Dcycle Blog

On the importance of the base currency of a balance sheet

April 09, 2020

First I must warn you that I am by no means an accountant; but I would like to share a particularity of reporting accounts in a currency different from the base currency. I’ll give an example with an organization that reports its balance sheet in USD but needs to provide progress reports to a partner in CAD.

We will use an accounting chart and standard double-entry accounting. Our chart will look like this for sake of this example:

1111 Bank account
4444 Revenue
7777 Expenses

Let’s take the following example of activity, the rates being actual rates for the given dates:

1 2020-01-07 1.30028 CAD (190) 4444 (146.12)
1 2020-01-07 1.30028 CAD 190 1111 146.12
2 2020-01-07 1.30028 CAD (100) 1111 (76.91)
2 2020-01-07 1.30028 CAD 100 7777 76.91
3 2020-03-18 1.45108 CAD (100) 1111 (68.91)
3 2020-03-18 1.45108 CAD 100 7777 68.91

Now, if our underlying currency were CAD, our reporting would be quite straightforward:

1111 (10)
4444 (190)
7777 200
Total 0

What’s going on here? We got 190 CAD in revenue (if you find it hard to wrap your head around why revenue is recorded as negative, think of it this way: the world is 190 CAD poorer; the world being poorer is your revenue). However we had 200 CAD of expenses, so our bank account (1111) went down by 10 CAD. The total for all accounts is zero, as it should be.

Let’s spice things up a bit and record our revenue as USD:

1111 0.30
4444 (146.12)
7777 145.82
Total 0

OK the total is still zero, which is good. Everything else requires a bit more thought. First of all, we recorded a net income now, and no longer a net loss. That’s because from a USD perspective, the 100 CAD we’re spending on March 18th is recorded as just 68.91 USD, a far cry from the 76.91 USD that 100 CAD was worth in January. Again, these are real exchange rates so this is not just a theoretical exercise.

So our balance sheet will record a net loss if we’re reporting in CAD and a net profit if we’re reporting in USD, because we’re benefitting from the exchange rate!

Now, let’s spice things up even more and say we’re reporting in USD, but one of our partners would like a follow-up on our activities in CAD. This, also, is not just theoretical: this is often how international government grants work. The field work is reported in USD (or the country’s currency) and the donor needs reports in its home currency (CAD). So here is what we would have in our report:

1111 0.30 (10)
4444 (146.12) (190)
7777 145.82 200
Total 0 0

The above table will look odd (how could 30 USD cents be converted to minus 10 CAD!?), unless you read this blog post first!

A note on exchange gains and losses

So, we’re making money on exchange rates, but why is that not recorded? Well, in the above way of doing things, from the perspective of the organization, that widget they’re buying just costs less in its home currency in March than it did in January; this is not a exchange rate gain or less, it’s simply a fluctuation in prices.

To understand when it’s appropriate to record currency exchange gains and losses, let’s imagine that the 190 CAD revenue was billed and recorded as revenue in January, but paid by the client in March. This would require a few more accounts:

1111 Bank account
1112 Receivable from Client A
4444 Revenue
4445 Accrued revenue
5555 Exchange gain or loss
7777 Expenses

Accrued revenue (account 4445) is revenue that’s recorded on paper, but isn’t yet cold hard cash. Account 1112 represents assets that are receivable from client A. Account 5555, if positive, is a loss we made on the exchange rates. If negative, it’s a gain we made on the echange rate.

What would a deferred payment in a foreign currency look like? Consider this journal, which we’ll look at in detail below.

1 2020-01-07 1.30028 CAD (190) 4445 (146.12)
1 2020-01-07 1.30028 CAD 190 1112 146.12
2 2020-01-07 1.30028 CAD (100) 1111 (76.91)
2 2020-01-07 1.30028 CAD 100 7777 76.91
2.1 2020-03-18 1.45108 CAD (190) 1112 (130.94)
2.1 2020-03-18 1.45108 CAD 190 1111 130.94
2.2 2020-03-18 1.45108 USD (15.18) 1112 (15.18)
2.2 2020-03-18 1.45108 USD 15.18 5555 15.18
2.3 2020-03-18 1.45108 USD (146.12) 4444 (146.12)
2.3 2020-03-18 1.45108 USD 146.12 4445 146.12
3 2020-03-18 1.45108 CAD (100) 1111 (68.91)
3 2020-03-18 1.45108 CAD 100 7777 68.91

Take a look, first, at entry number 1: notice that our revenue is recorded as accrued revenue (4445) producing a receivable asset (1112) of 190 CAD, the equivalent of 146.12 USD. No money has changed hands, just just gave client A an invoice for 190 CAD, recrding the equivalent 146.12 USD as revenue, albeit accrued revenue, not yet cash.

