 Hello and welcome to the session. This is Professor Farhad and this session would look at IAS 21, which is foreign currency transaction. This topic is covered in international accounting, the CPA exam, as well as the ACCA exam. As always, I would like to remind you to connect with me on LinkedIn. YouTube is where you would need to subscribe. I have 1500 plus accounting, auditing and tax lecture. If you like my lecture, please share them, put them in the playlist, let the world know about them. If you're benefiting from them, it means other people might benefit, so please share the wealth. This is my Instagram account and this is my Facebook account. Please follow me on Instagram as I'm trying to grow my following and this is my website. On my website, if you choose, you can donate the support in the channel. And on my website, I constantly have some sort of an offer. Right now, Becker is offering the $1000 off of their Becker bundle. Please check it out. If you're interested, I strongly encourage you to do so. Today, we're gonna be discussing export import transaction and simply put when we have two entities from two different countries buying and selling from each other or when you buy in a different country or buy supplies from a different country, you're gonna be exposed to foreign currency risk. So when two parties from different countries enter into a transaction, they must decide which of the two countries' currencies to use to settle the transaction. So let's assume a US company is buying from a German company. Well, we might have to pay in Euro or if we're selling to a German company, they may pay us in Euro. So we have an exposure. So the exposure can be summarized into from two components. From two perspective, you could be an exporter basically selling a US company selling to Germany. A transaction exposure exists when the exporter allows the buyer to pay in the foreign currency and also allow the buyer to pay sometime after the sale has been made. If they pay you immediately, there's no risk because you could convert the currency immediately and you're done, okay? So the exporter is exposed to the risk that the foreign currency might decrease in value between the date of the sale and the date of the payment, thereby decreasing the amount of domestic currency in which the foreign currency can be converted. So what is the risk if you are an exporter? What is your risk? If you're an exporter, you are going to have an account receivable. The risk is the foreign currency might depreciate. So simply put, if you are an exporter, you have an account receivable because you're gonna be receiving that foreign currency and what you want, the risk is the decreasing amount of the domestic currency in which the foreign currency can be converted. Simply put, let's talk US versus a German company. If you are a US exporter and you expect to receive German, not German marks, euros, if you're expecting to receive euros, you want the US dollar to weakened, you want the US dollar to weakened and you want the euro to strengthen. So you want the euro to appreciate, you want the euro to appreciate because you're gonna be receiving euros and as the euro appreciate, you can convert the euro into more US dollar. So you want your local currency to go down. So if US currency is your local currency, your home country, then you want your local currency to go down. On the other side, if you're an importer, means you're buying, okay, a transaction exposer exists when the importer is required to pay in a foreign currency and is allowed to pay sometime in the future. So you buy something but you're gonna pay for it down the road. Well, if you pay for it now, you know, there is no risk because you know what you're paying now, you'll pay it and you get done with it. But when you pay in the future, you're gonna have to buy that foreign currency and you never know how much you're gonna have to pay for it. Therefore, the importer is exposed to the risk that a foreign currency might increase, increase, appreciate between the date of the purchase and the date of the payment. Here, you want your home currency or your local currency in this situation. You want your local currency to go up, to appreciate. You want your local currency to appreciate. Why? Because as your local currency appreciate, you need less of it to buy the foreign currency. So you want your local currency. So if you are US importer, you want the dollar to strengthen and the euro to weaken if you are an importer. And the opposite is true if you're an exporter. If you're an exporter, you want your US dollar because that's your local currency to weakened. So when you receive the euro, you can buy more US dollar with the euro. Okay? Let's take a look at the summary of the state. This table will summarize what I just said. So if you are an exporter, you're gonna have, and your exposure is an asset, specifically an account receivable. So what is your foreign, how would you like your foreign currency? Well, you want your foreign currency to appreciate. If your foreign currency appreciate and you're an exporter, you're gonna have a gain. If the foreign currency goes down, you're gonna have a loss. Why? Because now you're gonna be receiving the euro, the foreign currency, and you can convert it into less US dollar. Now the opposite is true. If you are an importer, if you are buying stuff, you would have a liability. Your exposure is a liability. What happened is this? As your currency, because you have to