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In the foreign exchange market, a historical exchange rate is the average exchange rate between two currencies over some specified period of time. In accounting, a historical exchange rate is the exchange rate between two currencies that prevailed at the time an asset was acquired or a liability incurred. Historical exchange rates are used when any of a variety of transactions denominated in a foreign currency take place — i.e., borrowing or lending, purchasing or selling goods and services, or investing. In addition, various items on financial accounting reports are carried using historical exchange rates according to government regulations and generally accepted accounting practices. A historical exchange rate may be applied when translating items on the balance sheet of a foreign branch or subsidiary and consolidating them in the financial reports of a U.S. parent company, for instance.
Whether historical exchange rates or current exchange rates are used to translate foreign currency denominated accounts for U.S. financial reporting purposes depends on whether the so-called functional currency of the foreign unit is the local foreign currency or the U.S. dollar. The current rate method is used if the functional currency is the local foreign currency. In this circumstance, all assets and liabilities translate at the spot exchange rate prevailing as of the end-of-period reporting date. Owner or shareholder equity, in contrast, is translated using the historical exchange rate that prevailed as of the original transaction date.
As they are accounted for at the exchange rate that prevailed when the transaction took place, items on financial statements accounted for using historical exchange rates may, and often do, differ from their actual economic or replacement values in the present day. The value of a building or office space purchased or leased by a foreign branch or subsidiary five years ago will, throughout the time that it is held, be accounted for in the parent company’s home currency and balance sheet with the historical exchange rate that existed five years ago, for example. This would most likely differ from its present day value, a discrepancy that would eventually be resolved when the asset was disposed of or the liability retired. Accounts would be updated to reflect the exchange rate at the time of the offsetting transaction, thus resolving the discrepancy. In terms of managing day-to-day operations of a business, managerial accounting practice keeps track of changes in exchange rates over time and periodically marks assets and liabilities to their present day market values.