The foreign exchange rates of a country is one of the most important indicators of a country’s economic performance. It is now also one of the most important factors that affects operating leases. The ASC 840 to 842 transition will result in greater income statement volatility for operating leases denominated in a foreign currency. This is because the lease liability to be re-measured to the lessee’s functional currency each period using the current exchange rate while re-measuring the right-of-use asset into the functional currency using the historical exchange rate.
Foreign exchange rates may fluctuate daily because of the changing market forces of supply and demand of currencies across countries. Given the volatility, it is important to understand what determines exchange rate fluctuations.
Eight Key Factors that affect Foreign Exchange Rates
- Inflation Rates: Consistently lower inflation rates exhibit appreciation in currency values while higher inflation rates exhibit depreciation in currency values.
- Interest Rates: Increases in interest rates cause currency values to appreciate. This is because higher interest rates attract more foreign capital by providing higher rates to lenders and in turn this causes an increase in exchange rates.
- A Country’s Current Account/Balance of Payments: A deficit in a country’s current account causes depreciation and balance of payments fluctuates the exchange rate of its domestic currency.
- Government Debt: A country is less likely to acquire foreign capital if it has government debt. This leads to inflation followed by a decrease in the value of the country’s exchange rate.
- Terms of Trade: An increase in a country’s terms of trade results in higher revenue, followed by an increase in demand for the country’s currency which then leads to an increase in the country’s currency value. All of these factors exhibit an appreciation in the country’s exchange rate.
- Political Stability & Performance: Lower risk for political turmoil leads to increased foreign capital, resulting in the appreciation in the value of a country’s domestic currency. A country with low political stability and performance may exhibit a depreciation in exchange rate.
- Recession: When a country experiences a recession, its interest rates will most likely fall which decreases its chances of acquiring foreign capital. As a result the country’s exchange rate is lowered because its currency weakens relative to that of other countries.
- Speculation: If a country’s currency value is expected to rise, the demand for more of that currency will also rise. This speculation leads to appreciation in the currency’s value followed by an increase in exchange rate.
Accounting for Foreign Exchange Rates
Foreign exchange rates add another level of complexity to the lease accounting process. The above factors impact the fluctuation of exchange rates. But how does this affect the lease accounting processes within your organization? Both finance leases and operating leases account for foreign exchange rates differently. See below for how to navigate fx rates.
Finance Lease Considerations
A lease liability represents a monetary liability and an ROU asset represents a nonmonetary asset. Therefore, a lease liability and ROU asset denominated in a foreign currency that are remeasured into an entity’s functional currency would be accounted for in the following manner:
- Lease Liability: Remeasured by using the current-period exchange rate, with changes recognized in net income in a manner consistent with other foreigh-currency-denominated liabilities
- ROU Asset: Remeasured by using the historical exchange rate as of the commencement date, provided that the lease has not been modified
Operating Lease Considerations
As discussed in Subsequent Re-Measurement of Leases Under ASC 842, operating lease costs consists of two components:
- Interest Expense: The expense associated with the accretion of the lease liability. For operating expenses, this is not presented on the income statement but is used to calculate the ROU asset reduction for the period.
- ROU Asset Reduction: difference between straight-line expense and interest expense.
Lessee’s would recognized the single lease cost, in its function currency, associated with an operating lease denominated in a foreign currency by:
- Interest Expense: Since the lease liability is a monetary liability, when remeasuring the time-value-of-money component of the lease cost related to the lease liability accretion, it would be appropriate for the lessee to use the average foreign exchange rate for the period.
- ROU Asset Reduction: When measuring the component of the lease cost representing the change in the ROU asset in each period, it would be appropriate for the lessee to use the historical exchange rate that was used when the ROU asset was initially recognized. In other words, the foreign currency rate that was in effect as of the date on which the ROU asset was initially recognized. In each subsequent period, this amount would be calculated by using the exchange rate employed to initially determine the ROU asset and would not change unless an impairment is recognized or the ROU asset is updated as a result of a liability remeasurement event (e.g., a lease modification).
Foreign exchange rates are remeasured into an entity’s functional currency when the books are closed each month. Irrespective of lease classification, a lease liability represents a monetary liability so as you account for spaces internationally, the foreign exchange rate becomes an important consideration for your accounting for your leases. Read more about how the foreign exchange rate fits into your lease accounting process with our Ultimate Guide to Navigating the Lease Accounting Lifecycle.
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