Foreign exchange accounting

A business may enter into a transaction where it is scheduled to receive a payment from a customer that is denominated in a foreign currency, or to make a payment to a supplier in a foreign currency. On the date of recognition of each such transaction, record it in the functional currency of the reporting entity, based on the exchange rate in effect on that date. If it is not possible to determine the market exchange rate on the date of recognition of a transaction, use the next available exchange rate.

If there is a change in the expected exchange rate between the functional currency of the entity and the currency in which a transaction is denominated, record a gain or loss in earnings in the period when the exchange rate changes. This can result in the recognition of a series of gains or losses over a number of accounting periods, if the settlement date of a transaction is sufficiently far in the future. This also means that the stated balances of the related receivables and payables will reflect the current exchange rate as of each subsequent balance sheet date.

The two situations in which you should not recognize a gain or loss on a foreign currency transaction are:

  • When a foreign currency transaction is designed to be an economic hedge of a net investment in a foreign entity, and is effective as such; or
  • When there is no expectation of settling a transaction between entities that are to be consolidated.

Foreign Exchange Accounting Example

Armadillo Industries sells goods to a company in the United Kingdom, to be paid in pounds having a value at the booking date of $100,000. Armadillo records this transaction with the following entry:

  Debit Credit
Accounts receivable 100,000  
     Sales   100,000

Later, when the customer pays Armadillo, the exchange rate has changed, resulting in a payment in pounds that translates to a $95,000 sale. Thus, the foreign exchange rate change related to the transaction has created a $5,000 loss for Armadillo, which it records with the following entry:

  Debit Credit
Cash 95,000  
     Foreign Currency Exchange Loss 5,000  
     Accounts Receivable   100,000

The following table shows the impact of transaction exposure on different scenarios.

Risk When Transactions Denominated in Foreign Currency

  Import Goods Export Goods
Home currency weakens Loss Gain
Home currency strengthens Gain Loss