The exchange rate is the price of a foreign currency that one dollar can buy. An increase in the value of the dollar means one dollar can buy more of the foreign currency, so you're essentially getting more for the same money. Businesses that import and export goods are highly sensitive to fluctuations in the exchange rate. But even if you trade domestically, you still have an indirect currency risk by virtue of the wider economy.
Overseas Supplier Payments
Whenever you contract with an overseas supplier, you're vulnerable to variations in the exchange rate. Suppose, for example, that you agree to pay 300,000 Chinese Yuan to your Chinese manufacturer for a shipment of goods in three months. In May 2018, the USD/CNY exchange rate sits at 6.377, making your invoice $47,044 if paid today. If the exchange rate moved to 6.4, it would raise your supplier payment to $47,619, which means you're paying an additional $575 for the same shipment of goods. Of course, the opposite is also true. If the dollar strengthened against the Yuan, then you'd end up paying less for your shipment.
As with supplier payments, if your business sells products or services to a foreign country, then a change in the exchange rate will have a direct impact on your bottom line. The nature of the impact depends on how you issue invoices. If you write an invoice in the foreign currency, there's a risk that you'll receive less money than anticipated if the exchange rate moves against you between the invoice date and the date of payment.
Issuing invoices in U.S.dollars should have a lesser currency impact. Now, the overseas purchaser must change its local currency into dollars to make payment. You'll receive the full invoice amount regardless of what the exchange rate is doing. The risk here is that your prices may become uncompetitive due to exchange rate fluctuations. You may lose market share to foreign competitors who do not have to factor in transactional exchange rate changes.
No business is an island. Even if you do not sell or buy from another country, the global economy will impact you in unforeseen ways. Suppose, for example, that you use trucks to move your products around the United States. If the foreign exchange rate changes and pushes up the cost of imported fuel, you will end up paying more for your shipments. Competition is another indirect consequence of exchange rate volatility. A depreciation of the dollar makes the cost of importing goods more expensive, which could result in a decrease in the volume of imports. Domestic firms should benefit in the form of increased sales, profit and job creation.
How to Account for Exchange Rate Fluctuations
When you sell or buy goods in a foreign currency, you must record the transaction in U.S. dollars based on the exchange rate in effect on the date of the transaction. If the exchange rate changes between the invoice date and the payment date, you'll record a "currency gain" or "currency loss" based on the new exchange rate. Your financial ledgers may show a series of gains or losses over a number of accounting periods if the payment or delivery date is far in the future.