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.
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.
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.
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 that are recorded on unpaid invoices at the end of the month or another accounting period
- Realized gains and losses that 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.
The easiest way to show the effect of currency gains and losses is through an example. Suppose Aardvark Inc. sells $100,000 of goods on December 8 to Le Chien, a company in France, and agrees to accept payment in euros. Aardvark records this transaction as a debit to accounts receivable of $100,000 and a credit to sales of $100,000.
On the date of the sale, one euro is equal to $1.15. So, Le Chien owes 86,957 euros ($100,000 divided by $1.15).
At the end of the year, the bookkeeper has to close the accounting records for Aardvark. On December 31, one euro is worth $1.12. This means that the accounts receivable due from Le Chien is now valued at $97,392 ($1.12 x 86,957 Euros). The accountant records an unrealized currency loss of $2,608 ($100,000 minus $97,392) in the accumulated other comprehensive account on the general ledger.
On the following January 18, Le Chien pays the full amount of 86,957 euros. However, the conversion rate for euros has further declined, and one euro is now worth $1.10. The value of the 86,957 euros that Aardvark receives from Le Chien has declined to $95,653. The accountant now records an actual realized loss of $4,347 ($100,000 minus $95,653) on Aardvark's profit and loss statement. The previous entries of unrealized losses in the accumulated other comprehensive account are journaled out.