Accounting for Foreign Exchange Transactions

In this article, you will learn about how to account for foreign currency transactions undertaken by the domestic company.

A foreign exchange transaction takes place when a domestic company (such as a company in the US) enters into a transaction with a buyer or seller in another country (such as UK) to buy or sell products or services and the payments for the transaction are in foreign currency (in this case pounds).

Let’s say the US company (whose records we are preparing), books an order to supply some goods to the UK company. We have the following details:

• The currency for the transaction is GBP.
• The functional currency of the US company is USD.

At the time of order:

• The total value of the order is GBP 75000.
• The exchange rate is 1 GBP = 1.33 USD.

At the time of settlement:

• The exchange rate is 1 GBP = 1.2 USD

The transaction will be recorded as follows:

If the US firm was entering into a transaction with a foreign firm but the transaction was to be settled in US dollars, then the US firm will account for the transaction in the same manner as if it happened with another US firm.  

However, in this case the transaction is with a foreign company and the transaction is being settled in foreign currency. This exposes the US firm to foreign exchange risk, i.e., the exchange rates may move unfavourably between the date the transaction is entered and the date the payment is settled.

Since the transaction is in GBP which is the reporting currency for the UK company, the UK company will record this transaction normally. However, the US company needs to translate the transaction into its reporting currency before the transaction is entered into its accounts.

On the date of recognition:

On the date of sale, the US company will record the transaction in its functional currency (USD). So, in this case, the US company will convert the value of sale in USD and recognize the sale at this value (75,000 * 1.33 = USD 100,000) in its ledger. The foreign exchange rate is the spot rate on that day.

• Credit ‘sales’ account by $100,000
• Debit ‘accounts receivable’ by $100,000.

On settlement date:

Remember that the transaction is happening in GBP, so the US firm will receive the payment in GBP. For reporting the transaction, the company will convert the GBP value into US dollars based on the exchange rate effective on that date. The new exchange rate is 1 GBP = 1.2 USD. The payment of GBP 75,000 will translate to USD 90,000 (75000*1.2).

Since the company had books a sale of USD 100,000  but the final settlement is for USD 90,000, there is a loss of USD 10,000 for the company. This is the loss due to change in exchange rate. In order to properly close the accounts, the company will record the payment receipt of USD 90,000, and show a loss of USD 10,000 against the total accounts receivable of USD 100,000

• Debit cash by $90,000
• Debit ‘foreign currency exchange loss’ by $10,000
• Credit ‘accounts receivable’ by $100,000

On Balance Sheet Date

It is possible that the transaction will be settled after many months and a balance sheet date falls between the transaction date and the settlement date. In this case the balances that are denominated in foreign currency need to be adjusted using the exchange rate on the balance sheet date and the gain/loss in the transaction needs to be recognized in the earnings.

The following tables illustrates the impact of change in exchange rates on sale/purchase in foreign currency for the domestic company.

The gain loss on a foreign exchange transaction should not recognized in the following cases:

1. Net investment hedges. When the transaction is designed as an economic hedge for net investment in a foreign entity.
2. Long-term inter-company transactions that are not expected to be settled in the foreseeable future. In such cases, the foreign currency gain/loss should be recorded as a Cumulative Translation Adjustment (CTA) in a set of consolidated financial statements.