How & When to Use Exchange Rates

If your company transacts internationally, you know you need to use exchange rates to not only convert foreign currency transactions from the local currency into USD but also to translate foreign currency financial statements.

In this blog, we’ll discuss some basic characteristics of exchange rates and how to use them most effectively for accounting purposes.

Exchange Rate Conversions: Indirect vs. Direct Quote

Most exchange rates are indirectly quoted in the marketplace as the number of foreign currency units to the USD. For example, yen at 106 means 106 yen per 1 USD. The Swiss franc is quoted the same way: 1.03 Swiss francs to every 1 USD.

Converting from foreign to USD: If we have 1,000,000 Japanese yen and we want to convert it to USD, we would take ¥1,000,000/106 = $9,433.96

Four exchange rates, including the Australian dollar, British pound, euro and the New Zealand dollar, trade on a direct quote basis. That means the exchange rate tells us how many USD make up 1 foreign currency unit. For example, euro at 1.12 means it takes $1.12 to make up €1.

Converting from foreign to USD: If we have 1,000,000 euro and we want to convert it to USD, we would take €1,000,000*1.12 = $1,112,000

This is important because ERP systems typically take in exchange rates in what we call the multiplicative form (direct quote) for ease of calculation. That means all of the indirect quotes, such as Japanese yen and Swiss franc rates, need to be flipped over. A rate of 106 for yen would be inverted to 1/106, or .00943396 when entered into the ERP system. This way all foreign currency transactions are processed with the same math.

Of course, this is VERY important for manual calculations, too. If you are using a banking document or a report from treasury operations to identify the correct rate for the transaction it is likely in the “trading convention” detailed above. When booking manual entries, it is critical to understand how the exchange rates need to be input into the system or you will end up with the wrong amount, which may be material.

Income Statement Rate

An income statement rate is used to 1) convert all foreign functional income statement lines into USD (for US reporting entities) for consolidations and 2) record new non-functional currency transactions, even if the transactions are impacting only balance sheet accounts (e.g. debit inventory and credit accounts payable at the income statement rate).

ASC 830 identifies the rate as a “current rate”. Some entities use a new rate each day, this is most appropriate for financial institutions and payments processors where the currency is the product. In many corporate settings, the use of a daily rate may actually distort earnings rather than deliver the appropriately weighted average rate. For instance, revenue transactions may be recorded daily throughout the month, but the foreign currency costs are accrued all at month end. When currencies move through a month, the distortion may result in an “average” operating margin exchange rate for that currency that is unexplainable and not something seen in the market. ASC 830 guidelines specifically permit “an appropriately weighted average exchange rate for the period”.

We generally recommend corporates use a single rate for a month of activity (revenues and expenses in the period at the same rate). The most common single rates used for a one-month period are:

1. The prior month balance sheet rate because it is available for all transactions from the first day of month and provides a weighted average (January activity at a January rate, February activity at a February rate, March….) rate for the quarter/year.
2. A simple average rate calculated from market days in the month, which generally requires all activity during the month to be recast at month end after the simple average is calculated. This provides a weighted average of the simple averages over the course of the year, and will reduce visibility before the recast.

We recommend using the same income statement rate to record new activity during the period AND to consolidate the financial statements to avoid the last minute creation of FX Gains/Losses when inter-company activity is recast to the consolidation income statement rate so the inter-company activity eliminates.

Balance Sheet Rate

Balance sheet rate is used to:

1. Convert all foreign functional assets and liabilities into USD (for US reporting entities) for consolidation, impacting CTA in OCI.
2. Adjust all non-functional monetary assets and liabilities into functional currency at a current rate during the period close process, impacting FX Gain/Loss in the earnings.

Balance sheet rates are generally (and most appropriately) captured on the last market day of the financial period. If no rates are available due to an economic crisis (e.g. Argentine peso stopped trading at year end in 2001), the appropriate rate is the rate from the first day trading resumes.

Historic Rate

Historic rates are the exchange rate applicable to a transaction when it was first recorded in the financials. Historic rates are used to:

1. Convert foreign equity (excluding hedge accounting OCI balances) into USD (for US reporting entities) for consolidation, contributing to CTA in OCI.
2. Capture the functional currency balance sheet value and related P&L activity for non-functional non-monetary assets and liabilities.

Rates Not Used

It is important to note that only an income statement or a balance sheet rate is used in accounting for a foreign currency transaction. A budget rate, negotiated rate, vendor’s invoice rate and so forth are NOT used to record the transaction.

Only cash conversions, which are captured at the rate one currency was exchanged for another, are an exception to the income statement accounting rule. Under this scenario any delta between the bank rate and the income statement rate ends up in foreign currency gain and loss line.

For more on the basics of FX accounting, follow our FX Basics Boot Camp webinar series. Click here to register for free!