 Hello and welcome to this session. This is Professor Farhad. In this session, we're going to be doing accounting for foreign currency transaction. This topic is covered in advanced accounting as well as international accounting, and it's surely covered on the CPA exam, the FAR section. If you want additional lectures about these topics, please go to farhadlectures.com. Now before I proceed, I would like to make a quick announcement. Please connect with me. I really like to know my viewers. I like to connect with them on a personal level so you could connect with me on LinkedIn. I have a Facebook page for my website. Obviously, if you're watching this on YouTube, please subscribe to my YouTube and connect with me on my Twitter account. So let's start to take a look at foreign currency transaction and what do they entail. So it's a very important concept and you need to learn about it. What are the problems with recording and reporting foreign currency transactions? Here's what's going to happen. You have a U.S. company buying goods and services from Germany. And here's what's going to happen. They're buying the goods and services from Germany. The German company, they want to be paid in euros. The U.S. company, they'll have to record their transactions in U.S. dollar. So transaction in a foreign currency must be translated. So now we're going to be doing what? We're going to be translating. It means express them in a dollar amount because we are U.S. centric. I am U.S. centric. We're always assuming we are the home currency, the U.S. currency, before they can be aggregated with domestic transaction. So any transaction will have to be translated. And if you are buying or if you are selling, you might have a receivable or a payable. So if you are buying from a foreign, from a Germany, you're going to have a payable. If you are selling to a German company, you're going to have a receivable. So you're going to have payable and receivable that are denominated in foreign currency. But when we report them, they're going to be reported in U.S. dollar. And if you don't know this, there's going to be changes in the value of the currency. Therefore, we might have a gain and we might have a losses, which we will talk about in this session. Now also, company might use hedging strategy with derivatives to minimize the impact of exchange rate. Why? Because exchange rate could go up, could go down, depending if you have a receivable or a payable. I'll explain this. You might be hurt or you might benefit. But you don't want to take that chance. You're not in the business of playing the foreign currency market. You are in the business of selling your product, making sure you are paid and making sure you are paid enough money to compensate you. So that's why you might use hedging strategies, which we would look at in the next session. So the hedging strategy, just hold on it for now. Basic terminology you need to be aware of when you are dealing with foreign currency translation is something called the direct exchange rate and the indirect exchange rate. They're basically the same thing depending on how the information is given to you. You need to know the difference. So what is a direct exchange rate? Okay, it's the unit of domestic currency. And again, we are the US domestic currency that can be converted into one unit of foreign currency. For example, we could say the direct rate is $1.51 pennies for one British pound. Simply put, you need $1.51 pennies to buy one British pound. Or we might say, for example, for a euro, $1.30 for a euro. So you need $1.30 for the euro, $1.30 US cent to buy one euro. This is the direct exchange. How much your currency buys in another currency? Okay, for example, you might need only 0.0010 to buy one yen. Or on the other hand, we can express the currency in the indirect exchange rate. What's the indirect exchange rate? It's how much you need foreign currency to buy US dollar. And all you have to do is take the direct rate and divide it by 1.517. So simply put, what you need to do is if you take 1 divided by 1.517, it means you need 65 British pound to buy US dollar. So simply put, you will need 65 British pound to buy a dollar. Now for the euro, let's do the same thing for the euro. How much euros do you need? Well, let's find out. 1 divided by 1.3. You need 76 euros to buy US dollar. Well, for the yen, 1 divided by 0.001. I just made up this up 0.001. You need 1,000 yen. So you need for the yen. So if you are a Japanese individual, you need to have 1,000 yen to buy one US dollar. This is the indirect rate. The US will say we need 0.001 to buy a yen, which is less than a penny. So make sure you know the difference between direct and indirect, and I will try to hopefully make it easier for you when we look at the problem. Other terminology you need to be aware of is the spot rate. What is the spot rate? The spot rate is the rate today. How much today, or at this moment for that matter, because the exchange rate changes constantly. How much you can