What closing rate to apply when more rates are available?
Let me answer one of your questions in this article. This is the question asked by Dipanjan from Botswana:
What to do if dual rates exist? Which closing rate to choose?
Hi Silvia, greetings from Botswana. Which closing exchange rate to use for translation at the year-end: buy rate, mid rate, sell rate?
We have lots of assets and liabilities denominated in foreign currencies and we need to translate all monetary items with the closing rate at the end of the reporting period.
The question is – what closing rate shall we use? There is more than one closing exchange rate stated in our country: mid rate, buy rate, sell rate. The differences would be quite material.
This is a great question because that’s the very practical issue that many accountants face so let me answer that.
Answer: Make a choice, but be consistent
In some cases the differences in exchange rates are small and the total impact of using different rates would not be significant for your financial statements. You can use the mid rate in this case.
It’s the spot rate. In my own country, we use EUR and for the translating the year-end balances of monetary assets and liabilities, we use the closing spot rate of EUR to foreign currency as declared by the European Central Bank.
However, in other circumstances, when there’s more than one rate, the differences can affect your financial statements a lot.
In this case IAS 21 prescribes that when several exchange rates are available, the rate used is that at which the future cash flows represented by the transaction or balance could have been settled if those cash flows had occurred at the measurement date – that’s stated in the paragraph 26 of IAS 21.
Therefore, you always have to ask: if the foreign currency receivable is paid now at the reporting date, at what rate will it be converted on our bank account?
And, the answer is:
Your receivables and other monetary assets would be settled at the buy rate and your payables and other monetary liabilities and the sell rate.
Buy rate is the rate at which the bank buys the foreign currency from you and therefore, when you have the receivable in foreign currency, you will get the foreign currency and you will sell it to the bank – and the bank will buy it from you at the buy rate. That’s why you translate the assets at the buy rate.
On the other hand, the sell rate is the rate at which the bank sells the foreign currency to you. So, if you have payable in foreign currency, you need to buy that foreign currency from the bank first in order to pay that payable and the bank will SELL it to you at the sell rate.
If this is too hard to remember, just remember the simple help or mnemonic – it is always beneficial for the bank, not for you.
Example: buy and sell rate
So, if you have 1 000 USD and you need EUR, the buy rate is 1.2 and the sell rate is 1.1 USD/EUR – which rate is OK to apply?
At the buy rate of 1.2, 1 000 USD is – let me calculate – 833 EUR, and at the sell rate of 1.1, 1 000 USD is 909 EUR – what amount would you get if you bring your 1 000 USD to the bank? The lower amount, of course – so you translate your asset of 1 000 USD with the buy rate of 1.2 at 833 EUR.
On the other hand, If you have to pay 1 000 USD to someone, but you have just EUR, how much you need to pay to the bank to get USD? The higher amount, 909 EUR – so you translate your liability of 1 000 USD with the sell rate of 1.1 at 909 EUR.
Let me warn you that here you should apply these rates consistently; i.e. always mid rate, or always buy-sell rates. You can’t just apply the mid rate once and then the buy-sell rate… you have to be consistent from period to period. Period.
Bonus question: How about unofficial exchange rates?
What if in your country, there’s some official exchange rate and an unofficial exchange rate? And, what if you’re using unofficial rate and that rate is widely and legally used?
In this case you can apply the unofficial rate for your translation, but only if you can strongly prove that the transactions can be, will be or were settled at that rate.
So, thanks to Dipanjan for this great question.
I put this answer into a video and you can watch it here on YouTube:
Any questions or comments related to dual rates? Please write below, thank you!
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