How do you choose the best foreign currency valuation method for cash management?

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If you manage cash in different currencies, you need to know how to value them accurately and consistently. Foreign currency valuation is the process of converting the balances of foreign currency accounts into your functional currency, using an exchange rate. But which exchange rate should you use, and when? In this article, we'll explain the main foreign currency valuation methods for cash management, and how to choose the best one for your situation.

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Akshay Rote

1 Historical rate method

The historical rate method uses the exchange rate that was in effect when the transaction occurred. For example, if you received 100 euros on January 1st, when the euro-dollar rate was 1.2, you would record it as 120 dollars in your books. This method is simple and consistent, but it does not reflect the current market value of your foreign currency balances. If the exchange rate changes over time, your historical rate may differ significantly from the actual rate.

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Income statement items should use the historical rate method for translating into the functional currency. Revenues and expenses should be translated at the exchange rate that existed when the underlying transaction occurred cause this shows the transactions true economic sense. Asset light business models should generally overall use the historical method to be true to the transactions. This ensures the right spirit is preserved in economic terms.

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2 Current rate method

The current rate method uses the exchange rate that is in effect at the end of the reporting period. For example, if you have 100 euros in your bank account on December 31st, and the euro-dollar rate is 1.1, you would report it as 110 dollars in your financial statements. This method reflects the current market value of your foreign currency balances, but it also introduces volatility and exchange rate risk. If the exchange rate fluctuates, your current rate may change from one period to another, affecting your income and cash flow.

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Balance sheet items should use the current rate method. Assets and liabilities should be translated at the current exchange rate. The foreign currency financial statements of a foreign business operation that has a foreign currency as its functional currency are translated using the current rate method, and the translation adjustment is accumulated as a separate component of equity. The foreign currency financial statements of a foreign operation that has the parent’s presentation currency as its functional currency are translated using the temporal method, and the translation adjustment is included as a gain or loss in income.

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3 Average rate method

The average rate method uses the average exchange rate for the reporting period. For example, if you have 100 euros in your bank account for the whole year, and the average euro-dollar rate for the year is 1.15, you would report it as 115 dollars in your annual report. This method smooths out the fluctuations of the exchange rate, and provides a more stable and representative value of your foreign currency balances. However, it may not capture the actual timing and impact of the transactions, and it may differ from the historical or current rates.

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4 How to choose the best method

Choosing the best foreign currency valuation method for cash management is not a straightforward decision. You need to take into account your objectives, preferences, and accounting standards. For instance, if you have frequent and large transactions, you may prefer the historical rate method as it preserves the original value of each transaction. On the other hand, if you have infrequent and small transactions, you may opt for the current or average rate method to reflect the overall value of your foreign currency balances. Additionally, if the exchange rate is volatile and uncertain, you may want to use the current rate method or the average rate method to reduce risk and volatility. Moreover, depending on your jurisdiction and industry, you may have to follow certain accounting standards and regulations that prescribe a specific foreign currency valuation method. Therefore, it is important to consult an accountant or auditor to ensure compliance with applicable rules. Ultimately, by carefully evaluating each method and aligning them with your goals and requirements, you can improve accuracy and consistency of your cash management while optimizing financial performance.

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Applying different translation methods for a given foreign operation can result in very different amounts reported in the parent’s consolidated financial statements. Foreign currency translation rules are well established in both IFRS and US GAAP. Fortunately, except for the treatment of foreign operations located in highly inflationary countries, the two sets of standards have no major differences in this area. Under both IFRS and US GAAP, the functional currency of a foreign operation determines the method to be used in translating its foreign currency financial statements into the parent’s presentation currency and whether the resulting translation adjustment is recognized in income or as a separate component of equity.

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How do you choose the best foreign currency valuation method for cash management?

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1 Historical rate method

2 Current rate method

3 Average rate method

4 How to choose the best method

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