Foreign Exchange

The foreign trading of American firms has grown of late years to such proportions that a practical acquaintance with the exchange values of foreign currencies is necessary for the accountant. The rate of exchange is the equivalent of the currency of one country in that of another. For instance, the standard value of the British sovereign in the currency of the United States is $4.8665; that is, the value of the quantity of pure gold in one sovereign in London is equal to that represented by $4.8665 in New York. Other things being equal, this should always be the par rate of exchange between the United States and England. The question of the rate of exchange between countries which have a gold standard is a comparatively simple matter. Where one of the countries has a silver currency, the variations assume more importance, for the reason that the intrinsic value of silver converted into gold must be accounted for. Paper currency, especially in times of war, causes a still greater complication, because in this case it is uncertain when such paper will be made convertible into gold or silver.

In addition to differences in exchange arising from the conversion of one currency into another, called the par rate, other things enter into exchange transactions which have a marked effect upon the actual, or market, rate of exchange. Such conditions as supply and demand for remittances between countries to satisfy debit balances; the necessary expenses, including cost of transmission (which can never be more than the actual cost of transporting the specie itself): interest on the money for the time the draft has to run to maturity or to the time of payment in the foreign country—these and other factors must be taken into account. The expense of cabling and the profits of the bankers who transmit the money must be added. Some intangible factors are the credit condition of the countries and the risks involved in making transfers.

The Accounting Problem of the Foreign Branch

From the viewpoint of accounting, the only problem in connection with foreign branches which differs from those of domestic branches concerns the conversion of the foreign currency—in terms of which the records of the foreign branch are kept—into the currency of the head office. Periodically—usually at the close of the fiscal period—the results as shown by the branch records must be incorporated with those of the head office. The problem involved is for the most part due to the fact that, while the activities of the various branches have been transacted and recorded in terms of one or more currencies, the net results of those activities are to be taken effect of, usually as a disbursement of dividends, in the terms of the head office currency. That is, earnings are made and expenses incurred in one currency, and the net result of the branch’s trading must be disbursed in terms of another currency. The fluctuations in exchange prevailing throughout the year at the time of the various transactions of the branch and at the time when the net results of the branch are disbursed as dividends from the head office, sometimes give rise to a very complicated problem if accurate and satisfactory results are to be secured.

It is impossible, from the standpoint of practice, to convert every transaction of the branch into the currency of the head office at the rate prevailing at the time of the transaction; and furthermore, the funds out of which ultimately some portion of the dividends must be paid are, at the close of the fiscal period, still held in the possession of the branch and so are not available except through the process of conversion. Accordingly, the question of the rate of exchange prevailing at the close of the fiscal period has a very important bearing on the correct showing of the branch’s activities on the head office books.

It is not purposed here to go into the question of organization, or method of keeping accounts for the foreign branch. As was stated above in connection with domestic branches, any system of accounts depends very largely upon the general organization of the head office and its branches, and this in turn depends on the degree of control and amount of information desired. The discussion will be limited to the assumption that the branch has an almost independent organization and is expected to make a full report periodically by means, at least, of a trial balance of the branch.

Accounts Opened on Books

On the books of the branch a Head Office Control or Adjustment account will be carried which represents the ownership of the head office in the branch; and on the head office books a Branch Control or Adjustment account which is the complement of the head office account on the branch books. Frequently, in addition to these interrelated accounts, a Remittance account is carried for the purpose of facilitating reference. In this account are entered the remittances made by the branch to the head office, instead of entering such transactions in the Head Office Control account. The problem to be discussed here concerns the method of converting the branch trial balance before incorporating it, and the root of the problem lies in the determination of the basis for the conversion of the various kinds of items listed therein. Fixed and current asset and liability items, expense and income items, the Head Office Control and Remittance accounts—all must be converted. For an accurate and equitable showing of the branch activities on the head office books under certain conditions, these different classes of items should not be converted at the same rate. Under other conditions no serious inequity results from the use of a uniform rate of exchange for the conversion of all items, and in practice such a rate is handled much more simply than different rates. Of course, the branch trial balance is in balance previous to conversion but is almost invariably out of balance after conversion. It becomes necessary, therefore, to take up the difference by means of a debit or credit to an account called “Exchange” or “Fluctuations in Exchange”—sometimes also called “Reserve for Fluctuations in Exchange.”

