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Understanding Currency Accounting: Exchange and Revaluation

Understanding Currency Accounting: Exchange and Revaluation

When we started our series on complex accounting challenges, we explained that our data consultants need to educate our clients in what we do before we can explain how we can do it for them. This is particularly true with foreign currency accounting. In Europe, it’s rare that to find a company of any significant size that doesn’t face currency issues. As a result, most European accountants have at least a basic understanding of what’s involved. In the U.S., that just isn’t the case. Given the size of our market, many companies expand extensively without ever trading internationally. And if they do trade internationally, often their trading partners use U.S. dollars. So, they operate internationally and still have no currency exposure.

But that’s not always the case. And indeed, with opportunities in developing worlds often outpacing those in the U.S. domestic market, it’s happening more and more.

So, in this series of blog posts, we want to explain the basics of currency accounting as it relates to accounting systems. We’ll discuss exchange, revaluation and translation. We won’t get into elements of currency that don’t relate to the systems we deal with – so we won’t talk about hedging currency risk and such.

Please note: The ISO (International Organization for Standards) assigns a three-letter code to all currencies. In this post, we’ll reference each currency by its full name and ISO code in the first instance. For all subsequent instances, we’ll reference the currency only by its ISO code.

Exchange on a Cash Basis

Let’s start with the basics. ACME Widgets starts selling its products abroad. Overseas clients pay them in Euros (EUR) and British Pound Sterling (GBP). For simplicity, let’s assume the client pays COD. The customer pays 10,000 GBP. Looking up the exchange rate, we find 1 GBP = 1.5 USD. So, when we record the information on our financial statement, we’ll show a credit to sales for 15,000 USD and a credit to cash for 15,000 USD. That gives us the following trial balance:

ACME Widgets
Debit Credit
Cash 15,000 USD
Sales 15,000 USD

Exchange and Revaluation of Accounts Receivable

Of course, that example is too simple. Few companies large enough to have currency risk operate on a cash basis.

So, let’s use a more realistic example. ACME sells the same goods for 10,000 GBP on April 15th. Again, the exchange rate is 1 GBP = 1 USD. Therefore, we have the following trial balance:

ACME Widgets
Trial Balance
Acct # Description Debit Credit
11000 Account Receivable 15,000 USD
40000 Sales 15,000 USD

Now, it’s month end. We still show 15,000 USD receivable on our books. But we need to ask – is that receivable still worth 15,000 USD? Indeed, if we look at the exchange rate on April 30th, we now find that 1 GBP = 1.6 USD. If they paid us 10,000 GBP, we’d receive 16,000 USD. This is revaluation. Revaluation is simply setting the value of a foreign currency asset to its current value if the asset were liquidated at this moment.

At month end, therefore, we need to book new entry. The entry affects two accounts.

Journal Entry
Acct # Description Debit Credit
11000 Accounts Receivable 1,000 USD
90000 Currency Gain Loss/Unrealized 1,000 USD

The gain or loss hits the income statement. We consider it unrealized because the customer hasn’t paid yet – this is just our best guess of how much we’ll gain or lose, but we aren’t sure. Generally, we make this a reversing entry so when we do get paid we can book a realized gain or loss entry.

Our trial balance now looks like this:

ACME Widgets
Trial Balance
Acct # Description Debit Credit
11000 Account Receivable 16,000 USD
40000 Sales 15,000 USD
90000 Currency Gain/Loss Unrealized 1,000 USD

The journal entry reverses at month end. Which makes the next entry easier to calculate.

Continuing with our example, let’s say it’s now May 15th and the customer pays us. We receive 10,000 GBP. Once again, we check the exchange rate. Now, 1 GBP = 1.55 USD. So, the payment is worth 15,500 USD, meaning we have a final realized gain of 500 USD. We include that as part of our entry reflecting the cash receipt. Because we’ve reversed our unrealized gain/loss entry, we can simply book the 500 USD amount. We’ve finished revaluation for this entry, and we’re back to simple exchange.

Journal Entry
Acct # Description Debit Credit
10000 Cash 15,500 USD
11000 Accounts Receivable 15,000 USD
90001 Currency Gain Loss/Realized 500 USD

And our trial balance looks like this:

ACME Widgets
Trial Balance
Acct # Description Debit Credit
10000 Cash 15,500
40000 Sales 15,000 USD
90001 Currency Gain/Loss Unrealized 500 USD

In our next blog post, we’ll cover translation and aspects of revaluation that relate to accounts and controls.

Let us know if you’re interested in Financially Aware Business Intelligence using tools like Jet Reports and Dynamics NAV Consulting.

 

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