pay in a different country, as the foreign currency depreciate, as the foreign currency goes down, you have a gain. Why? Because your local currency can buy you more. But as the foreign currency, as the foreign currency appreciate, you have a loss, because now you need to use more local currency, US dollar, to buy the foreign currency to settle the liability. So make sure you understand this grid before you proceed. It's very, very important. Let's take a look at an example to start to illustrate this whole concept and how do we record transaction because that's what we are interested in as accountant. We are not finance. So assume that Xeemco sells goods to a Spanish customer at a price of 1 million euro when the spot exchange rate is $1.50 per euro. That's fine. If the payment were received at the date of the sale, the company would have converted 1 million euros into 1,500,000 dollar. And this amount would clearly be the sales revenue. So if they paid you immediately, they're gonna pay you 1 million euros. You would convert to US dollar and you'll get 1.5 million. Instead, we're gonna be paid three months later. At the end of three months, the euro exchange rate is $1.48. And now we can convert 1 million euros at a rate of $1.48, thus receiving only 1,480. So the question is, how should we account for the change in value of $20,000? So copy this data down. We started the transaction. It was $1.50 when we made the sale, the transaction, the foreign currency exchange rate by the time we settled, it was $1.48. Conceptually, there are two accounting methods to account for the changes in the value of the currency. One is called the one transaction perspective. And the second is the two transaction perspective. And I'm gonna go over this one transaction, but that's not what we use. We really use the two transaction perspective. The one transaction perspective assumed that the export sale is not complete until the foreign currency receivable has been collected and converted into US dollar. So what we're saying is the transaction is not done. It's a one transaction and it's not completed until we receive the foreign currency and we convert it. So the company would eventually report the sale at $1,480,000 because this is what they really did if they're using the one transaction perspective. It means the sale did not happen until we received the money and we converted it. At that point, it was $1,480,000. This approach is criticized because it hides the fact that the company could have received $1.50,000 if we got the money on the transaction date, which is the rate was $1.50. So the company incurred $20,000 loss because the depreciation in the euro, but that loss is varied in an adjustment to sales. So basically what we're saying is this approach, it doesn't take into account the fluctuation in the currency. And this approach is not acceptable for GAP or IFRS. So what we have to do, we have to use the two transaction perspective. So both US GAP and IFRS, which is IAS 10 and ASCA 30, the foreign currency matters require company use what's called two transaction perspective and accounting for foreign currency transaction. So what do we mean by two transaction perspective? This perspective treats the export sale and the subsequent collection is two separate transaction. So what we're saying is this, we made the sale, we made an export sale, that's one transaction. Then we extended credit in the foreign currency, which is, it's a second exposure, which is a second transaction. The income effect from each of these decision should be reported separately. So the sale is one transaction, extending the credit is another transaction. Therefore we have two transactions. So under this approach, we would record the US dollar value of the sale at the date that it occurs. So basically 1.5 million, okay? So at this point, the sale is completed at 1.5 million. There's no subsequent adjustment to sale. So when we make the sale, the rate was dollar 50. So therefore we have sales at 1,500,000. We don't adjust the sales anymore. Now any subsequent difference, any difference between the number of US dollar that could have been received at the date of the sale and the number of US dollar actually received at the date of the payment due to the fluctuation in the exchange rate is the result of the decision to extend foreign currency credit to the customer and that should be treated separately. So this is what we mean by the two transaction perspective. It's a sale, that's one transaction, record the sale, the date that it took place. Then you extended the credit and that credit in a foreign currency, that's really another transaction, that's another risk. Therefore you have to account for it separately. So the difference is treated as either a foreign currency exchange gain or a foreign currency exchange loss and that goes in the income statement. So using the two step perspective, let's take a look at the journal entries. So on the date of the sale, we would record the sale at 1.5 million. We would record at the spot rate. The spot rate was dollar 50. Now the date of the payment, what we do is we debit foreign currency loss 20,000, reduce to receivable 20,000 and to adjust the receivable to the new spot rate. Then we receive the cash. Now can we combine those two entries? Sure we can, of course we can. So notice the, first we have to reduce the AR. So here's what happened. We have an AR. It started at 1.5 million. We reduced it by 20,000. Then we received the funds, 