AS 11 Effect of Change in Foreign Exchange Rate (part1)

This is the most important and popular topics among students pursuing professional examinations. They find it harder to grasp in comparison to other Accounting Standard but I bet they are gong to find it easy to understand after reading my following three posts on this Accounting standard.

This AS deals with:

1)      Accounting for foreign currency transaction;

2)      Translating the financial statements of foreign operation;

3)      Accounting for foreign currency transaction with forward exchange contract.

Foreign currency transaction:

A transaction which involves foreign currencies is generally known as foreign currency transaction. The transactions will only involve foreign currency when two parties are from different countries. Thus, A living in India, imports or exports goods for $ 50000 from B living in USA, is a foreign currency transaction.  Similarly, X, living in China, borrowed money from Y, living in Japan, is also a foreign currency transaction. This Accounting Standards guides us the accounting treatment for these foreign currency transactions.

Accounting treatment:

To understand the accounting treatment of the foreign currency transaction, first we need to understand what are monetary and non-monetary items?

Monetary items---

Monetary items are those which do not change their values with the period of time. Such as: Cash, Loans and advances, Receivables, Payables etc. The value of them does not change. Suppose, a man purchased goods on credit for Rs 50000 -now, if the man pays to his creditor after 2 year or 4 or 5 year his dues will not change; regardless of the value of money changes with the passage of time he will have to pay 50000 as his outstanding amount. Or suppose, if taken loan, only fixed rate of interest will be charged--- that’s it, not more than that.

Non-Monetary items---

These are the items that changes their value with the passage of time. There are only three non-monetary items such as: Fixed assets, Investment, and Inventories. Now take fixed assets –there value will never remain constant their value can decrease or increase after a certain period of time.

After getting these two terms cleared, we are ready to learn accounting treatment of foreign currency transactions.

This AS says that --

At the initial stage, all the transactions should be recorded at the rate existed at the time of transaction.

 At the balance sheet date, the monetary transactions (transaction related with monetary items) are recorded at closing rate, whereas, non-monetary transactions (transaction related with non monetary items) are recorded at rate prevailing in the time of transactions.

From the above treatment, one thing is sure that amount involve in non monetary transactions will remain same from beginning date to balance sheet date, but amount in monetary transaction will change because of different exchange rate between the time at which transaction happens and time of recording them at balance sheet date, or at the time of settlement of that transaction, this difference in exchange rate is called Foreign exchange difference.

To illustrate this point, Suppose, ABC LTD, India, purchased goods worth $10000 from John&co.LTD USA on 4/February/2013. ABC LTD made payment on 4/7/2013. Company closes its financial year on 31^st March. The exchange rates were as follows:

4/Feb—50/$

31^st March 2013—45/$

4^th July---48/$

In the initial stage- that is, on 4^th Feb the purchased would be recognized in the books of ABC LTD at price 50*10000=500000.

In the balance sheet date, that is on 31^st march the purchased would be recognized at closing rate -45*10000=450000 and would recognized profit of 50000 Indian rupees in the profit and loss statement as their creditor gets lessen by 50000.

In the settlement date that is, on 4^th July, the amount of payment would be 48*10000=480000 RS - thus, it would recognized loss of 30000 Indian rupees in p/l statement as  it has to pay 30000 more to its creditor.

Remember, Exchange difference arises only because of monetary items or you can say monetary transactions; non monetary items have no role to play in it.

Non-monetary items which are valued at fair value should be recorded at a rate prevailing in the time of valuation.

The contingent liability denominated in foreign currency is disclosed in the balance sheet at closing rate.

This was all about foreign currency transactions. In my next post we will learn foreign operation and its Accounting treatments.