The Difficulty of Making Accounting Estimates ‒ The Impact of Foreign Exchange Rate

Some accounting estimates are very difficult to assess and evaluate, both for company management and auditors. In addition, even seemingly simple estimates may be of surprise in terms of their partial components such as the development in currency rates. In the past twenty years, the Czech crown’s rate towards the euro and the US dollar has seen interesting evolution. Therefore, let us have a look at a number of practical examples from various industries.

Net Realisable Value in Mass Production

One of the important estimates made by company management as part of the closing operations involves assessing the net realisable value under Section 26 (1) of the Accounting Act. Specifically, this refers to provisions against the inventory of finished products.

In some industries, such as the automotive industry, frequently the output (and sometimes also the input) prices are determined in foreign currencies (principally the euro). As such, at the balance sheet date, the company management assesses whether the total inventory of finished products held in stock as of the balance sheet date includes saleable products; also, the stock price in CZK is compared with the anticipated selling price (which is net of the costs of goods sold) denominated in EUR and translated into CZK (principally using the foreign exchange rate promulgated by the Czech National Bank as of the balance sheet date). In some cases, the anticipated selling price may be difficult to determine, and in some cases not. Generally, the selling price may be determined based on the underlying contract, order, price list, or a recent similar transaction. It stands to reason that if the exchange rate development moves towards appreciating the Czech crown, situations may arise in which the anticipated selling price, net of the selling costs, is lower than the stock price (actual internal costs of production), due to which the inventory value has to be decreased through the recognition of a provision.

In day-to-day business, such situations can get even more precarious, when arguing that, in fact, some products are not loss-making, as they are sold together with the profitable ones as part of so-called car sets, ie sets of parts for a particular car model, agreed with the relevant customer. For the sake of completeness, let us add that when identifying loss-making products held in stock or in the manufacturing programme, also the eventuality of impairment and/or the creation of a reserve for onerous contracts shall be taken into consideration, both under IFRS and the Czech accounting regulations.

Net Realisable Value in Toll Manufacturing

Conversely, in the construction industry and in some types of cost-intensive toll manufacturing (such as the production of complex asset groups), the output price may be denominated in a foreign currency (however, this practice is less frequent). Such cases typically occur when the customer is a foreign entity. Therefore, increased attention should be paid in such events. As an instance, let us think about a project comprising the construction of a complex structure or the production of a mining machine, which may take several years. During this time, that is between the point at which the contract is concluded with the investor and the point at which the project is completed and an invoice is issued (which is regarded as the key point to account for the income to be reflected in the financial statements under Czech accounting regulations), significant fluctuations in the foreign exchange rate of the Czech crown and the relevant foreign currency may arise. Frequently, construction or project-based companies with complex toll manufacturing programmes maintain in their project databases the contract value in CZK, which is recorded at the inception of the project, using the exchange rate applicable at the point the contract originates. However, as exchange rates change over time, the exchange rates maintained in the databases should be updated. Accordingly, cases may arise in which the Czech crown appreciates over time and, as a result, not all costs get covered at the point of billing, due to which the value of the inventory of work in progress needs to be decreased by way of a provision as of the balance sheet date. Such cases may get even more delicate, if the given project spreads over multiple years, everything goes according to the plan, and ultimately the Czech crown appreciates no earlier than in the last year of the project. Reminiscing Goethe and his metaphor of the grey theory and the green tree of life, we can say that this simile quite fits situations of this kind. In regular business, though, companies seek to prevent such risks by way of hedging.

Retroactive Price Adjustments

In some branches of the manufacturing industry, such as the automotive industry or product manufacturing (of metal, wood, essential chemical substances, and others) that serves for additional industrial processing, retroactive price adjustments are a frequent phenomenon. On one hand, determining the prices of such components may be complex in itself (for instance in interdependence of the prices of oil, gas, or non-ferrous metals); on the other hand, such prices may also include the foreign price element. In these cases, the pricing negotiations can take long, which is typically attributable to the power enjoyed by one of the contractual parties. Given that price adjustments generally affect the whole supply-customer chain, in terms of closing operations, they represent a complicated test both for various departments of the given reporting entity (such as the sales, marketing and planning departments), and a test in terms of good judgemental skills based on prior experience, that is, based on prior price adjustments. In these terms, the best practice to be applied both by professional accountants and auditors is to review the communication that includes the price adjustments per piece or another agreed unit, and to interview the relevant individuals from the company management.

Here is an example of what may seem simple, but in fact is not: There is a list of a certain volume of purchased or manufactured pieces (or other units) of products maintained in an Excel spreadsheet for year X; for these products, an adjustment of EUR 0.50 per piece was made; the adjustment was accounted for in the financial statements for year X as the best estimate of the price to be additionally paid. However, if the price negotiations are long-winded (which in day-to-day business may represent even multiple years), and at the same time, the alternative using the Excel spreadsheet still represents the best estimate (that is, there is a specific volume and financial amount equalling the price adjustment per piece), the “only” thing outstanding to be done is to reflect the foreign exchange rate developments. It shall be noted that in cases like these, revaluation is a step that gets easily omitted (due to the fact that the original Excel list still serves as the best estimate, which has been accounted for based on an internal document, using one financial amount in CZK, and the fact that there has been no progress in the price negotiations). Hence, the impact hereof can be “significantly material” ‒ if intensification of “material” is even possible.

Golden Bricks as Employee Benefits

Another interesting topic are employee benefits in the form of pension insurance schemes and payments or other benefits provided upon life and professional anniversaries or retirement. In connection with these benefits, questions of how they shall be valued with regard to certain variables (such as the salary growth rate or interest rate development) arise. Other queries may relate to the number of served years; the degree to which the provision of benefits is obligatory (ie how easy full benefit cancellation is in terms of the requirements set by the reporting entity’s trade union(s), if any); the number of employees staying with the company in the future with regard to the current (high) fluctuation rate; or how many employees will reach the age at which the benefits fall due (demographic point of view); and the like.

Given the above, a question shall be asked as to whether companies do not tend to neglect reporting reserves if the employee fluctuation rate is high and the year-on-year impact of benefits actually provided remains the same.

It shall be emphasised that transactions of this kind are not only subject to the IFRS (IAS 19) treatment. Frequently, similar queries are tackled under Czech accounting regulations as well.

Therefore, in auditing reserves for employee benefits, clients and auditors often engage actuaries. With regard to golden bricks, it shall be noted that the volume and value of golden bricks determined based on an expert appraisal may be defined, for example, in grams of gold (as translated in terms of purity). Therefore, to determine a reserve in CZK, the price of gold shall be additionally elaborated on. This is due to the fact that gold prices are typically denominated in USD or other foreign currencies. As such, the exchange rate of the Czech crown shall be reflected in determining the amount of the reserve. Accordingly, the reserve amount may vary at individual balance sheet dates. This would be the case even if the volume of gold expressed in grams were the same, as on one hand, the price of gold denominated in a foreign currency alters, and on the other, the exchange rate of the Czech crown towards the relevant foreign currency also changes.


By way of the above cases, we have demonstrated that when reporting accounting estimates, the impact of the development in the Czech crown’s exchange rate towards other foreign currencies needs to be duly considered in terms of the client’s industry, the transaction itself, and the transaction features. This is attributable to the fact that the exchange rate of the Czech crown can develop over time.

The article is part of dReport – March 2019, Accounting news.

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