Handling Fluctuations in Foreign Exchange

The proper handling and ultimate disposition of this Exchange or Fluctuations in Exchange account requires some consideration. If there is a loss in the conversion of the branch trial balance into the head office currency, that may be treated as a current expense to be charged ultimately to the current period’s profit and loss. Any profit accruing from the same source may be similarly handled. Some concerns set aside all profits accruing in this manner into a Reserve for Fluctuations in Exchange account, against which are charged any losses incurred through conversion. If the first period shows a loss on conversion, it would, of course, be necessary to reserve out of that period’s profits a sufficient amount to take care of the loss. Usually, however, the items of profits and losses on conversion of exchange counterbalance each other fairly well throughout succeeding periods. The item is for the most part comparatively small and either method of handling it is satisfactory and gives sufficiently correct results under normal conditions but often too inaccurate under abnormal conditions.

Conversion of Branch Results

The basis on which the closing entries are converted from the foreign to the local currency is a very important factor. If the ratio between the two countries is more or less stable, an average rate may be adopted without much variation in the established values. All profits or losses on exchange resulting from differences between actual rates on current transactions and this average rate will be entered in the Fluctuations in Exchange account. However, in periods of rapidly fluctuating rates of exchange, or in transactions with branches where silver currency or depreciated paper or non-guaranteed currency are in use, the conversion of all items at some arbitrary or average rate will not give accurate or satisfactory results. In such cases certain practices have been established as being the most equitable in converting the various accounts of the branch balance sheet into the local currency for the purpose of amalgamating them into the home office balance sheet. These practices are summed up as follows:

First convert the foreign currency into dollars at the following rates:

To arrive at the average rate in the case of fixed assets it is sufficient to take the rate prevailing at the end of each month throughout the year and divide the total by twelve. This becomes necessary where construction or purchases of fixed properties take place throughout the year. The difference, if the rate is less than par, is credited to the capital expenditure and debited to Profit and Loss on the head office books. The branch is notified of the adjustment and makes a similar entry crediting Exchange and debiting the head office with the amount.

Current assets and liabilities are converted at the rates current at the date of the balance sheet because the balance sheet should represent these values at the exact cost of converting them into cash at the present moment. If in practice they were actually liquidated, this could not be realized but in principle it represents the present condition. Revenue items are convertible at the average rate because they represent items accumulating during the entire fiscal period; they represent the result of the business activities for the past period, at varying rates of exchange. Since the remittance account represents the actual cash paid for cash transmitted, there is no occasion for changing the rate which has been used at various times during the period. The Control or Adjustment account likewise was converted at the time the entries were made to it and represents the exact cost of the various transactions recorded in it.

After all balance sheet items have been converted according to the rates prescribed, it is a general custom to provide a reserve account to cover any losses on exchange not provided in the conversion of the accounts. This is done for the purpose of guarding against overstating values and thus paying dividends out of the capital, since the conversion into head office currency merely serves as a medium of estimating what the foreign investment really represents to the stockholders.

An illustrative problem is given below with its solution based on the principles of conversion just stated. It is to be noted that in practice, within the limitation stated on page 546, a uniform rate of conversion is generally made use of for all items except remittances, for which the actual rate is used.

Illustrative Bookkeeping Problem

Problem. At the close of the fiscal period a condensed trial balance report of the London branch of a New York concern showed as follows:

Trial Balance—London Branch

The London Control account on the New York books showed a balance of $474,750, and the Remittance account $237,987.50. Set up, in journal form, the entries necessary to take on the New York books the results of the period’s activity at London and show the London Control and London Profit and Loss accounts after adjustment, using the additional data:

Solution

Conversion of London Trial Balance

Journal Entries to Adjust New York Books

Appended are the London Control account as it would appear after posting the above entries on the New York books; and the London Profit and Loss account on the New York books.

London Control

Local Supervision of the Foreign Branch

A question which enters into the accounting with foreign branches arises in connection with the law of the land in which the branch is opened. “Most foreign countries have some regulations as to what books must be kept, and the manner of recording the transactions. In France, for instance, the law requires that a summary of all transactions shall be entered through the journal, which therefore becomes the posting medium for every transaction. This book has, in the first instance, to be produced to a public official, who examines it to see that it is duly paged, none missing, etc., and then stamps it as correct, and anything requiring legal proceedings in which accounts are concerned must be proved from the journals with the official visa.”