Let’s go out on a limb here and assume client A actually pays the invoice in March. Of course, Client A still pays the amount stated in their currency and doesn’t care about exchange rates, so they pay 190 CAD. This triggers a maelstrom of accounting activity:

Journal entry 2.1

In entry 2.1, we move 190 CAD (now worth 130.94 USD) from our receivables account (1112) to our cold hard cash account (1111).

Journal entry 2.2

From our client’s perspective, they paid the full amount on the invoice emitted in January, 190 CAD. However from our perspective, pecause we’re reporting in USD, our invoice was for 146.12 USD when it was emitted, and when we recorded our revenue; however when it was paid it was worth only 130.94 USD. As the saying goes, you win some, you lose some. So after journal entry 2.1, our client, in account 1112, still owes 15.18 USD on paper. To remedy this, we’ll remove 15.18 from our client account and record it as an exchange loss (account 5555).

Journal entry 2.3

In this journal entry, we’re transforming accrued revenue (the 146.12 USD we recorded as USD revenue in January) into actual revenue. This means we need to deduct from our actual revenue account (4444) because, don’t forget, revenue is recorded as negative, and add to our accrued revenue account (4445) to bring that one 0.

From an accounting perspective, now, we are recording 146.12 USD as real revenue, but an exchange loss expense of 15.18 USD, which corresponds to the 130.94 USD we actually deposited in our account. Let’s look at how we would report all this activity:

1111 (14.88) (10)
1112 0 (22.03)
4444 (146.12) (212)
4445 0 (22.03)
5555 15.18 22.03
7777 145.82 145.82
Total 0 0

Transit accounts

I use two different types of accounts which should always be zero:

  • clearing accounts: according to Wikipedia, this is “temporary account containing costs or amounts that are to be transferred to another account”. Therefore clearing accounts might contain money for one journal entry, meaning the exchange rate does not have time to change while there is money in the clearing account.

  • transit accounts: these accounts can contain money for more than one day, something like:

1 2020-03-17 1.42069 CAD (100) REVENUE (70.39) (100)
1 2020-03-17 1.42069 CAD 100 TRANSIT 70.39 100
2 2020-03-18 1.45108 CAD (100) TRANSIT (68.91) (100)
2 2020-03-18 1.45108 CAD 100 BANK ACT 68.91 100

In the above example, I’m recording revenue on March 17th, but actually depositing the money on March 18th. If my reporting is in CAD, it’s all good, my TRANSIT account is 100 + (100) which sums up to zero.

However, if I’m recording in USD, my transit account is suddenly 70.39 + (68.91) = 1.48 USD. Because I need my transit account to always be zero, I need to do something with this money. I can record it as a loss, like this:

3 2020-03-18 1.45108 USD (1.48) TRANSIT (1.48) (2.15)
3 2020-03-18 1.45108 USD 1.48 EXCH. LOSS 1.48 2.15

But now if I want to do a report in USD with CAD equivalent, I get:

REVENUE (70.39) (100)
TRANSIT 0 (2.15)
BANK ACT 68.91 100
EXCH. LOSS 1.48 2.15

Not only is it odd that 0 USD be converted to (2.15) CAD, but doubly odd because a transit account should always be zero. Always? Well, yes, if we’re reporting in our base currency. But this exhange loss needs to come from somewhere in CAD, and it cannot come from the actual operation because 100 + (100) is equal to zero, so it comes from the exchange.

The importance of the base currency

Your base currency, we’ve seen, has a major impact on the underlying way in which your organization conceptualizes its accounting. Simply converting from one currency to another currency is always an endeavour which will yield approximate results.

Further reading