Foreign exchange accounting
/How to Account for Foreign Exchange
Foreign exchange accounting involves the recordation of transactions in currencies other than one’s functional currency. For example, a business enters 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, the accountant records 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, the accountant uses 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.
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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.
Example of Foreign Exchange Accounting
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 journal 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 |