made a purchase on account, we’re going to get inventory and then we’re gonna have an accounts payable that we’re going to pay at a later time we’re going to pay it in 180 days on 930. Now then you add the foreign currency component to this, when you make the payment on 930. It’s not going to be in US dollars, you’ve agreed to make the payment in pounds, so you can have to pay the $1,000 in pounds 180 days from today. So typically the point in time that on 330. If we’re saying the spot rate at that point in time, we could say is 1.3 $5 to the pound. And that’s typically what we’ll put the inventory on the books for at that point in time. If you think about 180 days forward, meaning what will What? Where will we be? Or what’s the predicted rate as of 330? What’s the predictive rate that it will be four 930, when we’re actually going to make the payment in pounds, because we’re gonna have to pay this thing in pounds 180 days later, then that’s going to be the forward forward rate, which is going to be in our example 1.4 dollars to the pound. So then the difference then is what we would call the spread, the difference is going to be the spread. And that’s basically the market you know, predicting the strengths and weaknesses of of the relations of the currency. Now, from an accounting perspective, the question of for us is obviously going to be well, okay, I’m trying to put the inventory on the books here and I’m trying to make a payment in pounds over here. How am I going Going to how am I going to account for this thing, and that’s what we’ll get into. And it’ll look a lot easier to do when we do the practice problems, this will all come together a lot more for you.
So I highly recommend working through the practice problems. And as we do so, the questions then will be well, when you know if there’s a timing difference, if the exchange happens right now, then there’s no real problem, we’ll use the spot rate. But if there’s some type of timing difference where the payments going to happen in the future, or if we have a forward contract, or we’re trying to hedge something or something like that, then we have these predictive rates. And then the question is, do we use the spot rate at this point, or do we use the forward the forward rate? And so those are some of the concepts we’ll get into and like I say, the best way to get into those is just to work through practice problems.