7.10.1.1 Examples of Exchange Rate Fluctuations
The following example illustrates the differences between the Currency Accounting Methods.
This is a United States Bank (USD) with holdings in Japan (JPY) and Germany (DEM).
Table 7-22 Examples of Exchange Rate Fluctuations
| Historical Rate at origination | Current Rate at As of Date | Forecast Month | ||||
|---|---|---|---|---|---|---|
| Local Balance | Exchange Rate | USD Balance | Exchange Rate | USD Balance | Exchange Rate | USD Balance |
| JPY 100,000 | 120 JPY/USD | $833.33 | 133 JPY/USD | $751.88 | 130 JPY/USD | $769.23 |
| DEM 2,000 | 1.8 DEM/USD | $1,111.11 | 1.69 DEM/USD | $1,183.43 | 1.6 DEM/USD | $1,250.00 |
In this example, the Japanese Yen holdings have decreased their US Dollar value since origination, and the German Mark holdings have increased their US Dollar value since origination. One month into the forecast, the Yen-to-Dollar exchange rate is forecast at 130 and the Deutschmark-to-Dollar exchange rate is forecast at 1.60.
- Temporal Method
If the Temporal Method is used, the change in value should be reflected in net income and passed through to retained earnings. The change in value from the current USD balances to the USD balance in Month 1 is reflected as a realized gain. In this case, the currency gain account would reflect a net amount of $83.92 for Month 1.
JPY currency change $ 17.35
DEM currency change $66.57
Currency gain for Month 1 $83.92
That is, (see Financial Element 465) the formula for total gain/loss on principal is:
Beginning Balance * [(1/current exchange rate) - (1/previous exchange rate)]
- Current Rate Method
If we apply the Current Rate Method, the Accumulated Translation Amount, a site contra-equity account, reflects a total of $74.79. This is derived from the accumulated difference between the USD balance from origination to Month 1 of the forecast. In this case, no principal payments have been made; the USD value of Yen holdings has decreased in value since origination, but the USD value of Deutschmark holdings has appreciated more, resulting in a net increase in value.
JPY Accumulated Translation Amount - $64.10
DEM Accumulated Translation Amount $138.89
Accumulated Translation $74.79
That is, (see Financial Element 950) the formula for unrealized gain/loss on principle is:
Ending Balance * [(1/current exchange rate) - (1/original exchange rate)]
- Historical Basis Method
All balances are carried at the historical rate, so there is no need for an accumulated translation account. Currency gains/losses are realized when cash flows are received.
Effect of Exchange Rate Forecasts on Cash Flows
Let us modify our example slightly, to show a payment made in Month 1.
The Amortization of principal and payments of interest must reflect the effect of changes in the exchange rate.
All methods treat interest payments in the same manner: They are valued when received and corresponding gains or losses are then realized (see Financial Elements 485-487). Therefore, the following discussion focuses on Currency Accounting for Principal Amortization. In this example, both the Yen and Deutschmark accounts have runoff equal to 5% of the outstanding balances.
Table 7-23 Effect of Exchange Rate Forecasts on Cash Flows
| Local Currency Runoff Amount | USD Runoff Amount (historical rate) | USD Runof Amount (current rate) | Realized Gain/Loss on Principal |
|---|---|---|---|
| JPY 5,000 | 120 JPY/USD$41.67 | 130 JPY/USD$38.46 | -($3.21) |
| DEM 100 | 1.8 DEM/USD$55.56 | 1.6 DEM/USD$62.50 | $6.94 |
- Temporal Method
In the Temporal Method, the effect of exchange rate fluctuations on the balance sheet is reflected at the period end based on the balance at the beginning of the period. This method requires no additional recognition of gain/loss on the principal because it has already been recognized on the beginning balance (see Financial Element 465).
- Current Rate Method
In the Current Rate method, the Accumulated Translation Balance (Financial Element 950) should reflect only the change in the value of the remaining balance, based on the current and historical exchange rates.
[JPY 95,000 / (130 JPY/$)] – [JPY 95,000 / (120 JPY/$)] =
$730.77 - $791.67 = -$60.90... or compute as:
Ending Balance * [(1/current exchange rate) - (1/original exchange rate)]
In addition to the Accumulated Translation Balance, a realized currency gain/loss should be reflected in the income statement. Realized currency gain/loss transactions reflect the change in currency from the time of origination of an instrument to the time of cash flow repayment when the initial balance loaned/invested/borrowed must be translated into the reporting currency. At each payment, the realized gain/loss on the principal cash flows (scheduled payments, maturing balances, and prepayments) are calculated based on the amount of the cash flow and the change in the exchange rate. That is, (see Financial Element 475) the formula for realized gain/loss on principle is: Principal Cash Flow * [(1/current exchange rate) - (1/original exchange rate)].
- Historical Basis Method
When payments are made, Historical Basis accounts should also reflect the realized gain/loss on the currency in the income statement. The method used should be the same as the method described for the Current Rate method; that is (see Financial Element), the formula for realized gain/loss on principle is:
Principal Cash Flow * [(1/current exchange rate) - (1/original exchange rate)].