exchange your currency into a foreign currency? The rate at which currencies can be exchanged today or this moment. Then you have to know what is a forward or future rate. What's the forward rate? It's the rate at which currencies can be exchanged at some future date. For example, today's date is what? Today is November the 16th. So this is the spot rate, November the 16th. Now I can look up the forward rate for a currency. For example, let's assume the euro today is $1.30. I want to know on December 16th or December 16th, a month from now, how much can I buy euro? Well, they might say you can buy the euro at $1.25. You might be able to buy the euro at $1.35. This is the forward rate. So if you know you're going to have to come up, you have to pay something in euro. For example, you want to pay your German supplier in euro. Today, the rate is $1.30, but you don't have to pay them until a month from today. Well, you don't want to wait until a month from today because a month from today, the euro could be $1.50 or the euro could be $0.90. Who knows? So you don't want to take that chance. You might buy something in the forward market to lock in your rate at $1.25, $1.35. Whatever the rate is, you can lock it. So it's the rate that you can lock. Basically, you will pay a fee and as a result, someone will guarantee that on that date, if you won't buy the currency, you can pay, for example, $1.28 and will guarantee you, will deliver German, I'm sorry, not German euros to you for that rate. So this is what the forward rate is and we're going to work problems with that. Forward exchange rate. This is what I'm talking about now. Contract to exchange currencies of different countries on a stipulated future date at a specified rate. This is called the future rate. So how much do we agree to exchange the rate? So someone will say, pay me $100 today as a fee and I will sell you the euro for $1.28, December the 16th. So basically, they are guaranteeing it. It's their risk. You're just going to pay them a fee. Okay, that's their job. What is a floating rate? Floating rate means the rate between currencies always fluctuate and that's why we have to learn about this chapter. So relationship between major currencies is determined by supply and demand factor, political risk, economic risk, so on and so forth. Okay, increase, risk the companies doing business with a foreign company. So what happened is this, when you buy goods and services from a foreign company and you have to pay them under currency, you might be taking a risk. Why? Let's assume you have a payable of 100,000 yen for payable 100,000 yen. All right, what does that mean? It means let's assume a month from today you have to pay this money. Today, what happened is this, today when the transaction took place, you owe the Japanese company 100,000 yen. Well, you can buy the yen at .0043. So this is the spot rate. On the transaction date, the spot rate. So right now you think, well, today, if I pay them today, all what I have to come up with is $434. Okay, now let's fast forward when the settlement date came. The settlement means when the day you need to pay them, to settle the transaction. Guess what? Now you need .006 to pay them the 100,000 yen. So 100,000 yen times .006, you need $625. You might be saying, oh, what's the big deal between 434 and 625? Well, if you add zeros to these amounts, then the risk is substantial. So that's why you have a risk when you buy Japanese product. You have the risk because you're going to have to pay them in Japanese yen. In Japanese yen between now and the settlement date could become cheaper, which is good, or it becomes more expensive, which is not good. So again, this, let's assume, just kind of just tell you, this also works in your favor. So let's assume on the settlement date, the rate is .0030. Just to make it easy. Then only what you have to pay is $300. So you thought you're going to pay 434, now you pay only $300. But again, that's the risk you are taking, and you're not in the business of foreign currency risk. You're in the business of buying material, building your product, selling your product. So transactions are normally measured and recorded in the terms of the currency in which they are reported, in which the reporting entity prepares its financial statement. Once again, we are talking US dollar for our purposes. So the reporting currency is usually the currency where the company is located. Again, US dollar for our purposes. Your reporting currency could be different. If you're in Canada, it's the Canadian dollar. Transaction between a US firm and a foreign company, okay? Company negotiate whether settlement is to be paid a US dollar or a foreign currency. So if it's a US dollar, there is not really a lot of risk, but if it's in a foreign currency, then you are taking a risk. If settled by foreign currency, the US firm measured the receivable or the payable in dollar. We have to measure them in dollar, but the transaction is denominated in foreign currency. So when we say