In this module, we will be discussing foreign currency transactions:

-Definition of a foreign currency transaction

-The terms being used with forex transactions

-Recording an ordinary import/export transaction

-Hedging transactions

-Recording of the different types of hedging transactions

Now, take a moment to pause and relax. Breathe.

NOW I WANT YOU TO THINK: THIS IS A PIECE OF CAKE.

To make it more convincing, go get a cheese cake. Lemon Square would do just fine.

Nope, we are not promoting any food products here. Just as an example.

Moving on…

In a company operating only within a particular country, foreign transactions has little effect.

On the other hand, if a company transacts with other countries, like importing or exporting goods, foreign exchange has significant effect on their financial recording.

As such, these foreign transactions should be accounted for, recorded and adjusted accordingly when forex rates change.

An example closer to home:

To a person like us who can shop online from international companies and pays in USD, a small transaction amounting to about $100 twice a year is not really a big deal.

But to a company that spends thousands or millions of USD to acquire goods, changes in forex rates are huge deals. The same can be said to a company that sells to foreign companies expecting to be paid in foreign currencies.

And so, we account for the effects of these changes in forex rates.

An increase or decrease in daily forex rates would mean a gain or a loss to the company.

Foreign exchange occurs when a company pays or collects in a currency other than their functional currency. The functional currency is the currency being used by a company in recording their transactions. In the Philippines, our functional currency is the Peso. If a company here transacts with a company in the US, or China, or some other country, and the contract specifies that payment is to be made in a foreign currency (not the Peso), then, the denomination should be converted into Peso using the date’s current foreign exchange rate.

Actually, it can also be two companies in the same country but using different currencies.

So, the key here is having two companies using different currencies that enter into a contract with each other. It doesn’t really matter if they’re on different countries or the same country. The point is having different currencies where one of the parties has to convert the transaction’s currency into their functional currency.

A forex transaction is a sale to or a purchase from another company denominated in a foreign currency.

Forex translation is applicable when a company has operations in multiple countries. For example, SM has branches in China. In those branches, transactions are denominated in Yuan. Since they are branches, and the head office is here in the Philippines, for consolidation purposes the financial reports from China should be translated to Peso so that it can be presented and combined with reports in the head office. It’s kinda hard to read a financial report that contains Peso and Yuan at the same time, right? Remember the principle of consistency? That applies to currency presentation, too. (This would be discussed in a separate course on FOREX TRANSLATION.)

Next, we have our parties to the transaction.

Seller – the company who sells goods/services to other countries. They are also called exporters.

Buyer – the company who buys or purchases or acquires goods/services from other countries. They are also called importers.

Bank/Financial institutions – sort of a third party. Sometimes when the buyer or seller is concerned about fluctuating exchange rates, they enter into a contract with a bank or financial institution and agree to finance the transaction using a certain rate or a fixed rate or a strike price. In this case, if the actual exchange rate differs from the rate used in the contract with the bank, the bank will bear the gain or loss.

Now, let’s go to our rates:

Forex rate/Current rate/Spot rate – this is the rate at a specific date. For example, today (February 15, 2017) the exchange rate between USD and PHP is $1 to Php 49.79.

Forex rates change every day, so watch the dates in the problems you are solving.

Direct exchange rate – If you are a company using PHP as functional currency, and you transact with a US company, a direct exchange rate is the equivalent of one foreign currency unit into your own currency. That would be $1 = Php 49.79.

Indirect exchange rate – This is a rate showing how much one of your currency is worth in a foreign currency. Example is Php 1 = USD 0.0201. We usually need the direct exchange rates, so when the given is indirect, you should convert it first by dividing the Peso with the Dollar. In our example, it would be 1/0.0201 = Php 49.75.

Next are the dates affected by a foreign exchange transaction.

Transaction date – This is when the purchase/sale transaction occurred, when the two parties agreed to a contract.

Year-end date – Most of the time, a purchase/sale transaction is on account, in which case the company records a receivable/payable on the transaction date but receives/collects the payment at a later date. When the transaction date and the date of payment are on different accounting periods, there should be an adjustment on the year-end date. This is following our principle on accounting periods.

Settlement date – This is the date in which the payment/collection is made.

Are you overwhelmed yet? Okay, you can simply pause and take a break. When you’re ready, continue then.

Done taking a breather? That was fast.

Seriously, take a break. Go drink some water. Or do some stretching.

Here we go, next is our hedging.

Hedging – a process where a company chooses to offset or minimize the effects of forex changes by entering into contracts with banks.

Hedged item – If your company is a seller with a foreign company, and you enter into a contract to hedge the sale transaction, your hedged item would be your Accounts Receivable from this sale. If you are a buyer, then your hedged item will be your Accounts Payable.

Hedging instrument – Examples of these are forex forward contracts, interest rate swaps and commodity futures contracts. We’ll get into the specifics of these a little later into the course.

Now we consider all these (the parties, the rates, the dates and the presence of hedging) in our recording of the forex transactions, and to compute our forex gain or loss.

Forex gain or loss – Basically, these arise in two ways.

If you are a seller, you have Accounts Receivable. This is what you will receive in payment. So, when the forex rate goes up, your Receivable also goes up. Here, you have a forex gain because you receive more. Now, the other way around: when the forex rate goes down or decreases, your Receivable also decreases. Here, you have a forex loss because you receive less.

If you are a buyer, you have Accounts Payable. This is what you will pay for what you purchased. So, when the forex rate goes up or increases, your Payable also increases. Here, you have a forex loss because you pay more. When the forex rate goes down or decreases, your Payable also decreases. Here, you have a forex gain because you pay less.

Other instances where you recognize forex gain or loss is when you enter into a hedging transaction (more on this later) or when you translate your financial statements into a different currency.