Accounting for Foreign Exchange Transactions

In this article, you will learn about how to account for foreign currency transactions undertaken by the domestic company.

A foreign exchange transaction takes place when a domestic company (such as a company in the US) enters into a transaction with a buyer or seller in another country (such as UK) to buy or sell products or services and the payments for the transaction are in foreign currency (in this case pounds).

Let’s say the US company (whose records we are preparing), books an order to supply some goods to the UK company. We have the following details:

• The currency for the transaction is GBP.
• The functional currency of the US company is USD.

At the time of order:

• The total value of the order is GBP 75000.
• The exchange rate is 1 GBP = 1.33 USD.

At the time of settlement:

• The exchange rate is 1 GBP = 1.2 USD

The transaction will be recorded as follows:

If the US firm was entering into a transaction with a foreign firm but the transaction was to be settled in US dollars, then the US firm will account for the transaction in the same manner as if it happened with another US firm.  

However, in this case the transaction is with a foreign company and the transaction is being settled in foreign currency. This exposes the US firm to foreign exchange risk, i.e., the exchange rates may move unfavourably between the date the transaction is entered and the date the payment is settled.

Since the transaction is in GBP which is the reporting currency for the UK company, the UK company will record this transaction normally. However, the US company needs to translate the transaction into its reporting currency before the transaction is entered into its accounts.

On the date of recognition:

On the date of sale, the US company will record the transaction in its functional currency (USD). So, in this case, the US company will convert the value of sale in USD and recognize the sale at this value (75,000 * 1.33 = USD 100,000) in its ledger. The foreign exchange rate is the spot rate on that day.

• Credit ‘sales’ account by $100,000
• Debit ‘accounts receivable’ by $100,000.

On settlement date:

Remember that the transaction is happening in GBP, so the US firm will receive the payment in GBP. For reporting the transaction, the company will convert the GBP value into US dollars based on the exchange rate effective on that date. The new exchange rate is 1 GBP = 1.2 USD. The payment of GBP 75,000 will translate to USD 90,000 (75000*1.2).