Using the Wrong FX Rates

EDudder

I have a bit of a 'hypothetical' question.

If a company were regularly putting incorrect FX rates into their system- how would this effect their year end financials?

Will this just be reversed by 'Realised FX Gains/Losses' or could it result in something being over/understated?

Sorry if this is a stupid question.

smcgiff

Depends on whether it's material. Are there fixed assets or other assets and liabilities of large value at year end originally valued in a foreign currency?

SBWife

Revenues and expenses maybe misstated on the income statement also.

smeharg

The P&L charge should be at the prevailing rate at the date of transaction. So if the rate is wrong then the charge in the accounts will be wrong.
Any error should correct itself when the cash is either paid or received. The only trouble is the correcting amount would be taken to an FX difference account rather than the relative expense or asset account.

Any monetary assets and liabilities (eg debtors, creditors, bank accounts - not fixed assets) should be restated at the year-end rate.

hivizman

Here's a numerical example. Suppose that an Irish company sells some goods to a UK company and invoices in £ rather than €. The invoice value is £5,000. The current exchange rate is £1 = €1.20, but the company uses an incorrect rate of £1 = €2.00. Then the sale will be recorded in the Irish company's accounts at €10,000 (2.00 x 5,000) instead of €6,000 (1.20 x £5,000). This overstates revenues by €4,000. The account receivable will also be stated in the accounting records as €10,000.

When the customer pays the amount due of £5,000, this will be converted into €6,000, and the difference between this and the amount at which the account receivable was recorded (a difference of €4,000) will be accounted for as a foreign exchange loss. In the income statement, realised foreign exchange losses are usually considered to be financial items, so the original overstatement of revenue is unlikely to be corrected. However, the net profit will be €10,000 (booked as revenue) less €4,000 (booked as foreign exchange loss), giving €6,000 (what it should have been had the transaction been translated correctly in the first place).

But what happens if the account receivable is still unsettled at the balance sheet date? As a monetary asset, it will be translated into euro at the closing rate of £1 = €1.20, but the translation difference may be omitted from the main income statement, being reflected only as "other comprehensive income" in a separate statement. So reported profit will be overstated by €4,000.

Back in the days before International Financial Reporting Standards applied in Ireland for listed companies, unrealised translation gains and losses were often reflected only as movements on reserves and were easy to miss when analysing accounts. A notorious example of the use of foreign currency translation to boost reported profits while hiding the losses in the notes was Polly Peck, which used transactions with connected companies in Turkey and Northern Cyprus to boost reported revenue while showing foreign exchange losses only as movements on reserves.

backtothebooks

hivizman wrote: »

Here's a numerical example. Suppose that an Irish company sells some goods to a UK company and invoices in £ rather than €. The invoice value is £5,000. The current exchange rate is £1 = €1.20, but the company uses an incorrect rate of £1 = €2.00. Then the sale will be recorded in the Irish company's accounts at €10,000 (2.00 x 5,000) instead of €6,000 (1.20 x £5,000). This overstates revenues by €4,000. The account receivable will also be stated in the accounting records as €10,000.

When the customer pays the amount due of £5,000, this will be converted into €6,000, and the difference between this and the amount at which the account receivable was recorded (a difference of €4,000) will be accounted for as a foreign exchange loss. In the income statement, realised foreign exchange losses are usually considered to be financial items, so the original overstatement of revenue is unlikely to be corrected. However, the net profit will be €10,000 (booked as revenue) less €4,000 (booked as foreign exchange loss), giving €6,000 (what it should have been had the transaction been translated correctly in the first place).

But what happens if the account receivable is still unsettled at the balance sheet date? As a monetary asset, it will be translated into euro at the closing rate of £1 = €1.20, but the translation difference may be omitted from the main income statement, being reflected only as "other comprehensive income" in a separate statement. So reported profit will be overstated by €4,000.

Back in the days before International Financial Reporting Standards applied in Ireland for listed companies, unrealised translation gains and losses were often reflected only as movements on reserves and were easy to miss when analysing accounts. A notorious example of the use of foreign currency translation to boost reported profits while hiding the losses in the notes was Polly Peck, which used transactions with connected companies in Turkey and Northern Cyprus to boost reported revenue while showing foreign exchange losses only as movements on reserves.

The gain or loss on the translation of the debtor in the above example goes to the income statement and not the OCI. Translation gains and losses on FX subsidiaries/associates/JV's in the group accounts go to OCI.

hivizman

backtothebooks wrote: »

The gain or loss on the translation of the debtor in the above example goes to the income statement and not the OCI. Translation gains and losses on FX subsidiaries/associates/JV's in the group accounts go to OCI.

Certainly the gain or loss on translating accounts receivable should go to the income statement, but I am aware of cases where such gains and losses have been lumped in with gains and losses on translating net investments in subsidiaries and so on in other comprehensive income, and the auditors haven't insisted on a correction because the amounts were considered immaterial.

However, the wording of IAS21 makes it clear that the normal treatment for exchange differences arising on the settlement of monetary items or on translating monetary items at rates different from those at which they were translated on initial recognition during the period or in previous financial statements is to recognise them in profit or loss in the period in which they arise - recognising gains or losses arising from translating monetary items that form part of an entity's net investment in foreign operations in OCI is very much an exception to this treatment.

So the better approach, to comply with IAS21, is to presume that all exchange differences on monetary items go to the income statement, and identify those differences relating to net investments in foreign operations as an exception, rather than presuming that all differences on monetary items relate to net investments in foreign operations and then trying to identify those differences that don't so relate.

Thanks to backtothebooks for pointing this out. The IAS21 accounting treatment still runs the risk of overstating revenues, though, if the initial transaction is booked at an inappropriate exchange rate.

EDudder

I've had a look over things and think due to the fact that realised gains/losses are going through the income statement, and debtors/creditors have all been valued at the year end rate, the net effect on the financials is either nil or immaterial.

I hope that sounds right. I have done other testing around this and the fx rates don't seen to be out by much, but just got worried when I noticed it. It's definitely bad practice anyway.