A foreign exchange gain/loss occurs when a company buys and/or sells goods and services in a foreign currency, and that currency fluctuates relative to their home currency. It can create differences in value in the monetary assets and liabilities, which must be recognized periodically until they are ultimately settled.
The difference in the value of the foreign currency, when converted to the local currency of the seller, is called the exchange rate. If the value of the home currency increases after the conversion, the seller of the goods will have made a foreign currency gain.
However, if the value of the home currency declines after the conversion, the seller will have incurred a foreign exchange loss. If it is impossible to calculate the current exchange rate at the exact time when the transaction is recognized, the next available exchange rate can be used to calculate the conversion.
How Currency Exchange Affects Businesses
Companies that conduct business abroad are continually affected by changes in the foreign currency exchange rate. This applies to businesses that receive foreign currency payments from customers outside the company’s home country or those that send payments to suppliers in a foreign currency.
For example, a resident of the United States will have the US dollar as their home currency and may receive payments in euro or GBP.
Since exchange rates are dynamic, it is possible that the exchange rate will be different from the time when the transaction occurs to when it is actually paid and converted to the local currency.
For example, if a US seller sends an invoice worth €1,000 and the customer pays the invoice after 30 days, there is a high probability that the exchange rate for euros to US dollars will have changed at least slightly. The seller may end up receiving less or more against the same invoice, depending on the exchange rate at the date of recognition of the transaction.
Realized and Unrealized Foreign Exchange Gain/Loss
Realized and unrealized gains or losses from foreign currency transactions differ depending on whether or not the transaction has been completed by the end of the accounting period.
1. Realized Gains/Losses
Realized gains or losses are the gains or losses on transactions that have been completed. It means that the customer has already settled the invoice prior to the close of the accounting period.
For example, assume that a customer purchased items worth €1,000 from a US seller, and the invoice is valued at $1,100 at the invoice date. The customer settles the invoice 15 days after the date the invoice was sent, and the invoice is valued at $1,200 when converted to US dollars at the current exchange rate.
It means that the seller will have a realized foreign exchange gain of $100 ($1,200–$1,100). The foreign currency gain is recorded in the income section of the income statement.
2. Unrealized Gains/Losses
Unrealized gains or losses are the gains or losses that the seller expects to earn when the invoice is settled, but the customer has failed to pay the invoice by the close of the accounting period. The seller calculates the gain or loss that would have been sustained if the customer paid the invoice at the end of the accounting period.
For example, if a seller sends an invoice worth €1,000, the invoice will be valued at $1,100 as at the invoice date. Assume that the customer fails to pay the invoice as of the last day of the accounting period, and the invoice is valued at $1,000 at this time.
When preparing the financial statements for the period, the transaction will be recorded as an unrealized loss of $100 since the actual payment is yet to be received. The unrealized gains or losses are recorded in the balance sheet under the owner’s equity section.
Recording Foreign Exchange Transactions
When preparing the annual financial statements, companies are required to report all transactions in their home currency to make it easy for all stakeholders to understand the financial reports. It means that all transactions carried out in foreign currencies must be converted to the home currency at the current exchange rate when the business recognizes the transaction.
For example, assume that a company paid €10,000 in salaries for part-time contractors located in Europe at an exchange rate of $1.15 to 1 euro, the transaction is recorded in the income statement as $11,500 at the end of the accounting period.
Example of Foreign Exchange Gain/Loss
Company ABC is a US-based business that manufactures motor vehicle spare parts for Bugatti and Maybach vehicles. The company sells spare parts to its distributors located in the United Kingdom and France. During the last financial year, ABC sold €100,000 worth of spare parts to France and GBP 100,000 to the United Kingdom.
At the time of sending the invoices, one GBP was equivalent to 1.3 US dollars, while one euro was equivalent to 1.1 US dollars. When the payments for the invoices were received, one GBP was equivalent to 1.2 US dollars, while one euro was equivalent to 1.15 dollars.
Therefore, the gains or losses from the currency conversions can be calculated as follows:
Sales to France
= (1.15 x 100,000) – (1.1×100,000)
= 115,000 – 110,000
= $5,000 (Foreign currency gain)
Sales to the UK
= (1.2 x 100, 000) – (1.3 x 100,000)
=120,000 – 130,000
= –$10,000 (Foreign currency loss)
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