CFM8001 - Accounting for foreign exchange: overview of foreign currency translation

Translating foreign currency amounts

Companies may sometimes have to physically exchange one currency for another. For example, if a customer pays a UK company in US dollars (and the company does not maintain a dollar bank account), the company will need to convert the dollars into sterling. It is far more common, however, for companies to have to translate items that are denominated in a foreign currency.

A company will need to translate foreign currency transactions, assets and liabilities into its local currency (the currency in which it will also usually prepare its accounts). How should it go about this?

A company that accounts in sterling sells goods to a customer for $100. At the time when it records the sale in its books, $100 is worth £60. The customer settles the account 30 days later: the $100 that the customer pays is then worth £65.

It is readily apparent in this case that the company should recognise an exchange profit of £5 in its accounts. It has made a real profit. But suppose that the $100 debt was still outstanding at the company’s accounting date. On the last day of the accounting period, $100 is worth £56. The company might decide to show the $100 debt in its balance sheet at the historical rate of £60, or at the closing rate of £56.

Clearly, the exchange rate that a company decides to use for a particular item will affect its reported profits. In the above example, if the company translates the $100 trade debt at the historical rate, it will not show any exchange gain or loss. If it translates the debt at the closing rate, it will show a loss of £4.