What is a Foreign Exchange Gain and Loss?
Most companies or businesses deal in various currencies due to the nature of their operations. It may include transacting with foreign suppliers or customers, overseas operations, foreign investments, etc. Usually, companies incur a gain or loss on each transaction due to variations in currency exchange rates. Therefore, any fluctuations of foreign currencies in relation to their home currency can lead to a foreign exchange gain or loss.
Usually, companies do not incur gains or losses for cash transactions. However, with credit transactions, fluctuations can lead to income or expenses. When companies complete these transactions, they will incur realized gains/losses. Sometimes, however, companies may also incur them on uncompleted transactions. These are known as unrealized gains or losses.
What is the accounting for Foreign Exchange Gains and Losses?
There are two types of foreign exchange gains or losses for which companies must account. As mentioned, these include realized and unrealized gains/losses. The accounting treatment for both of these is as below.
Realized gains/losses
Under accounting standards, companies must record every transaction at the time of occurrence. When these transactions are in foreign currency, companies must translate them to their functional currency. This currency is usually the currency used in the environment in which they operate. If the payment gets completed immediately, there will be no foreign exchange gains or losses.
However, when the settlement occurs at a different date, foreign exchange gains or losses will occur. At the time of reimbursement, a company will measure the difference between the initial value and the current value for the transaction. Any variations will result in a financial gain or loss.
For example, a company purchases goods worth £1,000 from a supplier from the UK. However, the company’s functional currency is USD. At the time of the transaction, the GBP/USD spot rate is $1.25. Therefore, the accounting treatment will be as follows.
Dr Purchases $1,250
Cr Payables $1,250
After a month, the company pays its supplier. At this time, the spot rate is $1.30. Therefore, the payment will give rise to a foreign exchange loss. The accounting treatment will be as follows.
Dr Payables $1,250
Dr Foreign exchange loss $50
Cr Cash/Bank $1,300
Unrealized gains/losses
Unrealized gains/losses relate to monetary balances that are in foreign currencies. At each reporting date, companies must retranslate these balances to the year-end exchange rate. Although the transactions do not get settled until after the reporting date, companies must still recognize gains/losses for them.
For example, a company purchased goods worth €2,000. The company’s functional currency is USD. The spot rate at the time of the transaction was $1.15. Therefore, the accounting treatment at the time was as follows.
Dr Purchases $2,300
Cr Payables $2,300
At the reporting date, the company had not settled the balance. As it is a monetary balance, the company must account for any foreign exchange gains/losses. Furthermore, at the reporting date, the spot rate was $1.17. Thus, the company now owes its supplier $2,340 (€2,000 x $1.17). Therefore, the accounting treatment will be as follows.
Dr Foreign exchange loss $40
Cr Payables $40
After the reporting date, the company settles the balance. At this time, the spot rate is $1.14. Therefore, the company will realize a foreign exchange gain, as follows.
Dr Payables $2,340
Cr Foreign exchange gain $60
Cr Cash $2,280
What is the difference between accounting for Foreign Exchange Gains and Losses under IFRS and GAAP?
Both IFRS and GAAP have similar standards when it comes to dealing with foreign exchange gains and losses. There are some differences in other areas. However, for the above types of gains/losses, the accounting treatment is similar. Under both standards, companies must account for these foreign exchange gains/losses in their profit or loss accounts.
Conclusion
Companies that deal in foreign currencies incur foreign exchange gains or losses. These may be of two types, including realized and unrealized. The accounting treatment for foreign exchange gains/losses is mostly similar under both IFRS and GAAP. Companies must report these gains and losses in their income statement.
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