1,480,000. Therefore at the end of the day, the receivable should go down to zero. So notice in this transaction, we made the sale and we received the payment within the same accounting period. What happened if we make the sale in one period and we don't receive the payment until the following period? That means in between we have to prepare a balance sheet. So now we're gonna have to look at balance sheet date before the date of payment. So what would be done accounting wise when the balance sheet falls between the date of the sale and the date of the payment? And the prior section we assume it all happens in the same accounting period. So let's assume that the company shipped goods to the Spanish customer on December 1st with the payment to be received on March. So this is the sale and this is the payment. Now remember the sale December 1st, we're gonna end the year December 31st and the payment is not made until year two. So this is year one, this is year two and this is the end of the year. So this is what we mean by balance sheet date before the payment. Assume that December 1st, spot rate is $1.50 but December 31st, by December 31st, the year I appreciated the $1.51. So I went from $1.50 by the December 31st of $1.51. So on December 31st, year one, when the books are closed, is any adjustment needed to account for the fact that the foreign currency has changed? Yes, in this situation we revalue, we revalue any payable or receivable. So we have to value the receivable. Remember we have the receivable at $1,500,000. Now we have to revalue it, okay? So under the two transaction perspective, the foreign currency exchange gain or loss arises as of the balance sheet date. So again, IAS 21 as well as ASC 830 require companies to use what's called the accrual approach to account for the unrealized foreign exchange gain or loss. So for firm report unrealized foreign exchange or loss and net income in the period in which the exchange rate changes. So any changes in the exchange rate, it's accounted right there in the income statement. Now fast we justify this approach by saying this is consistent with the accrual accounting and result in reporting the effect of a rate change that will have cash flow effect when the event causing the effect takes place. So what they're saying the exchange rate fluctuation affect the cash flow therefore use the accrual method. Therefore any changes goes into net income for that period, okay? So any change in the exchange rate from the balance sheet date to the date of the payment result in a second foreign currency gain or loss and is reported in the second accounting period. So in the first period, we have either gain or loss goes on the income statement then by the time we receive the payment it may fluctuate again will have a gain or loss and that's separate. Let's take a look at this example. Again, we made the sale December 1st, 1.5 million. So we record the sale at the spot rate dollar 50. At the end of the year, the rate was dollar 51. Therefore what happened is we have an account receivable. We recorded it at 1,500,000 December 1st then we adjusted this account by the end of the year for $10,000. Now by the time we got the payment three one year two the rate was dollar 48. Now what we have to do now, dollar 48 means, dollar 48 means our receivable should be worth. Our receivable right now, let me just show you our receivable as of December 31st is 1,510,000. By the time we got the payment our receivable should be 1,480, because the rate went to dollar 48. What do we have to do? We have to credit receivable we have to credit receivable by 30,000 and book a foreign exchange loss. And remember the foreign exchange loss and foreign exchange gain both of these goes on the other income or other expenses. This will be other income and this will be other expense because that's a loss other income slash expense or other income expenses. Then we received the cash, we received 1.4 million then we credit account receivable 1.1480,000 and receivable is gone. Now bear in mind what happened in this transaction. First we had a gain of 10,000 then we had a loss of 30,000 overall we had a loss of 20,000. Now remember this transaction and this transaction we did not have any forward contract or option contract simply we did not have any protection. So the foreign currency we had a gain then we have a loss. Now some people might argue you reported a gain at the end of the year and that gain basically did not materialize. Is this a violation of conservatism? You can argue it is, you can argue it's not but let's assume by the end of the year you had a loss then you end up with a gain then did you violate conservatism and it's debatable. So the point is some people argue that this method is a violate conservatism because you reported a gain that really never happened. So this is basically a basic accounting dealing with foreign currency transaction. In the next session we're gonna start to talk about derivatives and hedging. So we're gonna have to take a look at this transaction and see how we can protect ourselves by not having $20,000 in losses or if we're gonna take losses we know exactly the maximum amount of losses we're gonna be absorbing. So we don't leave it for chance. If you have any questions about this topic please email me if you happen to be studied for your CPA exam study hard. If you visit my website please consider making a donation to support the channel. Good luck and see you on the other side of success.