you're going to have to pay 100,000 yen, well, we don't record on our books 100,000 yen. We convert 100,000 yen at 0.04, and we say it's 0.004, and we say we have a payable of $400. Okay, so it's denominated in the foreign currency, but it's recorded in US dollar. So foreign currency transaction require payment or receipts in a foreign currency, okay? So US firm exposed to risk to unfavorable changes in exchange rate. Now, just one, you know, it could be unfavorable or it could be favorable, but what we are discussing here is the risk and risk. We're going to assume unfavorable. Now, how does it work? If the direct exchange increases, what does that mean? Okay, or it means the foreign currency weakened if the direct exchange increases. So let's assume $1.30 to buy a euro. Okay, this was the spot rate. Now, let's assume you have a payable. We have an accounts payable, and you purchase 100,000 worth of euros. Right now, you need $130,000. Let's assume the foreign currency unit strengthened. What does that mean? It means now you need $1.40 to buy a euro. Okay, $100,000 times $140. Now your payable is $140,000. Well, it means more dollars needed to acquire the foreign currency. What happened is this, the foreign currency strengthened. You need more. Instead of $130, you need $1.40. Now, what happened is you have to come up with more dollars. What does that mean? It means you are at a loss. You are at a loss. Now, let me give you the other scenario. The other scenario is if the opposite happened. Well, let's look at the other scenario. If the direct exchange decreases, so simply put now, so the euro now is $1.25, and you have to come up with 100,000 euro. So you need 125,000. It means the foreign currency weakened. Well, guess what? Now you need fewer dollars to acquire the foreign currency. Therefore, you are at a gain. You are at a gain. So remember, but this relationship is the opposite. If you have a receivable, if you have an account receivable, if you have an account receivable, you want the US dollar to weaken. If you have a receivable in foreign currency, you want the US dollar to weaken. Why? Because when you receive the German, the euros, if the US dollar is cheaper, you can buy more US dollar. So the opposite with account receivable. If you have a receivable, you want your home currency to go down. If you have a payable, you want your home currency to go up to strengthen. It means the other currency to go down. So if your currency is strengthened and you have a payable, you want that. You want a strong currency if you have a payable. What dates we need to be aware of? Okay. Translate an account in denominated in foreign currency. We have to be concerned with three dates. Sometimes it's two dates. Sometimes it's three. First is the transaction date. The date the transaction takes place. Two is the balance sheet date. Balance sheet date means that the transaction took place and it's not going to be settled until the next period. Then what's going to happen? You have to prepare the balance sheet. So you have to worry about the balance sheet date, but we have to do on the balance sheet date. Then we have the settlement date, the date that you have to pay the money. This is the settlement date. Three different dates. And this is as complicated as it gets. So what you have to do in those states, increases or decreases is generally reported as a foreign currency transaction or gain. Sometime referred to exchange gain or exchange loss. Know that it goes on the income statement. So any gains and losses in a foreign currency goes on the income statement. This is important. This is important. Gains and losses from a foreign currency goes on the income statement. In other words, they don't go on the balance sheet and other comprehensive income. They go on the income statement. So let's take a look at an example to see what we are doing here. Okay. During December of the current year, Tel-Atax system, a company based in Seattle entered into the following transaction sold. So we're going to have a receivable. Seven office computers to a company located in Colombia for 8,541,000 pesos. On the state, the spot rate is 365 pesos per US dollar. So simply put, we shipped goods to Colombia. As a result, the Colombian will have to pay us, but they're going to pay us in pesos. Not Mexican, Colombian pesos. And we know as of today, as of today, each 365 pesos will buy a US dollar. This is the indirect exchange. This is the indirect. If you are not comfortable with the indirect exchange, convert the indirect exchange into a direct exchange by taking one divided by 365, which is 0.0027. So each 0.0027 US dollar will buy you a pesos. Or in other words, 365 pesos will buy you US dollar. It's the same thing. So how do we record the transaction? Well, guess what? First, we have to record the transaction in US dollar. We have a receivable. So we'll take the amount of the pesos, which is 8,541 pesos. And we're going to divide it by 365 pesos. And as a result, we're going to have a receivable of $23,400. Once again, we divide it because we are giving how much pesos can buy us in US dollar. So we have a receivable of $23,400 and sales of $23,400. This is called the transaction date. On the transaction date, we use the spot rate. And the spot rate was each 365 pesos will buy you a US dollar. Or 0.007 US dollar will get you a pesos, a Colombian pesos. Now, let's take a look at the transaction on December 31st because this is the balance sheet. Prepare the journal entry to adjust the account as of December 31st. Now, what I want you to do, I want you to create a receivable. Create a receivable, a T-account receivable. I'm just going to put it right here. A receivable, account receivable. And we have in that receivable 23,400. So on the side, on a piece of paper, right, 23,400. Now, assume on December 31st, the direct exchange was 0.00268. So could you tell me what happened now to the Colombian pesos? We used to need 0.0027. Okay? Now all what we need is 0.0026. What happened to the US dollar? The US dollar strengthened. Strengthened, get is stronger. The US dollar is stronger. Is this good for us or bad for us? This is bad. Why is it bad? Well, because we have a receivable. It means, now, if we get the money, we buy less US dollar because the dollar strengthened. Therefore, what's going to happen is this. I shouldn't have erased this, but I will do it again. So remember, we have a receivable of 23,400. Now we re-measured the receivable. Well, that's an error. So now we have 8,541,000. If we converted at the date, at December 31st straight, now our receivable is worth 22,840, but it was worth 23,400. What does that mean? It means we lost the receivable, lost value of $500. Let me do the T-account here. Account receivable, we had 23,400. Now we're going to have to reduce by 510. Now the receivable is 22,890. Therefore, we have to reduce the receivable. So we credit the receivable 510, and we debit transaction loss, which is an income account. It goes on the income statement. Now the receivable is 22,890. We're not done yet. We haven't settled the transaction. We're going to wait until the settlement date. But all what we know now is of December 31st, we have a loss. Let's look at the settlement date. The settlement date was January 10th. Assume that the direct exchange rate at the settlement date is 0.32. What happened now? Well, here's what happened. The rate started at 0.0027. Then it became the direct exchange became 0.0026268. So the US dollar strengthened. Then by the settlement date, the US dollar weakened. Now we need 0.0032. The US dollar weakened. Now if you want the indirect exchange, in case you are wondering what's the indirect exchange, just take 1 divided by 0.0032. It means now you need 312 pesos to buy a dollar. So the pesos increased in value. It means we weakened. And we like this. Why do we like this? Because we like this because we have an account receivable. We want the US currency to go down. It means we need more US dollar to buy a pesos. It means the pesos will buy you more US dollar. We're receiving pesos. We want the US dollar to go down. We want the US dollar to go down. Now let's compute how much do we need. Well, by the settlement date, once everything is settled, let's compute what we need. We have 8,541,000 pesos. Now we're going to settle them. It means we're going to have to pay it. Pay it at 0.0032. Simply put, I'm sorry, we're going to convert them at 0.0032. We are going to receive 27,331 dollars. Hold on a second. The last time the receivable was worth 22,890. By the time they paid us, the pesos really went up and we did very well. So this is the US dollar. So we're going to be receiving. Once we receive the pesos, we convert it at 0.0032 because the US dollar weakened and bought us more US dollar. Account receivable is 22,890. That's the last time we computed the receivable, 22,890. We remove it and we have again a 4,441 and this gain goes to income. So we have a gain. Notice because you have a receivable, you wanted the US dollar to weaken. First, it strengthened. First, it strengthened at the settlement date. You had a loss. By the 10 days later, the US dollar weakened. Something happened from December 31st on January 10th, which is good for us. The US dollar weakened. The pesos went up. Therefore, you had a large gain. And this is really a large gain. 4,400. Now bear in mind, overall, you had a gain of 4,400. But remember, this is not the net gain. If you want to know the net gain, 4,400 minus the $510. Remember, you had a loss earlier. You had a loss. So the difference between them is the net gain on the transaction, the net gain. Now let's take a look at another on the other side of the entry. Now we did the receivable. Let's do a payable because it's good to look at both to see how this works. During December of the current year, Tel-Atax company, a company in Seattle, Washington, entered into the following transaction. Now we purchased computer chips from a Taiwan company. So we're going to have a payable, a foreign currency dominated payable. That's worth half a million Taiwanese yen. The direct exchange on this date, the direct exchange was 0.0391. Simply put, we sold them, I'm sorry, we bought from them half a million worth of Taiwanese dollar. Now they want to receive Taiwanese dollar. They're not interested in US dollar. Therefore, today, if we take half a million times 0.0391, so how much are we responsible for? So half a million times 0.0391. We are responsible for 19,500. We have a payable of 19,500. So this is the direct exchange. So you need three pennies, 3.91 pennies to buy. So simply put here what we're saying, you need 0.0391. If you want to know the indirect exchange, take one divided by 0.0391. So you need 10.98 to buy a dollar. 