Foreign currency transactions are denominated in a currency other than the company’s functional currency. Foreign currency transactions may result in receivables or payables fixed in the amount of foreign currency to be received or paid. A foreign currency transaction requires settlement in a currency other than the functional currency! A change in exchange rates between the functional currency and the currency in which a transaction is denominated increases or decreases the expected amount of functional currency cash flows upon settlement of the transaction. This change in expected functional currency cash flows is a “foreign currency transaction gain or loss” that typically is included in arriving at earnings in the income statement for the period in which the exchange rate is changed. An example of a transaction gain or loss is when an Italian subsidiary has a receivable denominated in lira from a British customer.
Similarly, a transaction gain or loss (measured from the transaction date or the most recent intervening balance sheet date, whichever is later) realized upon settlement of a foreign currency transaction usually should be included in determining net income for the period in which the transaction is settled.
An exchange gain or loss occurs when the exchange rate changes between the purchase date and sale date. Merchandise is bought for 100,000 pounds. The “exchange rate” is 4 pounds to 1 dollar. The journal entry is:
[Debit]. Purchases = 25,000
[Credit]. Accounts payable = 25,000
(Note: 100,000/4 = $25,000)
When the merchandise is paid for, the exchange rate is 5 to 1. The journal entry is:
[Debit]. Accounts payable = 25,000
[Credit]. Cash = 20,000
[Credit]. Foreign exchange gain = 5,000
(Note: 100,000/5 = $20,000)
The $20,000 using an exchange rate of 5 to 1 can buy 100,000 pounds. The transaction gain is the difference between the cash required of $20,000 and the initial liability of $25,000.
Note that a foreign transaction gain or loss has to be determined at each balance sheet date on all recorded foreign transactions that have not been settled.
A U.S. company sells goods to a customer in England on 11/15/X7 for 10,000 pounds. The exchange rate is 1 pound is $0.75. Thus, the transaction is worth $7,500 (10,000 pounds × 0.75). Payment is due two months later. The entry on 11/15/X7 is:
[Debit]. Accounts receivable—England = 7,500
[Credit]. Sales = 7,500
Accounts receivable and sales are measured in U.S. dollars at the transaction date employing the “spot rate“. Even though the accounts receivable is measured and reported in U.S. dollars, the receivable is fixed in pounds. Thus, a “transaction gain or loss” can occur if the exchange rate changes between the transaction date (11/15/X7) and the settlement date (1/15/X8).
Since the financial statements are prepared between the transaction date and settlement date, receivables that are denominated in a currency other than the functional currency (U.S. dollar) have to be restated to reflect the spot rate on the balance sheet date. On December 31, 20X7, the exchange rate is 1 pound equals $0.80. Hence, the 10,000 pounds are now valued at $8,000 (10,000 × $.80). Therefore, the accounts receivable denominated in pounds should be upwardly adjusted by $500. The required journal entry on 12/31/X7 is:
[Debit]. Accounts receivable—England = 500
[Credit]. Foreign exchange gain = 500
The income statement for the year-ended 12/31/X7 shows an exchange gain of $500. Note that sales is not affected by the exchange gain since sales relates to operational activity.
On 1/15/X8, the spot rate is 1 pound = $0.78. The journal entry is:
[Debit]. Cash = 7,800
[Debit]. Foreign exchange loss = 200
[Credit]. Accounts receivable—England = 8,000
The 20X8 income statement shows an exchange loss of $200.
Which Transaction Gain Or Loss Should Not Be Reported In The Income Statement?
Gains and losses on the following foreign currency transactions “ARE NOT“ included in earnings but rather are reported as translation adjustments:
- Foreign currency transactions designated as economic hedges of a net investment in a foreign entity, beginning as of the designation date.
- Inter-company foreign currency transactions of a long-term investment nature (settlement is not planned or expected in the foreseeable future),when the entities to the transaction are consolidated, combined, or accounted for by the equity method in the reporting company’s financial statements
- A gain or loss on a forward contract or other foreign currency transaction that is intended to hedge an identifiable foreign currency commitment (e.g., an agreement to buy or sell machinery) should be deferred and included in the measurement of the related foreign currency transaction.
Losses should not be deferred if deferral is expected to result in recognizing losses in later periods. A foreign currency transaction is deemed a hedge of an identifiable foreign currency commitment if both of these conditions are met:
- The foreign currency transaction is designated as a hedge of a foreign currency commitment.
- The foreign currency commitment is firm.