Currency – a definition
A currency is a system of money in general use in a particular country or region. Despite the fact that currencies sometimes share names (like the Australian, New Zealand and US dollar), each region’s unique currency is valued differently. That results in different purchasing power. For example, if you go to the USA with one New Zealand dollar, you won’t be able to purchase a US dollar worth of goods.
Understanding exchange rates
Also known as the foreign exchange rate or the forex rate, the exchange rate is the measurement of how much one currency is worth in terms of another currency.
For example if the Australian dollar is trading at 1.0156 to the US dollar [AUD/USD 1.0156], a single Australian dollar is worth 1.0156 US dollar.
The Reserve Bank of Australia (RBA) provides daily currency exchange rates against the Australian dollar.
Unrealised currency gain or loss
Unrealised currency gain or loss occurs when there is an outstanding receivable or payable account in a foreign currency and that currency fluctuates against the Australian dollar after the original date of the transaction.
This will result in either a currency gain or loss, however it won’t be realised until money is received or the payment is made. An unrealised currency gain or loss is not physically real: you won’t find it in your business bank account.
However, if an unrealised gain or loss has a significant dollar value due to a large number of foreign currency dealings or a substantial currency fluctuation, it’s prudent to recognise it in the profit and loss statement of the business.
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Realised currency gain or loss
Realised currency gain or loss occurs when the foreign transaction has been completed, and the currency profit or loss is recognised in your profit and loss statement.
In reality the profit figure won’t be that pure, because different banks have marginally different rates to the RBA, and are likely to charge a fee for transacting in a foreign currency. This will either reduce your profit or increase the loss incurred.
Foreign currency case study
Expanding your business overseas is certainly an exciting step, but you need to be fully aware of and plan for the risks involved. You need to understand the options available to you, and build buffers into your pricing.
The Australian dollar is very strong at the moment, it buys more overseas, and imports are cheaper than normal. This won’t always be the case, and you can’t build a long-term business on a favourable exchange rate. Unexpected currency fluctuations can be favourable or can critically drain your cash flow.
Here’s an example of how currency fluctuations could affect you:
1 July 2010 [AUD/USD 0.8366]: Arnold’s Gym enters into an arrangement to purchase US$1000 worth of exercise equipment from America. If Arnold paid for his purchase on this date, he’d have paid $1195.31 in Australian dollars ($1000 divided by 0.8366) but instead, he deferred payment.
1 March 2011 [AUD/USD 1.0156]: Arnold’s Gym calculates that its unrealised currency gain is $210.67 from the purchase. This is because the AUD/USD rate has moved favourably from 0.8366 to 1.0156. This figure is arrived at by dividing $1000 by 1.0156 (= $984.64) and then subtracting it from the cost in Australian dollars on the original transaction date ($1195.31 – $984.64 = $210.67).
21 April 2011 [AUD/USD 1.0769]: Arnold’s Gym fully pays for the purchase from 1 July 2010. The AUD/USD rate has moved from 0.8366 to 1.0769. The realised gain from the transaction is calculated by dividing $1000 by 1.0769 (= $928.59) and subtracting that from the cost in Australian dollars on the original transaction date ($1195.31 – $928.59 = $266.72). This is realised in the profit and loss statement.
By delaying the payment Arnold has benefitted from the strengthening Australian dollar, and has gained $266.72 more profit than he would have if he’d paid in July, and $56.05 more than if he’d paid in March.
Fluctuations are the name of the game
Of course, had the Aussie dollar dropped instead of rising, Arnold’s story wouldn’t have had such a happy ending.
I’ve heard of some businesses that traded with foreign companies for a full year before realising that they only broke even on what they’d bought and sold, and that all profits were actually coming from favourable currency movements.
In a different market environment where the currency fluctuated in an adverse direction, they could have incurred significant losses. Just because you’re very busy and selling lots of stock doesn’t necessarily mean that your business is profitable.
Foreign currency transactions can be confusing, especially when you’re first starting out. Please share your experiences or questions below.