10.98 Taiwanese to buy a dollar, just if you're interested in that. So on the transaction date, we record the payable, either debit purchases or debit inventory, depending on the inventory system we are using. On this date anyhow, we have an accounts payable dominated in a foreign currency of 19,550. Again, what I suggest you do is to create a T-account, call it accounts payable, and park in there 19,550. And this took place on December 12th. On December 31st, the Taiwanese rate, now if we want to buy Taiwanese dollar, we need 3.0351. Well, what was the priority? The priority was 0.0391. Now the rate, all what we need is 0.0351. We need less US dollar. What does that mean? We are at the game. Now in this situation, the US dollar is stronger and that's good. Why? Because we have a payable. We have a payable, we want to have a strong US dollar. Why? Because with a strong US dollar, we need less US dollar to buy Taiwanese dollar. Okay, so let's see how it works. So now half a million times 0.0351. Well, we need 0.0351 to buy the Taiwanese dollar. So we need to come up with 17,550. The balance in the payable was 19,550 when we initially took the transaction on December 12th. Guess what? We have 2,000. We are responsible $2,000 less. So now what's going to happen? You debit the payable 2,000. Now you are responsible for 17,550. And unfortunately, that's not the settlement date. That's the balance sheet date. So now we adjusted our books to make sure we show the risk of deferring currency transaction or in this situation, a reward. We have a gain. Remember, this gain goes to income. So now our net income went up by $2,000 as a result of this transaction. That's very good. But not yet. Not yet. We still going to have to wait until the settlement date. Now, maybe we should do it now and settle it today and send them the money. Okay? But we're going to have to wait. Okay? On January 10th, that's when the settlement date took place, the exchange rate was 0.0398. What was the prior date? The last time we did it was 0.0351. Oh boy. Now the US dollar strength, the US dollar weakened. We need now 0.0398 to buy a Taiwanese dollar. So we have half a million of those. We are responsible for 0.0398. Let's do the math. Let's see how much do we need. Half a million times 0.0398. We need $19,900. We need $19,900 to settle. Yeah, to settle because we have a payable. And the last time we thought our payable was $17,500. Okay? Last time we measured the transaction. Well, simply put. So we need to come up with cash $19,900. Our payable is $17,550. Now we have a transaction loss of $2,350. Now that's not too bad. Well, what's the net transaction? What's the net foreign currency transaction? We had the gain of $2,000, a loss of $2350. Yes, overall we had a loss of $350. Overall. Okay? Compared to the initial first transaction. Okay? So we have a loss, but it's only $350. Just make sure you remember that any foreign currency transaction gain or losses are included in net income, are included in net income. And we have two transaction approach for this. The sale or purchase is viewed as a transaction separate from the financing arrangement. Okay? Therefore the dollar amount recorded in sales or purchases is determined by the exchange rate on the transaction date. And what we can do, we can have the adjustment of the foreign currency denominated and receivable or payable recorded directly the transaction gain or loss recorded in net income. Okay? So it's just basically simply put all in all gains and losses goes into net income from foreign currency translation. We have a receivable might go up, a receivable might go down, a payable might go up, a payable might go down. The offsetting entry either a gain or a loss in the foreign currency and gain or a loss once again goes into net income. Now why I keep emphasizing this point? Because when you look at, when we look at the translating financial statement, well, we have to know if it goes into net income or OCI, other comprehensive income. So that's why I'm emphasizing this point. If you have any questions, any comments by all means email me and please visit my website for more lectures. If you happen to visit the website, please consider donating. If you're studying for your CPA exam, as always study hard. It's worth it.