If your company buys or sells goods abroad, and you pay or create invoices in a foreign currency, then you'll need to convert the invoice to your home currency on your income statement. The first conversion occurs when you create or receive the invoice, the second on the date the accounting period ends and the third when you settle the invoice. If the exchange rate changes between the conversion dates, you'll record the difference as a foreign currency transaction gain or loss.
How Exchange Rates Affect Your Business
Any company that does business abroad is going to be affected by the currency exchange rate. A common scenario is when you buy raw materials from overseas and are invoiced in a currency other than your home currency – typically U.S. dollars if your business is based in the United States. Because exchange rates are dynamic, there's a high chance that the exchange rate will be different if you settle the invoice in 30 days than if you settle the invoice today. Whether you'll end up paying more or less against the same invoice depends on which direction the exchange rate is moving.
The same will apply if you raise an invoice in a foreign currency such as Euros and the customer pays you in Euros, 15-or-30 days after the invoice date.
The Obligation to Record in the Home Currency
An important rule of accounting is that your balance sheet and income statement must be reported in your home currency. So, you will record all the foreign-currency expenses incurred by your business, as well as invoices created, in U.S. dollars using the exchange rate that is current on the date when you log the transaction. For example, if you purchase goods at the cost of £10,000 GBP and the exchange rate is 1.3 dollars to the British pound, then you would record an expense of $13,000.
Currency Gains and Losses
When you enter an invoice at one rate and pay it at another, this will generate an exchange gain or loss depending on which way the exchange rate has changed. There are two categories of gains and losses:
- Unrealized gains and losses which are recorded on unpaid invoices at the end of the month or another accounting period.
- Realized gains and losses which are recorded at the time of payment or receipt.
So, you'll have to run a currency conversion when you first log the transaction and again at invoice settlement. If the settlement date is a long way in the future, you may have to recognize a series of gains or losses over multiple accounting periods. Currency gains and losses that result from the conversion are recorded under the heading "foreign currency transaction gains/ losses" on the income statement.
Recording the Exchange
The easiest way to show the effect of currency gains and losses is through an example. Suppose Aardvark Inc. sells goods to a company in France with a current value of $100,000. Aardvark records this transaction as a debit to accounts receivable of $100,000 and a credit to sales of $100,000. Later, when the customer pays, the exchange rate has changed, and the invoice is settled in Euros at an equivalent rate of $95,000. Aardvark has incurred a loss of $5,000. It records the loss as follows:
- A debit to cash of $95,000, which is the amount received.
- A credit to accounts receivable of $100,000, the same amount when recording the transaction.
- A debit to foreign exchange losses of $5,000, which is the difference between these two figures.
You can see from this that if Aardvark failed to calculate the loss (or gain) on the exchange account, then accounts receivable would not match the sales receipts and the balance sheet would become "out of balance."