How to Account for Foreign Exchange
Accounting for foreign exchange transactions entails registering transactions in currencies other than one’s functional currency. For example, a company engages into a transaction in which it is scheduled to receive a payment in a foreign currency from a customer or to make a payment in a foreign currency to a supplier. On the date of recognition, the accountant records each such transaction in the functional currency of the reporting entity, depending on the exchange rate in effect at the time. If determining the market currency rate on the day of transaction recognition is not practicable, the accountant utilizes the next available exchange rate.
If the projected exchange rate between the entity’s functional currency and the currency in which a transaction is denominated changes, record a gain or loss in profits in the period when the exchange rate changes. If the settlement date of a transaction is sufficiently far in the future, this might result in the recognition of a series of profits or losses across a number of accounting periods. This also implies that the stated amounts of the connected receivables and payables will reflect the current exchange rate as of the next balance sheet date.
The following are the two scenarios in which you should not record a gain or loss on a foreign currency transaction:
- When a foreign currency transaction is intended to be and is successful as an economic hedge of a net investment in a foreign firm; or
- When there is no expectation of a transaction between organizations to be consolidated being settled.
Example of Foreign Exchange Accounting
ABC 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. ABC records this transaction with the following journal entry:
| Debit | Credit | |
| Accounts receivable | 100,000 | |
| Sales | 100,000 |
Later, when the customer pays ABC, 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 ABC, 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 |