“Since the work of organizing and installing systems of accounting in branch houses abroad is of undoubted and growing importance, it is necessary to have not only a practical acquaintance with the currencies in which the foreign books are kept, and the laws of the land in regard to the kind of books which must be kept, but in addition a thorough knowledge of the manner in which transactions are to be transmitted periodically to the home office, and of their assimilation with the home accounts and the drafting of the final accounts, balance sheets and profit and loss statements becomes indispensable.”

The Foreign Sales Agency

Where the foreign branch is merely a selling agency for the home office, and invoices must be made out at the home office in foreign currency, a convenient way to handle these accounts is to keep a separate set of records for each foreign currency. A foreign sales journal, customers ledger, and cash receipts journal, together with foreign notes receivable and sales returns and allowances journals, where necessary, will comprise all books of original entry needed to secure sources for postings to the customers’ individual accounts in terms of foreign money. In this way all charges for goods sent, and credits for returns, allowances, cash and notes received and discounts allowed, can be kept entirely in foreign currency.

Method of Conversion of Results

Periodically—say, once a month—the total transactions for the month must be converted into home currency and brought into the general ledger. In normal times a fixed average rate of exchange based on past experience gives sufficiently accurate results, saves many tedious calculations and much unnecessary work. At certain times and in certain businesses the prevailing rate of exchange on the actual day, or the monthly average of daily rates, may need to be used to secure satisfactory results. With the use of the fixed average rate, as above, the totals of foreign sales and sales returns journals are converted into home currency and carried respectively as debits and credits to Accounts Receivable control, and credits and debits to Sales. The total of the discount column of the cash receipts journal is converted, at the average rate, and charged to Sales Discount and credited to Accounts Receivable control.

The conversion of the cash received must be handled differently, however. The actual rate at which the foreign draft or bill received in payment of the customer’s account is converted by sale to the banker—and so credited to the home office bank account—almost always differs from the average rate at which the item was charged to the customers’ controlling account. This, of course, makes no difference with his individual account which is kept in foreign currency, but does make necessary an adjustment of the general ledger Accounts Receivable control in order to make it agree with the foreign customers ledger when converted at the average rate.

Accordingly, in the general cash book two additional columns are provided, viz.: Profit on Exchange and Loss on Exchange columns, which are used somewhat as is the Sales Discount column. Every foreign draft or bill when received is entered, in foreign currency, in the foreign cash book and posted from there to the credit of the customer. When that draft or bill is sold at the bank (it may be held for some time after receipt for a favorable turn of the money market) and so converted into home currency, it is entered in the Accounts Receivable column at a figure representing conversion at the fixed average rate. The difference between this figure and the actual amount received at the bank is entered in either the Profit on Exchange or Loss on Exchange column as the case may be, with extension of the actual amount into the bank column as a charge to the bank account. Thus, the total of the Accounts Receivable column when posted to the general ledger Accounts Receivable control adjusts that account so that it controls the foreign customers ledger converted at the average rate. The totals of the Profit on Exchange and Loss on Exchange go as credits and debits respectively to the Profit and Loss on Exchange account.

The foreign sales agency often collects the accounts and remits total collections periodically by purchase of one bill or draft on its local bank for the total. There must, of course, accompany each such remittance a statement of the detailed receipts for proper credit to individual accounts. The general cash book will show only the total remittance, however. Regular agency accounts as explained in Chapter XXX will secure the control of the home office over the agency’s expenditures.

It is usually best to make the foreign customers ledger self-balancing. The Adjustment account necessary to effect this may, if desired, be kept in both foreign and home currency, thus showing on its face, by the balance of the home money columns, the agreement of the foreign ledger with its control account on the general ledger. If, instead of one fixed average rate of conversion, varying rates are used, the keeping of the Adjustment account in both currencies becomes imperative.

Where, in the case of foreign sales, the sales invoice and charge to the customer are made in home currency and payment of that amount in home currency is demanded, the problem of conversion, as explained above, is not encountered, foreign sales being recorded and handled in exactly the same way as home sales.

The Foreign Purchasing Agency

If the purchase is made in terms of foreign currency and settlement must be made in that currency, a procedure and system may be used exactly similar to that just explained for handling sales.

In both the sales and purchase record books, returns may be entered in the same record by using red ink, and deducting the red ink totals at the end of each page. This obviates the necessity of keeping subsidiary adjustment accounts in a separate book, and brings all information regarding the branch transactions in one compact record.