Accounting for Foreign Exchange Differences on Invoices
Foreign currency exchange rates always fluctuate with changes in fundamental economic and monetary conditions in different countries. Changes in the value of the dollar relative to foreign currencies affect the value of past foreign-currency denominated transactions. Therefore, foreign exchange gains or losses are bound to occur in purchases and sales invoices for international transactions. It is important to account for such foreign exchange differences, because they affect the profits of small businesses.
According to provisions of the International Accounting Standards 21, or IAS 21, the currency of the country in which a business entity conducts its primary operations should serve as its primary currency. The business entity can then convert all transactions denominated in foreign currencies back to the functional currency using the spot rates of the transaction date. As such, a U.S.-based business should convert any transactions denominated in foreign currencies to dollars using the applicable spot conversion rates. Consequently, fluctuations in the conversion spot rates bring about foreign exchange gains or losses on invoices.
Receivables are current assets -- that is, they are readily convertible into cash. Therefore, foreign exchange gains or losses on receivable invoices affect accounts receivable and the respective currency gains or losses accounts. Since assets are debited when they increase, foreign exchange gains on invoices are debited in the accounts receivables and credited in the currency gains account. Currency exchange losses on receivable invoices are credited in the accounts receivables and debited in the currency losses account.
Payable invoices are current liabilities. Foreign exchange differences arising from payable invoices affect accounts payables and the currency gains/losses account. If the dollar gains value against the Chinese yuan, a business spends less on the payment of previous invoices in China, because the dollar converts to more units of the yuan. This represents a decrease in liabilities that should be debited in the accounts payable and credited in the currency gains account. In contrast, a dip in value of the dollar would see a company spend more on the payment of previous invoices denominated in foreign currency. Since the foreign exchange loss that follows increases the liability of the business, it is credited in accounts payable and debited in the currency losses account.
Foreign exchange differences on invoices should be accounted for monthly because foreign exchange rates fluctuate between the date when an invoice is issued and the date when its payments are settled. Tracking these changes on a monthly basis ensures the business captured the right value of the foreign exchange gains or losses for each invoice.