exchange rate

Exchange differences in foreign currency receivables

Author: Veronika Žáčková
exchange rate
An exchange rate conversion is a common financial closing operation, especially for entities operating in a foreign currency. Simply put, at the balance sheet date, the current exchange rate of the Czech National Bank will be used to convert all foreign currency balances of the company’s assets and liabilities or open monetary items in other currency than the Czech one. However, this area can be quite problematic, therefore, we would like to summarize the basics of revaluation of foreign currency receivables and their provisions. A new interpretation of the National Accounting Council I-42 issued at the end of last year also deals with this topic. 

Exchange rate conversion is associated with the detection of the current amount of Czech currency units for an item in a foreign currency and is therefore closely related to an exchange rate risk. The exchange rate risk arises for the entity when holding foreign currency assets, and thus in some entities, balances on foreign currency bank accounts as well as outstanding amounts of outstanding receivables and payables in foreign currency are regularly recalculated to determine the final amount which should be paid or how much will eventually be credited to the bank account at the end of the period.

On the contrary, there is no sense in converting already paid amounts of assets, receivables, and payables, although the original invoice was issued in a foreign currency only because the exchange rate changed during or at the end of the year. For this reason, the values of buildings and machinery acquired in a foreign currency are not converted. Similarly, this applies to costs and revenues arising from invoices received or issued in a foreign currency, that have already been paid, and thus no additional exchange risk incur.

As already mentioned in the introduction, the National Accounting Council also comments on the issue of exchange rate differences, most recently in October and November 2020 through its interpretation I-42 and I-43. These interpretations express the expert opinion of the National Accounting Council on the practical application of Czech accounting rules which, however, are not legally binding. Their goal is to contribute to the formulation of optimal and uniform procedures in the area of accounting and financial reporting. They mainly deal with issues that are not addressed by Czech accounting regulations or are addressed insufficiently or in areas that are addressed inconsistently in accounting practice.

In Section 4 par. 12 of the Accounting Act it is stated that foreign currency receivables and provisions created for them are kept in Czech currency as well as the foreign one. The conversion rate is based on the exchange rate announced by the Czech National bank, whereas it may be a daily or a fixed exchange rate enshrined in the entity’s internal regulations. The payment of the invoice issued in a foreign currency is then accounted for at the set exchanged rate on the date of payment and the identified exchange rate difference is settled in the statement. Provisions that temporarily reduce the value of receivables, for example, due to unrecoverability, reduce the company’s comprehensive income and are usually converted at the entity’s exchange rate at the date of a provision is accounted.

Interpretation I-42, issued in November 2020, determines the accounting treatment of showing the foreign exchange risk which is arising from receivables reduced by its provisions. In this context, accounting practice addresses, for example, whether exchange rate differences also arise for provisions, where to account for exchange rate differences arising from the conversion of a receivable in a foreign currency, and where to account for those arising from the conversion of provisions.

Although the interpretation does not contain a precise accounting procedure, it provides an important starting point that the exchange rate risk on foreign currency receivables arises only from future cash flows (incomes) that the entity expects to receive in the future. The explanation for the Interpretation states that the part of the receivable for which a provision is created no longer represents a sufficient probability of future cash flows because the entity does not expect it to be settled, thus there is no risk of gain or loss from a change in the exchange rate. According to the Interpretation, the exchange rate difference for a foreign currency receivable arises only from the net value of the receivable, i.e. from the values of the receivable reduced by the related provision (expressed in foreign currency). This exchange rate difference is reported in the profit or loss for the accounting period.

The interpretation comments on two approaches often used in practice to account for exchange differences on receivables and related provisions:

  • A procedure which, according to the Interpretation, does not reflect a true representation of exchange rate risk in accounting, where the exchange rate difference from the conversion of a foreign currency receivable is accounted for to financial costs and revenues. The provision created for a foreign currency receivable is converted and the arose difference is accounted for as a creation, or more precisely settlement of provision in operating costs and revenues. This method is used in a wide range of companies.
  • Second approach is, where the exchange rate difference from the conversion of a foreign currency receivable is accounted for to financial costs and revenues. In case the provision related to the receivable in a foreign currency does not change throughout the time, it is converted at the current exchange rate and the arose difference is also accounted for to financial costs and revenues. However, in case the amount changes over time, the exchange rate difference, and the change in the amount of the provision must be reported separately in the operating as well as financial profit or loss. According to the Interpretation, this solution reflects a true representation of exchange rate risk accounting, nevertheless, it converts the entire (gross) value of the receivable, although the future cash flow objectively arises only for that part of the receivable, of which the payment can be expected. With this method, the result is correctly reported as the exchange rate difference from the net receivable, however, the National Accounting Council does not consider this method to be completely correct.

In conclusion, it is important to mention that the application of the Interpretation I-43 is fully within the competence of the entity and the comments do not address the practical transition to the proposed conceptual solutions. The decision on implementation of these methods carries certain accounting as well as tax risk, so we strongly recommend considering the circumstances of individual cases, their significance, and potential impact on the company’s accounting.

If necessary, do not hesitate to contact our experts in the area of accounting and taxes, we will be more than happy to help you. In our next newsletter, we would like to introduce you to news in the area of Interpretation of I-43.

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Veronika Zackova
Veronika Žáčková
Accounting Manager

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